By IMD Professor Arturo Bris
In the summer of 2008, the US financial sector suffered one of the most damaging events in its history. The volatile stock market, induced by the subprime market, led to the default of Lehman Brothers, and subsequently to a massive global crisis.
We are now in a post-crisis period. Yet, looking back to between 1945 and 2008, we see that the frequency of financial crises and recessions is quite high: on average, there is one crisis every 58 months (using data from the US National Bureau of Economic Research). In other words, statistically speaking we should expect the beginning of the next crisis in April 2015, which would end by March 2016. So are we in a post- or a pre-crisis period?
I do not want to be the bearer of ill tidings, but I think we should always wonder what the cause of the next crisis will be. There is no single episode of financial panic in the last 50 years that could not have been prevented. This time, let us look ahead, not react after the crisis.
The world economy is now more interconnected than ever. Financial markets are heavily regulated while capital markets are expanding in Asia, Africa and Latin America. The banking sector is going through a concentration process with fewer and fewer players left. Mexico, Indonesia, Nigeria and Turkey (the MINT countries) are coming into focus after Brazil, Russia, India, China and South Africa (the BRICS) have disappointed. Europe seems to be back in the game, with Germany leading the recovery of the continent. The US is still the world's most competitive economy,according to the IMD World Competitiveness Ranking. The process of deleveraging the balance sheets of governments and companies is under way. Interest rates and government bond yields are at historical lows and stock markets have recovered to pre-crisis levels.
So what is there to worry about? There are eight possible scenarios that could cause the next crisis, none more important or likely than the others. For some, prevention is straightforward. For others, I am not sure there is much we can do. Some of them represent imminent threats. A few are more long-term, less dramatic sources of instability.
Stock market bubble
Between June 2013 and June 2014, world stock markets returned 18 per cent on average. Of course, performance was uneven, not unlike a "normal" year: the market return was 30 per cent in India, and a meager 8 per cent in China. However, most companies that announced results during 2014 disappointed markets, and for most large corporations, stock markets have reacted negatively to annual earnings. The reason is that, driven by excess liquidity and a lack of alternative opportunities, a lot of money has flown in to equity markets. The Yale University economist and Nobel Prize winner Robert Shiller has shown that the gap between stock prices and corporate earnings is now larger than it was in the previous pre-crisis periods: 2000 and 2007. If markets were to return to their normal earning levels, the average stock market in the world should fall by about 30 per cent.
Chinese banking system
Shadow banking (lending by anything other than a bank or outside the control of financial regulators) now represents more than 100 per cent of GDP in the US, and about 70 per cent in China. This is more of a problem in China than in the US, for two reasons. First, in China the banking sector is protected from foreign competition — only local banks are allowed to operate independently in the country. As a result, without any threat in a huge market, the biggest banks in the world are now Chinese. They are truly too big to fail.
The second reason is that a big part of Chinese shadow lending goes to central government and provincial governments. Banking regulation in China is considered to be very stringent, but we know what happens when regulators become self-interested. Without a doubt, the next banking crisis will be triggered by a Chinese bank.
An energy crisis now would not be caused by the scarcity of energy sources — quite the opposite. The development of fracking techniques and growing supply of gas in the US have turned shale gas into a potent geopolitical weapon. If the US Congress were to allow energy exports, energy prices in the world would fall significantly. This would be great for companies, but would trigger geopolitical problems in Russia and West Asia. These countries rely on energy demand from western Europe and China, where energy costs are currently hurting competitiveness and where a cheaper alternative would be welcomed with open arms.
New real estate bubble
The conditions in 2005-07 that led to a real estate bubble are back: low interest rates, growing demand, and increasing real estate prices in some markets. With respect to the demand factor, in current market conditions, the only attractive investments for institutional investors are real estate and equities. As a result, prices are increasing.
The Bank for International Settlements has recently released data on real estate prices in several markets from 2013. Between the end of 2007 and the end of 2013, residential property prices increased by more than 80 per cent in Brazil, 60 per cent in China, and 15 per cent in Canada.
There are also fears of a bubble in other countries such as Switzerland and the United Arab Emirates. Like any other bubble, it will only become one once it bursts. What is different in 2014 is that now central banks have a great tool to prevent real estate bubbles: Basel III and its countercyclical capital buffer.
The norm for companies is now to be BBB-rated. In the US, there are only three firms that still are AAA-rated: Johnson & Johnson, Exxon Mobil and Microsoft. There were 61 in 1982. Since interest rates are low, companies see the benefits in debt financing. But this means that firms are also more sensitive to changes in interest rates. Typically a BBB rating is associated with a probability of default of about 4 per cent in five years. Therefore, we should expect that in the next five years, about 16 companies in the S&P500 index will go bankrupt. One of them could be the new Enron.
From Nigeria to Ukraine, and from Syria to Venezuela, the world risk map shows too many hot areas where geopolitical events could trigger a world crisis. Why should anyone care about Ukraine or Syria? Because financial markets tend to overreact to political events. And because, given the financial linkages among countries, negative sentiment in China will trigger a market collapse in the US and vice versa. Let us not forget the lessons of the Great War (we are now commemorating the 100-year anniversary): the butterfly effect can be deadly in politics.
Over the last few decades the world has become richer and more prosperous. While the percentage of the population in absolute poverty is today at its lowest level ever, the absolute number of poor people continues to grow. In this context income inequality is one of the social battles that we need to fight. But the problem with fighting income inequality is that the usual solutions (typically taxes) hinder the competitiveness of nations. This is one of the long-term crises that will require smart leadership to avoid inefficient solutions.
There is too much money out there. It is the result of quantitative easing policies that central banks have followed. The excess liquidity in the system is concentrated among financial and non-financial firms. Citigroup has more than $487 billion in cash; Apple about $150 billion. It is paradoxical that, in some cases, banks and firms are so rich that they could buy entire countries (if one takes into account the total GDP minus government debt). If the corporate sector were to unload such massive financial resources (as is their moral obligation) on to society, they would create hyperinflation and hence financial crisis. But otherwise we are in a situation in which central banks print money that they will have to take out of the system later. We know how quantitative easing works, but we do not know how to exit from it.
While we can already see these eight sources of a new coming crisis, the problem is that many obvious solutions that governments can implement would be detrimental to world competitiveness and could hinder local economies. More taxes, more regulation and more protectionism all create a more hostile environment to economic growth and competitiveness.
Politicians and corporate executives should now look to diversify, to seek varied geographical presence, to be flexible, resilient and to manage risk. They should cultivate and reward talent and improve their credibility in society. To boost their nations' competitiveness and their chances of inclusive economic success, leaders need to invest internationally and make acquisitions in order to make their countries attractive to foreign capital. In order to avert the next crisis and others after that, global leaders should be making employment, sustainability and social cohesion the top priorities of their nations.
Arturo Bris is a professor of finance at IMD and directs the IMD World Competitiveness Center. He will present on the fundamentals of finance and on competitiveness at IMD's Orchestrating Winning Performance program in Singapore from November 17–22.