Recently, media outlets have been abuzz with speculation about an impending recession in Europe and the US. While a global recession is not good news, cyclical variation – the expected ups and downs brought on by regular or recurring causes – must be distinguished from a financial crisis. In this blog, I review some of the more recent financial crises and draw conclusions that can help us understand the nature of the current situation. Whether we will face another Global Financial Crisis as in 2008 and 2009 is not a given; however, given the severe impact of a financial crisis on global living standards, we should create awareness about the role of financial institutions in such disasters.
It is difficult to predict what might trigger a global financial crisis. Crises occur when the underlying economic vulnerabilities of a given system collide with a triggering event that overwhelms the entire system. These events can be difficult to predict – they often entail notoriously unreliable things such as human agency and behaviour. Thus, it is easier to focus on the vulnerability of our economic systems. In my book, I explore the interplay of three types of vulnerabilities that may help us predict financial crises: fundamental, policy-induced and institutional vulnerabilities, the latter of which are essential to predicting financial crises.
There are many types of financial crises but they share some characteristic similarities, foremost a collapse of the local exchange rate. Most commonly, crises are either related to events such as defaults or bank runs, or can be defined in terms of currency movements or with respect to inflation rates. These events tend to be interconnected and rarely are contained.
Certain indicators of financial crises can be used to enhance early warning systems about the health of the economy. At the moment, these systems tend to focus on external events, in particular on capital account crises - macroeconomic imbalances and so on. However, other factors are just as important: To generate some understanding of these indicators, I will review the Global Crisis of the 1980s, the Asian Financial Crisis of the 1990s, and the Great Financial Crisis of 2008. In addition, there will be a focus on crises related to transitions from state-planning based economy to a market-oriented economy, which have often led to a loss in GDP and to severe currency distortions.
The Global Crisis of the 1980s was preceded by a boom in commodity prices in the 1970s – which helped commodity exporting regions, in particular Latin America – to generate enormous profits at a time when global growth was flourishing. Relatively high rates of inflation in economically developed countries led to low real interest rates sparking capital flows towards the emerging world. In addition, investors extrapolated the state of low default rates in Latin America indefinitely into the future, assuming that such patterns would continue uninterrupted. However, the build-up of loans and liabilities did not end well, as increasingly higher interest rates in the West as well as a collapse in commodity prices led to defaults ranging from Mexico in 1982 to, subsequently, Argentina, Brazil and many other developing countries. These incidents coincided with a collapse in global demand, triggering a vicious downward spiral.
In the 1990s, capital flows began returning to Latin America; this time via publicly issued bonds instead of bank loans which led to a false perception of security among investors, as bonds were considered more difficult to renegotiate than loans. Moreover, a wave of democratisation in Latin America further appealed to Western investors. Again, as the tide turned, Mexican peso value collapsed in 1994, Argentina, Brazil and Uruguay faced severe financial distress at the end of the 1990s and in the early 2000s.
In 1997, the emerging Asian economies, specifically Thailand, became affected by an exchange rate crisis. A notable exception was China, which was better able to withstand the Asian financial crisis due to fewer vulnerabilities, as the country had made adjustments earlier on in this decade. In addition, the Chinese banking system was more isolated and hence, more protected from global capital flight. The reasons for the Asian financial crisis range from financial-sector weaknesses regarding external-sector problems to contagion, among others. However, just before the crisis, there was no indication of an impending disaster. There was optimism, and even talk of an East Asian miracle. Leaps in public education as well as state-led, export-oriented industry policy contributed significantly to this success story. Export-led growth combined with the reluctant lifting of import restrictions served as a growth model. The overall economic prosperity also led to a higher degree of social inclusiveness in these countries, contributing to the perception of economic success.
