Rate hikes “risk a financial earthquake,” warns Ken Rogoff

The greatest threat lies in the combination of undisclosed debt and liquidity mismatches in the shadow banking sector, which has supplanted traditional banking and largely escaped regulatory scrutiny.

These players are not subject to the normal mark-to-market rules that force them to admit increasing losses. The pre-warning signal is muted. Central banks don’t know where the land mines are or what interest rates will bring the system down.

Japan is the wild card

The huge joker this time around is that serious trouble could also be brewing in Japan’s $12 trillion (US$17.8 trillion) bond market, which is typically the calmest haven in global finance.

Japan has defied gravity for decades, running budget deficits for years with no discernible cost or inflationary impact.

But inflation has returned in the wake of the COVID-19 pandemic, pushing the country out of a poor but stable equilibrium into an unstable one. The Bank of Japan is riding a tiger as it tries to manage its exit from extreme quantitative easing and its policy of keeping bond rates low.


“The Japanese haven’t had a rate hike in three decades and nobody is positioned for it,” says Rogoff.

“The national debt is 260 percent of GDP, and half of that is overnight debt.”

The dam has already started to break. The Bank of Japan (BoJ) last month raised its longstanding 10-year bond limit from 0.25 percent to 0.5 percent in what appears to be a minor change but is actually a bombshell for international capital flows.

The BoJ has had to spend more than $100 billion over the past two weeks to defend the next line against the market rush. The swap market is already pricing in another jump to 1 percent.

An explosion in the Japanese bond market would be a black swan event. The country is the world’s largest creditor, with US$3.6 trillion in net external wealth. It owns 8 percent of France’s national debt. A sudden repatriation of funds would trigger contagion through the international system.

Olivier Blanchard, another former IMF chief economist, has also warned that Japan’s finances are less stable than they appear.

He fears that the country could spiral into a debt spiral and a funding crisis after deflation, which could leave the Japanese Treasury in extreme trouble.

Rogoff’s central premise is that global real interest rates “revert to the mean” over time. The more suddenly it happens, the greater the financial trauma. The current edifice of international borrowing and debt contracts is based on the assumption that real interest rates will remain pinned to the ground.

In September we had a taste of what could happen if UK gilt yields soar, triggering a self-reinforcing doom loop in a trillion pound segment of the UK fixed income industry.

The Bank of England contained the crisis with great skill and made profits from bond transactions. However, the episode sparked an immediate global contagion, alerting officials at the IMF and the Basel-based Financial Stability Board (FSB).

“It could burst anywhere,” says Harvard professor Ken Rogoff.Credit:Louie Douvis

“If it can happen in the UK, which is very well regulated, it can happen anywhere,” says Rogoff.

Europe’s pathologies

The liability-driven investments at the heart of this meltdown were legitimate hedging tools, Rogoff argues, since pension funds benefit from higher interest rates. The surprise was the severity of the global bond sell-off that started the process.

“Liz Truss has been blamed, but the underlying cause was Jay Powell’s rate hikes in the US, which pushed rates up for everyone,” he says.

The eurozone has its own stubborn pathologies, even though it weathered Vladimir Putin’s energy war remarkably well. But the long-term effects of monetary tightening are only just beginning to take hold.

The ECB’s anti-inflation hawks are back in charge and are adamant to push rates into “restrictive” territory and start selling bonds (quantitative tightening), a process that is likely to continue until something breaks.

“The glue that holds the eurozone together is the world of zero real interest rates,” says Rogoff. “As long as they stayed at zero, you could use QE as a transfer subsidy from North to South and it didn’t seem to cost anything. The underlying problem was never solved.”

The ECB’s bond purchases since 2015 have soaked up Italian bond issuance and shielded the country from market forces. This stopped in June. The ECB cushioned the blow for a few months by postponing the rollover of its existing portfolio from German Bunds to Italian bonds, but even that has reached its limits.


Markets doubt whether a new “anti-spread” tool (TPI) can be activated under any circumstances just before an emergency occurs. Doing this sooner would violate the no-bail clause in EU contract law and look all too much like fiscal dominance, leading to legal challenges.

But Italy is at least a “known-known” and the Meloni government has so far been careful not to provoke trouble.

Shadow banking threat

The global shadow banking system is a “known-unknown” system with a ubiquitous maturity mismatch. Many borrow in the short-term capital markets for long-term lending or invest in illiquid assets – pretty much the story of Northern Rock or Lehman Brothers before the global financial crisis.

Unlike regular banks, they cannot borrow from central banks’ emergency lending window, and they lack a stable base of savers protected by deposit insurance.

According to Rogoff, private equity groups have borrowed heavily to play in real estate markets, which are distressed to varying degrees.

Prices in the $21 trillion US commercial real estate market are down 13 percent from their peak. Average US home prices are falling faster than during the subprime crisis, although they haven’t fallen nearly as much yet.

“I think the real estate market still has a long way to go. Some of these private equity firms are going to go bust,” he says.

The FSB says the “non-bank” shadow sector now accounts for half of the $487 trillion in total financial assets globally. It warns that over $50 trillion of that is “vulnerable to runs” if liquidity dries up or there is an external shock.

To borrow Warren Buffett’s famous adage, you don’t find out who’s swimming naked until the tide goes out.

The Daily Telegraph, London

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https://www.smh.com.au/business/the-economy/interest-rate-rises-risk-a-financial-earthquake-20230117-p5cd1e.html?ref=rss&utm_medium=rss&utm_source=rss_business Rate hikes “risk a financial earthquake,” warns Ken Rogoff

Brian Lowry

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