Bracing for the Bust C.P. Chandrasekhar

The message from the October meetings of the International Monetary Fund (IMF) and the World Bank, which normally exude optimism, is glum. In January this year, the IMF noted that “the cyclical upswing under way since mid-2016” was growing stronger, contributing to “the broadest synchronised global growth upsurge since 2010”. It now feels that while “the global economic expansion remains strong”, it has “become less balanced and with more downside risks”. This does not just mean that one more sighting of the “green shoots of recovery” is proving to be premature. Given the IMF’s predilection for underplaying bad news, it suggests that a return to recession is a real possibility.

The IMF points to two factors—rising interest rates in the United States and a stronger U.S. dollar—that are contributing to downside risks, while throwing in rising trade tensions as an additional cause for concern. However, these factors in themselves are not recovery-threatening.

The first, namely rising interest rates as part of a dose of monetary tightening, was long overdue. For almost a decade now, the U.S. Fed and Central banks in other developed economies have been focussed on quantitative easing and interest rate reduction as antidotes for the recession triggered by the 2008 financial crisis.

In the event, Central bank balance sheets were overly fat, the global economy was awash with liquidity and interest rates were near zero. There was little disagreement on the need to unwind balance sheets, rein in liquidity infusion and raise interest rates. The only question was when and how fast. The signs of a recovery in the U.S. offered as good an opportunity as any to begin this long overdue exercise. To the extent that the rise in U.S. interest rates and the improved performance of the U.S. economy trigger a shift of investment in favour of dollar-denominated assets, a strengthening of the dollar would follow, making that too an expected outcome.

The reasons why these inevitable movements in interest rates and the dollar are identified as sources of concern relate to the consequences they have in the current global environment.

Rising interest rates in advanced nations are reversing the flow of capital from developed to developing markets. This is because much of the portfolio investment in “emerging markets” undertaken during the years of easy money reflected the “carry trade” encouraged by differences in interest rates.

Interest Rates

Investors borrowed cheap in dollar and euro markets and invested in emerging markets that offered much higher interest rates. When those interest rate differences narrow, portfolio capital tends to flow out from developing countries. That outflow, besides limiting liquidity, weakens currencies, triggers speculation, and leads to a collapse (as happened in Argentina and Turkey) or a significant fall (as seen in Brazil, South Africa and India) in the value of local currencies vis-a-vis the dollar. This accelerates capital outflow.

Rising interest rates also hurt private players in emerging markets who borrowed quite happily during the cheap money years but now find that their debt service burden is rising sharply. This is true across the globe. But it is particularly true in the emerging markets where firms and other borrowers chose to pile up foreign debt, which was cheap but carried the risk of turning costly in local currency terms if the latter depreciated.

Today, they are faced with a double whammy—rising interest costs that increase debt service commitments and sharply depreciating currencies that increase the domestic currency value of those commitments even more, hurting their bottom line and even presaging defaults.

The potential for currency crises, debt defaults and a liquidity crunch inherent in this situation portends a substantial growth slowdown and even a return to recession. That is the “downside risk” the IMF is concerned about. That downside risk is great because of the huge build-up of debt in recent years.

According to the IMF, “total non-financial debt in countries with systemically important financial sectors now stands at $167 trillion, or over 250 per cent of aggregate GDP, compared with $113 trillion (210 per cent of GDP) in 2008.” This rise of nearly 50 per cent in non-financial debt over the last decade is surprising. A major cause for the 2008 crisis was the build-up of household and corporate debt, facilitated by a process in which risks were ‘shared’ through the creation and sale to third parties of securities backed by debt assets. So, ‘deleveraging’, or reduction of debt on the balance sheets across firms and households, was widely seen as crucial to any process of post-crisis restructuring. Contrary to that requirement, the debt overhang has actually risen sharply in the years since the crisis.

The IMF recognises why this has happened. “The unconventional monetary policies implemented since the global financial crisis were aimed at easing financial conditions to support the economic recovery,” it said. “In such an environment, total non-financial sector debt—borrowings by governments, non-financial companies, and households—has expanded at a much faster pace than the growth rate of the economy.”

