The outlook for the global economy is gloomy. Stock market indexes like the Dow Jones Industrial Average and the Nikkei Index have been quite volatile in recent months. The recent flattening of the yield curve of U.S. Treasuries suggests that the U.S. economy is on its way to a recession, finishing almost a decade long expansion. Many other negative factors exist for stock markets, including the U.S.-China trade war, the United Kingdom's impending withdrawal from the European Union (Brexit), and the Italian fiscal issue that might destabilize the euro. All these factors increase the volatility of stock prices and thereby the level of uncertainty, making investors sell off stocks. It is quite likely that U.S. treasuries will keep attracting investors as safe haven assets, leading to a rise in the government bonds' prices and a decline in the yields.
Given this background, there is a natural question to ask. Will we experience another global financial crisis like the one that started in the United States a decade ago? In my view, if any financial instability ever arises, it would likely start from developing countries, especially emerging market economies (EMEs), rather than the U.S. or other developed countries.
To understand why, let us first review the experience EMEs had with financial liberalization because it is closely related to the current situation of the world economy.
Financial liberalization refers to a set of policies that deregulate the regulatory controls over cross-border capital flows to make it easier for foreign investors to invest in the domestic country and for domestic investors to invest overseas. Under the Bretton Woods system (the international monetary system that was built in 1944 upon a web of fixed exchange rate arrangements to gold and the U.S. dollar), cross-border financial transactions were banned in principle. After the Bretton Woods system collapsed in 1973, developed countries (especially in the U.S.) first started liberalizing financial markets in order to provide a greater variety of financial instruments. This was followed by developing countries in the late 1970s. For these countries, financial liberalization meant an effective way to gain access to foreign capital and supplement their pools of savings needed for economic growth.
Among developing countries, Latin American countries actively implemented financial liberalization in the late 1970s, and East Asian countries did the same in the first half of the 1990s. In both cases, the countries hoped financial liberalization would bring about active investment and economic development. However, in retrospect, both experiments ended in financial crises. Latin American countries experienced a debt crisis in 1982, and East Asian countries underwent a currency crisis in 1997-1998.
Both financial crises ended once the crisis-hit countries received rescue loans from the International Monetary Fund (IMF). However, these two crises revealed that the IMF's emergency assistance can be a problem. At the time of the Asian financial crisis, it was pointed out that the IMF emergency assistance exacerbated the crisis situation, causing severe contraction in output of the crisis economies.
Many researchers have argued that the IMF did not properly understand the economic situations of the individual crisis economies. The Fund applied similar measures to the Asian crisis economies as it did to Latin American economies despite wide differences in the economic and industrial structures. As a result, the IMF was accused of aggravating the economic situation through its emergency aid. For example, the conditionality for the IMF emergency loans to the crisis-hit countries, including Indonesia and South Korea, included severe fiscal austerity plans, just as it did in the case of the Latin American crisis-hit countries. However, accumulating public-sector debt by the Asian crisis countries was not as big of a problem as was in the case of the Latin American crisis economies. Consequently, the countries that swallowed the conditionality experienced severe output contraction (South Koreans call the Asian crisis the "IMF crisis," indicating that they blame the IMF for their economic hardship).
Since then, many developing countries have also shared a view that the IMF policy reflects the intentions of the U.S. and other Western countries—the Fund is there for the banks of advanced economies, not for the crisis-hit economies. Hence, agreeing to its conditionality has become viewed as a "surrender" to the Western world. Thus, in the 2000s, the reputation of the IMF significantly deteriorated among developing countries.
Because of the "IMF stigma," developing countries, particularly EMEs, came to believe that it would be better to insure themselves against the risk of a financial crisis by building up foreign reserves than to expect to rely on emergency loans from the IMF. In the minds of the policy makers of these countries, self-insurance through holding massive foreign reserves would allow them to avoid laborious negotiations with the IMF and the U.S. and simply respond to a crisis situation flexibly and promptly.
This way of thinking toward the IMF and self-insuring through holding foreign reserves was particularly conspicuous in China. At the time of the Asian financial crisis, China saw Hong Kong manage to defend its exchange rate to the U.S. dollar from ferocious speculative attacks thanks to its ample foreign reserves. China already foresaw that financial liberalization was inevitable in the near future, and that it may face financial instability once it starts liberalizing its financial markets. The country decided to hold a vast amount of foreign reserves to be prepared for a future financial instability.
