Is the world on the verge of a new financial crisis? Ilias Alami looks at the data and finds a precarious situation.
While a variety of economic and financial indicators increasingly paint a bleak picture, the upcoming policy choices in developed countries will have far-reaching consequences for global financial stability.
In the so-called developed countries, the situation remains precarious. Even though economic activity is at a four-year high in the Eurozone, high rates of long-term unemployment and considerable deflationary pressures are persisting. In the UK, the relatively better performance has weak bases: real incomes have continued falling, productivity has not increased, and the real estate bubble has kept on inflating. In the US, despite some significant job creation over the past couple of years, it is likely that the fragile recovery has largely been driven by asset-price bubbles. After a slight improvement last year, the Japanese economy is now back in recession.
Many countries across the developing world do not fare better. China, the locomotive of the global economy over the past fifteen years, has recently shown increasing difficulties, and analysts have warned against the monumental proportions of its construction and credit bubbles. The recent fall in global commodity prices (in part due to the slowdown of the Chinese economy) has badly hurt emerging and oil-producing countries, causing deficits in both budgets and current accounts, and downward pressures on their currencies.
In addition, patterns of global private capital flows have largely worsened the economic woes of developing and emerging countries (DEC). Indeed, after a brief episode of capital flight when the global financial crisis burst in 2008, private capital flows to DEC rapidly recovered between 2009 and mid-2013. Large and volatile inflows were driven by the better economic dynamism in DEC than in developed countries (the so-called ‘two-speed recovery’). Besides, large interest rates differentials between DEC and developed economies provided a lucrative opportunity for carry trade, the interest rates in the latter group of countries being close to zero or negative in the context of expansionary and ‘unconventional’ monetary policy (the quantitative easing programmes). This boom in private capital flows has contributed to the formation of a huge stock of short-term foreign investment in DEC (or what has been termed ‘new forms of external vulnerability’), making these countries extremely vulnerable to a reversal of capital flows.
From mid-2013, capital flows to DEC have slowed down or reversed, as financial investors expected monetary authorities in developed countries (especially the US Federal Reserve) to ‘normalise’ their policies, that is, increase their base rates and ‘taper’ their quantitative easing programmes. The fear that this return to ‘normal’ would spark a global recession, as well as serious troubles in China since mid-2015 and the slump in global commodity prices, triggered the worst episode of capital flight from DEC since the 1980s, severely aggravating their economic situation. For instance, Brazil, which post-crisis performance was praised by the international financial community, is now spiralling into recession. In a year (2015), the Brazilian real has depreciated by a third against the dollar.
In other words, expansionary and unconventional monetary policies in developed countries have largely failed to stimulate investment and spark a sustainable economic recovery. What they have considerably contributed to, however, is the build-up of financial fragility and risks. Financial fragility and risks have been unevenly distributed across the world market, with DEC disproportionately bearing their brunt.
In that context, the upcoming policy choices of developed countries’ monetary authorities will certainly have far-reaching consequences for DEC, and for global financial stability in general. On the one hand, the Federal Reserve is likely to finally increase its base rate next week (for the first time in about ten years), due to concerns over financial stability, and the slight improvement of the US economy. This expectation is widely shared amongst financial commentators. On the other hand, the European Central Banks announced a few days ago the prolongation of its expansionary monetary policy and its quantitative easing programme until (at least) March 2017. This could cause a ‘great policy divergence’, with unclear international repercussions in terms of global capital flows and their uneven impacts across the world market. What is likely, though, is that an uncertain global financial environment would translate into large interest rates differentials and acute exchange rate volatility, potentially worsening the vulnerability of DEC as well as their economic situation. An appreciation of the US dollar would also hurt private companies in DEC, which got heavily indebted in dollars during the 2009-2013 boom in capital flows.
Three important conclusions can be drawn from this short analysis. Firstly, as an increasing number of analysts and international organisations (including the IMF) are sounding the alarm bell about the next financial crisis, this time the epicentre may well be in DEC, with potentially devastating consequences for the populations in these countries. Secondly, the present situation sheds light on the sheer lack of mechanisms of multilateral governance of private capital flows. Thirdly, it underlines the severe limitations of the monetary policies recently deployed in developed countries: an unprecedented creation of money has maintained global capitalism on life-support over the past few years, but failed to spark a sustainable recovery, and resulted in destabilising flows of capital across the world market. The associated build-up of financial vulnerability may well be the shock that triggers the next financial crisis.