After a panicked end to 2018 in the financial markets, and a jittery start to the new year, an increasing number of investors, analysts and economists are beginning to warn about “the crisis of 2019”, as often as not to be followed by “the recession of 2020”.
Part of the reason is simply the feeling that the world is overdue for another downturn. A look at the economic history of recent decades shows that major financial crashes tend to come along every five to seven years.
So, for example, there were the oil crises of the 1970s, the Latin American debt crisis of 1982, the Black Monday stock market crash of 1987, the Tequila Crisis of 1994, the Asian financial crisis of 1997-98, the dotcom bust of 2000 and the worldwide recession that followed, the credit crunch and global financial crisis of 2007-08, and the European debt crisis that peaked in 2012.
Seven years on from that episode, and more than 10 years after the implosion of Lehman Brothers, financial markets have accumulated a whole new batch of excesses that are ripe for correction, as well as some old ones that previous crunches failed to correct.
But although many in the financial world fear a new crisis is looming, there is little agreement about what will trigger the shake-up, or where it will start.
Lots of observers in the West point to China. They note how in just 10 years debt levels have soared from 150 per cent of gross domestic product to more than 250 per cent, even as economic growth has slowed, eroding borrowers’ ability to service their debt.
Others cast a wary eye towards Europe, where it is likely Germany and Italy are already in a new recession, and where the “doom loop” between rising Italian government bond yields and weakening Italian bank capital is stronger than ever, threatening a whole new crisis of confidence in the euro zone’s single currency.
But although these concerns are real, the probability that the next financial crisis will originate in either China or Europe is relatively low. That’s because crises are not usually triggered by insolvency – when liabilities exceed assets – but because of illiquidity, when institutions run out of ready cash.
In China, where the state owns and controls the banking system, officials have their hands on all the levers necessary to ensure plentiful supplies of liquidity in case of an emergency. And in the euro zone, the 2012 pledge by European Central Bank president Mario Draghi to do “whatever it takes” to preserve the single currency still stands.
Faced with a new crisis, the ECB can once again open the funding taps to avert disaster. That will not solve the euro’s deep-seated underlying problems, but it will postpone a day of reckoning for the currency that many believe will be inevitable without far-reaching structural reforms of Europe’s economic governance.
Instead, it is more likely that the world’s next big financial crash will originate in the United States. And while there will be differences from the 2008 crisis, there will also be telling similarities; history doesn’t repeat, but it does rhyme.
In the years before 2008, a protracted period of low interest rates encouraged banks to ramp up lending to risky borrowers, and to repackage their loans and sell them on to yield-hungry investors. Back then, the risky borrowers were “subprime” homebuyers. This time around they are American companies. With benchmark interest rates close to zero for most of this decade, US companies have binged on debt.
Many have borrowed ever-greater sums, not to invest in productive assets like new factories, but to buy back their own shares, so juicing up their stock prices and generating ever bigger bonus packages for their executives. As a result, over the last 10 years, the value of US corporate bonds outstanding has tripled from about US$2.5 trillion to US$7.5 trillion. And of that amount, roughly 45 per cent is rated “BBB” – just one grade above junk.
That’s not all. Since the 2008 crisis there has also been a boom in so-called leveraged loans – loans to high-risk corporate borrowers – with the market doubling in size from US$550 billion to around US$1.1 trillion. And most of these loans have been repackaged and sold on to investors as “collateralised debt obligations” – just as subprime mortgages were repackaged and sold on in the 2000s.
But it is in the corporate bond market that there is the greatest cause for anxiety. That’s because even as the amount of debt outstanding has ballooned, new regulations introduced after the 2008 crisis have discouraged banks and brokers from trading the bonds on their own account.
As a result, few Wall Street finance houses either hold inventories of corporate bonds or are prepared to quote firm prices to investors come what may.
In short, the market has grown in size, even as its reservoir of trading liquidity has dried up.
That is likely to be a problem. Much of the US corporate debt market is owned by exchange-traded funds (ETFs) and foreign institutional investors, many of which are prohibited from holding junk bonds, and all of which expect to be able to sell their holdings without difficulty should they want or need to.
It is not hard to imagine that as the US economy slows after its long cycle of expansion and US companies face tightening margins, an increasing number are likely to face difficulties servicing the debts they ran up to fund share buy-backs.
Sooner or later, some BBB-rated borrowers will get downgraded to junk status. When that happens, ETFs and institutional investors will attempt to sell the bonds they hold – only to find few dealers willing to quote them reasonable prices.
As investors take fright, US corporate bond prices will collapse. ETFs will rush to liquidate their holdings to meet redemptions, worsening the price slump. Leveraged investors such as hedge funds will face margin calls they will not be able to meet, which in turn will cast doubt on the financial integrity of the investment banks that extended them the leverage. Other banks will stop dealing with the investment banks, liquidity in the financial system will dry up, and suddenly the world will find itself facing a repeat of the September 2008 death spiral that led to the implosion of Lehman Brothers.
All this, of course, is speculation. It may never happen. But on the other hand, it is a plausible scenario, and one that is making investors increasingly uneasy. All we can say for sure is that sooner or later the next financial crisis will strike, and that it could unfold more or less as described here. Let’s hope it doesn’t. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 25 years