Oliver Wyman Group has released a very interesting piece about the potential for a future financial crisis (thanks to the FT). They make the case that the next great financial crisis will occur around 2015 and will be the result of a massive bubble in commodity markets that results in widespread economic collapse and sovereign defaults.
I’ve described in recent reports how the financialization of the USA is helping to drive commodity prices higher (see here for more) and generate economic instability. This, combined with the other two major structural imbalances in the global economy (China’s flawed economic policy and the inherently flawed single currency system in Europe) are creating an environment that is ripe for disequilibrium and turmoil. The potential for bubbles is not only likely, but now appears like a near certainty.
Wyman describes how the bubble will form in commodities and ultimately collapse:
Based on favorable demographic trends and continued liberalization, the growth story for emerging markets was accepted by almost everyone. However, much of the economic activity in these markets was buoyed by cheap money being pumped into the system by Western central banks. Commodities prices had acted as a sponge to soak up the excess global money supply, and commodities-rich emerging economies such as Brazil and Russia were the main beneficiaries.
High commodities prices created strong incentives for these emerging economies to launch expensive development projects to dig more commodities out of the ground, creating a massive oversupply of commodities relative to the demand coming from the real economy. In the same way that over-valued property prices in the US had allowed people to go on debt-fueled spending sprees, the governments of commodities-rich economies started spending beyond their means. They fell into the familiar trap of borrowing from foreign investors to finance huge development projects justified by unrealistic valuations. Western banks built up large and concentrated loan exposures in these new and exciting growth markets.
The banking M&A market was turned on its head. Banks pursuing high growth strategies, particularly those focussed on lending to the booming commodities-rich economies, started to attract high market valuations and shareholder praise. In the second half of 2012 some of these banks made successful bids for some of the leading European players that had been cut down to a digestible size by the new anti-“too big to fail” regulations. The market was, once again, rewarding the riskiest strategies. Stakeholders and commentators began pressing risk-averse banks to mimic their bolder rivals.
The narrative driving the global commodities bubble assumed a continuation of the increasing demand from China, which had become the largest commodities importer in the world. Any rumors of a slowing Chinese economy sent tremors through global markets. Much now depended on continued demand growth in China and continued appreciation of commodities prices.”
The bubble bursts
Western central banks pumping cheap money into the financial system was seen by many as having the dual purposes of kick-starting Western economies and pressing China to appreciate its currency. Strict capital controls initially enabled the Chinese authorities to resist pressure on their currency. Yet the dramatic rises in commodities prices resulting from loose Western monetary policies eventually caused rampant inflation in China. China was forced to raise interest rates and appreciate its currency to bring inflation under control. The Western central banks had been granted their wish of an appreciating Chinese currency but with the unwanted side effect of a slowing Chinese economy and the reduction in global demand that came with it.
Once the Chinese economy began to slow, investors quickly realized that the demand for commodities was unsustainable. Combined with the massive oversupply that had built up during the boom, this led to a collapse of commodities prices. Having borrowed to finance expensive development projects, the commodities-rich countries in Latin America and Africa and some of the world’s leading mining companies were suddenly the focus of a new debt crisis. In the same way that the sub-prime crisis led to a plethora of half-completed real estate development projects in the US, Ireland and Spain, the commodities crisis of 2013 left many expensive commodity exploration projects unfinished.
Western banks and insurers did not escape the consequences of the commodities crisis. Some, such as the Spanish banks, had built up direct exposure by financing Latin American development projects. Others, such as US insurers, had amassed indirect exposures through investments in infrastructure funds and bank debt. Inflation pressure in the US and UK during the commodities boom had forced the Bank of England and Fed to push through a series of interest rate hikes that forced many Western debtors that had been holding on since the subprime crisis, to finally to default on their debts. With growth in both developed and emerging markets suppressed, the world once again fell into recession.
Of course, this scenario is already largely playing out in real-time. We are seeing investors drive up the prices of commodities as the global economy recovers and speculators look for the next big boom. Wyman elaborates:
However, it is already apparent that increasing commodities prices are also creating inflationary pressure in China, which is exacerbated by China holding its currency artificially low by effectively pegging it to the US dollar. This makes commodities look like an attractive hedge against inflation for Chinese investors. The loose monetary policy in developed markets is similarly making commodities look attractive for Western investors. This “commodities rush” is demonstrated in the right-hand chart below, which shows the asset allocations of European and Asian investors. A recent investor survey by Barclays also found that 76% of investors predicted an even bigger inflow into commodities in 2011.
Ultimately, they conclude that the imploding commodity bubble will lead to another financial crisis and sovereign defaults. Their “base case” scenario involves mostly European nations experiencing defaults. This looks not only likely, but probable. It is likely that the periphery of Europe will remain mired in recession for several years as austerity measures put downward pressure on their economies and the euro governments fail to enact a true fix to the flawed single currency system. Persistent weakness in Greece and Ireland will cause continual political turmoil and ultimately the scenes of Egypt would not be surprising throughout many parts of Europe as citizens demand real change. The euro would likely remain the primary European currency, however, several periphery nations would reconsider their involvement.
Now, where I disagree with the Wyman analysis is in their “worst case” scenario. Any regular reader knows that it is highly flawed analysis to conclude that the USA could potentially default on its obligations – all of which are denominated in the currency in which it alone has monopoly supply of. This simple point eludes even the brightest minds in economics today. A default of the USA is impossible. The only form of default could come through hyperinflation. Considering the deflationary collapse that would likely result during the Wyman “worst case” scenario I think it’s likely that we would once again see the USA become the global safehaven and the USD would not collapse, but surge as it did in 2008. Still, the economic impacts would be deeply negative for the entire global economy though a collapse of the USA is not on the table.
We continue to see increasing disequilibrium in the global economy. The flaws in the euro, China’s misguided economic policy and the endless financialization of the USA are the three primary factors contributing to what is unavoidable future calamity. It’s clear that none of these countries are willing to risk any sort of near-term pain that would be required to fix these structural imbalances so it’s not a stretch to assume that we will continue the boom/bust cycle that has become a trademark of the last 25 years of global economic growth. The commodity bubble will merely be a symptom of these imbalances.
Wyman concludes that this event could be several years away, however, I fear that this event could easily occur sooner than 2015. We remain in one continuing balance sheet recession with rippling waves that could cause these imbalances to resurface sooner than anyone believes. The resulting impacts will be broad and have the potential to forever change the way we approach future economic growth and the way governments intervene in markets. I would expect the Bernanke Fed to be in the middle of the ensuing storm. Such a crisis would likely result in wide ranging policy changes that will finally clear the imbalances of the credit crisis and create a foundation for truly sustainable economic prosperity.