Financial cycle dip could tip economies into recession: BIS

London

A DOWNTURN in bonds and equities could tip economies into recession, the Bank of International Settlements (BIS) says.

"Since the early 1980s economic downturns have been triggered more by financial booms gone wrong than by monetary policy tightening," said Claudio Borio, head of the BIS' Monetary and Economic Department.

In its latest quarterly report, the BIS highlights the dangers of soaring foreign currency debt of European, Asian and emerging nations, a burgeoning derivatives market and the recent downward trend of global stock markets.

The BIS, the central bank's central bank, is renowned for its warnings about the global financial system. Some economists contend that the Basle, Switzerland-based institution leans on the pessimistic side. Nevertheless, the BIS has outstanding data on the global banking system, so it has to be taken seriously. Indeed, its economists cautioned that there would be a slump some time before the 2008 financial crash.

The recent stock market slides are probably the first of many, as investors adjust to a world of tighter monetary conditions and the threat of economic downturn, the BIS said in its December quarterly review.

"Two factors appear to have been at the root of the financial market repricing, despite strong earnings announcements, mixed signals from the economy and changes in the perception of the Federal Reserve's stance," said Mr Borio. They are a potential downturn in the US economy and global trade and political tensions.

European markets are also fragile.

"Worries about a hard Brexit shook markets in the United Kingdom, with sterling taking a knock. In the euro area, the source of tension was, once again, the darkening outlook of Italy's already delicate fiscal condition."

The BIS is particularly worried about the "comparative weakness of the European banking sector" and the "especially weak Chinese stock market" as policymakers "seek to deleverage China's economy while keeping up growth".

On the positive side, emerging market economies have been improving their macroeconomic and financial frameworks and the oil price drop provided some relief to oil importers. The BIS warns, however, that the leveraged loan market in the US and abroad continues to be overstretched.

"The bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors," said Mr Borio. "Should this debt be downgraded if and when the economy weakens, it is bound to put substantial pressure on a market that is already quite illiquid."

The quarterly report shows that US dollar liabilities of non-US banks stood at US$12.8 trillion at the end of June 2008. If net off-balance sheet positions are included the liabilities rise to US$14 trillion, levels that were last experienced at the height of the 2008 to 2009 financial crisis. Emerging market economies' (EMEs) banks had cross-border claims of US$3.7 trillion, of which US$1.4 trillion had been provided to borrowers in EMEs. The BIS noted that banks from developing countries now account for more than 12 per cent of global cross-border lending, up from about 3 per cent in mid-2008, as they ramp up lending to emerging market companies.

The BIS quarterly has a chapter on clearing risks in the over-the-counter derivatives markets. Notional values of interest rate and credit default derivatives contracts have soared to 4.4 times the world's gross domestic product, up from 2.8 times in 2008.

Regulatory standards have improved and there is stress tests of counter parties in the markets but risks remain, according to the BIS. In September 2018, for example, a Norwegian trader's default wiped out roughly two-thirds of Nasdaq Clearing's commodities default fund.