Thursday , 29 February 2024

Risk of Global Financial System Contagion Increasing – Here's Why

It is widely accepted that Greece is insolvent even though the higher echelons of euro-zone politics still hesitate to use the term, and default swap prices…give virtually 100% odds that Greece will default. The handling of the issue has heightened the perception of risk for other problem countries of the euro zone…such that investors now give 60% odds of default by Portugal…and 30%-plus odds for default by Italy… Even France, with its S&P AAA rating, is now rated more likely to default than Brazil! [In addition, the U.S. is facing the liklihood of a fiscal policy impasse in Congress that could well lead to a recession. As such, as we see it, the risk of contagion in the financial system around the world has risen dramatically. We substantiate our contentions below.] Words: 1612

So say Krishen Rangasamy and Matthieu Arseneau, analysts with the National Bank (, in a report* which Lorimer Wilson, editor of (Your Key to Making Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Rangasamy and Arseneau go on to say:

Though euro-zone disunity has never been more apparent, it increasingly clear that the euro countries are all in the same boat. French and German public finances are of course in much better shape than those of the troubled countries yet the exposure of their financial institutions to the debt of the latter amounts to 24% of France’s GDP and 15% of Germany’s.

Yield spreads of European and U.S. financial institutions are now the widest since 2009. Fortunately, corporate financing has not been compromised. Financing rates for companies rated BAA by Moody’s are currently lower than at any time since the 1960s.

In our view, to calm the storm, the euro zone needs to:

  1. define a threshold of solvency for the countries concerned,
  2. provide unfailing support to countries rated “solvent”, including Italy and Spain given the size of their debt,
  3. if the debt of countries rated “insolvent” is restructured then governments and central bankers must provide the necessary liquidity for the banks to absorb the shock to prevent a crisis of public finances from becoming a financial crisis,
  4. [institute] major reforms in the medium term to make the troubled economies more competitive,
  5. bring spending on social programs…into line with what countries and governments can afford. Overly generous pensions in an aging society place enormous pressure on budgets and weigh on economic growth.

Global Economic Growth

Adding to financial fears caused by the European crisis are fears of a slowdown in the advanced economies [of the world]…The global economy, as a whole, expanded at more than 3% [in Q2 thanks to] a 5.6% growth rate in the emerging economies [which] was eight times that of the advanced economies. Real global industrial production rose in July for a third straight month, ([al]though Japan has yet to fully recover its lost capacity) and is now at a new high. Global trade volume was also up in July, a sign that this output is finding buyers, and has [also] continued to support commodity prices.

Commodity Prices

Despite the high market volatility and heightened risk of recession that have depressed equity markets worldwide, prices of many commodities have so far declined only modestly. In particular there has been very little decline in grain prices, which are a proxy for food prices in general because grains are feed for livestock (meat, fish, dairy products). As for oil, the price of Brent crude – a much better indicator of global supply and demand than the West Texas Intermediate– remains high. Thus global consumer spending is unlikely to have got a lift in Q3 from lower food and energy bills and that is unfortunate, especially since global 12-month inflation rose in July to 3.9%, the highest since 2008.

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In the current turmoil, however, central bankers are worrying much less about inflation than about the prospect of global economic downturn. After all, since commodity prices have now stabilized, their previous run-up may have only [been] a transient impact on inflation. Observers no longer exclude the possibility that the ECB, among others, could backtrack and try to provide stimulus to the economy.

Global Employment Growth

Global employment growth remained impressive in Q2 – a 3% annual rate overall despite sluggish hiring in the advanced economies – but the outlook has darkened since then. The employment subindex of the PMI Manufacturing index for emerging economies is now just below 50, suggesting a plateau in hiring, and services are barely positive at 51. The employment and services indexes for the advanced economies are slightly above 50, a sign that employment is not contracting. All in all, we continue to see the global economy expanding 3.7% in 2011 and 3.5% in 2012, rates that are below the average of the 2002-2007 period.

