These are great times to be paid in US-Dollars. The world’s unofficial reserve currency is on a roll, beating all comers as the US economy grew at an annualize rate of 4.2% in the second quarter of this year. To put that into perspective, that is almost double the eurozone second-quarter growth of 2.1%. The US economy is now enjoying the second-longest period of economic growth since the Second World War, and if sustained into the next summer it will beat the 10-year record between 1991 and the dot-com meltdown in March 2001.
To stop the economy overheating, the US Federal Reserve has been increasing interest rates, which is driving the greenback even higher. The latest increase came last week, when Chairman Jerome Powell announced that the Fed was lifting rates by 0.25% to a range between 2 and 2.25%. This is the third increase this year, and the eighth since it started tightening in 2015, a continuing reversal of the unprecedented monetary easing following the Great Financial Crisis (GFC) as the regulator pivots to a course of higher interest rates and Quantitative Tightening (QT). The GFC had led to concerted efforts to stimulate economies using monetary policy and bailing out of failing banks. The result was a sharp build-up of global debt.
With central banks lowering nominal and real interest rates to unprecedented levels and injecting liquidity through unconventional monetary policies, the world embarked on a borrowing spree, effectively driving up real estate and asset prices on financial markets. Public debt in advanced economies rose by more than 30 percentage points of GDP, with total global debt – including government, household, financial and non-financial corporates – reaching some 250 trillion US-Dollar by the second quarter of this year.
The United States government could soon pay more in interest on its debt than it spends on the military, health insurance for the poor or children’s programs. The run-up in borrowing costs is a one-two punch brought on by the need to finance a fast-growing budget deficit, worsened by tax cuts and steadily rising interest rates that will make the debt more expensive. With less money coming in and more going toward interest, political leaders will find it harder to address pressing needs like fixing crumbling roads and bridges or to make emergency moves like pulling the economy out of future recessions. Within a decade, more than 900 billion US-Dollar in interest payments will be due annually, easily outpacing spending on myriad other programs. Already the fastest-growing major government expense, the cost of interest is on track to hit 390 billion US-Dollar next year, nearly 50% more than in 2017, according to the Congressional Budget Office. In the past, government borrowing expanded during recessions and waned in recoveries. That countercyclical policy has been a part of the standard Keynesian toolbox to combat downturns since the Great Depression. The deficit is soaring now as the economy booms, meaning the stimulus is pro-cyclical. The risk is that the government would have less room to maneuver if the economy slowed.
Aside from wartime or a deep downturn like the 1930s or 2008-2009, this sort of aggressive fiscal stimulus is unprecedented in U.S. history. Pouring gasoline on an already hot economy has resulted in faster growth. Finding the required money to pay investors who hold government debt will crimp other parts of the government budget. In a decade, interest on the debt will most probably eat up 13% of government spending in the US, up from 6.6% in 2017.
Deficit hawks have warned for years that a day of reckoning is coming, exposing the United States to the kind of economic crisis that overtook profligate borrowers in the past like Greece or Argentina. But most experts including us say that isn’t likely because the dollar is the world’s reserve currency. As a result, the United States still has plenty of borrowing capacity left because the Fed can print money with by far fewer consequences than other central banks. And interest rates plunged over the last decade, even as the government turned to the market for trillions each year after the recession. That’s because Treasury bonds are still the favored part of international investors in any economic storm.
The assets of the world’s largest central banks – the US, UK, EU and Japan – have increased to 15.3 trillion US-Dollar, an unprecedented 38% of GDP, of which about two thirds comprise government bonds.
The large global debt build-up now threatens a new financial crisis. Higher interest rates and QT is leading to a growing vulnerability of emerging markets economies. Over 200 billion US-Dollar of dollar – denominated bonds and loans issued by emerging market governments and corporates will mature during 2018 and they will need to repay or refinance about 1.5 trillion US-Dollar in debt in 2019 and in 2020. Emerging and middle – income countries with high debt levels, large fiscal and current account deficits and US-Dollar denominated debt maturing over the near term will face rollover risk.
