Hyun Song Shin, who is on leave from Princeton while chief economist at the Bank for International Settlements in Basel, spends a lot of time wondering what could cause the next financial crisis. He suspects it will be something different from the leveraged bets on housing that were at the root of the last crisis.
So, what might it be? Perhaps the steady rise of the U.S. dollar on global currency markets.
In recent presentations at the Brookings Institution, Mr. Shin documented the growing use of the U.S. dollar by borrowers and lenders outside of this country. U.S. banks and bond investors have lent $2.3 trillion outside the U.S. Foreign banks and foreign bond investors have lent much more: $6.5 trillion.
(Mr. Shin and colleagues at the Bank for International Settlements elaborated on his latest analysis in the bank’s new Quarterly Review posted Sunday.)
Here’s how Mr. Shin sees the world: A manufacturer in an emerging market borrows in dollars, perhaps because it sells a lot of goods in dollars and sees borrowing in dollars as a hedge. A local bank lends the dollars, borrowing from some big global bank. When the emerging-market currency is strong and the dollar is weak, that manufacturer’s balance sheet looks sturdier–and the local bank sees that and lends more readily. Thus a weak dollar can lead to a global credit boom.
When the dollar rises, though, all this runs in reverse, effectively tightening global financial conditions, particularly in emerging markets. The emerging-market currency falls. The manufacturer has trouble making payments on its dollar loans; so do its peers. Banks lend less readily. Capital investment stalls. Global money managers–the ones with lots of short-term wholesale deposits that search the world for the best yields–see a falling local currency and a weakening economy and pull money from the emerging-market banks.
Then, global asset managers who had been lured by a high-growth story see that it is now over and do the same thing, selling emerging-market corporate bonds. That pushes up interest rates that businesses in emerging markets have to pay, and weakens them further in a vicious cycle.
“Even if you have long-term investors and you don’t have [leveraged investors], if events in the financial markets translate into events in the real economy, you can get a feedback loop,” Mr. Shin says. And this, he adds, is a very different mechanism than the insolvency of highly leveraged financial institutions that was at the heart of the recent global financial crisis.
All this is a timely reminder that all the important steps taken to strengthen the foundations of the world’s banks in response to the last crisis aren’t a cause for complacency.