The Asian financial crisis of 1997 was essentially a currency crisis caused, in part, by the fixed-exchange rate systems pursued by Asian countries. Contagion plays a big role in such crises as it spreads to countries that are financially interdependent with those that are already experiencing the crisis. This particular crisis started in Thailand, but quickly affected other Asian economies. As one of the lessons from the crisis, the supervisory framework governing some of the Asian economy’s financial sector needed to be significantly reviewed. When regulatory institutions are weak, hidden weaknesses in the balance sheets of the financial sector are only discovered when it is already too late. A boom of credit and the concentration of these funds in certain sectors such as real estate often resulted in over-investment and was followed by busts. Moreover, the debt burden of these countries needed to be monitored carefully, not only in terms of its level but also changes in the level and composition of the debt. External account imbalances certainly also play an important role in this respect. When a pegged currency (fixed exchange rate) leads to an overvaluation of the real exchange rate and the trade balance keeps deteriorating, a country is in significant trouble. Eventually, the exchange rate would have to be dropped, unless severe capital controls are introduced, leading to short-run excessive movement in exchange rates – or “overshooting” – in these times of stress. The latter certainly adds to an environment of political instability. Thus, keeping the situation in control and holding up the credibility of a country’s institutions is of utmost importance in these circumstances.
During the 1990s, the transitions of most communist countries in Eastern Europe and East Asia gathered pace. Policies such as price liberalisation, balanced fiscal and tight monetary policies as well as privatisation of government owned companies were the prevailing doctrine. What was not expected was the sharp decline in output that accompanied these changes. One country that did significantly better than others was China, whose growth trajectory since 1978 has been steeper than in any other country. The diverging paths between China and Russia are particularly striking. There are multiple reasons: for instance, China’s reform efforts focused on the agricultural sector, while Russia mostly ignored that sector during its transition. China’s township and village enterprises created opportunities for the rural population to engage in the initial phase of a more capitalist society. This step was virtually impossible for Russia, as Stalin had eliminated any rural reform ambitions already in the 1920s. Moreover, the Soviet Union disintegrated into various nation states at the end of its Communist period; China, on the other hand, remained unified.
From the early 2000s, the low interest rates in the US certainly led to subprime loans. In general, the decade can be characterised by increasing globalisation, in particular lower trade barriers, as well as the shift of former planned economies to the market, which entailed a support of global growth at the cost of building-up weaknesses. The most significant sign of the expansionary monetary policy pursued by the US during the 2000s was the negative real federal funds rate between 2001 and 2005, which pushed asset prices increasingly higher and became one reason for the global financial crisis in 2007. Alan Greenspan was the key policymaker supporting the aggressive cuts in the US policy rate, which triggered the easy-credit environment and part of the flows that resulted in the asset price bubbles. Excessive and unfounded optimism about ever-increasing house prices also contributed to the crisis. The peaking of real estate prices in 2006, in line with the higher interest rate environment after the bottom of the policy rate cycle had been reached in 2003, led to the burst of the bubble in 2007 and to the vicious spirals in 2008 and 2009.
While fundamentals – the primary financial data necessary to determine the health of the economy, (GDP, inflation rate, etc.) – play an important role in crisis predictions, policy-induced vulnerabilities and institutional fragilities need to be present as well to make for a severe financial crisis. With respect to the former, monetary policy is currently tight with increased interest rates to address the inflation problem, some may even say too restrictive given current global challenges, and hence, policy-induced vulnerabilities should be another factor to watch. But most important are institutional vulnerabilities. Douglas North described institutions as the “rules of the game,” and that these rules matter is beyond doubt.
It would be too much to discuss the variety of institutions globally, but what can be said is that in Europe, the war in Ukraine has put a severe pressure on the system. Institutions in emerging markets tend to be weaker and this can now be observed in Europe too. The Asian financial crisis has shown that smaller or larger emerging markets can cause serious trouble on a global scale. Put differently, I would like to encourage stakeholders to look beyond fundamental variables to assess whether the current global slowdown will end in a financial crisis or even in a variety of crises. Policy-induced and institutional variables must be monitored closely and should be part of any efforts to predict and prevent financial crises.
Sebastian Petric is a Senior Asset Allocation Strategist with LGT and worked previously as a capital market researcher with Raiffeisen Bank International and as a director in the investment office of UBS. He was educated at the Vienna University of Economics and Business, the London School of Economics, and the University of Oxford. Sebastian has a strong interest in asset pricing, development finance, inclusive globalisation and sustainable economic growth and recently published his book entitled: Predictability of Financial Crises: The Impact of Fundamental, Policy-induced and Institutional Vulnerabilities on China Compared to other Emerging Markets