Financial stability risks: old and new
Presentation by Mr Hyun Song Shin, Economic Adviser and Head of Research of the BIS, at the Brookings Institution, Washington DC, 4 December 2014.
Our understanding of crisis propagation is heavily influenced by the experience of the 2008 crisis. Watchwords are credit growth, leverage, maturity mismatch, complexity and "too big to fail". While these factors are still relevant, it does not follow that future bouts of financial disruption must follow the same mechanism as in the past. Yet accountability exercises tend to focus on known past weaknesses rather than asking where the new dangers are.
Two factors are crucial in understanding current risks to financial stability. The first is the shift in the pattern of financial intermediation from banks to capital markets, especially through the issuance of corporate bonds by emerging market firms.
The second is the role of the US dollar as the global unit of account in debt contracts whereby borrowers borrow in dollars and lenders lend in dollars irrespective of whether the borrower or lender is located in the United States. Total outstanding US dollar-denominated debt of non-banks located outside the United States now stands at more than $9 trillion, having grown from $6 trillion at the beginning of 2010. The largest increase has been in corporate bonds issued by emerging market firms responding to the surge in demand by yield-hungry fixed income investors.
What are the assets that back up these dollar debts? Property developers that finance domestic projects clearly face a currency mismatch. Oil producers have dollar cash flows, but the financialisation of oil means that oil has attributes of a collateral asset that backs up the dollar liabilities. As with any collateral asset, a fall in the price of oil is associated with tighter financial conditions, and any belated attempt to pay down dollar debts will serve to push the dollar higher, generating a vicious circle. Given the sheer size of dollar debts racked up by firms with effective currency mismatch, a stronger dollar constitutes a significant tightening of global financial conditions.
What are the consequences for the global economy? Much depends on the behaviour of investors. Long-term investors are meant to be a stabilising influence in financial markets, absorbing losses without insolvency. However, recent experience has shown that such investors have limited appetite for losses, frequently joining in any selling spree. To the extent that investors had ventured into domestic currency instruments, tightening of global conditions translates to higher long-term domestic interest rates also. What happens in financial markets does not always stay in financial markets; financial disruptions have real economic impact. If tighter financial conditions induce firms to curtail their investment spending, slower global growth is a direct consequence. Slower growth then undermines the narrative fed to investors about higher growth in emerging markets, resulting in further selling, thereby completing the feedback loop. Such a mechanism is different from that underpinning the 2008 crisis. Rather than insolvency and runs, the vicious circle works through slower growth.