Global Financial
System
Faces Growing Risks
By Nick Beams
12 April 2005
World
Socialist Web
The
International Monetary Funds semi-annual assessment of the state
of global financial markets is a rather contradictory document. It opens
by asserting that the resilience of the global financial system
has further improved in the last six months because of continued
improvement in the corporate, financial and household sectors
in many countries. However, it then devotes considerable space to outlining
the growing dangers posed by the increasing complexity of the entire
structure.
According to the
Global Financial Stability report issued last week, benign conditions,
including low interest rates and low credit risks, have helped strengthen
the financial system over the past six months. But they have also led
to the growth of complacency, always a source of danger. At present
risk premiums for inflation and credit risks leave little or no
margin for error in terms of financial asset valuations. A combination
of low risk premiums, complacency and untested elements of risk
management systems with complex financial instruments could ultimately
become hazardous to the financial markets.
Among the risks
it identifies are a continued widening of the US current account deficitnow
running at $665.9 billion per year, or 5.7 percent of gross domestic
product (GDP)continued rises in oil and other commodity prices,
feeding through to the general inflation rate and negative surprises
for corporate earnings and credit quality.
There is no visible
sign of a sustained decline in capital inflows into the US. But the
report warns that undue delays in addressing the present
global imbalances or serious doubts about the willingness
of central banks to continue to accumulate dollars and thereby fund
the US deficit could spark strong incentives for investors, private
and possibly even public, to reduce future dollar purchases or even
reduce their existing dollar holdings. This could trigger a further
significant decline in the dollar, sparking an increase in interest
rates, which would dampen economic demand in the US.
While it does not
mention it by name, the reports authors clearly had General Motors
in mind when they noted that another area of concern was the downgrading
of a major global company to subinvestment grade for reasons that may
not be linked to negative events in the global economy. Credit
rating agencies have threatened to reduce GM debt to junk bond
statusa move that could lead to financial turbulence as investment
funds are forced to sell off GM bonds and shares.
Over the past decade
and a half, the global financial market has seen the rapid growth of
complex financial instruments aimed at spreading risk and increasing
stability. But, in a period of market fluctuations, this process could
itself become a source of greater instability. These instruments, the
report notes, rely on quantitative mathematical models for value, assessments
and pricing. Therefore, there is a risk that models that are overly
similar in their construction could cause investors to rush to exit
at the same time, leading to market liquidity shortages.
This warning recalls
the crisis surrounding the hedge fund Long Term Capital Management (LTCM)
in September 1998 that led to a $3 billion bailout being organised through
the New York Federal Reserve. The threat to global financial stability
was not because LTCM was a rogue trader but the reverse.
Its investments, based on complex mathematical models, were very close
to those of other funds. Consequently, had LTCM gone down, others would
have followed.
The report notes
that while risk management has been strengthened and become more sophisticated
in recent years, the process still depends on financial institutions
having ready access to liquidity in times of market stresses.
Most risk management models dealing with the new complex instruments
such as derivatives have not yet been put to a live test.
So there is still doubt over whether the anticipated counterparties
will stand ready to absorb the additional market and credit risks from
those who would like to shed it.
In other words,
no matter how complex or sophisticated the model, the age-old problem
of the capitalist market remains. There is no guarantee that, in times
of trouble, sellers will be able to find a buyer. Therefore there is
the possibility that a relatively small problem can rapidly escalate
into a crisis. In the words of the report: The question of a liquidity
shortage as a potential amplifier for market price shocks is still one
of the major blind spots in our financial landscape.
One danger area
is the willingness of banks and other financial institutions to take
on increasing risk in the search for profits in the face of declining
opportunities. There are signs this is taking place. According to a
report in the Financial Times of April 6, the Bank of Japan (BOJ) has
warned that the countrys banks are increasing their investments
in high-risk instruments such as hedge funds and derivatives in an attempt
to boost profitability, even though they do not always understand the
risks involved.
The move to high-risk
areas reflects the difficulties confronting lenders in an environment
of falling demand for loans, low interest rates and surplus deposits.
According to the report, the BOJ found that while the banks investments
in high-risk assets were small compared with their total assets, the
structured nature of the products means losses can eliminate a proportionately
large amount of capital.
At the macro level,
the biggest potential source of instability is the weakness of the US
dollar and the mounting US payments deficit. But, as an editorial in
the Financial Times of April 3 noted, the worlds two other major
currenciesthe euro and the yenare not in much better shape.
The euro had nothing to recommend it other than not being the
dollar and the euro economy remained sluggish. As for the yen,
the editorial pointed out that investors are still waiting for
the Japanese economy to develop a self-sustaining economy and
that late last year Japan again flirted with recession.
The dangers to the
stability of the global capitalist economy contained in the ever-growing
indebtedness of the United States have been highlighted in an article
by former US Federal Reserve Board chairman Paul Volcker published in
the Washington Post at the weekend.
Volcker began by
noting that under the apparent placid surface of the world economy there
are disturbing trends: huge imbalances, disequilibria riskscall
them what you will. Altogether the circumstances seem to me as dangerous
and intractable as any as I can remember, and I can remember quite a
lot. What really concerns me is that there seems to be so little willingness
or capacity to do much about it.
The US economy was
being held together by a massive inflow of capitalrunning to more
than $2 billion every working daywhile the central banks have
been willing to increase their dollar holdings. The difficulty
is that this seemingly comfortable pattern cant go on indefinitely.
I dont know of any country that has managed to consume and invest
6 percent more than it produces. The United States is absorbing about
80 percent of the net flow of international capital. And at some point,
both central banks and private institutions will have their fill of
dollars.
Volcker claimed
that it was not difficult intellectually to set out the scenario for
a soft landing and economic growth. China and the other
East Asian economies had to encourage an exchange rate appreciation
against the US dollar; Japan and Europe had to aggressively pursue pro-growth
policies; and the United States had to increase its rate of savings.
But there was little possibility of any of these policies, much a less
a combination of them, being implemented. So I think we are skating
on increasingly thin ice.
On the present trajectory,
the deficits and imbalances will increase and at a certain point the
sense of confidence in capital markets that benignly supports the flow
of fund to the US could fade. Then a combination of events could disturb
markets leading to damaging volatility in both exchange markets
and interest rates.
Volcker did not
know whether the present situation would end with a bang or a whimper
but as things stand it is more likely than not that it will be
financial crises rather than policy foresight that will force the change.
There was a taste of what could develop in the stagflation of the 1970sa
volatile and depressed dollar, inflationary pressures, a sudden increase
in interest rates and a couple of big recessions.