US Banking Crisis Turning Global
The proposed $700-billion financial markets rescue plan had better work, or a truly global crisis could ensue, in Oxford Analytica’s view.
The unfolding US banking crisis is spreading to the entire global financial system, potentially exerting a systemic impact, OxAn says. Thus, the first truly global crisis could emerge, challenging policymakers’ pre-globalisation economic toolbox.
As noted in an earlier OxAn report, much remains unknown about the nature of the global economy in the absence of sufficient data and adequate theoretical frameworks. “As a consequence, the impact that the current crisis may have on the global economy is uncertain. However, past crises have much to say about the likely contagion mechanisms and suggest questions that should be asked during this one.”
Financial contagion. Financial sector contagion takes three forms:
• Counterparties. There is a direct impact through counterparty channels. The list of financial institutions liable to be affected includes all but the most isolated and remote financial service institutions of the world.
• Risk perception. The second channel is indirect, through risk perception. The problem is that many global relationships evolve day-by-day, resulting in significant uncertainty about the way risk spreads in the global economy.
• Cost of capital. The price of risk rises substantially. This affects all asset classes that are categorised as high risk and can easily have an impact on low risk asset classes as well.
Sectoral contagion. If liquidity shortages last, a systemic impact is likely in non-financial sectors. As has happened during the past few days, this can lead to a substantially increased number of liquidity interventions by central banks and even some treasuries. Arguments then emerge over whether there is a meaningful distinction between ‘illiquidity’ and ‘insolvency’, signalling policymakers’ anxiety levels.
Although the liquidity crunch tends primarily to be local — albeit with important global inter-linkages — the demand effect of the crisis is truly global, and this will affect all open economies. The problem is that the ‘prescribed’ and well-tested textbook answer — namely tight fiscal policy coupled with somewhat loose monetary policy — is implausible on the global level. This is due to the lack of an institution that could coordinate such a global-level policy response.
In short, the financial crisis could lead to an overall systemic crisis through worsening local credit conditions, as well as through shrinking global real economy demand.
Global contagion. As a consequence, a truly global contagion is in prospect. All previous crises were geographically limited: they were either mature economy crises with some consequences for some emerging markets; or they were emerging market crises with limited contagion to other emerging market regions or to mature markets. The increased level of integration since the burst of the dot.com bubble means that there is a serious risk that the current financial crisis will reach all sectors and all countries:
• While the usual weak spots of emerging markets (eg, Thailand, The Philippines, South Africa, Argentina, Hungary) could suffer substantially in the wake of what is essentially a mature economy financial crisis, those with more robust structures — although with chequered pasts — may also be tested (eg, Turkey, Indonesia, Mexico).
• At the same time, the successful new global powers are either still not strong enough (China, the Gulf states), still too isolated (India, Brazil), or happen to be in the midst of ongoing turmoil (Russia), such that no significant global impetus can be expected to come from their direction.
• The global exposure of the European banking sector, as well as the importance of global demand in the continent’s real economy reduces the probability that EU policymakers could provide a global panacea.
• The Japanese economy, though important, is too small and too slow to boost the global economy, and is itself sliding into recession.
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