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Beware the risks of contagion leading to next big downturn

Economy Watch

The First World War is often said to have begun because of a chain of events which started with the assassination of the Austrian Archduke Franz Ferdinand on the streets of Sarajevo in June 2014.

This is the classic example of how one event can have massive global consequences.

Catastrophe occurred because there were weaknesses in the global political system and mechanisms which allowed a crisis to spread.

There are parallels to the state of the world economy in late 2018 given underlying weaknesses such as levels of debt and mechanisms which would facilitate spread effects.

The tendency for financial crisis to spread is referred to as contagion. There have been a number of relatively recent examples of contagion.

In the mid 1990s a currency crisis in Mexico spilled over into other developing countries through the so-called 'Tequila effect'. In 1996 the Thai stock market crashed and at the start of the next year a number of South Korean car and steel conglomerates toppled over.

The East Asian economic crisis of 1997 followed. A large depreciation of the Russian rouble in 1998 was followed by a similar decline in the Brazilian real. The factors which make contagion more likely include: large trade flows, intensive international activity by banks and a copy-cat sentiment.

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Is there a candidate for a Franz Ferdinand moment is the world economy?

Turkey is a possibility. A financial crisis has followed a dispute between two populist presidents, Trump and Erdogan. The Turkish government had imprisoned an American pastor and the US applied tariffs against Turkey. On the surface the Turkish economy was booming during the last five years.

The only OECD country to grow more quickly was the Republic of Ireland.

Unfortunately, much of that growth was fuelled by borrowing and particularly loans denominated in dollars or euros.

By the end of August the Turkish lira had depreciated 40% against the dollar. Turkey has had persistent current account deficits of 6% of GDP or more and so has always been vulnerable to any loss of external confidence.

Could Turkey generate much by way of contagion effects? The evidence is mixed. The UK itself is not particularly exposed to Turkey in terms of trade flows or banking activity.

A recent report by McKinsey noted that banks generally now have much stronger capital reserves than they did back in 2007 at the time of the banking crisis.

They are also less likely to be involved in cross-border loans. That said, there are a number of emerging markets which mirror aspects of Turkey's weaknesses. Mexico and South Africa, for example, have also borrowed large amounts in dollars.

At the end of August, Argentina pushed its interest rates up to 60% to try to halt the slide in the peso.

From the point of view of prospects for the global economy perhaps the real concern is what could happen in China and how that might lead to contagion.

According to McKinsey world debt increased by $72trn during 2007-17 and one-third of that increase was in China. Much of that extra Chinese debt was in local government and in businesses.

One-third of the Chinese corporate debt relates to the construction and real estate sectors.

That in itself might cause warning signals: economic convergence between East and West could imply China is now imitating some of the features of the western economies prior to the crash of 2007-9.

China's own total debt to GDP ratio has increased from 145% in 2007 to 256% in 2017.

Admittedly, that latter ratio is still lower than the UK's and much lower than that in the Republic of Ireland.

A debt correction in China would lead to lower consumption in that country and hence lower imports from the West.

How far would that matter?

About 5% of total UK exports go to China - that is equivalent to about 1% of GDP.

American exports to China represent a similar proportion of US GDP. Other countries, notably Germany, would be more exposed.

Contagion could also occur through the banking sector - some UK banks have made large loans in China.

The future is inherently uncertain. There are plenty of elements of systemic risk: over and above Turkey and the emerging markets or China, there is the extent of debt at the household level and the rise of the crypto-currencies. Wise economists should not claim to have infallible skills to predict that future.

That said, a knowledge of economic concepts is useful as a way of thinking about the range of possibilities which could happen.

We should all be cautious and beware of the pride that goes before a fall.

The couple of years prior to August 2007 were marked by statements from the UK government, IMF and US Federal Reserve to the effect that the world economy was very robust.


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