At the onset of the GFC of 2008, banks in the Middle East, especially the GCC, were not highly leveraged and did not have any direct linkage or exposures to the US sub-prime crisis. Financial instruments like mortgage backed securities and other instruments that became toxic assets, were absent from the markets. Ten years later, banks in the region of the GCC remain well-capitalized, and largely compliant with the latest BIS requirements. Similarly, the region’s financial markets were not directly exposed. The bottom line is that the lack of international integration of the financial markets in the region meant limited spill-over effects from developed markets. But under-developed domestic financial markets generate an imbalance in regional banks’ US-Dollar balance sheets. They rely heavily on less-stable funding such as short-term interbank deposits, wholesale sources, bonds and swaps. When the possible crisis hit, these sources of funding melt and melted in the past like ice in the desert.
Banks and financial institutions found their correspondent bank lines and facilities evaporated. Similarity, the market meltdown meant that sovereign wealth funds and central banks found their “liquid assets” turned illiquid; prices plummeted and there were no counterparts. These financial and liquidity shocks were compounded by the sharp decline in oil prices with the onset of the Great Recession. For GCC economies there was downward pressure on wages, income and on domestic asset prices, including real estate, which fell sharply. But the GCC banking sector was spared a full blown crisis. Policy responses included sustained government spending, lower interest rates – in tandem with the Fed – , an easing of liquidity through direct injections in the money market and access to new central bank facilities, reductions in reserve requirements and relaxation of prudential loan-to-deposit ratios. Kuwait, Saudi Arabia, the UAE and other countries in the wider Arab world introduced the first time in history of the Middle East deposit guarantees which helped stem capital outflows. In the aftermath, the GFC led to a strengthening of the regulatory framework and oversight in the GCC countries through the introduction of Basel III requirements, which improved risk management and operational efficiency, and the establishment of credit information bureaus to enhance credit risk assessment and management.
Room for improvement remains, corporate governance needs to be strengthened along with greater disclosure and transparency. Strong corporate governance is core to mitigating the microeconomic, internal risks of banking and financial crisis.
In our opinion the next financial crisis is likely to be triggered as central banks starting with the Fed ending QE and initiating QT. The large overhang of global debt, rising international interest rates with QT, a contraction of liquidity and credit growth, increase the risk of a recession in our opinion by end of 2019 to beginning of 2020. These risks are being compounded by Trumpian trade wars, which can derail the recovery of growth of international commerce and severely dampen investment. First warning signs are already there: trade volumes are already declining along with dampened business confidence and delays in investment decisions. The expectation of a downturn and recession can trigger a global financial crisis in advance of the downturn.
Three policy reforms in our opinion can help prepare the GCC countries in advance of the next financial crisis:
First, the GCC should build local currency financial markets. A major lesson from the GFC and from the Asian crisis is and was the danger of over reliance on foreign currency bank financing for cyclical sectors such as housing, real estate and long gestation infrastructure investment. Developing local currency financial markets which includes government debt to finance budget deficits and development projects along with housing finance and mortgage market will help the GCC for their future.
Second, the GCC should establish a modern and credible legal and regulatory financial infrastructure to support and attract foreign direct investments: the GCC should enhance to debt enforcement regimes by decriminalizing bounced cheques and building the capacity of the courts, they should develop insolvency frameworks to support out-of-court settlement and corporate restructuring to support the evolving start-up corporate and entrepreneur market. In addition they should introduce laws to facilitate mergers and acquisitions, as well as securitization to support the development of asset backed and mortgage-backed securities and other structured debt instruments.
Third, the GCC should develop a counter-cyclical fiscal policy tool box for economic stabilization. This requires reforming existing budget laws to allow for deficit financing, along with the institution of fiscal rules.