The Greatest Risk Facing the International Banking System

There are a number of threats facing the international banking system; however, the greatest risk is the amount of debt that has been accumulated around the globe. History has shown us the outsize role that debt has played in creating boom-bust cycles and a heavy reliance on borrowed money makes the banking system more vulnerable to economic shocks. Global debt increased USD 3 trillion in the first quarter, to bring total world indebtedness to USD 246.5 trillion, or 320% of global GDP. This is up from a debt-to-GDP ratio of 269% in 2007. This problem is not specific to any one area, but persists around the globe as central banks continue to be accommodative.

Japan

Japan, once a saving nation, began experimenting with debt in the mid-1980’s to boost economic growth. But by 1999, the economy had barely budged, so the country adopted a zero-interest rate policy. More recently, in 2014 the Bank of Japan starting acquiring USD 67 billion of Japanese debt each month, and then in 2016 introduced negative interest rates. Today, Japan's government debt-to-GDP ratio stands at 238%. This ratio has grown from 1980 when it its ratio hit a low of 50.6%. To compare, the US’s ratio currently stands at 106%. Greece’s is at 181%.

Unfortunately, these purchases, as well as moving to a negative interest rate policy, has had the same effect on the economy as moving to a zero-interest rate policy had. While increasing debt may not stimulate its economy, luckily for Japan it does not have to rely on foreign investors like Greece. The Bank of Japan buys most of its own debt. However, should Japan need foreign buyers, borrowing costs would increase and as Japan is the third largest economy, the impact around the globe would be large.

 China

The world’s second-largest economy, China, is also awash in debt. In 1979 China began to open up to foreign trade and foreign investment. China also began to implement free market reforms. As a result, China became one the world’s fastest-growing economies, realizing, on average, double-digit growth through 2012. China’s wage differential with the West underwrote exponential growth, driven by exports.

However, the financial crisis of 2008 cooled demand for Chinese goods. To keep unemployment low, the government passed a $586 billion stimulus package. This stimulus enabled China to keep growth close to double digits, but growth became predicated on debt. Its total corporate, household, and government debt now stands at 303% of GDP. To put this in perspective, China has taken on more debt than the US, Japanese, German, and Indian commercial banking systems combined. The size of the debt is not the main concern, but the rapid growth of that debt is, especially when a large portion is owed by unproductive and over-leveraged state-owned entities.

For China to continue to grow, it has to transform its economy from an export-driven one to a consumer-driven one. Transforming to a consumer-led economy will not be easy. Many Chinese have not benefited from the boom and China remains overwhelmingly poor.

The Chinese are thus in a trap. If the country continues aggressive lending to failing businesses, it gets inflation. That increases costs and makes the Chinese less competitive in exports. On the other hand, allowing businesses to fail brings unemployment, a serious social and political problem. Over the short term, China’s central bank has the ability to cover the losses, so there is little chance of a liquidity crisis like the 2008 crisis in the US—as long as the government continues to back the banking system. However, without effective structural reforms over the long term, China’s financial resources will be exhausted.

United States

In the US, where the 2007 financial crisis began, the Federal Reserve quickly stepped in to supply liquidity. While it was necessary for the Fed to step in to avoid a deeper crisis, it could be argued that the Fed’s policies during the previous 20 years induced the crisis. Since 1987 under Alan Greenspan, the Fed has stepped in to protect the markets from a serious decline by lowering interest rates and taking on debt. This availability of cheap credit provoked the US’s first real estate bubble. When the bubble burst, the stock market plummeted, and the economy dropped. The cause of this woe was the massive growth of debt—by consumers, banks, and investment banks alike. To keep the system from collapsing, Bernanke nationalized Fannie Mae and Freddie Mac, bailed out the banking system, and reduced rates further. In addition, the Fed began its quantitative easing (QE), whereby it bought government debt and poured money into the banking system. As a result, corporate and household debt declined, but the Fed’s balance sheet grew enormously. Since that time, though, household debt has climbed and met an all-time high of USD 13.95 trillion in the second quarter of 2017. When compared to household income and servicing costs, it is still below crisis levels. But if rates rise, servicing costs on government and household debt could become onerous.

Fortunately, the US economy has grown in the +2% range for the last several years and interest rates have remained low, allowing the Fed to reduce its balance sheet somewhat. However, if the economy were to stall in the near future, the Fed has fewer tools to assist.

European Union

The US financial crisis led to the European debt crisis. The economic slowdown quickly illustrated how heavy debt burdens can exacerbate the situation. The resulting debt crises in Greece, Ireland, Spain, Portugal, Italy, and Cyprus serve as examples. In 2010, the European Central Bank, the International Monetary Fund, and European nations stepped in to alleviate the situation. As a result, the European Financial Stability Facility and the European Stability Mechanism were created, along with the ECB’s quantitative easing and negative interest rate policy. As a whole, the European economy remains in a precarious state. While government debt as a percentage of GDP has fallen to 88%, it still remains above its 2007 level of 65%. The European debt crisis exposed the weakness in harmonizing monetary policy without coordinating fiscal policy. Without a coordinated fiscal policy, which will be difficult due to national interests, the economies of many individual countries remain at risk, and weaning off central bank assistance may be difficult.

Conclusion

Global debt continues to increase, and in some countries debt is rising quite quickly. The financial crisis demonstrated that a country with a heavy debt burden could get into economic trouble regardless of whether its debts are held by the government (Greece, Italy), households (Spain, the United States), or financial institutions (Ireland, Britain).

About the Author

Rick Cloutier, CFA, is the chief investment strategist for Washington Trust Bank with over 25 years of portfolio management and investment experience. He is responsible for directing the portfolio management, research, and trading activities for the bank’s multi-asset class strategies. He is also responsible for overseeing the client portfolio manager team and portfolio analytics team. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, the Journal of Business Management and Economics, and the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University. 

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