Although this is unlikely to precipitate a global banking crisis, it will hit banking profits worldwide. And it will hasten the financial system shake-out in Japan, especially if structural reform in China leads to a collapse of the Hong Kong dollar peg (to which Japan’s banks are vulnerable).
Other OECD economies will be affected too. Trade balances will weaken dramatically, as emerging economies have accounted for close to 40% of the developed world’s merchandise export growth since 1989. Contraction in exports to emerging economies will chop GDP growth by 0.5% in Japan, 0.2% in Europe and 0.4% in the US. Lower investment spending will exacerbate that. I now expect global GDP growth to slow to 2.0% next year.
Shake-outs in emerging financial systems are more commonplace than you might suppose. Outside Africa, which has experienced a long list of failures, there have been 30 to 40 banking crises in the world since 1980, mostly in emerging economies.
The common feature was a rash of speculative poorly supervised lending, usually during a period of rapid economic expansion. On average, domestic credit grew three times as fast as GDP (in real terms). The inevitable result was that non-performing loans rose to unsustainable levels, often over 10% and even 20% of total lending.
Solutions were painful and costly. In the main, governments (or their not-so-independent central banks) stepped in to foot the bill. Usually this was accompanied by bank closures, mergers with healthier institutions, or capital issues. Very often a big chunk of losses accrued to depositors.
The overall economic cost of banking failures is difficult to gauge. The direct cost generally accrued to governments, but also affected electorates later through austerity programmes or high real interest rates. Based on the fiscal cost of bail-outs alone, at least 10% of GDP (spread over a number of years) seems to be a representative figure. But some banking crises cost very much more than that. For example, Argentina’s systemic crisis of the early 1980s cost more than 50% of annual GDP.
Last year’s currency crisis in east Asia was also founded on credit bubbles and fast economic growth. From 1994 to 1996, east Asian annual real GDP growth averaged 8.8%. Domestic credit grew much faster – by 11.3% in real terms. The ratio between real credit growth and real GDP growth was highest in Malaysia, the Philippines and Thailand. Argentina, Brazil, and the Czech Republic all experienced domestic credit growth at least twice as fast as their economies were expanding. The stock of credit in Latin America rose from 31% of GDP to 32%, between 1993-96. But in central and eastern Europe, domestic credit jumped from 27% to 32% of GDP, while in east Asia it soared from 112% to 120%.
What has this credit explosion meant for banks in emerging markets? In early 1997, average non-performing loans were up to 17% of total lending. The most indebted banks are in eastern Europe, where Russia, the Czech Republic and Slovakia have ratios above 30%. Globally, only four other major countries have ratios of 15% or above. The list should surprise nobody – Thailand, Korea, China and Mexico.
Bad debts are more likely to cause systemic failure in economies where financial depth is great. East Asia has a more developed financial structure than either Latin America or eastern Europe. Domestic credit, at more than 100% of annual GDP, is three times as important in east Asia as in the other regions. In contrast, domestic credit accounts for a much smaller proportion of GDP in Russia, Brazil and Mexico. So the collapse of a particular bank poses less of a systemic risk to these economies. All three countries have bad debt ratios below 7% of GDP.
But Korea, the Czech Republic and Slovakia exhibit all the hallmarks of an impending financial crisis. They have bad debt ratios above 20% of GDP, and above 15% of total loans, with sizeable current account deficits to match. If foreign capital won’t flow in voluntarily, it may have to be loaned officially – or else banking assets must be sold off wholesale to foreign investors.
China, too, has big potential banking difficulties. But it doesn’t exhibit the kind of credit bubble or current account deficit that would make this an urgent problem, although China has other constraints. To restructure its economy and absorb laid-off workers into the private sector (and to handle rapid urbanization), China needs to grow at a sustained 11%-12% annually. This will be tough in the wake of regional competitive devaluations and slower global growth.
So China needs to stimulate domestic investment-led growth. That means looser money: lower interest rates and a weaker renminbi. And it means Beijing has to avoid its own banking crisis-in-waiting (domestic credit is already equivalent to annual output, and 30% of that is non-performing).
The bad debts of the four major state banks, which account for around a third of all bank lending, could soon be taken over by the government. That would raise China’s 30% public debt-to-GDP ratio to over 40%, but it would revitalize the banking system.
What are the main effects of widespread banking crises in emerging markets? The first is a collapse in domestic bank lending. On average, in years subsequent to banking crises, credit growth fell 9% in real terms (22% in terms of pre-crisis loan growth). In developed countries, the contraction in bank credit was less dramatic, but still severe.
The second impact is a slowdown in real GDP growth rates. Here the experience is more mixed, with some countries (where crises were less systemic) sustaining positive growth rates. This supports our forecast of a sharp slowdown in east Asian (and other developing) economies over the next two years. We expect domestic demand in the region (excluding China) to contract by around 4% in real terms in 1998 and real GDP growth to fall to just above zero. That’s compared with an average real GDP growth of 6.7% in 1996-7 and a consensus 1998 real GDP growth forecast for the region of 5.3%.
A slowdown in domestic demand in emerging countries, exacerbated by a credit crunch, will affect the OECD in two ways. First, it means a sustained fall-off in exports. If combined exports to emerging economies from the US, Japan and the EU fall by 4% next year, and their combined imports from these countries rise by 3% in volume terms, the net trade impact would knock 0.3-0.4% off industrial economies’ 1998 real GDP growth rate. The dynamic impact on OECD capital spending could raise this hit to 0.5%.
Second, although industrial countries’ overall bank lending to east Asia is not enormous, many leading banks in the OECD have significant asset and profit exposure. Worst-affected will be Japan, where 6% of total bank lending is to east Asia.
All this is probably not enough to cause a systemic crisis in the world’s banking system. Even if the emerging economy bad debt ratio of 17% of total loans turns sour, and that proportion is mirrored in developed banks’ lending to these regions, losses would amount to around 1.2% of US, European and Japanese combined GDP (or less than 4% of their banks’ total lending). Those are big numbers. But they won’t bring the roof down.
Still, in the short term, capital will undoubtedly flee to the safe-havens of the US and Europe. That means real interest rates in developing economies will stay high over the next two to three years. So investors should avoid the domestic financial sector in most emerging equity markets. Stick to safe-haven long bonds in the US, the UK and Germany. Contagion isn’t over by a long shot.
David Roche is president of Independent Strategy, a London based research firm.
