Globalization comes in for opprobrium from both the left and the right. The attacks tend to focus on free trade in goods. Services - and financial services in particular - seem to be outside the global-bashers' ken. I am basically a free trade guy, but defending free trade is not the purpose of this article. Its purpose is to put cross-border lending into the perspective of the last 40 or so years of booms and busts. And in that perspective, I see good reasons why nations might want to restrict the inflow of certain kinds of capital-basically short-term debt that is likely to run in the event of a recession-and thereby to turn a normal recession into financial rout. I discussed some of these issues at seekingalpha.com last fall.
This is Part I of a three-part series. Part I explains how cross-border lending causes financial crises. Part II outlines the current state of cross-border lending. Part III evaluates the dangers that appear from the current state of cross-border lending.
I would argue that most of the financial crises of the last 40 years have become crises because of the influx of foreign capital during the boom period, then flight of foreign capital at the outset of the bust. These crises include:
much of Latin America in the 1980s (unable to repay the U.S. banks that lent to the sovereigns in the 1970s), the Mexican Tesobono crisis of 1994 (a run on the peso, bailed out by the U.S. government), the Asian Tiger crises of 1997 (runs on all the currencies and the failure or government bailout of almost all the large banks), the Russian ruble meltdown of 1998 (leading to the Russian repudiation of the old Ruble debts of the Soviet Union), the U.S., Spanish and Irish real estate crashes and consequent financial crises of 2007-2009 (funded in varying degrees by German, Swiss, U.K., Austrian and French banks, almost always through the local banking system or some other form of financial intermediary), the Icelandic bank meltdown of the same period (following a mass delusion that Icelanders were naturally excellent investment bankers), and the Greek sovereign defaults of 2010 et seq. (the lending German, French and other European banks that had the delusion that a nation in the Eurozone could not default were bailed out by the Eurozone sovereigns, as well as the IMF and ECB).
The Texas and New England massive bank failures of the 1980s were basically home grown, as was the Japanese lost decade of the 1990s-plus-some. They resulted mostly from banks trying to make money in a difficult business. There are other crises of the period, such as in Finland and Sweden, that I have insufficient knowledge about to include in this litany, one way or the other.
Are we going to see a similar cross-border-fueled financial crisis soon?
As investors, we want to know whether some part of the world is headed for a type of financial crisis similar to the ones I listed above, in which event pretty much anything we have invested there will sharply decline in value.
The problems with foreign money
The basic problem is that foreign money usually knows less about local conditions than local money does. Thus foreign money tends to overinvest in sectors that appear safest, which usually includes sovereign debt, real estate and banking. Why the foreign money is blind to the long and inglorious history of sovereign defaults, the origin of a majority of financial meltdowns in real estate lending, and the inherent instability of banks I do not know. But that's the way it is. Those avenues seem like the safest when reaching for yield. And maybe they are-maybe other types of cross-border investments would be even worse. See my 2017 book, Instability: Booms, Busts, the Fragility of Banks, and What To Do about It for details of some of some of the crises and an extended discussion of why banks are naturally fragile.
Another general fact about foreign money is that it does like to take currency risk by lending in the local currency. It therefore takes obligations only in a global currency such as dollars or euros. Typically, the local borrowers (often banks) turn that hard currency into local currency in order to fund loans or projects. Thus, when the worm turns and the loans from foreigners are called, the call is for dollars or euros that the borrower does not have. That forces the borrower to sell local currency, thereby driving down the value of the local currency and vastly increasing the total cost of the financing. The plunge in the value of the local currency also causes havoc in the local economy, making the whole experience (that began so hopefully with the celebration that foreigners wanted to lend us money) worse and worse.
The foreign money also often is late to the party. It comes into a jurisdiction only after the outward success of the local economy, and it basically pumps up the chosen sectors, thereby making them ripe for a bust. The foreign money frequently is the critical "marginal funding source" that turns prosperity into unsustainable asset price boom. And to make matters worse for the local jurisdiction, much of the foreign money recognizes the risk of a bust and, therefore, invests in short-term debt, thus hoping to escape losses by getting out the door first when the panic begins. And sometimes it does so successfully, thereby exacerbating the local debacle. That was the case in the Asian Tigers in 1997 and in Russia in 1998.
Here is how the BIS described the problem in its Annual Report published in June 2017:
"International credit has been a key source of procyclicality. Such flows tend to procyclical with respect to the recipient economy's business and financial cycles. Cross-border bank loans and portfolio debt flows are both positively correlated with domestic business and credit cycles. FDI flows tend to be acyclical, while portfolio equity flows into advanced economies even appear to be slightly countercyclical.
