"The three main systemic risks to monitor"

Analysis - 3/21/2016

Mathilde Lemoine, Group Chief Economist at Edmond de Rothschild, spoke in Paris on Thursday 17 March at the closing conference of the GI Forum's "Economic Climate and Systemic Risk" conference series

She spoke alongside Thomas Gomart, Director of the Institut Français des Relations Internationales (IFRI) and Anne Le Loirier, First Deputy Governor of the Banque de France. The discussions were chaired by Cyrille Lachèvre, a journalist with L'Opinion.

Photo (from left to right): Cyrille Lachèvre, Mathilde Lemoine, Thomas Gomart, Anne Le Loirier.

Here are some extracts from her talk.

"A risk is systemic if it causes instability which prevents the proper functioning of the financial system and ultimately has a negative impact on growth and well-being.
With this definition, I identified what seemed to me to be the three biggest risks: liberalisation of the Chinese financial market, negative interest rates and rising private and public debt in the Eurozone.

Let's look in detail at each of them:

1 - Liberalisation of the Chinese financial market
Uncertainty on the Chinese financial market could spread and impact investment and growth in China as well as developed countries.
When it joined the WTO in 2001, China committed to liberalisation of its financial system. It was slow to introduce these reforms, although they are now a key strategic focus for Chinese President Xi Jinping. This liberalisation is now seen as essential to support the transition in China's growth. It is no longer enough to invest in infrastructure. Funding is now needed for new businesses and new technologies, to promote the spread of innovation within the Chinese economy. This will lead to an increase in productivity, which has decelerated sharply in the last 10 years, from 10% to 6.5%.
This change in growth model is not possible without funding.

The Chinese authorities have already taken a number of measures, including liberalisation of interest rates and opening up of the domestic inter-banking bond market to foreign institutional investors. They also manage RMB inflows and outflows to avoid excessive currency volatility.
So far, the authorities have maintained control of this financial liberalisation. However the difficulty of the task, recent communication blunders and a lack of transparency could trigger banking and financial panic at any time. The high level of corporate debt, at 160% of GDP and the rise in default rates are all elements which could significantly push up corporate bond yields in China, as well as in the United States and the Eurozone. Credit markets are highly correlated. This would therefore lead to a rapid decline in the investment outlook.

2 - Negative interest rates
Remember that for negative nominal interest rates, we are in uncharted territory. There is no theory and very little economic literature on the subject, since economic texts have traditionally considered it to be an impossibility!

What could the implications be?
Firstly, it means that time no longer has a cost. This has significant consequences for the behaviour of economic players. Theoretically, it should encourage more consumption and less anticipation. Reasons to invest are also increasingly few and far between despite cheap borrowing.
The question is whether negative nominal interest rates are an instrument of monetary policy or a reflection of long-term weakness in nominal growth.
To my mind, they reflect long-term weakness in nominal growth.

The systemic risk lies in the fact that these rates are set by central banks. It would be different if actual interest rates were negative due to a recovery in inflation.
The introduction of negative nominal rates is weighing down the investment outlook, without triggering any increase in consumption. This is what Keynes called "the savings paradox". Households could be encouraged to increase their savings to achieve the same amount of income from them. But in that case, the effect would be the complete opposite of that sought, without stimulating investment.
And unless banks can find other sources of profit, negative interest rates will have a long-term impact on their growth model.
In the short term, investors will turn to real estate, which has higher actual profitability. There is a risk of a bubble if productivity and therefore growth continue to decelerate. There is therefore a systemic risk of the creation of negative nominal rates.

3 - Rising debt in the Eurozone
Both public and private debt is rising sharply in the Eurozone.
Monetary policy is encouraging debt, both to buy property and to invest in the public sector.
At the start of 2015, we saw a reinterpretation of the stability pact. Governments gave themselves more flexibility in relation to their budgets. At the same time, the European context (electoral timetable, migrant crisis, etc.) has led to an acceleration in public expenditure.

In what way is this a systemic risk?
Without appropriate governance, there is a significant risk of poor allocation of resources causing a decline in productivity, deflation and greater poverty.
The central bank is also creating foreclosure effects which encourage bubbles.
That is why the central banks most sensitive to systemic risk, such as the Bundesbank, are considering implementing macro-prudential measures (particularly to limit real-estate borrowing).

In conclusion, I would like to emphasise what these three risks have in common: they all result from the "manipulation" of asset prices by central banks. The objective of unconventional monetary policies is laudable to the extent that they have reduced borrowing costs to historical lows. But central banks now "make" the bond market, and, through a foreclosure effect, the prices of other asset markets. Asset prices are therefore increasingly decorrelated from fundamentals, making macro-economic changes totally dependent on decisions by governments and central bankers. We must build these major institutional changes into our forecasts."