Global Debt Could Spark Global Crisis if Central Banks Bungle Tightening

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Andrey Kuzmin/Adobe Stack

While we read presidential tweets, or worse, listen to megalomaniacs gloat about successful missile launches, a quiet shift has been going on in the financial markets.

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Political risks as a driver of exchange rates have either faded into the background or have already been fully priced into non-dollar currencies. Meanwhile, the driver in currency markets has shifted back to central bank actions and the macroeconomic factors that drive them.

You only have to see the sharp reaction in Europe to recent comments made by Mario Draghi, president of the European Central Bank, concerning “reflationary pressures” at work, causing an immediate 2% spike in the Euro, to see the market’s focus is firmly back on inflation-related indicators, with wage growth in the different currency areas taking on a particularly critical role.

The Associated Press reported last month that inflation across the 19-country Eurozone held up better than anticipated in the face of waning energy prices — a sign that the region’s economic recovery is reverberating across the single-currency bloc.

The article went on to say that according to Eurostat, the European Union’s statistics agency, June’s consumer prices rose by an annual 1.3% with core inflation rate, which strips out the volatile items of food, alcohol, energy and tobacco, rose to 1.1% in the year to June from 0.9%. The article sees the increase in core rate because of higher wages as unemployment across the region steadily falls and economic growth improves. The market is interpreting this as leading to the European Central Bank starting to rein in stimulus sooner than previously estimated. A pincer movement of higher interest rates and tapered stimulus would have a strongly supportive impact on the value of the Euro.

Meanwhile, across the pond in the U.S., the Federal Reserve has already announced similar trends are in play with two rate rises this year, as well as the possibility of the Fed selling assets as early as September (although year’s end remains more likely as a start date).

Even Brexit crisis hit Britain is toying with raising rates.

At the recent Bank’s Monetary Policy Committee (MPC), the minutes showed a major split in opinion regarding raising U.K. interest rates. Three external members of the MPC — Ian McCafferty, Michael Saunders and Kristin Forbes — wanted to raise rates by a quarter point to 0.5% but were outvoted by four full-time Bank staffers, including Governor Mark Carney, The National reported.

Broadly speaking, ending stimulus and raising rates due to a recovering global economy is a good sign — it is a natural response to a positive trend and is far better than the opposite state of affairs.

But the Institute of International Finance in Washington released figures showing that global debt has reached a staggering $217 trillion (£168 trillion), according to The National. That’s 327% of world GDP and well up on where it was at the onset of the last financial crisis back in 2007.

If official interest rates start to climb up from near zero than an awful lot of companies and governments are going to go bust, the paper observes, caught between rising interest rates and a stronger dollar and Euro.

This will take some fine balancing by central banks, raising rates and reversing stimulus fast enough to avoid a rise in inflation, but not too fast to cause acute pain among debtors. Failure to strike the balance could, in a year or two, push us back into another cycle of bust.

Let’s hope they know what they are doing.

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