Seven years ago, BNP Paribas disturbed the midsummer calm of financial markets by announcing that it was suspending withdrawals from three investment funds, saying it was unable to assess the value of subprime mortgage securities and other investments held by the funds. That ripple, on August 7, 2007, would develop over the following year and a half into the biggest financial crisis since the Great Depression and demonstrate that in today’s complex and interconnected financial markets, risks originating in one part of the world can wreak havoc far away.
That fact holds truer than ever these days as investors desperate for yield in the face of quantitative easing (QE) by the Federal Reserve and other leading central banks have piled into just about every asset class imaginable, from equities and credit to real estate and infrastructure. Many investors distrust current valuations in areas like U.S. stocks and high-yield bonds but feel obliged to participate in the rally even as they keep close to the exits, in case new turmoil erupts. That unease was one of the biggest themes that emerged at the Delivering Alpha conference held by Institutional Investor and CNBC earlier this month.
What could trigger a new crisis? The International Monetary Fund has sought to address that question since 2011 with an annual Spillover Report, which looks at how policies and developments in one part of the global economy can affect the rest of the world. The latest installment, released today, puts a focus on two main risks: an earlier than expected tightening of monetary policy by the U.S. and U.K., which could cause a repeat of the taper tantrum that roiled financial markets and hammered many emerging-market economies last year, and a slowdown in emerging-market economies, which could cause a spike in bad loans and sizable capital losses for banks in developed countries.
The Fed has steered markets to anticipate an initial rate hike around the middle of 2015, but recent strong employment gains have led some analysts to believe the Fed might have to hike rates sooner, and faster, to contain inflation pressures. Most analysts expect the Bank of England to begin raising rates even earlier. Mindful of the last year’s tantrum, chair Janet Yellen has tried to sharpen the central bank’s communications to avoid any surprises, but it’s debatable if she can succeed. After six years of zero rates and a massive buildup of the Fed’s balance sheet, the coming tightening will be unprecedented for the Fed and financial markets.
In its report, the IMF assumes that an earlier tightening move would drive up long-term interest rates by 100 basis points in the U.S. and the U.K. and cause knock-on effects in other countries. By comparison, U.S. long rates rose a little more than 100 basis points at the peak during the taper tantrum before settling about 60 basis points higher, with the ten-year bond currently trading just below 2.5 percent.
The nature of the tightening is critical, the IMF says. If the Fed hikes rates in response to a stronger economic recovery, the rest of the world would benefit more from increased trade than it loses through higher rates. Under this scenario, global gross domestic product would be 1.6 percentage points higher than baseline projections in 2019. For vulnerable emerging-markets economies running sizable current-account deficits, the hit to growth could be as much as 4 percent. But if rate rises stem from miscommunication by the Fed or a panic move to risk-off positions by investors, rate repercussions would be greater in other countries, and global GDP would be 0.6 points below the baseline.
The other big risk scenario looks at the impact on the global banking system of a persistent slowdown in emerging-markets economies, with growth a half percentage point below the IMF’s baseline projection of a little over 5 percent for the next three years. Fund economists didn’t pick that number out of the air. That is the same amount that the IMF has reduced its growth forecasts for emerging-markets economies in each of the past four years.
Banks in the advanced economies doubled their exposure to emerging markets between 2005 and 2013, to 20 percent of foreign claims. A persistent slowdown in emerging-markets growth would cause a rise in bad loans, bank deleveraging and capital losses. The IMF projects those capital losses would average around 1 percent of GDP for banks in advanced economies on average, but the hit could be more than 3 percent of GDP for Swedish banks and more than 2 percent for banks in Austria, Denmark, the Netherlands and Spain.
These risk scenarios aren’t independent, of course. A bumpy QE exit by the Fed combined with a persistent slowdown in emerging-market economies would tend to magnify each other and reduce global GDP by 1.5 to 2 percentage points, the IMF estimates. Not quite 2008–’09 redux, but that would represent a substantial hit to a global economy that the IMF projects will grow by 3.4 percent this year and 4 percent in 2015.
The Spillover Report offers plenty of other downside scenarios to keep investors awake at night. A worsening of the Ukraine crisis could disrupt natural gas supplies to Western Europe, push up the price of metals such as palladium and nickel and generate hefty credit losses in Russia and neighboring countries, it warns. A 1 percentage point drop in China’s growth rate would depress Asian economies by 0.3 points on average. The list could go on and on.
The purpose of the report isn’t to fan pessimism in financial markets but to spur global policymakers to closer cooperation. “Collaboration takes on renewed importance if sharply tighter external financing conditions and slower growth were to conspire to create deeper stress in more vulnerable emerging market economies,” the report states.
Evidence of cooperation is scant at the moment, though, with the exception of a hardening U.S.-European stance on sanctions against Russia. The Fed and the European Central Bank are leaning in different directions. Hacking allegations have soured relations between Washington and Beijing. Brazil, Russia, India, China and South Africa have agreed to launch a BRICS development bank as a sort of protest against the Western-led financial order. The rise of ISIS in Syria and Iraq and the Israeli invasion of Gaza raise fears of a wider Middle East conflagration.
Given all that discord, the IMF report seems likely to fall on deaf ears. That may be the biggest risk of all.
Follow Tom Buerkle on Twitter at @tombuerkle.
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