The global boil­ing point

The threat of a new global eco­nomic cri­sis looms

The Ukrainian Week - - CONTENTS - Li­ubomyr Shaval­iuk

On July 3, Bloomberg an in­ter­na­tional busi­ness news agency, re­ported that the Bank of Amer­ica (BoA), the se­cond largest by as­sets in the US, sees the sit­u­a­tion on fi­nan­cial mar­kets to­day as signs of many par­al­lels with what hap­pened just be­fore the Asian fi­nan­cial cri­sis of 1997-1998. This news is worth pay­ing at­ten­tion to for two rea­sons. Firstly, fi­nan­cial com­pa­nies, es­pe­cially world lead­ers in this sec­tor, typ­i­cally avoid talk­ing di­rectly about any pos­si­ble cri­sis. Even if they see one com­ing, they nor­mally won’t broad­cast their con­cerns as they pre­fer to make money on it them­selves, qui­etly ad­just­ing the nec­es­sary in­vest­ment de­ci­sions. Sec­ondly, the Bloomberg com­ment was picked up by sev­eral Ukrainian publi­ca­tions and roused avid dis­cus­sion among lo­cal economists. It’s clear that Ukraine risks hav­ing a new cri­sis and plenty of ink has been spilt on the sub­ject, but so far there hasn’t been any­thing much about a pos­si­ble global cri­sis. The Ukrainian Week de­cided to look in-depth at the big­gest risks that might lead to it.

The world econ­omy is see­ing de­struc­tive pro­cesses of global sig­nif­i­cance nearly ev­ery day. The mi­gra­tion cri­sis in Europe, Brexit, cur­rency and trade wars, Amer­ica’s exit from the Iran deal North Korea’s nu­clear bravado—all of these de­vel­op­ments af­fect eco­nomic process well be­yond the bor­ders of the coun­tries in­volved. Still, such pro­cesses ex­tremely rarely lead to a large-scale eco­nomic cri­sis: if the global econ­omy is in good shape, it ad­justs to the new con­di­tions fairly eas­ily. So, in or­der to an­a­lyze the risks of a new global cri­sis, these events need to be largely ig­nored.

What, then, could lead to a new global eco­nomic cri­sis? The an­swer comes from a sur­pris­ing cor­ner: clas­si­cal 19th­cen­tury economists: crises arise in the foun­da­tions of the eco­nomic sys­tem it­self, caused by its struc­ture and be­com­ing neg­a­tive in re­sponse spe­cific ten­den­cies.


A num­ber of such trends can be seen to­day, the main one be­ing the ever-tighter mone­tary pol­icy of the US Fed­eral Re­serve, which has two com­po­nents. One is rais­ing the prime rate: at the end of 2015, the Fed raised the rate 0.25% for the first time in more than seven years, sig­nal­ing that the im­pact of 2008-2009 had been over­come and the Amer­i­can econ­omy was in de­cent shape. Then there was a one-year break, af­ter which the Fed be­gan rais­ing the prime rate ev­ery quar­ter or two. It seems that the con­di­tions for these steps are in place: in­fla­tion is ris­ing in the US, hav­ing gone up to 2.9% in June, the high­est it’s been since early 2012, while un­em­ploy­ment was at 3.8% in May, sim­i­lar to the low point in 2000 reg­is­tered right af­ter the Asian cri­sis and the peak of the dot­com bub­ble— al­though it rose to 4.0% again in June. In­deed, based on in­fla­tion and un­em­ploy­ment rates, the US econ­omy is on the verge of over­heat­ing and the main in­stru­ment to cool it down to­day is rais­ing the prime rate, just as the Fed is do­ing.

But this par­tic­u­lar in­stru­ment has a num­ber of side ef­fects. Firstly, yields on T-bills tend to rise (see At­trac­tive Debt). A few weeks ago it broke 3% on 10-year bonds, al­though it did not stay at that level long. Un­der these con­di­tions, these bonds are com­pet­i­tive on in­ter­na­tional mar­kets with Italy at 2.68%, Poland at 3.20%, Hun­gary at 3.50%, Thai­land at 2.61%, and many more coun­tries. Un­der­stand­ably, US bonds win the com­pe­ti­tion be­cause the risks on Amer­i­can papers are so much lower than those of other coun­tries. And so as the Fed raises its rate, cap­i­tal will grad­u­ally move over to the United States, while developing coun­tries will feel a

short­age. This will neg­a­tively im­pact their balance of pay­ments and their macroe­co­nomic in­di­ca­tors.

