The writer is president of Rockefeller International
As the US Federal Reserve raises interest rates, debate rages over whether or not this tightening cycle will trigger a recession. History suggests an interesting answer: since World War II, Fed tightening has had a range of outcomes for the economy, from hard landings to soft landings, but has always led to financial crises somewhere – including including all the major global crises of recent decades.
With the rapid spread of bank and mortgage credit, the first signs of a crisis often materialize in an increase in corporate and household indebtedness, concentrated in real estate. Today, however, these signs are only reaching worrying levels in a few countries, led by Canada, Australia and New Zealand.
But it doesn’t offer much comfort. The steady stream of easy money flowing out of central banks has fueled serial crises for decades. Regulators typically try to address the sources of the latest crisis, only to divert credit to new targets. After the global crisis of 2008, authorities clamped down on the main sources of this collapse – big banks and mortgages – which pushed the flow of easy money into less regulated sectors, especially corporate lending by “ shadow banks.
It is in this area beyond the regulators that the next crisis will arise.
Shadow banks include creditors of all kinds, from pension funds to private equity firms and other asset managers. Together, they manage $63 billion in financial assets, up from $30 billion a decade ago. What started in the United States has spread around the world, and lately shadow banking has grown fastest in parts of Europe and Asia.
Although it has recently shrunk under government pressure, China’s shadow banking sector is still one of the largest in the world, accounting for 60% of gross domestic product – up from 4% in 2009 – and deeply enmeshed in subprime loans to local governments, real estate companies and other borrowers. In Europe, hotbeds include financial centers like Ireland and Luxembourg, where shadow banking assets, particularly pension funds and insurers, have grown at an annual rate of 8-10% in recent years.
Borrowers to watch more closely are corporations. In the United States, corporate debt as a percentage of assets remains near record highs, especially for companies in sectors hardest hit by the pandemic, including airlines and restaurants. A third of publicly traded companies in the United States do not earn enough to pay their interest. Any increase in borrowing costs will make life difficult for these businesses, which need easy credit to survive.
Many of them depend on costly junk debt, which has doubled over the past decade to $1.5 billion, or about 15% of total US corporate debt. Their vulnerability was revealed at the start of the pandemic, when default risks briefly increased, but was quickly concealed by massive injections of liquidity from the Fed.
The biggest booms are taking place in the 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 $1.2 billion. A substantial part of this is direct lending from private investors to often risky private borrowers, many of whom are in this market precisely because it is unregulated.
Nothing highlights the unbridled search for returns in private markets more clearly than the so-called business development companies. Some of the world’s biggest asset managers are raising billions for BDCs, which promise 7-8% returns on loans to financially fragile small businesses. As one investor told me: swing a stick in Manhattan these days and you’re bound to hit someone involved in private lending.
These risks are symptomatic of the financialization of the global economy. Optimists say household finances are sound, so the economy will do well, even if markets are hit by higher interest rates. But again, it’s making the mistake of focusing on the past and ignoring all that has changed.
Over the past four decades, as financial markets have grown to more than four times the size of the global economy, feedback loops have changed. Markets that once reflected economic trends are now big enough to drive them. The next financial crises are therefore likely to arise in new areas of the markets, where growth has been explosive, and where regulators have yet to arrive. The even greater risk, in a highly financialized world, is that a crash in the markets will settle the debate on the impact of Fed tightening on the real economy.