Is another financial crisis looming?

Excessive leverage has been the single most important cause of economic and financial instability in the world. And we seem to be right in the midst of the problem once again, after barely having been able to shrug off the 2008 impact.

Be it the developed world or the developing ones, debt binges at various points of time have caused stress and vulnerabilities. Right from the Third World debt problem of the early 1980s to the Asian economic crisis of the late 1990s (along with individual episodes in Mexico, Russia, Brazil, and Argentina) and the global economic meltdown in the later part of the 2000s, excessive leverage was the problem.

If it is the imprudence of the governments that led to sovereign failures, the most recent being Greece, reckless borrowing by corporates created the junk bond crisis that took quite some time to clear. Individuals too had their time on the debt scene, with the subprime crisis in the US and credit card excesses in Korea. Trillions of dollars of national wealth were eroded each time countries were faced with the outcome of the overhang of debt.

This time, the warning bells are for emerging markets where non-financial firms seem to have overstretched themselves. During the period 2004-14, corporate debt in emerging markets grew from $4 trillion to over $14 trillion. China, Turkey, Chile, Brazil, India and Peru were countries where corporate debt/GDP ratio moved up anywhere between 15 and 30 percentage points during the decade.

Excesses in corporate leverage could impact the domestic economy. Recent developments in corporate debt of emerging markets firms, discussed by IMF in a recent report, could prove worrisome for policymakers and regulators. Leverage has risen in vulnerable and cyclical sectors such as construction, mining and oil (leverage on construction is steepest in China). Major inducements for raising debt are not increased profitability or productivity, but easy availability of money and lower interest rates. That made emerging market corporates even negotiate for longer maturities.

Corporates also seem to have used easy debt for buyback of shares to consolidate their control and thwart competition. For instance between pre-crisis (2004-2007) and post-crisis (2010-13) years, key performance indicators for emerging market corporates such as profitability, asset quality, and solvency declined. This normally should have made corporates become more prudent, but in reality more debt was acquired even for projects with lower profit potential.

Accommodative monetary policies in the form of quantitative easing and near zero interest rates in a large part of the developed world for nearly a decade were the major incentives for emerging market corporates building up debt. The Global Financial Stability Report (October 2015) noted, “As advanced economies normalise monetary policy, emerging markets should prepare for an increase in corporate failures.”

And that is only for starters. More problems are piling up for emerging markets. In 2010, stock markets globally lost $10 trillion worth of value. FTSE emerging index fell over 21 per cent. Brazilian stock market Bovespa saw a steep erosion in market capitalisation from about $1.5 trillion in 2011 to about $461 billion now, placing it below that of Mexico’s market cap of $467 billion. Global investors have taken away $40 billion (19 billion from stocks, 21 billion from bonds) from emerging market stocks and bonds during the September 2015 quarter, a level similar to 2008. Even a 250 billion yuan infusion could not prop up the falling stock market in China.

Emerging markets are facing intense pressures from slower growth, rising debt burden, capital outflows and declining prices for commodity exports. Frequent bouts of debt leading to financial stress and crisis put the global policy framework into question. The IMF introduced the Special Data Dissemination Standard (SDDS) in March 1996, which has gone through as many as eight reviews, the latest in 2012. SDDS is built on the principles of data coverage, periodicity and timeliness, access by the public, integrity and quality and covers key variables in real, fiscal, financial and external sectors.

Countries undergo periodic financial sector assessment programmes. Financial Stability Boards were created to make periodic studies. A number of reports such as Global Financial Stability Report (IMF) and the Global Financial Development Report (World Bank) bring out empirical research and perspectives on a wide range of current developments with regular frequency.

Serious gaps, however, still exist in appreciation and understanding of aspects of growth and stability. This is despite so much research and dissemination being available in the public domain, apart from the power of various instruments and interventions that rest with the government and the central banks. The world has not yet finished with the outcome of splurging by sovereigns in the euro region and now a fresh crisis could hit the emerging market corporates.

India, fortunately, is relatively positioned on a stronger pitch as of now. Its currency lost only about 5 per cent against the US this year, domestic economic growth remains buoyant, foreign direct investment is surging and corporate profits growth is expected to be in the range of 12 per cent, against the current Asian average of 3 per cent.

Corporate debt during the last decade grew by about 15 percentage points (as a per cent of GDP) as against the emerging markets average of 26 per cent. India should harness these positives to avert repercussions of stress in global and emerging markets. Leverage should lead to higher levels of investment to make growth strong and sustainable. But when it is splurged on short-term pursuits the outcome could be quite scary, as it has turned out in the past.

The writer was the chief economist of Indian Banks Association. The views are personal

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