Global debt levels are dangerously high and central banks cannot keep the game going indefinitely, warns the high priest of orthodoxy
By Ambrose Evans Pritchard
Debt ratios have reached extreme levels across all major regions of the global economy, leaving the financial system acutely vulnerable to monetary tightening by the US Federal Reserve, the world's top financial watchdog has warned.
The Bank for International Settlements said the wild market ructions of recent weeks and capital outflows from China are warning signs that the massive build-up in credit is coming back to haunt, compounded by worries that policymakers may be struggling to control events.
"We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major fault lines," said Claudio Borio, the bank's chief economist.
The Swiss-based BIS said total debt ratios are now significantly higher than they were at the peak of the last credit cycle in 2007, just before the onset of global financial crisis.
"We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major fault lines."
Claudio Borio, head of BIS economic department
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Combined public and private debt has jumped by 36 percentage points since then to 265pc of GDP in the the developed economies.
This time emerging markets have been drawn into the credit spree as well. Total debt has spiked 50 points to 167pc, and even higher to 235pc in China, a pace of credit growth that has almost always preceded major financial crises in the past.
Blue is external dollar loans, red is securities
Adding to the toxic mix, off-shore borrowing in US dollars has reached a record $9.6 trillion, chiefly due to leakage effects of zero interest rates and quantitative easing (QE) in the US. This has set the stage for a worldwide dollar squeeze as the Fed reverses course and starts to drain dollar liquidity from global markets.
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Dollar loans to emerging markets (EM) have doubled since the Lehman crisis to $3 trillion, and much of it has been borrowed at abnormally low real interest rates of 1pc. Roughly 80pc of the dollar debt in China is on short-term maturities.
These countries are now being forced to repay money, though they do not yet face the sort of 'sudden stop' in funding that typically leads to a violent crisis.
The BIS said cross-border loans fell by $52bn in the first quarter, chiefly due to deleveraging by Chinese companies. It estimated that capital outflows from China reached $109bn in the first quarter, a foretaste of what may have happened in August after the dollar-peg was broken.
Credit in Emerging Asia has jumped fourfold since 2000 to $25 trillion
China and the emerging economies were able to crank up credit after the Lehman crisis and act as a shock absorber, but there is no region left in the world with much scope for stimulus if anything goes wrong now.
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The venerable BIS - the so-called 'bank of central bankers' - was the only global body to warn repeatedly and loudly before the Lehman crisis that the system was becoming dangerously unstable.
It has acquired a magisterial authority, frequently clashing with the International Monetary Fund and the big central banks over the wisdom of super-easy money.
Mr Borio said investors have come to count on central banks to keep the game going but engenders moral hazard and is ultimately wishful thinking. "Financial markets have worryingly come to depend on central banks’ every word and deed,” he said.
A disturbing feature of the latest scare over China is a "shift in perceptions in the power of policy", a polite way of saying that investors have suddenly begun to question whether the emperor is wearing any clothes after all following the botched intervention in the Shanghai stock market and the severing of the dollar exchange peg in August.
"Financial markets have worryingly come to depend on central banks’ every word and deed."
Claudio Borio, head of BIS economic department
The BIS 'house-view' is that the global authorities may have put off the day of reckoning by holding interest rates below their 'natural' or Wicksellian rate with each successive cycle but this merely stores up greater imbalances, drawing down prosperity from the future and stretching the elastic further until it snaps back. At some point, you have to take your bitter medicine.
The BIS report said the rich countries have failed to right the ship over the last seven years or bring leverage back down to manageable levels, as the Nordic states succeeded in doing after the banking crises a quarter of a century ago. Instead they seem to be caught in a Japanese trap.
"Aggregate private debt has barely stabilised, let alone started to correct downwards, even in the corporate sector. And government debt continues to rise steadily, in a manner reminiscent of Japan’s trend deterioration in the 1990s," it said in its quarterly report released over the weekend.
Britain, Spain, and the US have cut household debt ratios but this is still not enough to offset the massive jump in public debt since the Lehman crisis.
France has suffered the worst deterioration of any major country in the developed world, with total non-financial debt levels spiralling upwards by 75 percentage points to 291pc, overtaking Britain at 269pc for the first time in decades.
The concern is what will happen as the Fed prepares to raise interest rates for the first time since 2006, perhaps as soon as this week.
A study on financial spillovers in the BIS report found that much of the global financial system remains anchored to US borrowing rates, whether or not countries have fixed exchanged rates or floating currencies, and regardless of normal theory on trade links and business cycles.
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On average, a 100 point move in US rates leads to a 43 point move for emerging markets and open developed economies, with powerful knock-on effects on longer-term bond rates. "We find economically and statistically significant spillovers," it said.
The grim implication is that emerging economies may face a monetary shock as rates ratchet higher, even if the liabilities are in their own currencies.
Total debt to GDP
Enthusiasts for the 'BRICS' and mini-BRICS insist that today's EM squall is entirely different to the crises in the early 1980s and mid-1990s since the governments of these countries no longer borrow in dollars or hard-currencies - though their companies clearly do, and on a very large scale.
The BIS data suggests that this assumption may be complacent. Emerging markets may just as vulnerable this time, and perhaps more so given the much greater stock of debt.
What remains unclear is whether QE by the European Central Bank will delay the denouement yet again. Cross-border loans surged by $748bn in the first quarter, and $536bn of this was in euro-denominated debt.
Even American companies are issuing securities in euros in record volumes - so-called 'reverse yankee bonds' - to take advantage of lower rates in Europe, often making an implicit bet that the euro will weaken further. Their foreign debt issuance has doubled in pace since 2013, reaching $93bn in the first half of this year.
Global banks based in London also appear to be borrowing huge sums in euros to fund activities around the world , pushing offshore euro liabilities to a record $2.8 trillion.
The ECB is in effect displacing the Fed. This may mean that the baton passes safely from one super-power bank to another, buying a little more time.
Mr Borio warns investors not to push their luck. "It is unrealistic and dangerous to expect that monetary policy can cure all the global economy’s ills," he said.
Nor is there any easy way out of the debt-trap now encompassing much of the globe. "If I were you, I would not start from here," he said.