Thus, the debt build-up is the result of the use of monetary policy measures such as easy money policies and low interest rates in response to the recession induced by the financial crisis. But, if that crisis was the result of excess debt, then measures that increase rather than reduce the dependence on debt are not just the wrong medicine but counterproductive, as the danger of another crisis suggests.

What is worse, that medicine has not delivered a robust recovery, with the return to growth restricted to a very few economies. In sum, governments and Central banks got it wrong when they relied on monetary measures as antidotes for the recession. That, however, is something the IMF is not willing to accept since it would imply that greater reliance on proactive fiscal policies, or enhanced state spending, which the IMF and financial interests rail against, were possibly the better option.

Sell-off in stock markets

The problems created by the reliance on unconventional monetary policies do not end with the danger of a debt bust. Stock markets across the world are coming off their highs. This is happening even in the U.S., which is recording good growth and improved corporate earnings, with the official unemployment estimate of 3.7 per cent being at its lowest in almost half a century

Over the week ended October 12, the U.S. stock market saw a massive sell-off, bringing to an end the longest bull run in its history that had taken stock indices to unprecedented highs. This establishes what was clear for long—that the bull run was the result of speculative fever triggered by the easy and cheap money environment. To the extent that easy access to credit fuelled the speculative boom in the stock market, the bust can result in defaults, when over-indebted investors find they are unable to recoup their capital and repay their creditors. That is another outcome that could squeeze liquidity and stymie growth.

Finally, despite the central role of opaque asset backed securities in aggravating the 2008 financial crisis, the issue of such securities has not diminished.

Noting that “leveraged finance, comprising high-yield bond and leveraged loan-based finance, has doubled in size since the Great Financial Crisis”, the Bank for International Settlements argues that this was facilitated by developments in the securitisations market.

“Originator banks are finding it easier to securitise and sell these loans. This can be seen in the growing investment in loans by securitised structures such as collateralised loan obligations, especially in the last couple of years.”

Nothing much has changed on the financial front since the crisis. What is different this time around is that the danger of a crisis is not focussed on the advanced nations, with the rest of the world, especially the emerging markets, only experiencing the after-effects. In fact, in 2008, countries like China and India were still seen as growth poles that could help moderate the intensity of the global crisis and even lead the recovery.

This time around, the disease will likely afflict the emerging markets too; these markets are already bearing the brunt of the financial volatility unleashed by the reversal of “overused” rather than “unconventional” monetary policies.

Yet, the IMF still finds reason to be positive about the state of some of these economies. In a statement made in Washington, reported by the Press Trust of India, the Director of the IMF’s Fiscal Affairs Department argued that while global debt had touched troubling levels, India had managed to moderate debt expansion. Private debt in India is placed at 54.5 per cent of the gross domestic product (GDP) and general government debt at 70.4 per cent, making a total of 125 per cent. That compares with a 247 per cent debt to GDP figure in China, for example.

India’s Vulnerability

The debt exposure figure does not mean, however, that India is not vulnerable. India’s vulnerability stems from its increased exposure to dollar debt, partly because of investment by foreign portfolio investors in debt markets and partly because of direct borrowing by corporations seeking to benefit from low international interest rates.

Rising U.S. interest rates combined with a widening of India’s current account deficit (owing to the rise in oil prices and other factors) have weakened the rupee considerably vis-a-vis the dollar. As a result, India has also been badly hit both by the exit of portfolio investors from debt markets and by the depreciation of the rupee that followed. Of the more than $12 billion pulled out by portfolio investors so far this year, more than $8 billion was from debt markets.

The rupee, meanwhile, has depreciated from less than Rs.64 to the dollar to around Rs.74. One consequence of the latter is a rise in the rupee servicing costs of foreign debt. Borrowers exposed to foreign debt are bound to feel the pressure.

Seen in those terms, the IMF’s sanguine assessment based on India’s overall debt-GDP ratio does not reveal the extent of the nation’s vulnerability.

(This article was originally published in the Frontline Print edition: November 9, 2018)