As one financial crisis ends, another may be on its way

Japanese investment bank Nomura has declared that the global financial crisis is finally over, announcing: "The end of the end of the world" is here.

Its verdict came in a report last week that wrote off 2013 as the last of the crisis age and shone the light on next year's themes of global economic recovery and a return to more normal financial conditions.

But if there is any lesson that should linger from the 2008 crisis, it is that danger lurks in exuberance.

Indeed, even as developed economies slowly get back on their feet, global markets are one step ahead of them.

As their memories of the last crisis recede for good, investors may already be sowing the seeds of the next one.

The giant pool of liquidity that flowed out of the rich world after the crisis, seeking higher returns in faster-growing countries, is coming full circle back to advanced economies.

Much of this money has spent the last few years sloshing around emerging markets blindly searching for yield and, in the process, pushing up the prices of all manner of assets - from properties to stocks.

Now, the wave of capital is finding its way back to the recovering economies of the United States and Europe, joined by more funds from emerging markets, whose own economies are starting to slow.

This cash is showing up in US stock markets. The Dow Jones Industrial Average and S&P 500 have both been hitting a series of all-time highs, while the Nasdaq touched a 13-year high last week.

Last weekend, Nobel prize-winning economist Robert Shiller cautioned that the boom in US stocks could turn into a bubble.

This is one illustration of investors' desperate search for yield. As they now turn to developed economies to find better returns, they threaten to add to risks in areas that are already vulnerable, the Monetary Authority of Singapore (MAS) warned in its latest financial stability review yesterday.

It noted that investors are throwing their cash into increasingly questionable areas in developed markets.

These include euro zone government bonds, despite the region's high sovereign debt and slow reforms; speculative-grade company bonds and other risky assets; and securities backed by commercial mortgages, an asset class best known for precipitating the collapse of investment bank Lehman Brothers and triggering the global financial crisis.

Increasing investments in each of these areas pose a different sort of risk, as the MAS points out.

Investors' willingness to lend money to peripheral European governments reduces pressure on them to implement necessary economic reforms, which could cause more harm down the road.

The demand for high-yield debt and high-risk instruments may signal that investors do not fully appreciate the possibility of more companies defaulting once interest rates rise and credit conditions tighten.

Meanwhile, signs of stress are emerging in the commercial mortgage-backed securities market, with defaults in Europe during the first six months of the year double that in the same period last year, the MAS said.

The issuance of such securities around the world is at its highest this year since 2007, according to financial data provider Dealogic.

At the same time, the quality of assets used as collateral for these securities "has declined significantly since the market restarted in 2010", Barclays analysts Keerthi Raghavan and Aaron Haan said in a report.

"Some investors have complained that credit standards are fast approaching levels last reached during the credit boom years of 2006-07, while others take a more sanguine view," they added.

The upshot is that even before the developed economies have fully recovered from the last financial crisis, they will need to pay close attention to where the next pressure points could emerge.

As the MAS puts it: "It is important to be watchful of capital inflows to vulnerable sectors in the advanced economies, which could lead to a build-up of risks.

"Investors need to exercise caution when dealing with high-yield debt and other new investment products. Policymakers need to stay vigilant and be prepared to take measures to manage risks that may emerge."

It is good advice for Asia too. To the extent that financial imbalances will always exist, policymakers here will also need to put in place structures that protect their economies from the caprices of capital flows, and prevent a dangerous accumulation of risk.

The irony is that the more stable a country's financial system and economic growth, the more likely it is to attract hot money. The trick is to learn how to better manage it as well.

Source: 4th December 2013 Straits Times

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As one financial crisis ends, another may be on its way

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