The fact that the world did not experience a systemic financial crisis in 2022 is a small miracle given the soaring inflation and interest rates, not to mention a massive increase in geopolitical risks.
But with public and private debt rising to record levels during the ultra-low interest rate era and recession risks high, the global financial system still faces a major test of endurance. A crisis in a highly developed economy – for example in Japan or Italy – would be difficult to contain.
Stricter regulation has reduced the risks for the core areas of the banking industry. But that has only caused risks to shift to other areas of the financial system.
For example, rising interest rates have put enormous pressure on private equity firms that have borrowed heavily to purchase real estate. With a precipitous, sustained decline in housing and commercial property prices on the horizon, some of these companies are likely to go bust.
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In this case, the core banks, which provided much of the financing for the property purchases of the private equity companies, could run into problems. One of the reasons this hasn’t happened is that lightly regulated companies are less forced to adjust their books to market prices.
But imagine that interest rates remain stubbornly high even during a recession. In this case, there will inevitably be a large number of payment defaults.
Japan could be the world’s most vulnerable country
The recent capers on the British bond market show how quickly the situation can deteriorate. While ex-Prime Minister Liz Truss was blamed, the real culprits were pension fund managers who bet long-term interest rates would not rise too quickly.
Japan is also at risk, where the central bank has kept interest rates at zero or negative for decades.
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With real interest rates rising around the world, the yen depreciating sharply and inflationary pressures high, Japan may finally be moving out of the near-zero interest rate era.
Higher interest rates would put immediate pressure on the Japanese government, as Japan’s national debt now amounts to 260 percent of gross domestic product. A sharp rise in interest rates would be manageable in a high-growth environment, but Japan’s growth prospects are likely to fall as long-term real interest rates continue to rise.
The key question is whether there are hidden vulnerabilities in the financial sector that could be uncovered if inflation continues to rise. The good news is that after almost three decades of ultra-low interest rates, Japanese expectations of near-zero inflation are well anchored – although that is likely to change should today’s inflationary pressures prove sustained.
The bad news is that the persistence of these conditions could easily mislead some investors into believing that interest rates will never rise, or at least not significantly. This means that bets on further low interest rates could run rampant in Japan, as previously happened in the UK. In this scenario, further monetary tightening could worsen the situation, creating instability and exacerbating the government’s fiscal problems.
So far, ultra-low interest rates have held the eurozone together
Another latent risk is Italy. In many ways, ultra-low interest rates have been the glue that has held the eurozone together. Unlimited guarantees on Italy’s debt, in line with former ECB President Mario Draghi’s 2012 pledge to do “whatever it takes”, were cheap as long as Germany could borrow at zero or negative interest rates.
But this year’s rapid rate hikes have changed those calculations. Today, the German economy looks more like it did in the early 2000s, when some dubbed the country the “sick man of Europe.” And while ultra-low interest rates are a relatively new phenomenon in Europe, there is concern that a sustained wave of monetary tightening could reveal vulnerabilities.
The global economy remains fragile, and there are fears that financial capricious like the ones we saw in the UK will repeat themselves.
About the author: Kenneth Rogoff was Chief Economist for the International Monetary Fund and teaches economics at Harvard University.
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