Post-crisis or pre-crisis?
History warns us that the next crisis is just around the corner. Arturo Bris outlines the shapes it is taking and what we can do to mitigate it
Six years ago the US financial sector suffered a breakdown that culminated in the collapse of Lehman Brothers and led to a massive global crisis. And yet, between 1945 and 2008, on average, there was one crisis every 58 months. Statistically speaking, we should therefore expect the next crisis to start in April 2015 and end by March 2016. Are we in a post or a pre-crisis period? And if we are pre-crisis, shouldn’t we enquire into the cause of the next crisis?
Here I present eight possibilities, in no order of importance or likelihood. For some, prevention would be straightforward. For others, I am not sure there is much we can do.
A bursting stock market bubble… Driven by excess liquidity and a lack of alternatives, money has flown into equity markets. Robert Shiller has shown that the gap between stock prices and corporate earnings is now larger than in the previous pre-crisis periods, 2000 and 2007. Most company results disappointed investors in 2014, and if markets were to return to their normal earnings levels, the average stock market should fall by about 30%.
.…or another in real estate. The conditions in place in 2005-07 for a real estate bubble are satisfied again – low interest rates, growing demand, increasing prices. The only attractive investments for institutional investors are real estate and equities, and Bank for International Settlements data suggest that some markets – China, the US, Canada, Brazil – show signs of overheating. What is different is that now central banks have a great tool to prevent real estate bubbles: Basel III and its countercyclical capital buffer.
A collapse of the Chinese banking system. Shadow banking represents more than 100% of GDP in the US and about 70% in China. But because China’s banking sector is protected from foreign competition, the biggest banks in the world are now Chinese. Moreover, a big part of Chinese shadow lending goes to local and central governments. Banking regulation in China is considered stringent, but we know what happens when regulators become self-interested. Without doubt, the next banking crisis will be triggered in China.
An energy crisis. I am not referring to scarcity of energy sources – quite the opposite. Fracking has turned shale gas into a potent geopolitical weapon. If the US Congress were to allow exports, world energy prices would fall significantly – great for companies, but a trigger for geopolitical problems in Russia and the Middle East. In Western Europe and China, where energy costs are currently hurting competitiveness, a cheaper alternative would be welcomed with open arms.
Corporate failures. The norm for companies is now to be BBB-rated. In 1982 there were 61 AAA-rated firms in the US; today there are Johnson & Johnson, Exxon Mobile, and Microsoft. Since interest rates are low, companies see the benefits in debt financing. But this makes them more sensitive to changes in interest rates. Typically a BBB rating is associated with a probability of default of about 4% 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.
A geopolitical crisis. From Nigeria to Ukraine, and from Syria to Venezuela, the map shows too many hot areas waiting to trigger a world crisis. Financial markets tend to overreact to political events and global financial linkages enable negative sentiment in China to trigger a market collapse in the US, and vice versa. One lesson of the Great War, is that the butterfly effect can be deadly in politics.
A poverty crisis. Over the past decades the world has become richer. But 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. For the sake of stability we need to tackle inequality, but the typical solution – taxes – hinders the competitiveness of nations. This is one of the long-term crises that will require smart leadership to avoid inefficient solutions.
The cash crisis. There is too much money out there. Citigroup has more than $487bn in cash, Apple about $150bn. If the corporate sector were to unload such massive financial resources onto society they would create hyperinflation. If they hold back, central banks must continue to print money that they will have to take out of the system later. In short, we know how QE works, but not know how to exit from it.
These are the potential crises. Unfortunately, potential solutions will damage competitiveness: more taxes, more regulation, more protectionism, a worse environment. So I suggest politicians and corporate executives diversify: seek geographical presence, flexibility, resilience and risk management. Educate and reward talent, and improve credibility in society. Invest internationally and make your country attractive to foreign capital. Finally, make employment, sustainability and social cohesion the top priorities of nations.
Arturo Bris is a professor of finance at the International Institute for Management Development (IMD) and director of the IMD World Competitiveness Center