BIS on "Financial Cycle Risk"

The annual report from the BIS is out,

In light of the above, the potential role of financial cycle risks comes to the fore. The main cause of the next recession will perhaps resemble more closely that of the latest one – a financial cycle bust. In fact, the recessions in the early 1990s in a number of advanced economies, without approaching the depth and breadth of the latest one, had already begun to exhibit similar features: they had been preceded by outsize increases in credit and property prices, which collapsed once monetary policy started to tighten, leading to financial and banking strains. And for EMEs, financial crises linked to financial cycle busts have been quite prominent, often triggered or amplified by the loss of external funding; recall, for instance, the Asian crisis some 20 years ago. Leading indicators of financial distress constructed along the above lines do point to potential risks (Chapter III). Admittedly, such risks are not apparent in the countries at the core of the GFC, where domestic financial booms collapsed, such as the United States, the United Kingdom or Spain. There, some private sector deleveraging has taken place and financial cycle expansions are still comparatively young. The main source of near-term concerns in crisis-hit economies is the failure to fully repair banks’ balance sheets in some countries, notably in parts of the euro area, especially where the public sector’s own balance sheet looks fragile (Chapter V). Political uncertainties compound these concerns. Rather, the classical signs of financial cycle risks are apparent in several countries largely spared by the GFC, which saw financial expansions gather pace in its aftermath. This group comprises several EMEs, including the largest, as well as a number of advanced economies, notably some commodity exporters buoyed by the long post-crisis commodity boom. In all of these economies, of course, interest rates have been very low, or even negative, as inflation has stayed low, or even given way to deflation, despite strong economic performance. Financial cycles in this group are at different stages. In some cases, such as China, the booms are continuing and maturing; in others, such as Brazil, they have already turned to bust and recessions have occurred, although without ushering in a full-blown financial crisis. EMEs face an additional challenge: the comparatively large amount of FX debt, mainly in US dollars (Chapters III, V and VI). Dollar debt has typically played a critical role in EME financial crises in the past, either as a trigger, such as when gross dollar-denominated capital flows reversed, or as an amplifier. The conjunction of a domestic currency depreciation and higher US dollar interest rates can be poisonous in the presence of large currency mismatches. From 2009 to end-2016, US dollar credit to non-banks located outside the United States – a bellwether BIS indicator of global liquidity – soared by around 50% to some $10.5 trillion; for those in EMEs alone, it more than doubled, to $3.6 trillion.