As shown in Figure 1, the amount of foreign reserves held by China rose steeply after the Asian crisis, growing close to $4 trillion in 2015. Although the amount has since declined, China still holds foreign reserves totaling as much as around $3 trillion, accounting for more than 30% of the global total (Figure 2).
This was not a phenomenon limited to China. Other countries such as EMEs in East Asia and oil exporting countries also accumulated massive foreign reserves in the 2000s. They all share the primary reason behind this behavior; again, EMEs feared the risk of experiencing financial instability that can arise from volatile swings in international capital flows after financial liberalization. Facing the irreversible trend of globalization, they reached the conclusion that they should build up foreign reserves and insure themselves against a financial crisis and create buffers against shocks coming from foreign markets.
What does the steep rise in the amount of foreign reserves held by EMEs mean to the world economy?
Simply, it means an increase in the amount of liquidity, or money flow, in the global markets. In terms of the accounting of a central bank, holding foreign reserves means the country of concern can issue currency with the reserves as the underlying assets. As a result, as the amount of foreign reserves held by countries grows, so will global money flow in the global markets. However, a rapid increase in global money can cause a financial bubble and therefore financial instability.
In summary, as long as financial globalization continues, individual EMEs will seek to hold more foreign reserves to create buffers against financial instability that can happen due to globalization. Thus, the attempt to secure crisis insurance itself sows more seeds of financial instability by increasing the amount of global money. It is ironic that building up foreign reserves as a crisis insurance creates a situation for which further insurance would be needed.
In the 2000s, a huge inflow of money played a role in exacerbating the asset bubbles in the U.S. and Europe. Once the global financial crisis broke out with the collapse of Lehman Brothers in 2008, most developed countries implemented massive monetary easing and the flow of money changed its course and moved toward EMEs in pursuit of higher yields, creating investment booms and currency appreciation in those economies in the first half of the 2010s.
Taking advantage of low interest rates in the U.S. and appreciation of their domestic currencies, many firms in EMEs raised funds in the dollar and actively made investments. As long as the values of the currencies remained strong, it was a low-risk investment. Indeed, as of the end of 2017, the dollar-denominated debt (excluding bank loans) of the EMEs totaled $3.6 trillion, up about 80% compared with the level at the end of 2010. Investment boomed and economic performance strengthened in many EMEs. At the same time, the prices of natural resources and commodities rose, bringing more wealth to resource-exporting countries such as Indonesia, Brazil and Russia.
However, after the U.S. Federal Reserve Board (FRB) started scaling back monetary easing in 2014 and began to gradually raise the policy interest rate in late 2015, all those favorable developments started to reverse course. The flow of money began to move back to developed countries, particularly the U.S.
The favorable economic environment for the firms in EMEs took a turn for the worse due to the monetary tightening in the United States. U.S. interest rates rose and the Trump administration's fiscal expansionary policy measures put the U.S. dollar on an appreciation trend, which meant that EME currencies started to depreciate. As a result, the repayment value of dollar-denominated debt swelled in terms of the domestic currency for EME firms, straining the balance sheets and negatively affecting financial markets.
As the risks faced by EMEs increased since 2016, a massive amount of money flew out of EMEs. Along with it, EME currencies depreciated, trapping EME firms in a vicious cycle of currency depreciation leading to a further rise in the debt burden in domestic currency terms.
Indeed, many EMEs saddled with vast amounts of dollar-denominated debt have experienced currency depreciation and falling stock market prices, including Turkey (with the debt to GDP ratio as of December 2017 at 23%), Argentina (18%), Indonesia (16%), Russia (13%), South Africa (11%) and Brazil (8%).
As described above, EMEs are vulnerable to policy shocks emanating from the United States, the economic superpower. Professor Hélène Rey of the London Business School argues that in the current globalized world, non-major economies cannot maintain monetary policy independence because the "global financial cycle" has a significant impact on their economic policies and conditions. Therefore, she argues, the non-major economies face a choice between two options—either to close their domestic financial markets through capital controls and maintain monetary independence, or to keep their financial markets open at the expense of policy independence.
