Dec 05, 2013

    Seeds of next financial crisis are being sown

    JAPANESE investment bank Nomura has declared that the global financial crisis is finally over, announcing: "The end of the end of the world" is here.

    The verdict predicted a return to more normal financial conditions next year.

    But if there is any lesson that should linger from the 2008 crisis, it is that danger lurks in exuberance.

    The giant pool of liquidity that flowed out of the rich world after the crisis, seeking higher returns in faster-growing countries, is coming full circle back to advanced economies.

    Much of this money has spent the last few years sloshing around emerging markets, blindly searching for yield and, in the process, pushing up the prices of all manner of assets - from properties to stocks.

    Now, the wave of capital is finding its way back to the recovering economies of the United States and Europe, joined by more funds from emerging markets, whose own economies are starting to slow.

    The Dow Jones Industrial Average and S&P 500 have both been hitting a series of all-time highs.

    Last weekend, Nobel prize-winning economist Robert Shiller cautioned that the boom in US stocks could turn into a bubble.

    The Monetary Authority of Singapore (MAS) has noted that investors are throwing their cash into increasingly questionable areas in developed markets.

    These include euro-zone government bonds, despite the region's high sovereign debt and slow reforms; speculative-grade company bonds and other risky assets; and securities backed by commercial mortgages, an asset class best known for precipitating the collapse of investment bank Lehman Brothers and triggering the global financial crisis.

    Increasing investments in each of these areas pose a different sort of risk, the MAS pointed out.

    Investors' willingness to lend money to peripheral European governments reduces pressure on them to implement necessary economic reforms, which could cause more harm down the road.

    The demand for high-yield debt and high-risk instruments may signal that investors do not fully appreciate the possibility of more companies defaulting once interest rates rise and credit conditions tighten.

    Meanwhile, signs of stress are emerging in the commercial mortgage-backed securities market, with defaults in Europe during the first six months of the year double those in the same period last year, the MAS said.

    The issuance of such securities around the world is at its highest this year since 2007, according to financial data provider Dealogic.

    At the same time, the quality of assets used as collateral for these securities "has declined significantly since the market restarted in 2010", Barclays analysts Keerthi Raghavan and Aaron Haan said in a report.

    The upshot is that even before the developed economies have fully recovered from the last financial crisis, they will need to pay close attention to where the next pressure points could emerge.

    The irony is that the more stable a country's financial system and economic growth, the more likely it is to attract hot money. The trick is to learn how to better manage it as well.