The increasing value of the dollar against other currencies could provide the trigger for another major global financial crisis. That is the conclusion to emerge from the latest Quarterly Review of the Swiss-based Bank for International Settlements (BIS). Sometimes known as the central bankers’ bank, it functions as a kind of watchdog over the global financial system.

The quarterly report focused on two key developments in financial markets during the recent period: sharp movements in August and October, pointing to underlying fragility, despite seeming buoyant conditions, and the rapid rise in dollar-denominated loans to so-called emerging markets, especially China.

The BIS pointed to the implications of the events of October 15, following an earlier experience of market volatility in August, when, for a brief period, financial markets began to resemble those of September 2008 following the collapse of the US investment bank Lehman Brothers.

“Mid-October’s extreme intraday price movements underscore how sensitive markets have become to even small surprises. On October 15, the yield on 10-year US treasury bonds fell almost 37 basis points (0.37 percentage points), more than the drop on September 15, 2008 when Lehman Brothers filed for bankruptcy.”

The report noted that this movement was large relative to actual economic and policy ‘surprises,’ as the most notable piece of news that day was the release of somewhat weaker than expected US retail sales data an hour before the sharp drop.

“A continued depreciation of the domestic currency against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions”

Commenting on this incident, Claudio Borio, the head of the BIS monetary and economic department, said it was possible to draw some comfort, as did those who referred to the speed of the rebound.

According to Borio, however, the real significance of the abrupt drop was the extent to which it underlined “the fragility—dare I say growing fragility?—hidden beneath the markets’ buoyancy.” Central banks issued soothing statements that calmed the situation, but this only “highlighted once more the degree to which markets are relying on central banks: the markets’ buoyancy hinges on central banks’ every word and deed.” The ‘highly abnormal’ was becoming ‘normal.’

The BIS also pointed to the potential impact of a continued rise in the value of the dollar on emerging market economies (EMEs), where firms have taken out dollar-denominated loans. In conditions where other central banks, notably the European Central Bank and the Bank of Japan, are engaged in quantitative easing while the US Fed is looking to tighten monetary policy, any consequent rise in the value of the US currency immediately increases the debt and real interest rate burden.

“The appreciation of the dollar against the backdrop of divergent monetary policies, may, if persistent, have a profound impact on the global economy. A continued depreciation of the domestic currency against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions,” the report said.

Since the Lehman crisis, debt levels in emerging markets have jumped by 30 percentage points and now stand at an amount equivalent to 175pc of gross domestic product.

The biggest rise has been in lending to China. It has become the largest emerging market borrower, with cross-border claims totaling $1.1trn in June this year, compared to $311bn for Brazil and more than $200bn each for India and Korea. The BIS reported that banks’ exposure to China was almost twice as large as any emerging market economy.

China is generally considered to have sufficient reserves to bail out companies that experience difficulties. In the event of a major crisis, however, it would most likely have to consider selling off some of its large holding of US treasury bonds, leading to upward pressure on US interest rates and creating turbulence in American financial markets.

Courtesy: WSWS

Published in Dawn, Economic & Business, December 15th , 2014