The se­cond side-ef­fect is be­cause yields on US Tbills are gen­er­ally per­ceived as risk-free, that is, they are the ba­sic rate on which eurobonds in most coun­tries are ori­ented. And so, if the cost of US debt keeps ris­ing, it au­to­mat­i­cally rises for many other coun­tries that bor­row abroad. For in­stance, in the mid­dle of Septem­ber last year, Ukraine placed 15-year sov­er­eign eurobonds at 7.375% and a few weeks ago, yields on these papers had grown to 9.5%: in short, they had jumped more than 2pp in less than a year. One of the rea­sons was the grow­ing cost of cap­i­tal in the US.

In re­cent months, a sharp rise in eu­robond yields in many developing coun­tries has be­come a steady trend. If these yields pass a cer­tain thresh­old, such as 10% or 15%, those coun­tries will have a very hard time bor­row­ing any sum on ex­ter­nal mar­kets, even a rel­a­tively small one. If this hap­pens at an in­con­ve­nient time, such as dur­ing an elec­tion cam­paign or when ma­jor ex­ter­nal debt ser­vic­ing comes due, this can lead to a balance of pay­ments cri­sis, with the re­sult­ing neg­a­tive im­pact on the do­mes­tic cur­rency and the over­all econ­omy.






For in­stance, when the Fed be­gan to sharply raise the prime rate from 3% to 6% over 1994-1995, the global fi­nan­cial sys­tem be­gan to ac­cu­mu­late im­bal­ances. Barely two years later, this turned into the Asian cri­sis in late 1997 and then Rus­sia’s de­fault in 1998. The en­tire cri­sis af­fected many coun­tries, in fact and many of them, like Ukraine, had to re­struc­ture their pub­lic debt. The par­al­lel be­tween events now and those two decades ago is pretty clear. Then, of course, it took two years for things to reach cri­sis point. How long it might take to­day is hard to say.


The se­cond com­po­nent of the Fed’s tight mone­tary pol­icy is re­duc­ing its own balance.Af­ter the 20082009 cri­sis, the US cen­tral bank went for quan­ti­ta­tive eas­ing, that is, re­deem­ing se­cu­ri­ties on the mar­ket us­ing newly-printed money, in or­der to stim­u­late the econ­omy. This blew up the Fed’s balance to US $4.5tn. Last year, a de­ci­sion was made that, start­ing in QIV 2017, the Fed­eral Re­serve would be­gin to grad­u­ally liq­ui­date the se­cu­ri­ties on its balance sheet. The pace of this shed­ding will go from US $10bn per month in QIV 2017 to US $50bn per month by the end of 2018.

This step is prob­a­bly even more dan­ger­ous for mar­kets than rais­ing the prime rate, be­cause the money the Fed re­moves from cir­cu­la­tion will be com­ing from ev­ery­where, but mostly from the weak­est as­sets. In other words, if high yields on US gov­ern­ment bonds, in and of them­selves, cause cap­i­tal to flee emerg­ing mar- kets, the re­duc­tion of the Fed’s balance sheet will only strengthen this trend. This es­tab­lishes a long-term fun­da­men­tal con­di­tion for a col­lapse on global fi­nan­cial mar­kets.

This trend can al­ready be seen on stock mar­kets (see When There’s Not Enough Air): the re­duc­tion of the Fed’s balance be­gan in Oc­to­ber 2017 and, by Jan­uary 2018, most mar­kets reached their peak and en­tered a sub­stan­tial, si­mul­ta­ne­ous ad­just­ment. In short, they fell. Whereas Amer­i­can stock in­dices were down only about 5.4% at the be­gin­ning of July com­pared to Jan­uary’s peak, Chi­nese stock mar­kets lost more than 22%, while the MSCI EM, an emerg­ing mar­kets in­dex in­volv­ing stocks from 24 coun­tries, was down nearly 17%. This is a clear in­di­ca­tion that stocks from these coun­tries are not fa­vored among in­vestors right now. This makes an out­flow of cap­i­tal im­pos­si­ble and prob­lems with the balance of pay­ments that, in some cases, is likely to grow into a full-blown cri­sis.

