There is a pronounced risk of a global recession during the next two years. But, if it comes, will it be a ‘normal’, V-shaped recession or a more L-shaped financial crisis, replaying what happened in 2008/09? We answered this question in a recent In Depth note drawing on our consultancy expertise, in this case highlighting a major ongoing project estimating financial vulnerabilities across 177 countries, captured in our proprietary Financial Vulnerability Indicator (FVI). Despite high levels of debt, globally, we found that the risk of a US-led global financial crisis is much lower now than it was back in 2007 — though certain individual economies might not be immune. And the next recession, even if it is not a global banking crisis, could lead to the endgame of sovereign default for some emerging economies too.
Financial vulnerability flows from financial imbalances. The most encompassing measure of financial imbalances is the ratio of debt (total debt, including government, household and corporate, excluding financial sector) to GDP. On that measure, global financial imbalances have increased dramatically both during and since the recession of 2008/09 and are now at their highest ever level, measured at PPP exchange rates — comfortably exceeding the high points previously achieved in the immediate aftermath of world wars.
High debt ratios alone do not necessarily imply that a financial crisis is imminent. We need to understand other factors too, such as: the growth rate of global debt; the term structure of that debt; its sectoral composition; the debt-servicing burden, which itself depends on the prevailing yield environment, and many others. These factors are all considered and combined in our FVI, which assesses the risk of four types of financial crisis in each country in the year ahead.
When the US sneezes the rest of the world catches a cold. That metaphor generally holds both for the US economy and the US financial system, given their respective size and importance in the world. And the epicentre of the global recession of 2008/09 was the US economy and its banking sector.
Until around the turn of this year, Fathom’s view was that a ratcheting up of US interest rates on the back of overheating and rising inflationary pressure would tip the US economy into recession again in 2020, dragging down the global economy with it. But with US inflation still sluggish (despite a strong labour market) and the Fed now showing a much more dovish face than last year, this is no longer our central scenario; but it is still the principal risk in our global outlook. The bad news is that a US-led global recession in 2020 is still a possibility; the question is whether that would lead to a 2008-style global financial crisis. The answer: a qualified “no”.
Contagion is one of the key drivers of financial crisis and is considered by the FVI, which takes into account within-country contagion (i.e. it recognises spillovers between crisis types — for example if a country experiences a banking crisis, the probability of it experiencing a currency crisis or sovereign crisis goes up) and across-country contagion (i.e. the chances of a banking crisis rise if the number of other countries experiencing a banking crisis is high). The FVI suggests that for most countries, the risk of experiencing a financial crisis, and contagion being a driver, is lower than it was in 2007.
Further analysis and simulations showed that the risk of a banking crisis had reduced between 2007 and 2019 in many systemically important countries — which are highly integrated into global capital markets — such as the US, UK, Germany, and remained low in emerging economies including Brazil, Russia, India and South Africa. Risks had increased, however, in China, Greece and Italy.
The de-risking of the systemically important countries like the US in terms of their vulnerability to a banking crisis has been achieved in part by shuffling the bad assets that would otherwise live in the private banks to the government or the central bank. The increase in central bank assets is illustrated above. On the sovereign risk side, the fiscal position of many countries has deteriorated, reflected by the budget balance and debt level of the median country in Fathom’s FVI.
The large reserve-currency nations like the US are probably immune from a sovereign debt crisis in the medium term at least. This is not to say that their debt-servicing costs cannot increase, nor that some fiscal tightening will not ultimately be necessary — but the risk of a sovereign default by the US, for example, is thankfully remote. The same is not true for smaller economies, especially emerging or less-developed economies. Sovereign crisis is often the endgame: Fathom’s FVI reveals a hierarchy of crisis types, starting with banking crisis, flowing into currency and sudden-stop crises, and ending with sovereign crisis. The next downturn could be the trigger for this endgame for some of these countries. Venezuela, Argentina, Zambia and Turkey were top of the pile in terms of sovereign risk.
The bottom line is that the US, the country that could tip the global economy into a recession, is less likely to experience a banking crisis now than it was in 2007. It may be smaller than China in PPP terms, and the risk of a banking crisis in China has increased. But the US has by far the largest and most globally integrated financial market — accounting for 35% of global market capitalisation and more than half of the MSCI All Country World Index. China’s financial system is smaller and less integrated into the global financial system than the US, which suggests that the potential negative financial spillovers from China are likely to be less than those from the US. China’s loose lending standards and doubling down on old growth methods are building up financial problems, but we do not expect the country to enter recession or experience a financial crisis within the next year or so.
For a global banking crisis to occur, we would need to see risk increase in the systemically important nations. That would be the corollary of another private credit cycle, which would last a few years and would be associated with a bull market in equities for that period. It might happen — but if it does, we will experience at least one more party first. Fathom will be monitoring these developments closely, through the lens of our FVI, so watch this space.
For more information on underlying FVIs please contact Fathom Consulting. The charts in this article have been created using Chartbook on Datastream. The Chartbook was initially created by Fathom Consulting in 2012 and is now a catalogue of approximately 9000 charts, covering over 170 countries, analysing up-to-date macro and financial data. Whether it is a particular topic, country or variable you are interested in charting, the Chartbook has everything you need. The Composite FVI, comprised of readings from all four underlying FVIs, is available for 176 countries in the Fathom Proprietary Indices section of Chartbook. To access Chartbook via Datastream search ‘cbook’.
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