"The close link between cross-border and domestic credit may add to financial stability risks. Cross-border credit tends to amplify domestic credit booms, as it acts as the marginal funding source: the cross-border component typically outgrows its domestic counterpart during financial booms, especially those that precede serious financial strains." (at p. 111)
That debt flows are dangerous to emerging economies but equity flows usually are not is illustrated by the following Graph VI.6 from the BIS annual report. But one should note also that cross-border credit can be dangerous to advanced economies for the same reasons.
One doesn't need to understand the BIS methodology to get the point.
ABCP in 2007-a global example
Foreign money can be dangerous to advanced economies as well as to EMEs (emerging market economies, which definition still commonly includes China). The phenomenon appeared in a convoluted format in the run on the ABCP (asset-backed commercial paper) market beginning in August 2007 that was a feature of the kickoff of the GFC. The ABCP run represented a new twist on the old paradigm in that the SIVs that issued the paper were nominally domiciled in Ireland, were backed by German Landesbanks, but actually funded the U.S real estate market (by buying the infamous CDOs) and sold their ABCP (the principal funding source of the SIVs) mostly to U.S. institutions. The Landesbanks were the foreign patsies that knew nothing about their U.S. investments and ended up footing the bill, along with their owners, the German states. The following graph (Figure 7) illustrates the ABCP "mountain":
ABCP basically was a fraud blessed by Fed and the Bundesbank, promoted by a couple of investment banks-notably Barclays-and the mountain shrank drastically when the world realized that the structure was unworkable without the bank guarantees that regulators had pretended were not guarantees. As has happened so often in international finance, structures designed to make loans appear safer than they actually were fell apart when the risks inherent in the loans began to cause losses. Policy makers everywhere should study the toxicology. Investors should do so as well because dangers may lurk in obscure instruments-usually instruments that are believed to be innovative.
The role of cross-border finance in the GFC
As investors, we want to know whether we are about to see a replay of one of the financial crises that I listed above. But to analyze the present, we need to know a little more about the past: For example, how did the cross-border finance enable the financial crisis of 2007-2009? It wasn't only the convoluted SIVs that provided cross-border funding. There were several sources. Even a decade later, this is a little-understood part of the story GFC story, but it is an important one that requires some detail to see how important it was. Therefore I will present some graphs as summaries of the mechanisms and magnitudes at work.
Overall, the U.S. was the recipient of a tsunami of foreign investment from 2000 to 2007, as illustrated by the following graph from a recent McKinsey report:
It is not surprising that such an inflow of money tended to go into a boom in real estate development and asset prices that were not sustainable. That is what foreign money tends to do, even in an economy as large as America's. (Foreign money that bought Treasury securities also financed the wars in Iraq and Afghanistan. Some may think those were more productive uses; others may not.)
European banks played a key role
The level of cross-border investments by French, German, Swiss and UK banks in the boom period of the 2000s is illustrated by the following graph that shows growth of dollar-denominated assets from a trillion dollars in 1999 to over four trillion by early 2007. It was an historic boom in cross-border lending and was followed by a period of rapid retrenchment.
(Graph prepared by the author from BIS Table 9D data)
The overall magnitude of Eurozone banks' cross-border lending was enormous, as the following graph illustrates. It grew from one trillion dollars (not all of it denominated in dollars) in 1999 to the peak of ten trillion in 2007. A large part of that growth was due to large Eurozone banks' confidence in lending to other Eurozone banks, regardless of their domicile.
Where all that cross-border finance was going is illustrated by the deteriorating current accounts of Ireland and Spain, whose banks were borrowing from other Eurozone banks to fund their growing real estate portfolios (which of course were about to collapse because the influx of foreign money led to overbuilding and inflated prices).
How did the European banks finance their investments in the U.S., Spain and Ireland? A look at the funding sources of the large French banks tells the basic story: They borrowed in the credit markets, including from U.S. money market funds, and they bulked up assets and liabilities without commensurate increases in equity capital. The four large French banks' funding sources graphs all look about the same. To illustrate the syndrome, I will show only one of them - Societe Generale (OTCPK:SCGLY):
Large banks in other jurisdictions funded their cross-border lending in much the same ways as the French banks. It is a common syndrome in creating boom/bust scenarios.
What to look for in Parts II and III
Are there now nations that have borrowed cross-border to fund asset booms? Are there now banks that have used open market funding to fund cross-border lending that is causing asset booms? Parts II and III will explore those issues.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.