It’s im­por­tant to note that the con­cept of quan­ti­ta­tive eas­ing did not ex­ist in the 1990s, so it could not be cur­tailed, ei­ther. And that’s what makes the cur­rent sit­u­a­tion much more com­pli­cated. Re­duc­ing the Fed’s balance will likely re­in­force and ac­cel­er­ate all the cur­rent trends on global mar­kets. The prob­lem is that the pace of this de­cline is only likely to keep ris­ing un­til at least the end of 2018, which means the pres­sure on mar­kets will keep grow­ing. Al­to­gether, the Fed has an­nounced that it plans to re­duce its balance by US $420bn, and this num­ber will in­crease to US $600bn over 2019-2020. For com­par­i­son, the IMF re­ports that all emerg­ing mar­kets put to­gether re­ceived around US $500bn in di­rect and port­fo­lio in­vest­ments in 2017. The num­bers speak for them­selves.


The other im­por­tant trend is the US gov­ern­ment’s soft fis­cal pol­icy. At the end of 2017, the Trump Ad­min­is­tra­tion ini­ti­ated tax re­forms that were passed by the Congress. It in­tro­duced a se­ries of in­no­va­tions, but the big­gest change was a re­duc­tion in cor­po­rate profit tax from 35% to 21%. The key re­sult of this re­form is that the US bud­get deficit will go up US $1.5 tril­lion over the next 10 years. This is the ba­sic fig­ure that was cal­cu­lated. Economists say that the spur to eco­nomic growth that this re­form should lead to will en­sure greater bud­get rev­enues, so that, ac­cord­ing to var­i­ous cal­cu­la­tions, the ac­tual deficit will only go up $0.51.3tn over the next decade, or about US $40-100mn a year.

Eco­nomic the­ory says that mone­tary pol­icy needs to al­ways be in­de­pen­dent of fis­cal pol­icy. In prac­tice, co­or­di­nat­ing them can lead to much bet­ter re­sults, but, more than any­thing, it helps avoid hav­ing them at cross pur­poses. This is the sit­u­a­tion in the US to­day, if we look at both poli­cies in the con­text of eco­nomic growth. On one hand, we have US mone­tary pol­icy that is clearly in­tended to slow down in­fla­tion and limit growth while the un­em­ploy­ment rate re­mains low. On the other, we have US fis­cal pol­i­cythat is clearly in­tended to stim­u­late growth. Yet the Trump Ad­min­is­tra­tion has been quite con­sis­tent in its in­con­sis­tency: It keeps do­ing things to at­tract busi­ness to the States, not only by re­duc­ing cor­po­rate taxes, but also by in­sti­tut­ing pro­tec­tion­ist mea­sures, in­clud­ing higher im­port tar­iffs, di­rected at stim­u­lat­ing do­mes­tic man­u­fac­tur-

ing. The prob­lem is that these mea­sures all work well when there is enough of a la­bor force on the do­mes­tic mar­ket. But when job­less­ness is low and im­mi­gra­tion is be­ing blocked in ev­ery way pos­si­ble, this kind of fis­cal pol­icy—and not just the fis­cal as­pect—only speeds up the over­heat­ing of the econ­omy and the neg­a­tive con­se­quences will last a very long time.

For fi­nan­cial mar­kets, how­ever, this is not the main point. What mat­ters more is that, as the deficit grows, the US will be is­su­ing US $40-100mn more gov­ern­ment bonds ev­ery year. With in­ter­est rates on T-bills very at­trac­tive to global cap­i­tal, any new is­sues will be grabbed up like hot­pies at a Satur­day mar­ket—at the cost of the same vol­ume of cap­i­tal not go­ing to emerg­ing mar­kets. That will only in­crease the neg­a­tive trends that can al­ready be seen there. In the end, the US is likely to win: more money will flow into the coun­try, which will nicely stim­u­late do­mes­tic de­mand and partly en­sure ad­di­tional eco­nomic growth, while the other share of ag­gre­gate de­mand growth will go into ris­ing prices. But the rest of the world will feel a se­ri­ous short­fall of cap­i­tal that could prove crit­i­cal to some of them—in­clud­ing Ukraine.


