Ten years on from the crisis, where might the future fault lines lie?
Ten years on from the collapse of Lehman Brothers and the deepening of the global financial crisis, the world seems to be a safer place. Banks are better capitalised and more tightly regulated, financial market volatility is low and central banks have begun to raise interest rates or signal the end of ultra-loose monetary policy.
The crisis has passed and the world is normalising, but what of the imbalances which lay at the heart of the disruption? The imbalance that arose in the early 2000s between the developed and emerging market current accounts ultimately proved to be unsustainable and forced the retrenchment that led to the worst recession since the great depression. How do those imbalances look today and where might we find the future fault lines for the world economy?
We find there have been significant shifts in the world economy such that the imbalances are less, but they have shifted so that the risks are different to those of a decade ago. Before examining those shifts, we first look at the factors driving the imbalances in the run up to the crisis.
Origins of the global financial crisis
The imbalances in the world economy originated in the “savings glut” a term which sprang to prominence in 2005 when Ben Bernanke, then a mere Fed governor, described the role it had played in the increase in the US current account deficit1. Shifts in the desire of many emerging economies to increase their savings, in the aftermath of a series of crises in 1997-98, combined with the emergence of China as a major exporter. These factors led to an excess of saving over investment and were reflected in the growing current account surplus of the region.
Much of this excess capital was built up in the foreign exchange reserves of Asian economies who either wished to protect themselves against a future currency crisis, or in the case of China to build a buffer against potential exchange rate appreciation.
Those foreign exchange reserves were then drawn into the US and other developed economies such as the UK where they boosted asset values, raised capital investment and reduced domestic savings. The subsequent widening of the gap between savings and investment was reflected in the deterioration in the current account of the US and developed economies - the counterpart to the increase in current account surplus in the emerging world.
Such a pattern of deficits and surpluses meant that capital was flowing “uphill”: from poorer developing economies to the richer developed world. It was largely sustained by the desire of China and other Asian economies to accumulate foreign exchange reserves to prevent their exchange rates from appreciating, which of course delayed the imbalance from correcting.
The savings glut and the financial crisis
Later, the savings glut was seen by many economists as a key factor in the global financial crisis. Much of the excess capital created by the glut ended up in the banking systems of the developed markets, particularly the US and UK, where it was fed into the economy at ever easier terms via an explosion in sub-prime lending which allowed households and corporates to leverage up. Effectively, the developed economies were unable to absorb the increase in capital flowing from the emerging world thus resulting in a major misallocation of capital. The epicentre could be found in the US and UK where easy mortgage finance caused house prices to soar. The subsequent bursting of the housing bubble then undermined confidence in the highly leveraged US and UK banks and had a systemic effect on much of the global financial system.
On this view, the savings glut created an imbalance which led to the worst recession since the great depression of the 1930s. Of course, other factors were needed to turn the imbalance into a crisis. Excess leverage and misaligned incentives (“greedy” bankers), lax financial regulation (complacent politicians) and monetary policy which was too focused on price rather than financial stability (complacent central bankers), all played a role. Nonetheless, the imbalance was a pre-condition for the crisis as it created a challenge which the key economic actors were unable to deal with.
Role reversal: the shifting savings glut
The financial crisis taught us that imbalances can persist for considerable periods, but they create distortions and bubbles which can result in a massive retrenchment. In this case the adjustment was not triggered by a decision by China and the Asian economies to stop accumulating foreign exchange reserves, but by the collapse of the sub-prime mortgage market. There was a “Minsky moment”2 where investors in mortgage-backed securities realised that the game was up and we saw a loss of trust and sudden stop in capital flows in the banking system.
This had a significant impact on the pattern of current account deficits and surpluses. Based on IMF data, the surplus in the emerging world has disappeared whilst the developed countries have moved from deficit to surplus. The gap between the two has narrowed considerably: problems with data collection mean that surpluses and deficits do not perfectly match, but we have gone from a gap of $1.2 trillion in 2008 to $400bn in 2017 (chart 1).
Chart 1: Global imbalances have reduced
Source: IMF, Thomson DataStream, Schroders, 10 September 2018
Both the reduction and the move in the imbalance can be seen as positive. First, the capital flows needed to sustain the imbalance are less, so reducing the world economy’s vulnerability to a Minsky moment and a damaging reversal. Second, capital is no longer flowing uphill, but has taken a more natural course from the rich to the poorer areas of the world economy thus supporting growth where it is most needed.
However, if we look at the breakdown of these shifts, questions remain over the new imbalances in the world economy.
The eurozone was the swing factor for the developed economies
On the developed side the swing into surplus was primarily driven by the eurozone which moved from deficit into surplus between 2007 and 2017. The shift was largely driven by the periphery with Italy and Spain accounting for around half of the swing and reflects their experience of boom and bust followed by a period of austerity.
Meanwhile, Germany remained in the black throughout, but still increased its surplus by a not insignificant $64bn. Similarly, the other big saver, Japan, also stayed in surplus despite seeing a temporary decline in 2012-14. However, the other major contributor to the turnaround in the developed country current account was the US which reduced its deficit by $245bn to $466bn between 2007 and 2017 (see chart 2).
