The writer is chair of Rockefeller International
As the US Federal Reserve raises interest rates, debate rages over whether this tightening cycle will trigger a recession or not. History suggests an interesting answer: since the second world war, Fed tightening has led to a range of outcomes for the economy, from hard to softish landings, but has always led to financial crises somewhere — including every major global crisis in recent decades.
With the rapid spread of bank and mortgage lending, the first signs of crisis often materialise in rising corporate and household debt, concentrated in real estate. Today, however, these signs are at worrying levels in only a few nations, led by Canada, Australia and New Zealand.
But that doesn’t offer much comfort. The constant flow of easy money out of central banks has fed serial crises for decades. Regulators typically try to address the sources of the last crisis, only to divert credit to new targets. After the global crisis in 2008, authorities cracked down on the main sources of that meltdown — big banks and mortgage lending — which pushed the flow of easy money into less heavily regulated sectors, particularly corporate lending by “shadow banks.”
This realm beyond regulators is where the next crisis will arise.
Shadow banks include creditors of many kinds, from pension funds to private equity firms and other asset managers. Together they manage $63tn in financial assets — up from $30tn a decade ago. What started in the US has spread worldwide, and lately shadow banks have been growing fastest in parts of Europe and Asia.
Though it has pulled back recently under government pressure, China’s shadow banking sector is still among the largest in the world at 60 per cent of gross domestic product — up from 4 per cent in 2009 — and deeply enmeshed in risky lending to local governments, property companies and other borrowers. In Europe, the hotbeds include financial centres like Ireland and Luxembourg, where the assets of shadow banks, particularly pension funds and insurers, have been expanding at an 8 to 10 per cent annual pace in recent years.
The borrowers to watch most closely now are corporations. In the US, corporate debt as a share of assets remains near record highs, particularly for firms in industries hardest hit by the pandemic, including airlines and restaurants. A third of publicly traded companies in the US do not earn enough to make their interest payments. Any increase in borrowing costs will make life difficult for these companies, which need easy credit to survive.
Many of them rely on expensive junk debt, which has doubled over the past decade to $1.5tn, or roughly 15 per cent of total US corporate debt. Their vulnerability was exposed early in the pandemic, when default risks briefly spiked, but was quickly covered up by massive injections of liquidity from the Fed.
The biggest booms are under way in private markets. After 2008, as regulators tightened the screws on public debt markets, many investors turned to these private channels, which have since quadrupled in size to nearly $1.2tn. A substantial chunk of it is direct lending from private investors to often risky private corporate borrowers, many of whom are in this market precisely because it is unregulated.
Nothing highlights the frenzied search for yield in private markets more clearly than so-called business development companies. Some of the world’s biggest asset managers are raising billions for BDCs, which promise returns of 7 per cent to 8 per cent on loans to small, financially fragile companies. As one investor told me: swing a stick in Manhattan these days and you are bound to hit someone involved in private lending.
These risks are symptomatic of the financialisation of the world economy. Optimists say that household finances are healthy so the economy will be fine, even as markets get slammed by higher interest rates. But this again is to make the mistake of focusing on the past and ignoring how much has changed.
Over the past four decades, as financial markets grew to more than four times the size of the global economy, feedback loops shifted. Markets, which used to reflect economic trends, are now big enough to drive them. The next financial crises are thus likely to arise in new areas of the markets, where growth has been explosive, and regulators haven’t yet arrived. The even bigger risk, in a heavily financialised world, is that an accident in the markets settles the debate over how hard Fed tightening will hit the real economy.
