Ten years after Lehman, four big risks

This article first appeared in The Edge Financial Daily, on July 4, 2018.
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IT has been a decade since Lehman Brothers collapsed and the time of year when the markets are worried about another “summer surprise.”

No two market shocks are identical, and no one has yet mastered the timing of market crashes. However, knowing where vulnerability lies makes for better risk management, and maybe more carefree vacations.

There are four main areas of worry that, taken together, suggest the global economy may be in a more fragile place than it was even on the eve of Lehman’s demise a decade ago.

First, as the Bank of International Settlements has repeatedly warned, there is a record level of indebtedness in the global economy.

It is not just the amount of public and private debt which is worrying, but also the deterioration in average quality.

There is now US$63 trillion (RM255.15 trillion) of sovereign debt outstanding, with total debt at US$237 trillion, a full US$70 trillion above pre-Lehman levels.

There are only 11 sovereigns and only two US firms left with a AAA rating, and there is a continuing decline in the average credit quality of outstanding loans and bonds. Servicing and rolling over this debt are likely to become much more expensive as monetary policy normalises after years of quantitative easing (QE).

The 2007 US deficit at US$161 billion or 1.1% of gross domestic product (GDP) pales in comparison to this year’s projection of US$804 billion. America’s public debt-to-GDP ratio has risen to over 105% of GDP from around 65% of GDP in 2008, with projections of a continued rise.

In the eurozone too debt is now 20% higher, rising 60% in Spain; and Italy’s public debt, already high in 2008, has now breached 130% of GDP, a full 30% higher than its 2008 level.

Clearly, there is far less room for governments to use increases in public spending and the so-called countercyclical policies that were crucial to avoiding a repeat of the great depression following Lehman’s demise.

Second, with QE having left central banks with a record US$15 trillion of assets on their balance sheets, and interest rates still close to record lows, there is limited room for a robust monetary policy response to another shock.

The last three recessions saw the US Federal Reserve cut interest rates by 5%, while pre-Lehman European Central Bank and Bank of England maintained interest rates of 4% and 5%, respectively.

With QE taps still open and real, and even nominal interest rates negative for several G-10 central banks, a repeat of the decisive central bank action that helped the world avoid a depression is impossible.

In fact, it is quite possible that monetary policy, as we saw with the taper tantrum in 2013, may become the source of instability as QE is wound down and interest rates normalise.

Third, the political centre, which was strong in 2008, has frayed considerably in almost all major economies. Populism of both the far right and far left variety is rising, partly in response to the crisis.

The electorate is more dissatisfied after what amounts to an almost lost post-crisis decade in which few saw an increase in their real wages, with many more experiencing economic and other forms of insecurity.

Political systems in most European economies have fragmented with an increase of small and even fringe political parties now represented in parliaments, as governing majorities become ever harder to cobble together.

Fourth is the collapse of trust and weakening in the international order. The US is pursuing not just an empty chair policy at international forums such as the G-7 and the G-20, which were crucial in marshalling international co-operation to tackle the last crisis, but the Trump administration has actively taken a wrecking ball to global international cooperation.

Perhaps even more alarmingly, the sensible political centre in the European Union (EU) is diminished, with populists in both core and periphery economies leaving little room for sensible eurozone-wide and pan-EU policies.

Brexit, the rising East-West divides, particularly on immigration and the new Italian government, are just the most obvious examples of a deeper malaise in EU politics.

Of course, banks are stronger today than they were in 2008, and policymakers have a bigger crisis toolkit.

But the combination of shrunken fiscal and monetary policy space, a record build-up of debt, the diminishing of the political centre, dismantling of the post war liberal world order and a nascent trade war means that things may be more fragile on every other count. — Bloomberg