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A New Bretton Woods Moment

For this week’s corporate finance column, former World Banker Les Nemethy takes a sobering look at the time bombs ticking away in the world financial system.

Kristalina Ivanova Georgieva-Kinova, the Bulgarian economist, and managing director of the International Monetary Fund since October 1, 2019. File photo by ID1974 / Shutterstock.com

Kristalina Georgieva, managing director of the International Monetary Fund, titled her recent October 15 speech at the IMF Annual Meeting “A New Bretton Woods moment”, hinting that COVID-19 may trigger a financial crisis of such scale as to require rejigging the Bretton Woods agreements, the foundation of our post-World War II financial system.

With the exception of a handful of countries like China and New Zealand, most governments have lost control over COVID-19. In other words, the virus has reached such a scale that contact tracing cannot be effective in suppressing contagion.

Given the uncertainties in most of the world about whether there will be further spikes in the virus, the extent of those spikes, possible lockdowns or other restrictions, economic forecasting becomes highly uncertain, if not impossible.

Lockdowns, due to their exorbitant economic cost, have been dropped from the agenda of many governments. Yet, the infection rate in the fall of 2020 is already higher in many countries than it was in spring (400,000 new infections tallied per day as at time of writing, and rising).

If fatality rates were to reach a certain threshold, lockdowns may once again become the ordre du jour (witness recent developments in Wales and Ireland). Or, if governments do no not impose lockdown, economic activity may shrivel due to people retreating into self-imposed isolation.

Record Debt

The world economy today is characterized by record levels of indebtedness (sovereign, corporate and personal) and record declines in GDP, which makes the debt all the less sustainable.

Debt levels were globally at record levels even before COVID-19 hit. And the solution for high debt during the coronavirus crisis seems to be taking on even more debt.

The only reason that the record levels of indebtedness have not created a financial crisis to date is that interest rates have been extremely low, often negative. (Even Italy has been able to float debt at very low interest, most recently, three year bonds at zero coupon, for example).

It is easy to see how, with mountains of debt, higher interest rates could bring down the house of cards. Inflationary expectations or loss of confidence in fiat currencies are two factors which might lead to higher interest rates.

In the United States, foreign interest in Treasuries seems to be evaporating, and the Federal Reserve has become the largest purchaser of them. The Fed and other branches of the U.S. government hold more than USD 10 trillion of the total USD 27 tln in Treasuries outstanding, and the share is growing rapidly.

While foreign and private buyers are shying away from Treasuries, an enormous amount of new debt needs to be issued, and old debt refinanced, over the next few years. Rapidly increasing issuance of Treasuries and diminished demand should lead to rising interest rates, save for the artificial suppression of interest rates by the Fed stepping in as the largest purchaser.

Other than mountains of debt and the possibility of rising interest rates, there are also numerous other time bombs ticking away in the financial system, to name few (though not in any order of importance):

• Sovereign Default. More than USD 100 billion has already flowed out of emerging countries since the spring of 2020, three times the outflows during the Lehman crisis, raising the possibility of sovereign default.

• Bank Default. This could be triggered by any number of factors, such as the high level of bankruptcies (which are set to rise exponentially). Then there are Collateralized Loan Obligations (CLOs), securities backed by pools of debt, similar to the Collateralized Mortgage Obligations that created the 2008 financial crisis; CLOs are basically bundles of corporate debt of differing quality, estimated to be over USD 1 tln in the United States by theatlantic.com. Another problem area are derivatives, given that there is no transparency concerning counterparty risk, this catalyzed financial markets seizing up during the Lehman crisis. Simply put, it was impossible to ascertain how risky banks were. This has not been a lesson learned from the Lehman crisis. The level of derivatives are higher than ever.

• Paper gold. This was the subject of a recent column of mine (see the October 2, 2020 issue of the Budapest Business Journal). In the event of a massive short squeeze, owners of ETFs and gold contracts could be victims of default; here we are talking about numbers potentially exceeding USD 100 tln.

Fortunately, the IMF has already stepped into shoring up emerging countries with more than USD 100 bln in new sovereign loans, and banks were much better capitalized going into 2020 than they were going into the Lehman crisis, but COVID dragging on and reaching new heights has the potential to create further stress in the system, and trigger a financial crisis, through any of the mechanisms mentioned above.

It is hard to predict when or where the financial system will experience its blowout; suffice it to say there are quite a few points of weakness or vulnerability. Should it happen, given the unsustainable levels of debt being accumulated, economists are beginning to talk about a reset of the global financial system.

“A New Bretton Woods Moment” is a strong hint that the IMF may also be thinking in this direction.

Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.