A new global credit crunch to come?

4 August 2018 by Michael Roberts

At the time of the general election in Turkey, I pointed out that Turkey was near the top of the pile for a debt and currency crisis. It was running a massive current account (trade and payments) deficit with other countries and its external debt (what it owes to other countries in credits) was over 50% of its annual output (GDP), the highest among major ‘emerging economies’, while it foreign exchange reserves to cover repayments and support the value of the currency, the Turkish lira, were just 12% of GDP. The country was now being run a self-aggrandising autocrat in (what we now call) “Trump-style”, and who was refusing to allow the main monetary authority, the Central Bank of Turkey, to impose higher interest rates in order to ‘curb’ inflation and attract ‘hot money’ from foreigners; or to implement any fiscal austerity, orthodox capitalist style.

The only escape valve was a collapse in the lira. And in the last few weeks, the currency has depreciated exponentially. And fear that Turkish banks and corporations will not be able to pay their debts and the economy will suffer a meltdown has driven up the cost of its bonds and insuring against default (CDS CDS
Credit Default Swaps
Credit Default Swaps are an insurance that a financial company may purchase to protect itself against non payments.

Turkey’s CDS spread and bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. spreads have risen nearly 350 basis points—the highest level seen since the peak of the Euro area debt crisis. Higher refinancing costs will put further strain on government budgets and corporate borrowers.

But Turkey is just the most extreme example of the growing debt crisis beginning to hit economies that depend on foreign capital flows and investment in order to grow (and that’s most). I have raised this prospect of an emerging economy debt crisis in previous posts, most recently with the fall of the Argentine peso. A strong dollar (the main currency of loans), rising interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
(with the Fed FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank : http://www.federalreserve.gov/
and now the Bank of England hiking policy rates) and higher oil prices for those that must import energy (eg Argentina, Turkey, Ukraine, South Africa etc): are the factors triggering this impending crisis – not seen since the Asian/EM crisis of 1998.

According to the IIF, the international research body of major multi-national banks, global debt (including financial sector debt) has reached $247trn, nearly 250% of world GDP GDP
Gross Domestic Product
Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another.
. That would mean world debt grew something like 13% in the three years ended 2017.

And as I have argued before, the locus of this impending debt crisis is not to be found in household debt (as it was in the global credit crunch in 2007 that led to the Great Recession) or in public sector debt (where governments have been applying stringent ‘austerity’ measures), but in corporate debt (the heart of capitalist accumulation).

The global financial crash of 2008-9, ten years ago, did not lead to a total collapse of capitalism, even though it triggered the worst slump in investment and production since the 1930s. The financial sector was bailed out by huge injections of credit and cash and the capitalist sector was supported by zero or even negative interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rate policy by the central banks and unprecedented levels of money ‘printing’, called quantitative easing. The result was not much of an expansion in investment or production. In the major capitalist economies, economic growth (real GDP growth) has averaged no more than 2% a year (slightly more in the US and less elsewhere). In the so-called emerging economies, average growth rates also fell back. But above all, debt in all sectors rose. The result was inflated financial asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). prices without the kind of “recovery” seen in previous ‘business cycles’.

Just a decade after the Great Recession, the average US non-financial business went from 3.4x leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. (debt to earnings) to 4.1x. They are now roughly 20% more leveraged than they were the last time all hell broke loose. While Trump boasts of 4% growth and the US corporate sector never having it so good, the level of corporate debt in the US, alongside rising interest rates, is setting the scene for a new debt crisis.

How will such a crisis emerge? In the next year, US companies must refinance about $4trn of bonds, almost all of it at higher interest rates. This will hit debt-burdened companies that are already struggling and make it almost impossible for some to keep operating. Lenders, i.e. high-yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. bond holders, will try to exit their positions all at once only to find a severe shortage of willing buyers. Something, possibly high-yield bonds, will set off a liquidity Liquidity The facility with which a financial instrument can be bought or sold without a significant change in price. scramble.

Almost half of US investment-grade companies are rated BBB (just above ‘junk’) and could easily slip into junk status in a downturn. Rising defaults will force banks to reduce lending, depriving previously stable businesses of working capital. This will reduce earnings and economic growth. The lower growth will turn into negative growth and we will enter recession. That is the likely scenario ahead.

Returning to ‘emerging’ economies, already banks and financial institutions globally are cutting back on their loans to the likes of Turkey etc.

But also capital flows from the non-financial sector to invest globally have declined. Global foreign direct investment (FDI) flows fell by 23% to $1.43 trn in 2017, according to the latest report by UNCTAD. Investment in new projects fell 14%. Interestingly, most of this fall was between the advanced capitalist economies. FDI flows to developing economies remained stable at $671 billion, after a 10 per cent drop in 2016. But inward FDI flows to developed economies fell sharply, by 37 per cent, to $712 billion.

Global capital movements, driven mainly by debt-related flows, increased rapidly in the run-up to the financial crisis but then collapsed from 22% of global GDP in 2007 to just 3.2% in 2008. The subsequent recovery was modest and short-lived. In 2015, flows were still only 4.7% of global GDP. Cross-border capital flows remain well below pre-crisis levels. Overall net capital flows to ‘emerging’ economies were actually negative in 2015 and 2016, before turning slightly positive in 2017.

According to UNCTAD UNCTAD
United Nations Conference on Trade and Development
This was established in 1964, after pressure from the developing countries, to offset the GATT effects.

, “projections for global FDI in 2018 show fragile growth”. Global flows are forecast to increase marginally, by up to 10%, but remain well below the average over the past ten years. Multi-national companies are cutting back on international investment, partly because of the risk of a future trade war after Trump’s protectionist measures; and partly because possible debt crises in the most vulnerable ‘emerging’ economies. But a key reason is a fall in profitability from overseas investment. UNCTAD found that the global average return on foreign investment is now at 6.7%, down from 8.1% in 2012. Return on investment is in decline across all regions, with the sharpest drops in Africa, Latin America and the Caribbean.

As a result, the rate of expansion of international production is slowing down. Assets and employees are increasing at a slower rate. Growth in the global value chain (GVC) has stagnated. Foreign investor profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. in global trade peaked in 2010–2012 after two decades of continuous increases. UNCTAD’s GVC data show foreign value added down 1 percentage point to 30% of trade in 2017. It’s not just as profitable to trade or invest globally compared to before the Great Recession.

The story of the last ten years since the Great Recession is that the world capitalist economy has staggered on at low levels of growth and investment and with virtually no improvement in real incomes for the 90%. And it has only staggered on because of a huge build-up in debt, particularly in the capitalist sector. Now, monetary authorities are trying to reverse the credit binge and restore ‘normality’. As a result, the cost of servicing that debt is on the rise and availability of more credit to finance is shrinking.

When we read the financial press, we see the huge profits being made by the top companies (mainly in the US – in Europe, profits are down even for the large), but the vast majority of companies are still not achieving the profitability they need to finance their debts if the cost of servicing rises sufficiently. And globally, banks and corporate investors are reducing their loans and investments because of low profitability and concerns about declining trade growth and a global trade war. And that pending trade war still has some way to go.

Michael Roberts

worked in the City of London as an economist for over 40 years. He has closely observed the machinations of global capitalism from within the dragon’s den. At the same time, he was a political activist in the labour movement for decades. Since retiring, he has written several books. The Great Recession – a Marxist view (2009); The Long Depression (2016); Marx 200: a review of Marx’s economics (2018): and jointly with Guglielmo Carchedi as editors of World in Crisis (2018). He has published numerous papers in various academic economic journals and articles in leftist publications.
He blogs at thenextrecession.wordpress.com

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