World leaders must act now to avoid a financial downturn
‘If a virus outbreak in central China is causing such global disruption, the most fundamental flaws in the current economic system cannot be ignored any longer’
The dramatic exodus of funds from emerging markets over recent days exceeds the peak panic of 2008 and is fast morphing into worldwide contagion, the top banking watchdog has warned. “We worry that a global ‘sudden stop’ in financing is beginning to emerge,” said the Institute of International Finance (IIF) in Washington. It warned that a multitude of shocks are combining with a commodity crash and mounting stress in the US bond and funding markets.
The danger is a confluence of three crises erupting simultaneously and feeding on each other: a violent reversal of flows to emerging markets; a blow-up in the BBB and high-yield segments of the bond market; and a fresh Club Med funding crisis triggered by fears of a wrenching economic contraction in Italy.
At the moment global asset markets are priced for a light recession. They are not priced for a deep downturn, let alone a series of seismic aftershocks exposing the fragility of an international system with record debt ratios near 322 per cent of GDP ($257trillion).
The United Nations’ economics arm (UNCTAD) said a toxic mix of asset price deflation and debt distress could now set off a “vicious downward spiral” if world leaders fail to stem the contagion. “Widespread insolvency and possibly another ‘Minsky moment’ cannot be ruled out,” it said. The world came close to that this week.
Whether it moves into this second and much more dangerous phase of financial metastasis and towards a deflationary bust depends on the ability of world leaders to repair the shattered machinery of the G20 and launch joint action along the lines of the London Conference in April 2009.
That gathering led by Barack Obama and Gordon Brown – with China’s Hu Jintao fully on board – was a catalytic moment. It proved to be the definitive circuit breaker for the crisis. It is even more vital now because monetary stimulus cannot carry the load any longer, as made disturbingly clear over the last week.
But is a G20 moment possible under a dysfunctional “America First” White House at war with the world? The Saudis chair the G20 at the moment and they are in an oil war with Russia.
Only Boris Johnson and Emmanuel Macron have both the clout and the diplomatic lines open to most capitals. They could join forces and pull off a diplomatic coup. The looming risk is that the US dollar will spike higher in a panic rush for safe havens – as happened in 2008 – causing global liquidity to evaporate and leading to seizure in the offshore dollar funding markets in Asia and Europe. The Dollar Index (DXY) has jumped to 98.13 over recent days but is not yet at the acute danger threshold. If it blasts higher in the current febrile circumstances, it will cause financial carnage through complex swap and derivative contracts.
A recent G20 report for the Robert Triffin forum warned that offshore dollar lending has exploded to
$18 trillion and overwhelmed the diminished firepower of global rescue bodies. A black swan event like Covid-19 is exactly what it feared.
“The risk of an unexpected and unplanned reversal of abundant global liquidity hangs over the world economy. Strong contagion across markets could make the endogenous dynamics of global liquidity very dangerous,” it said.
The purely “private component of global liquidity” has mushroomed to $12trillion, and this is highly geared to spasms of greed and fear, setting off potentially unstoppable chain reactions. Forced deleveraging can expose the “liquidity illusion” in a heartbeat.
The concern is that this lethal process could collide with $3.4 trillion of BBB debt perched just above junk status (five times pre-lehman volumes) and liable to a cascade of downgrades as earnings shrivel, leading to automatic fire sales by ETFS and funds with strict legal mandates.
Beneath the BBBS are junk bonds with a record share weighed down by a debt-to-earnings ratio (EBITDA) of six times, as well as $2.4trillion of leveraged loans packaged into securities on largely “cov-lite” terms with little or no creditor protection – and even more prone to accidents than in 2008, according to the US Treasury.
Emerging markets may be the detonator for this nitrogycerine. The IIF said its daily tracking data of fund flows show that withdrawal from emerging markets are the worst ever seen by a “large margin”. This matters given that these economies are now 60 per cent of global GDP and most of global growth, with vastly greater linkages to the financial system than during past crises. The MSCI emerging markets fund (EEM) for equities rebounded yesterday but has still fallen 26 per cent since mid-january.
Robin Brooks from the IIF said a decade of zero rates and QE has steered huge sums into risky “highbeta assets”, many in developing states. Lebanon has already defaulted this year. South Africa, Mexico and Chile are overstretched. The weaker oil exporters from Nigeria, to Algeria, Iraq, Angola, Colombia, Kazakhstan and Azerbaijan are all facing a brutal fiscal shock from Covid-19.
Mr Brooks said the economic heart attack in Argentina and Turkey after they were hit by investor flight in 2018 is a foretaste of what could now happen on a much bigger scale. “We worry that the unfolding ‘sudden stop’ now has a similar potential, just on a more global and systemic level.”
Richard Kozul-wright, UNCTAD’S economics chief, said the global damage could be $2trillion and warned that developing countries no longer have the same “self insurance” that defended them in 2008. The average ratio of foreign reserves to short-term debt has halved since then, and liabilities have tripled.
He warned of a worldwide “deflationary panic” that turns into a protracted slump. It is imperative that governments do “whatever it takes” this time to keep demand alive. The lesson of the last decade is that it is not enough to rely on central banks alone in a Keynsesian liquidity trap when they are pushing on the proverbial string. This time fiscal stimulus must do the heavy-lifting.
“It should be clear that if a virus outbreak in a food market in central China is causing such global disruption, the most fundamental flaws in the current economic system cannot be ignored any longer,” said UNCTAD.