Chart 2: Developed economies swing to surplus driven by eurozone & US
Source: IMF, Thomson DataStream, Schroders, 10 September 2018
China and oil drive the emerging markets
On the emerging market side, the move from surplus to deficit has been driven by China and the oil producers. China has seen its current account surplus decline by around $200bn to $165bn since 2007, whilst the $250bn surplus generated by the Middle East and North Africa in 2007 has now evaporated (chart 3).
Chart 3: China and the Middle East drive decline in emerging market surplus
Source: IMF, Thomson DataStream, Schroders, 10 September 2018
From this perspective the savings glut has moved from Asia and the Middle East to the eurozone, with the US completing the picture by borrowing less than before the crisis. The fall in the Middle East and North African surplus largely reflects the decline in oil prices from more then $100/ barrel ten years ago, although increased public spending (post Arab spring) has also played a role.
The noise created by the trade dispute with the US means that the decline in China’s current account surplus has been missed by much of the media commentary. Despite the persistence of China’s surplus on goods with the US, the overall current account surplus has fallen from nearly 10% of China’s GDP in 2007 to 1.4% last year. The collapse in global trade clearly played a significant role as developed economy import demand fell. However, we would also note that since 2012 China’s services account has moved into significant deficit so offsetting the surplus on goods (see chart 4).
Chart 4: China current account, goods and services balance
Source: Thomson DataStream, Schroders, 7 September 2018
The decline in the services balance largely reflects the increase in Chinese tourism. According to the China Outbound Tourism Research Institute, in 2017 Chinese tourists made 145 million cross-border trips compared with 10.5 million in 2000. In this respect, China has become an important source of demand to the world economy with the number of tourists accounting for 10% of all international travellers3.
Where are the future fault lines?
Pulling this together, the reassuring news is that the scale of imbalances is considerably less than ten years ago; however, this analysis highlights areas of potential future stress in the world economy. On a regional basis we would draw out several implications.
1. The emerging markets (EM) are more vulnerable
The downside of capital flowing downhill for the recipients is that they become more dependent on external financing. The emerging markets are not running a deficit at anything like the rate of the developed world prior to the financial crisis and many economies remain in surplus. However, compared to the past the region is more dependent on external capital as witnessed recently by the pressure on EM currencies and foreign exchange reserves as the Federal Reserve has raised interest rates and tightened liquidity.
Driven by China the emerging markets could move into deficit. Going forward the visible surplus is under pressure from the trade war as the US demands a $200bn reduction in its bilateral deficit. Second, the invisible deficit is likely to continue to grow as more Chinese take trips overseas. This, however, will also be dependent on developments in the US.
2. The US current account deficit persists
The US current account deficit has narrowed significantly over the past decade as highlighted above. However, the expansion of fiscal policy under the Trump administration and subsequent increase in the budget deficit is likely to drive the current account deficit wider. The US twin deficits are likely to return. Consequently, we may see the emerging markets avoid falling into deficit and even temporarily return to surplus.
While the US economy has been robust and interest rates have been rising ahead of the rest of the world there has been little problem in financing the current account deficit, as reflected in the strength of the US dollar. However, as policy normalises elsewhere, US assets will look less attractive and financing will not be on such favourable terms. This may ultimately force a retrenchment of fiscal policy and spell of weaker growth in the US.
3. The inevitable appreciation of the euro? Mario Draghi as Sisyphus
As we have seen, the major imbalance today is between the euro area and the rest of the world. In many ways the euro area is playing the role of China and the emerging economies in the run up to the financial crisis. Today the imbalance is sustained by the European Central Bank’s (ECB) ultra-loose monetary policy which is driving investors out of the euro into other currencies in search of yield. Consequently the euro has stayed weak and the ECB’s loose monetary policy has its counterpart in the accumulation of foreign exchange reserves by China a decade ago.
The weak euro has been an important tool in the battle against deflation in the region. However, it has been said that trying to keep a currency with a current account surplus down is a Sisyphean task. The pressure for appreciation is always there (given the excess demand for the currency in goods and services markets) and whilst the ECB has been successful in preventing a sharp appreciation, eventually it will let the boulder slip. Such a development would pose a significant challenge to the eurozone which is still struggling to generate sustainable 2% inflation and faces considerable growth and debt challenges in its periphery.
Imbalances reduced, but new fault lines are emerging
The reduction in imbalances is reassuring for the world economy and future growth. In particular the world economy is no longer dependent on the recycling of China’s surplus into the US. The flip-side is that China and the emerging markets have become more vulnerable to tighter global liquidity conditions. Moreover, this analysis highlights the considerable challenge being faced by the eurozone which has become the “new China” in the world economy in terms of its current account surplus.
Consequently, in thinking about fault lines which could trigger the next crisis it would be worthwhile to focus on the eurozone which currently combines a current account surplus with a weak currency only through an extraordinary loose monetary policy. In a perfect world, eurozone recovery would be accompanied by higher interest rates and a stable currency. In practice, this could prove a major challenge as the ECB attempts to unwind its stance without a significant appreciation of the euro and the subsequent risk of derailing activity in the region. There is a danger that, like Japan before it (another economy with a current account surplus struggling to create inflation) the eurozone will find itself stuck with a very loose monetary policy for an indefinite period.
2. The phrase Minsky Moment refers to a period of time when a market fails or falls into crisis after an extended bullish period with highly inflated market speculation and unsustainable growth.↩
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.