Debt risk, market turmoil threaten financial crisis

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Nagging debt risks, heated currency wars and renewed market turmoil are making the global economy a precarious place, six years after the financial crisis.

On the sixth anniversary of the S&P 500's biggest one-day drop in history – a 106-point plunge on Sept. 29, 2008, that marked the beginning of one of the worst market collapses of all time – the respected annual Geneva Report on the World Economy is raising concerns about a "poisonous combination" of record and still-rising global debts and chronically slow growth. It warned that this leaves the world exposed to a heightened risk of further economic stagnation and even another potential financial crisis.

The report comes in the midst of a disquieting September funk in global financial markets, as the sharp divergence between the accelerating U.S. economy and stagnation in much of the rest of the world has fuelled growing nervousness and rising volatility. Deepening concerns about slowdowns in China and Europe have sent some commodity prices to eight-month lows, and a flight to the U.S. dollar has roiled currency and bond markets.

The straw stirring the entire murky mix is the likelihood that the U.S. Federal Reserve Board will start raising interest rates next year even as other central banks are leaning the other way – raising considerable uncertainty about how well the global economy and financial markets can weather such a pivotal policy change.

The report, by the Centre for Economic Policy Research, a leading European economic think tank, warned that raising interest rates too quickly while the world is still so heavily in debt "would risk killing the recovery. Beyond pushing the economy into a prolonged period of stagnation, this would also put at risk the deleveraging process which is already very challenging."

The report said that "contrary to widely held beliefs, the world has not yet begun to de-lever."

It estimated total debt of all kinds (government, corporate and consumer) at a record 212 per cent of annual global gross domestic product, up from about 185 per cent in 2008.

While the world's advanced economies have curbed the pace of debt accumulation since the crisis, emerging markets have accelerated debt growth amid historically low global interest rates – with China leading the way.

"This group of countries are a main source of concern in terms of future debt trajectories, especially China and the so-called 'fragile eight' [Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa and Turkey], which could host the next leg of the global leverage crisis," the authors said.

Meanwhile, many advanced economies are caught in a "vicious loop" of high debt and slow growth.

Debt reduction through austerity reduces spending and thus slows growth; slower growth reduces incoming revenues and thus limits the ability to reduce debt.

This is a factor in the stubborn lack of global capital investment that has been limiting economic expansion – and Canada is no exception.

Standard & Poor's on Monday pointed a finger at consumer debt as it lowered its 2014 growth forecast for the Canadian economy to 2.3 per cent from 2.5 per cent.

"Consumers might still be postponing purchases, worried about the heavy debt burdens they built up in the past decade, and this could be short-circuiting the growth we normally see in recoveries," said S&P global fixed income analyst Robert Palombi. Without that consumer pick-up, he said, businesses lack a key catalyst to invest in expansion, which in turn has stifled employment growth.

The Fed's looming rate increases come as many other central banks are taking policy paths that will weaken their currencies, in what some observers see as a currency war – in which countries compete for lower exchange rates to entice trade demand.

The European Central Bank is edging toward full-fledged quantitative easing, the Bank of Canada has recently been lowering expectations on the pace of Canada's rate cycle and the Reserve Bank of New Zealand even recently intervened in the foreign exchange market to dampen its dollar.

The result has been a rapid rise in the U.S. currency that is sending ripples through financial markets – raising questions about whether the stronger greenback will weigh on the U.S. recovery.

"For the first time since 1994, the Fed could embark on a tightening phase while the U.S. dollar is appreciating," said National Bank Financial economists Stéfane Marion and Matthieu Arseneau in a research report.

"For some investors, a stronger greenback combined with Fed rate hikes is synonymous with a double whammy for the U.S. economy and global growth."