Now that the Federal Reserve has started the process of normalizing interest rates, the global economy is soon likely to learn that Fed quantitative easing was anything but a free lunch. Since while over the past few years quantitative easing might have provided much needed temporary support to a struggling US economy, it also has contributed importantly to an extraordinary number of financial vulnerabilities around the globe. Sadly, past experience would suggest that a number of these are likely to be triggered in the year ahead by a tightening in the interest rate cycle.
There would seem to be at least three major financial market vulnerabilities in the global economy that can leave little room for economic policy complacency. First, and among the more immediate of these vulnerabilities, is a likely deepening in the economic crisis in major emerging market economies like Brazil, Indonesia, Russia, and South Africa. Years of ultra-low US interest rates helped fuel a super-sized international commodity boom and precipitated a massive flow of capital into the emerging market economies, which now account for more than a third of the global economy. Indeed, according to the Bank for International Settlements, emerging market corporates have borrowed as much as US$3¼ trillion over the past five years in US dollar-denominated debt.
Now that the international commodity cycle has turned to bust and now that capital flows have started returning to the United States in search of a safer haven, the emerging market country currencies are now practically in free fall. This would suggest that it has to be only a matter of time before we have a wave of emerging market corporate defaults that could shake the international financial system from which they have borrowed so lavishly.
A second major financial market vulnerability can be traced to the growing divergence in monetary policies between the world’s major economies. This contributed to more than a 10 percent effective US dollar appreciation over the past year. A clear and present danger for the global economy is that this trend towards a stronger US dollar and a return of capital to the United States will be exacerbated by a further divergence in relative monetary policy stances between the Federal Reserve on the one hand and the European Central Bank and the Bank of Japan on the other.
A further strengthening of the US dollar is likely to highly complicate China’s efforts to rebalance its distorted economy from one which relies excessively on investment and export-led growth to one that has domestic consumption play a larger role. This is especially the case since it is occurring at a time that China’s economy is already slowing and that there has been more than US$800 billion in Chinese capital outflows over the past year. It is also occurring at a time that the Chinese economy is characterized by massive excessive manufacturing capacity as well as by over-investment in its property sector.
The Chinese authorities have mainly responded to the weakening in China’s economy by easing monetary policy and by moving away from the dollar towards a basket of currencies in setting its exchange rate. There is the very real danger that this policy mix might hasten the already very rapid pace of Chinese capital outflows and speed up the pace of Chinese currency depreciation. That in turn would raise the risk of unsettling global financial markets. It would do so by inducing China’s Asian competitors to weaken their currencies and by prompting the European Central Bank and Bank of Japan to further cheapen the Euro and Japanese yen through even more money printing.
A third financial market vulnerability, which is very much closer to home, is that we could soon get widespread default on Puerto Rico’s US$72 billion debt mountain. Such an event is bound to have a meaningful impact on the US municipal debt market. Like the emerging market economies, ultra-easy Federal Reserve policy made it all too easy for Puerto Rico to borrow in the US capital market despite its gross misallocation of those resources. This has put the island in a position where it now is simply not able to pay back its creditors. In the absence of a bankruptcy framework for the island, this is all too likely to lead to the messiest of debt restructurings in 2016 that could be unsettling to the financial markets.
It goes without saying that, in addition to the three likely sources of global financial market vulnerabilities in 2016 identified above, there very well could be other such vulnerabilities. These could include further political fragmentation in highly indebted European countries like Greece, Portugal, and Spain; a sterling crisis precipitated by the United Kingdom’s largest external current account deficit in the post-war period; or an oil supply disruption in a very troubled Middle East. Hopefully, none of these eventualities will materialize. However, they would be yet further reasons for global policymakers to be anything but complacent about the global economic outlook in the year immediately ahead.
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