Imagine for a moment this title was a front-page headline, splashed across the world’s newspapers and financial times. Markets would immediately react, and not favourably.
As it stands today, the risk of this potential financial crisis is low, but the world has already caught a small but powerful glimpse through the example of Greece of what could happen to markets should this risk become a full-blown reality.
To better understand how Canadian exporters and investors can protect against this potential risk, it’s important to first to understand how the risk originated.
Although it’s been over a decade since a global financial crisis took the world’s economies by storm, it’s that very event that brought us to this point.
In 2007, global economic growth was averaging around 5%. In 2008 it fell to 3%. In 2009, it plummeted to -0.2%. Global trade volumes followed suit. In 2007, world trade volumes were around 7.9%, but in 2009 fell to -10%.
Central bankers and financial ministries saw the writing on the wall. Suddenly there was a real fear of a return to the ‘Dirty 30’s' and the Great Depression.
Immediate action was required.
To weaken the effects of the crisis, central banks began lowering interest rates and governments began spending.
In 2007, the Federal Reserve Funds rate was at 5%. It dropped to 2% in 2008 and then again to 0.125% in 2009.
These were abnormally low numbers. Other central banks cut policy rates as well, including the European Central Bank.
On the spending side, governments provided a badly needed fiscal push by focusing on capital investments. This concentrated effort took place across much of the world and involved multiple markets.
As interest rates dropped quickly, the temptation for some emerging markets to borrow was too strong—their thirst unquenchable.
So, they borrowed. And in some cases, a lot. This caused the economic wheels to start turning again, and stagnant economies began to improve—but the wheels in some countries spun too quickly, resulting in a current account deficit. This caused a negative imbalance that had to be corrected.
The cure? Interest rates are low, so emerging markets just borrowed more to finance it, year after year. For six and seven years.
From 2009 to 2015, interest rates were kept low. But in December of 2015, the Federal Reserve changed one of the most liberal monetary policies in history and increased rates from 0 to 0.5%.
Only in the last year has the Federal Reserve become more aggressive in their interest hikes. It’s now going to cost emerging markets more to borrow. Compounding the issue is the fact that the European Central Bank hasn’t started to increase its rate yet and likely won’t for another year meaning this risk can become more pronounced.
Now that interest rates are increasing, lenders are slow to offer credit to emerging markets with high current account deficits. Lending money to triple A developed markets is a much safer bet.
But it’s the emerging markets with lots of short-term debt that’s rolling over, or long-term debt that’s maturing, that need credit. And if they can secure it, they’ll pay a premium.
It’s these markets that will really feel the pinch. Without cheap capital funding to battle their current account deficits, their domestic growth will slow and so will the influx of foreign exchange. This will further undermine risk perceptions by portfolio investors. The economic tide is slowly changing, and the fear is some emerging markets may get swept out to sea.
The world has already witnessed a couple of countries feel this pinch and watched as their currencies depreciated. To date in 2018, Argentina, South Africa and Turkey have all witnessed a sharp drop in the value of their currencies.
And there’s more.
Investors are wary of many countries (at least half a dozen) that are over-leveraged; they borrowed too much and grew too quickly. A tightening of global liquidity could possibly lead to defaulted loan payments and that could have a catastrophic effect on their economy.
If you took any economics courses in school, you might remember your professor talking about a basic principle that states you need to “save money in the good times and spend in the bad.” Some may argue it isn’t necessary, but quite a few countries thought it was wise and followed this principle. As a Canadian exporter or investor, you’re happy they did as it could present some lucrative opportunities.
How? Because if these markets were conservatively run, the portfolio movement will still find them attractive and this influx of cash will present other exporting or investing opportunities.
While opportunities may avail themselves, if Canadian exporters and investors aren’t properly prepared (hedging their FX) or don’t fully understand the risks or volatility involved with some markets, they could lose their investment. The more you know, the better you perform.
Not being properly diversified will also work against you, especially given recent trade concerns both internationally and within North America.
Canadian exporters and investors need to appreciate how quickly things can change in some markets, the slightest nuance can have a major impact. Some good resources are EDC’s guide to managing business and export risk and their Country Risk Quarterly.
The most important thing companies need to know is the current market system will show no interest in economies with imbalances on the external side.
Preparation usually equals success.