In short, to­day two pow­er­ful global trends are in swing: shrink­ing liq­uid­ity in the global fi­nan­cial and eco­nomic sys­tem, and an out­flow of money from emerg­ing mar­kets to devel­oped ones, es­pe­cially the US, which is more prof­itable and less risky. The over­all im­pact of these forces will be neg­a­tive for developing economies. What’s more, it’s been ev­i­dent since the be­gin­ning of 2018: af­ter the Jan­uary-Fe­bru­ary col­lapse on stock mar­kets, yields on the gov­ern­ment bonds of coun­tries like Brazil, Ar­gentina and Turkey went up sev­eral per­cent­age points. In other coun­tries, se­cu­ri­ties re­acted less strongly, but nearly all mar­kets felt some out­flow of cap­i­tal.

This, in turn, is putting pres­sure on bal­ances of pay­ment and down­ward pres­sure on na­tional cur­ren­cies. The MSCI EM Cur­rency In­dex fell 6.3% from its peak in March to the be­gin­ning of July. The DXY strength­ened al­most the same amount, the dol­lar in­dex that ag­gre­gates the rate of the green­back against the cur­ren­cies of a bas­ket of devel­oped economies. What’s more, all of this echoes trends from 20 years ago, be­cause the DXY grew over 1995-1997 by al­most 25%, cre­at­ing many prob­lems for coun­tries with large for­eign debts. For some, the bur­den proved more than they could bear.

What the ul­ti­mate im­pact of these two trends will be on the US is an open ques­tion. If more EM cap­i­tal flows to US stock and bond mar­kets than the Fed is pre­pared to swal­low, a new in­vest­ment boom will take place. All the nec­es­sary con­di­tions are in place, given that the tech­nol­ogy gi­ants for whom an ab­bre­vi­a­tion has even been in­vented—FAANG for Ap­ple, Amazon, Net­flix, Google—are all show­ing mirac­u­lously steep growth. It’s pos­si­ble that what we are look­ing at is a dot­com bub­ble 2.0, but this will hap­pen only if the US has a con­stant net pos­i­tive in­flow of cap­i­tal. If there should be a cap­i­tal short­fall even on the US mar­ket, we will likely see a si­mul­ta­ne­ous col­lapse across all or nearly all stock mar­kets in the world. If that hap­pens, it won’t be pos­si­ble to avoid dev­as­tat­ing con­se­quences on a global scale.

Right now, it’s prob­a­bly early to talk about a cri­sis, but the first har­bin­gers are al­ready there. A few weeks ago, Ar­gentina turned to the IMF for fi­nan­cial sup­port be­cause it was un­able to handle the pres­sure on its balance of pay­ments and the Ar­gen­tinean peso lost nearly a third of its value just in the last two months. Of course, the fi­nan­cial sys­tems of developing coun­tries are far more sta­ble than they were 20 or even 10 years ago, so a large scale cri­sis is un­likely to emerge to­mor­row, next month or even next quar­ter. All the more so that fi­nan­cial mar­ket pro­cesses tend to move in waves and most re­cently the sit­u­a­tion ap­pears to have im­proved a tiny bit.

How­ever, the ba­sic trends that led to the re­cent de­cline in EM stocks have not gone away. The im­bal­ances will con­tinue to ac­cu­mu­late and will sooner or later make them­selves felt with new force. Per­haps it’s just a mat­ter of time. But the worst thing for Ukraine is that it will suf­fer along with ev­ery­one else, and pos­si­bly even more.

It could be that the next wave of cap­i­tal flight from developing coun­tries will hap­pen at the same time as Ukraine’s do­mes­tic prob­lems grow more acute, what with the dis­rup­tion of IMF co­op­er­a­tion and sub­stan­tial debt pay­ments that loom over 2018-2019. This could lead to some of the worst losses in the world for Ukraine and Ukraini­ans—in which case the BoA’s par­al­lels with the 1990s will look un­for­tu­nately pre­scient.

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