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Could there be a second financial crisis?

There are 2 obvious potential sources for a second financial crisis - China and the Euro-zone. But both have cried wolf before and could do so again.

China and the Euro-zone both have systemic financial problems, and the conventional wisdom about both is that we should be concerned but not alarmed. This is probably correct but nagging doubts remain.

Contrary to most people’s impression, total global private sector debt has continued to swell since the financial crisis and Great Recession. Global general government debt has rocketed as well. General government debt, as a proportion of GDP, is at historic highs. It is now higher than after World War 1, but not as high as after World War 2. This is not a good starting point if there was to be a global economic downturn.

China has significant potential for a debt crisis. It was described in 2018, by one of the ratings agencies as a “debt iceberg with titanic credit risks”. The Institute for International Finance (IIF) estimates that total debt in China reached 300 percent of GDP in 2018. This is China’s ‘Great Wall of Debt’. China’s debt to GDP ratio has increased by around 150 percentage points since the Great Recession. The primary, though not exclusive source of the build-up, has been a surge in corporate debt.

In 2018 the IMF stated that: “International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risk of a disruptive adjustment”.There is no clear answer in the economic literature as to at what point the debt to GDP ratio turns red, but what is clear is that it has turned amber. The Bank for International Settlements (BIS) has undertaken a great deal of analysis of previous financial crises and this shows that a very rapid run-up in the debt ratio, in a short-time, is one of the biggest predictors of looming financial crisis.

A fascinating 2019 briefing from the Federal Reserve Bank of San Francisco, cited China banking sector analysis from Autonomous Research: “In nominal terms we’re talking about a Chinese banking sector in 2008 that was around $9 trillion, so the delta [the change] in just 9.5 years is $30 trillion. By next year if we keep up this pace of growing through 2019, that delta in 10 years is going to be equivalent in size to the entire US banking sector, Japanese banking sector and UK banking sector combined”. This is an utterly astonishing statistic and a salutary warning. Economic history teaches that credit booms are followed by credit busts.

Bloomberg reported in 2016 that hidden lending on bank balance sheets and off-balance sheets totalled more than $5 trillion. Whilst China doesn’t have sub-prime products, and mortgage down-payments in China are more significant than in the US, the shadow banking issue represents “more than five times the amount of sub-prime loans outstanding in the US at the time of the 2008 financial crisis”.

There are numerous factors that might be pleaded in mitigation to show that, this time it’s different, due to the nature of the state or bureaucratic model of capitalism in China. In many instances the state lends to itself e.g. state-owned banks lend to state owned enterprises. A large part of the corporate debt build-up is attributable to infrastructure spending that would be classified as public investment outside of China. All this means that the default risk is different in China and that hopes of a “beautiful deleveraging” could yet come to pass.

The conventional wisdom is that the euro crisis won’t return. The euro crisis was brought under control when the ECB committed itself to huge bond market purchases. Moreover, the vital signs with regard to a potential crisis, are very different now as compared to before. Bond yields and implied risk from credit default rates are lower. But this doesn’t mean the threat of a return of the euro crisis has disappeared. There remain deep concerns regarding the Italian banking system and the scale of non-performing loans.

Nominal GDP in Italy is around 25 percent below trend. This has given rise to the so-called Italian Death Cross chart, with nominal GDP relative to trend falling, and bank bad debt rising. When nominal GDP is this far below trend, banking sector difficulties are almost a given. The Economist recently ran with a leader article entitled, The Italian Job, which argued that, “At best Italy’s weak banks will throttle the country’s growth; at worst, some will go bust”.The consequences of banks going bust, and the so-called sovereign-bank loop are frightening. This is a scenario where the banking system begins to implode due to the interrelationships between banks, and an already highly indebted public sector moves into much deeper deficit, driving up bond yields and undermining bank capital even more.

On top of this, and potentially interacting with it, Italy faces a third decade of lost growth, having grown very little in the 2000s and 2010s, and now facing a demographic implosion that could undermine growth in the 2020s. The consequences for existing political and economic institutions could be grave, with euro exit an increasing possibility. Ambrose Evans-Pritchard, writing in The Daily Telegraph, has written that Italy leaving the euro “may be the only way to avert a catastrophic deindustrialization of the country before it is too late.”

The domino effect would then kick-in. Wolfgang Munchau, writing in The Financial Times, has stated that: “An Italian exit from the single currency would trigger the total collapse of the euro-zone within a very short period. It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash”.

This is a scary story, but it’s also been one that has been told many times over recent years and has still failed to come to pass. Many economists, including myself, have cried wolf on this before and been proven incorrect.