'Perfect storm': Global financial system showing danger signs, says senior OECD economist - Brisbane Times

This time central banks are holding a particularly ferocious tiger by the tail. Global debt ratios have surged by a further 51 percentage points of GDP since the Lehman crisis, reaching a record 327 per cent (IIF data).

This is a new phenomenon in economic history and can be tracked to QE liquidity leakage from the West, which flooded East Asia, Latin America, and other emerging markets, with a huge push from China pursuing its own venture.

It has the makings of a perfect storm. At best, the implication is that yields on 10-year Treasuries - the world's benchmark price of money - will spike enough to send tremors through credit markets.

The edifice of inflated equity and asset markets is built on the premise that interest rates will remain pinned to the floor. The latest stability report by the US Treasury's Office of Financial Research warned that a 100 basis point rate rise would slash $US1.2 trillion of value from the Barclays US Aggregate Bond Index, with further losses once junk bonds, fixed-rate mortgages, and derivatives are included.

The global fall-out could be violent. Credit in dollars beyond US jurisdiction has risen fivefold in 15 years to over $US10 trillion. "This is a very big number. As soon as the world gets into trouble, a lot of people are going to have trouble servicing that dollar debt," said Professor White. Borrowers would suffer the double shock of a rising dollar, and rising rates.

The great disinflation of the last three decades was essentially a global "supply shock". The opening-up of China and the fall of the Berlin Wall added 800m workers to the traded economy, depressing wages and unleashing a tsunami of cheap goods. The "Amazon effect" of digital technology capped price rises. The demographics of the baby boom era played its part by boosting the global savings glut.

But there was another feature that is often neglected. Central banks intervened "asymmetrically" with each cycle, letting booms run but stepping in with stimulus to cushion busts. The BIS says one result was to keep insolvent "zombie" companies alive and block the creative destruction that leads to rising productivity.

"Everything could now go into reverse: the baby boomers are gone; China's working age population is falling; and zombie companies are going to be forced out of business at last as borrowing costs rise," said Prof White.

While higher inflation is needed in one sense to right the global ship - since it lifts nominal GDP faster, and whittles down debt - the danger is that the shock of higher rates will hit first.

Central banks are now caught in a "debt trap". They cannot hold rates near zero as inflation pressures build, but they cannot easily raise rates either because it risks blowing up the system. "It is frankly scary," said Prof White.

The authorities may not yet have reached the end of the road but this strategy is clearly pregnant with danger. Global finance has become so sensitive to monetary policy that central banks risk triggering a downturn long before they have built up the safety buffer of 400 to 500 basis points in interest rate cuts needed to fight recessions.

Source: 'Perfect storm': Global financial system showing danger signs, says senior OECD economist - Brisbane Times