U.S. Double-Dip Recession Worries

Concerns abound as to whether the U.S. can avoid a double-dip recession. Though early indications suggest that the American economy remained above water in the third quarter, there are significant risks to growth in subsequent quarters such as a spillover from any euro-zone implosion and domestic frailties including a stagnant labour market and anemic consumption. Today’s slow-growth environment warrants some stimulus, but with the Fed now almost out of bullets, fiscal policy seems better positioned to do the job…[although] political impasse in Congress threatens to deprive the U.S. of the only major tool it has left to head off another downturn.

Is the U.S. heading for recession?…The Conference Board and University of Michigan indices [suggest that it is] but, at this writing, the major economic indicators generally don’t show the U.S. on the verge of recession. The Chicago Fed’s National Activity index, which sums up 85 monthly indicators in a single number, suggests an economy continuing to chug along, albeit slowly. The latest reading for August was still above the -0.7 that is typically associated with the onset of a recession. Another indicator, the Philadelphia Fed ADS index, which tracks business conditions on a weekly basis, suggests that we are well above levels that are associated with recessions.

U.S. Nominal GDP Growth

While real GDP tends to get all the attention from observers, nominal GDP isn’t to be discarded entirely given that it gives an indication of the government’s abilities to fill its coffers via tax revenues and on that front the news is good since nominal GDP climbed to a new high in Q2. In the third quarter, growth seems to have accelerated somewhat based on strong readings for industrial output in July and August. Exports have done reasonably well, rising to a record share of GDP in the second quarter. Exporters are being supported by a highly competitive U.S. dollar, now at a historic low in real terms.

U.S. Consumer Spending

That said, there are a number of risks to continued growth. For instance, the main component of the U.S. economy, consumer spending, appears to have flattened. Consumer confidence has dropped back into depressed territory since the recent stock market plunge, but the weak employment picture can also be blamed for anemic consumption.

U.S. Labour Market

The U.S. labour market is evidently facing challenges not seen since the Great Depression, with employment still 5% below the pre-recession peak reached almost four years ago. Its atypically slow recovery has much to do with structural problems. For instance, workers laid off in hard-hit industries (e.g. construction after the collapse of the housing market) face difficulties in competing for jobs that require other skills. Moreover, going too long without a job can result in atrophy of skills and a resulting loss of employability. Here the outlook is quite bleak: the proportion of jobless Americans who have been unemployed for more than 27 weeks remains near historic highs. These structural problems explain the divergence since the labour market trough of mid- 2009 between the help-wanted index and actual employment. They also explain why, despite massive slack in the labour market, wages are rising in some sectors of the economy particularly in areas where there are shortages because of skills mismatch. These inflationary pressures make the Fed’s job of promoting growth and employment even more difficult.

Future U.S. Quantitative Easing?

With interest rates at zero, some would argue for a third round of quantitative easing (QE), or asset purchases. While QE may have been appropriate last year when the U.S. was facing the threat of deflation, core inflation recently hit 2%, the upper bound of the Fed’s implicit target range. The Fed could resort to other options but the overall impact on economic growth is unlikely to be significant if QE2 is any guide so while the Fed says it is ready to do more if necessary, its capabilities seem limited at this point.

Fiscal Policy Impasse?

Fiscal policy has better potential to help boost America’s economy over the near term but given the polarization of U.S. politics, it is hard to see Congress coming to the rescue. If the recent debt ceiling saga is an indication, President Obama’s $450-billion plan to stimulate employment is unlikely to be implemented in its current form. Moreover, if the joint committee on debt reduction fails to reach agreement by its December deadline, $1.2 trillion in automatic spending cuts come into effect. The resulting fiscal drag could send the U.S. back into recession.

In our view, [fiscal policy impasse] is the biggest risk to growth in the U.S. in 2012. However, as suggested by our call for US GDP growth to accelerate to 2.2% next year, we remain optimistic that common sense will prevail among US politicians and that an agreement will be reached.