The new year greeted investors with one of the worst sell-offs on record with the first phase of turbulence triggered by concern over the impact of China’s slowing growth on emerging markets, with the gloom then spreading as questions were raised about the strength of the U.S. economy.
A second, but perhaps more worrying phase, followed in February, with investors focused on the health of global banks in the wake of the Bank of Japan’s decision to adopt negative policy rates.
"In a matter of days, the universe of sovereign bonds trading at negative yields expanded from $4 trillion to more than $6.5 trillion," once again stretching the boundaries of the unthinkable, said Claudio Borio, head of the monetary and economic department at BIS.
This phase of turbulence in financial markets hammered home the message that central banks have been overburdened for far too long. Economic growth in most countries continues to be disappointing at the same time that inflation remains stubbornly low while fiscal space is dwindling and structural measures lacking.
“Market participants have taken notice,” Borio said in connection with publication of the latest quarterly review from BIS, known as the central bankers' bank.
“And their confidence in central banks’ healing powers has – probably for the first time – been faltering. Policymakers too would do well to take notice,” he told journalists.
Behind the concern over China’s growth and the health of global banks lurks the reality that productivity growth is declining while the stock of global debt continues to rise, narrowing the room for political manoeuvre, a set of factors that Borio termed “the ugly three.”
Total global debt, which includes debt by governments, households and non-financial companies, now accounts for over 250 percent of global economic output, up from less than 110 percent at the end of 2007.
Most worrisome right now for Borio is the steep rise in private sector debt, especially in emerging market economies, with the strongest rise seen amongst corporates whose profitability has been declining, and among commodity exporters, hit by the fall in commodity prices.
This rise in debt has gone hand in hand with strong property price booms, all eerily reminiscent of the financial booms seen in many of the economies that were hit by global financial crises
For the BIS, debt helps explain what at first appears to be unrelated events.
It sheds light on the slowdown in emerging market economies, provides clues about the vicious cycle between a rising U.S. dollar and tightening financial conditions for firms and countries that borrowed in dollars, gives hints about the reason for the weakness in oil prices, and may even illuminate the puzzling slowdown in productivity growth.
“Put differently, we may not be seeing isolated bolts from the blue, but the signs of a gathering storm that has been building for a long time,” Borio said.
Debt denominated in U.S. dollars taken out by borrowers from emerging markets has doubled from 2009 to some $3.3 trillion, though there are signs that it is no longer rising.
Data from the third quarter of last year confirm that borrowers from emerging markets have been cutting back on new issuance, with borrowers from China even paying back foreign currency debt, partly explaining the rapid fall in foreign currency reserves, Borio said.
Along with the depreciation of many emerging market currencies against the U.S. dollar, and rising credit spreads, this provides Borio with telltale signs that external financing conditions for such borrowers are starting to tighten at the same time that financial cycles in many of these countries are maturing or turning.
"It is as if two waves with different frequencies came together to form a bigger and more destructive one," Borio said.
Click to read the BIS March 2016 quarterly review.