For
Kenneth Rogoff
Former chief economist at the IMF and professor at Harvard University
With inflation on the rise and the end of ultra-low interest rates, the financial markets will have to grapple a huge stress test in 2023. Although banking systems are stronger than in 2008, a contraction in the real estate sector could hit heavily leveraged private fund companies, producing a systemic crisis.
The fact that the world has not experienced a systemic financial crisis in 2022 is a small miracle, given the rise in inflation and interest rates, not to mention a sharp increase in geopolitical risk. But with public and private debt soaring to record levels during the bygone era of ultra-low interest rates and high recession risks, the global financial system faces a massive stress test. A crisis in an advanced economy – Japan or Italy, for example – would be difficult to contain.
It is true that less flexible regulation has reduced risks for key banking sectors, but this has only caused those risks to be transferred to other sectors within the financial system. Rising interest rates, for example, put a lot of pressure on private equity firms that borrowed heavily to buy real estate. Now that residential and commercial property is on the verge of a steep and sustained decline, some of these companies are likely to fail.
So, major banks that provided much of the financing for privately-funded property purchases may find themselves in trouble. That hasn’t happened yet, in part because less regulated companies are under less pressure to bring their books up to market value. But suppose interest rates remain high even during a recession (a distinct possibility as we emerge from an era of ultra-low rates). If so, widespread payment defaults could make it difficult to keep up.
The UK’s recent financial woes prove this the kind of unknowns that could arise as global interest rates rise. While former Prime Minister Liz Truss has shouldered the blame for the near collapse of her country’s bond markets and pension system, the main culprits have turned out to be pension fund managers who essentially bet that long-term interest rates they wouldn’t go up too fast.
Even Japan, whose central bank has kept interest rates at zero or negative for decades it could be the most vulnerable country in the world. In addition to ultra-low rates, the Bank of Japan has also applied yield curve control, thus keeping five- and 10-year bonds around zero. With real interest rates rising around the world, the yen depreciating sharply and inflationary pressures mounting, Japan may finally emerge from the era of near-zero rates.
Since then, higher interest rates would immediately put pressure on the Japanese government the country’s debt accounts for 260% of GDP. If the Bank of Japan’s balance sheet were supplemented, about half of the government debt purchased by the private sector would actually be in short-term bonds. A 2% interest rate hike would be manageable in a high-growth scenario, but Japan’s growth prospects are likely to decline as long-term real interest rates continue to rise.
Almost certainly Japan’s colossal public debt limit the possibilities of policy makers to manage long-term growth. However, given the government’s fiscal powers and the possibility of debt deflation, the problem should be manageable. The real question is whether there are hidden vulnerabilities in the financial system that could emerge if inflation continues to rise and Japan’s real interest rates reach US levels. This has been the norm for most of the past 30 years. even though Japan’s inflation expectations today are much lower than that of the United States.
The good news is that after nearly three decades of ultra-low rates, Japan’s near-zero inflation expectations are well anchored, albeit with the possibility of variation if current inflationary pressures persist over time. The bad news is that if these conditions persist, it may lead some investors to believe that rates will never go up, or at least not that much. This means that bets on interest rates remaining relatively low are becoming as prevalent in Japan as they were in the UK. In this context, further tightening of monetary policy could blow things upcreating instability and adding a problem to the public budget.
Italy is another example of latent risk. In many ways, ultra-low interest rates have been the glue that has held the Eurozone together. Open guarantees for Italian debt, in line with former European Central Bank president Mario Draghi’s 2012 pledge to do “whatever it takes,” came cheap when Germany could borrow at zero or negatives. But these rapid rate hikes have changed that calculus. Today the German economy looks more like it did at the turn of the century, when some called it “the sick man of Europe”. And while ultra-low rates are relatively new to Europe, it should not be forgotten that a sustained wave of monetary tightening could, as in the case of Japan, reveal huge pockets of vulnerability.
if it occurs a global recession without a financial crisis, there’s a good chance the next economic shock will be milder than expected. In a scenario of negative growth, high inflation and rising real interest rates, that would be a very fortunate outcome.
Source: Clarin
