Flash crashes, debt default and panic selling haunt IMF

Every year, the great and the good (if that is an appropriate term for finance ministers and central bank governors) come together at the International Monetary Fund and World Bank meetings in order to "save the world". This year they met in Peru where the air of the Andes appeared to infuse them with optimism.

The very fact that they expressed optimism seemed to calm markets. It was rather like the "no business" meetings held during the Great Depression when financial leaders would simply smoke behind closed doors and then claim to have come up with solutions - which fooled everyone for a while.

Bankers, brokers and other denizens of the financial jungle went to Lima to hear what those in high places were doing to avert another global financial crisis, while those supposedly in control of the situation were intent on hearing the market view - a case of the blind leading the blind.

Two big questions dominated debate: what if the Federal Reserve begins raising US short-term interest rates soon, and what if China's economic slowdown accelerates and deepens? On the first, the answer seems to be that no-one knows. On the second, it is that it probably won't.

But the litany of threats extended beyond the Fed and China. There is the commodity market slump that is profoundly affecting exporters, not least those in Latin America and Asia, while not helping importers who face weak global demand for their manufactured exports. Lima had little solace to offer them.

Obviously, the Fed's next move has multiple implications - for the US dollar and other exchange rates, capital flows (and thus the evolution of interest rates beyond the US) and for trends in corporate investment, etc. That in itself is enough to give Fed chairperson Janet Yellen sleepless nights.

But, as we heard in Lima, there is another spectre haunting global capital markets and that is the danger of corporate debt default among emerging market companies that have used zero interest rate regimes to borrow massively in debt markets - a great deal of that in US dollars.

Since 2008, when the Fed introduced quantitative easing (QE), corporate debt in 18 leading emerging markets has soared by 30 per cent to near US$24 trillion, of which almost one-fifth is in foreign currency, according to Hung Tran, managing director of the Institute of International Finance.

CORPORATE DISTRESS

"If the dollar strengthens against local currencies (which it is doing already) servicing that debt will be much more onerous," he noted in Lima. "Borrowers are already under pressure because emerging market growth is going down, corporate earnings are going down, and both are correlated with the downturn in world trade and commodity prices. This means more corporate distress in emerging markets and a rise in non-performing loans."

That in turn, added Mr Tran, means that emerging market companies in Asia and elsewhere may be unable to make needed capital investments, which in turn threatens to pull down growth rates in these key economies. Banks are not so exposed now to this kind of debt crisis, because emerging market borrowers have turned heavily to bond markets where the rule is caveat emptor, or "let the investor watch out" in effect.

Investors have smelled blood in emerging markets and can sniff the approach of higher interest rates in the US and elsewhere. They have begun pulling money out big-time from emerging markets. Overall, capital flight from these markets has hit a 27-year high and is forecast by the IIF to turn net negative to the tune of US$165 billion this year for the first time since 1988.

There is the danger of more "flash crashes" (as Mr Tran described them in a conversation with BT in Lima) occurring on stock markets. Here, as he said, we are not talking so much about emerging and "frontier" markets but right in the heart of the capitalist world, New York. He instanced the incident on the New York Stock Exchange in August when the prices of some blue-chip companies crashed by 20 per cent within five minutes of the opening.

Secondary market liquidity has been profoundly affected by structural and regulatory changes in securities markets and the system is still largely untested in times of crisis, he said. "The challenge now is if the Fed were to normalise monetary policy - which they will in October or November or in the first quarter of 2016 - how would the impact be handled by trading systems. A lot of investors have been piling into fixed income instruments, corporate bonds and high-yield bonds and if they needed to rebalance their portfolio, how would that be transacted?"

Bankers in Lima meanwhile spoke of the danger of "panic selling" in debt and equity markets.

Then, there is China; not only the largest by far among emerging markets but also the world's second largest economy behind only the US and ahead of Japan. Here there did appear to be some good news. The head of the IMF's Asia Pacific department, Changyong Rhee, told BT in Lima: "We do not believe in the idea of a hard landing for China." The current pace of slowdown is still in line with expectations, he said, as China transits from export-led manufacturing growth to a domestic consumption and services model.

CHINA DOING OKAY

The IMF, Mr Rhee said, had been "a little surprised" by the sharper-than-expected slowdown of the Chinese manufacturing sector. "But if you look at data for service and consumption services, it is quite robust," he added. Imports are holding up well, allowing for the slowdown in global trade. "If China's domestic demand was losing momentum, one would see a sharp fall in the volume of imports," he argued. Not everyone was quite so optimistic on China but few were really pessimistic either and dismissed talk of China's growth rate falling soon to 5 per cent or lower.

While China has been quite widely criticised for the way it handled its stock market crash, the spectre of crash in other financial markets certainly haunted the Lima meetings. Both the IMF and the World Bank seemed intent on playing down risks, caught as they are between the desire to send veiled warnings of impending doom and the need to calm markets and prevent a selling of securities that could cause a re-run of the 2008 global financial crisis. A difficult, if not impossible, balancing act.