In the meantime, the challenging environment will continue for EMEs. The U.S. FRB indicates that it will continue monetary tightening until the end of 2019. In addition, the U.S. budget deficit is expected to grow due to the active government spending and tax cuts implemented by the Trump administration. As a result, the dollar is likely to remain on an appreciation trend, which means EMEs' debt burden will grow. The dollar appreciation would also weaken U.S. exports, and therefore, the U.S. trade and current account balances might deteriorate; in addition to the U.S.-China trade war which will only exacerbate the situation. Furthermore, the expected weakening of the U.S. economic conditions will spill over to other countries, including EMEs. Recent declines in the prices of natural resources and commodities will also negatively contribute to resource-exporting countries.
What should we have in mind in this kind of situation?,
First of all, it is very important to accurately understand where the risk exists. The recent volatility of U.S. stock markets tends to direct our attention to the economic trend of the United States and makes us concerned that another global financial crisis may be caused by the United States. While it is true that the United States may soon enter a recessionary phase and that the housing market may slow down, the U.S. financial system is not as vulnerable as it was before the outbreak of the last global financial crisis. It is unlikely that another subprime problem would arise. Since the last financial crisis, financial regulation has been tightened. For example, it is no longer possible for mortgage applicants to receive loans without background checks. Nor is it likely that asset- (i.e., mortgage-) backed derivatives will flood the market and suddenly turn into toxic assets. Hence, financial risk in the U.S. is small.
Most importantly, the U.S. economy is still robust. As of November 2018, the unemployment rate stood at 3.7%, the lowest level since 1969. The wage increase still remains at a high level while inflation is not very high (with the rate of 2.2% as of November 2018). The U.S. economy is more robust than the euro-area economy or the Japanese economy. Thus, the outbreak of a financial crisis starting with the United States as the epicenter is quite unlikely.
Given the high price-earnings (PE) ratios, U.S. stock markets will continue to experience market corrections and the economy is likely to enter a mild recession. However, it is unlikely for the U.S. situation to have a global impact.
In the end, if there is going to be any financial instability, it will be caused somewhere in the emerging market economies. As has happened in the past, a rise in the U.S. interest rates and appreciation of the dollar could impact emerging market economies significantly. In some emerging market countries, such as Turkey and Brazil, the amount of foreign reserves is not very high.
The good news this time, however, is that few major EMEs have their currencies pegged to the U.S. dollar, unlike many EMEs did in the 1980s and 1990s. Argentina, which recently received an emergency loan from the IMF, had not adopted a fixed exchange rate arrangement before its latest crisis. In light of this, while capital flight from EMEs might occur, the possibility of those countries experiencing a sudden, discrete crisis or speculative attacks, both of which are typical for countries with fixed exchange arrangements, is quite low. Instead, a stagnation could occur in emerging market economies relatively slowly and stay there for a long, lingering period, as was the case with Brazil in recent years.
Another risk that we need to be aware of is that prolonged economic stagnation could lead to a rise of populism. Populist leaders could pursue nationalism on the diplomatic front and protectionism on the trade front. Both crude nationalism and protectionism could aggravate financial instability.
Over the long term, the current international monetary system that is predominantly dependent on the U.S. dollar needs to be changed. Instead, developing a multi-currency international monetary system collectively based on the dollar, the euro and the Chinese yuan would be ideal.
As long as international finance remains overly dependent on the U.S. dollar, countries around the world will continue to be susceptible to the global financial cycle essentially defined by U.S. monetary policy. Under a multi-currency system, instead, the countries that issue major currencies could check each other's fiscal and economic conditions, collectively imposing multilateral disciplines. Such a system may also prevent a particular country from enjoying privileges as the issuer of the key currency as the United States does now.
In order to create such a system, the euro area needs to ensure stability and credibility and solve problems like the latest budget problem with Italy. Meanwhile, the Chinese yuan cannot establish its position as a major international currency to the same extent as the dollar, the euro, and even the Japanese yen in its current circumstances. In order for the currency to become a major currency, China needs to further open its financial markets. That is clear from Japan's experience of failure with the yen in that respect.
Again, we need to remind ourselves that the next financial instability, if it happens, could start in emerging market economies. To be prepared for that, we must improve international cooperation and communication through international organizations and initiatives such as the G20 while we stem the spread of protectionism and nationalism and strengthen the existent mechanisms that provide relief to crisis-hit countries.