The Hidden Trigger for the Next Financial Crisis
Market crises are frighteningly regular.
Yet it’s surprising how few people see them coming.
That’s partly because the triggers for economic crises can come from the most unlikely places.
The Asian Financial Crisis began in 1997 with a Thai land developer defaulting on bonds.
The US subprime crisis in 2007 began with an unknown subsidiary of insurance company AIG in a dingy office in London.
In both cases, the trigger for the market crash was an unremarkable company turning over less than $100 million a year. Yet, though only a small part of a much wider problem, both brought the financial market to its knees.
These two crises happened 10 years apart. And it’s now been a decade since the last major crisis.
Which means the question of the next crisis isn’t a case of if but when and what.
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The early warning signs that we’re due for another crisis are flashing red.
There is roughly $10 trillion in US dollar-denominated loans swimming in emerging markets (EMs).
These loans need to be paid back in greenbacks. And with the Federal Reserve Bank raising rates, it means the interest payable on those loans is only going to rise.
What’s more, meeting these repayments is becoming more difficult. The majority of emerging-market currencies are weakening against the US dollar. In fact, all EM currencies are down on average 5% compared to the US dollar since the start of June.
Take Turkey as an example. Due to a mixture of local policy and too much debt, the Turkish lira has tumbled a whopping 21% against the US dollar.
The weakening lira makes Turkey’s $450 billion in US dollar-denominated debt harder to repay. Ever more lira is needed to pay off the loans, which are becoming more expensive as the Fed funds rate rises.
That puts Turkey precariously close to defaulting on its debt.
But is Turkey a likely trigger for a financial crisis? Probably not.
Don’t get me wrong; Turkey is facing the prospect of undergoing a localised market crash. President Recep Tayyip Erdogan regularly makes erratic, on-the-fly decisions that are out of step with Western markets. Inflation is high but the currency is weak. In addition, monetary policy is inconsistent, so unpredictable changes are causing the lira to fall further.
Erdogan has ordered the Central Bank of the Republic of Turkey to double its gold holdings this year. He’s also repatriated gold held in the US to a newly-built vault in the country’s capital, Ankara.
In my view, bringing home its gold enables Turkey to default on its US dollar-denominated debt obligations.
That’s a real possibility.
Still, no party benefits if Turkey is allowed to default on its debt. While 59% of Turkey’s long-term loans are in US dollars, 34% are in euros.
Germany is one of Turkey’s biggest lenders. Erdogan may be hell-bent on ending Turkey’s relationship with US dollar-denominated debt. But Germany has stepped in financially once before in 2012 to help the country sort out its finances.
All told, there’s roughly half-a-trillion dollars of debt in Turkey that is a massive risk to financial markets.
Some sort of bailout or postponement of repayments will have to be reached if Turkey decides it doesn’t want to cough up the coin to pay off the loans.
Venezuela’s economic death spiral
If we rule out Turkey, what does that leave as the likeliest trigger?
As you’ll know, Venezuela is in a death spiral right now.
The South American nation recently missed a deadline to repay a Chinese loan one that was given a two-year grace period in 2016.
Not only that, hyperinflation is ripping through the country, with the IMF predicting it will hit 13,000% this year. Even those with high-paying jobs and a decent savings account are finding that inflation has made the bolivar practically worthless.
Shortages of food and work have seen one million people flee to Colombia. In short, the economic crisis in Venezuela is now a humanitarian crisis.
Make no mistake; it’s a dire situation in Venezuela. But, once again, it’s too obvious as the trigger for a financial crisis.
And, what’s more, the country’s vast oil reserves means there will always be some financial backer willing to take a risk on the South American country.
What does that leave as the likeliest trigger?
China’s $16 trillion problem
For years, economist have been calling for the debt-fuelled Chinese economy to burst.
And yet China has worked out how to avoid the house of cards from collapsing.
But it hasn’t been easy.
To stop money leaving the country, China closed capital accounts in 2015. It was either that or de-pegging the yuan from the US dollar.
China sits atop the debt pile rankings, with a known $1 trillion US dollar-denominated debt obligation.
The Chinese government has managed to stay on top of its debts. The Chinese corporate sector not so much.
There’s some US$103 billion (aussie dollars) in Chinese corporate bonds due this year. That’s double the figure from 2017. And four times the size the Republic of Turkey to double its gold holdings within of the corporate bonds that were due in 2016.
Using corporate bonds for funding is a new lending tool for the Chinese private sector. It picked up in popularity in 2015.
As a way to get corporations out of China’s shadow banking system, corporate bonds were encouraged by the government as alternative loans.
Yet in its short life-cycle, defaults are rising steadily in the $16 trillion Chinese corporate bond market.
In 2017, 26 companies missed repayments, defaulting on $5.2 billion in debt.
So far in 2018, there have been 20 defaults, totalling $4 billion.
That means, only half-way through the year, there’s a good chance corporate bond defaults in China will double that of last year.
Yet the problem here isn’t so much the corporate bond defaults. They happen frequently enough.
What is unusual is that Chinese authorities are allowing companies to default on debt in a managed economy.
Much like that Thai developer that triggered the Asian Financial Crisis, you never know what the bonds are linked to until the debt isn’t paid, that is.
Remember, crises tend to build from small, ignored pockets of financial markets.
The next crisis is not likely to be any different.