Do credit booms foretell emerging-market crises?
A commonly watched indicator of financial stability may produce too many false alarms
Mar 15th 2018
ON THE morning of December 7th 1941, George Elliott Junior noticed “the largest blip” he had ever seen on a radar near America’s naval base at Pearl Harbour. His discovery was dismissed by his superiors, who were thus unprepared for the Japanese bombers that arrived shortly after. The mistake prompted urgent research into “receiver operating characteristics”, the ability of radar operators to distinguish between true and false alarms.
A similar concern motivates research at the Bank for International Settlements (BIS) in Basel, Switzerland. Its equivalent to the radar is a set of economic indicators that can potentially detect the approach of financial crises. A prominent example is the “credit gap”, which measures the divergence between the level of credit to households and non-financial firms, expressed as a percentage of GDP, and its long-term trend. A big gap may reflect the kind of unsustainable credit boom that often precedes a crisis. Anything above 9% of GDP is reason to worry, according to Iñaki Aldasoro, Claudio Borio and Mathias Drehmann of the BIS.
The biggest blips on the oscilloscope include Canada (9.6%), Singapore (11.1%) and Switzerland (16.3%), according to the latest readings, released on March 11th. But the one that has kept everyone’s eyes peeled is China, with a gap of 16.7% in the third quarter of 2017 (the latest BIS figure available).
As a crisis-detector, the credit gap has some appealing operating characteristics. It can stand alone. It can be estimated quarterly across many economies. And, according to Mr Aldasoro and his co-authors, it would have predicted 80% of the crises since 1980 in the countries and periods for which data are available.
The problem is that it has also predicted many crises that never arrived. When such early-warning indicators flash red, the chance of a crisis in the next three years is “around 50%”, says Mr Drehmann. The BIS provides over 5,200 credit-gap readings for the period since 1980. In over 850 instances, the gap exceeded 9% but skies remained clear.
The problems seem worse in emerging markets. Their data are patchier, covering just 13 crises. Of this unfortunate number, only eight were preceded by a big credit gap. (Another three struck within three years of the start of the data, which may be too early to provide a fair test of the indicator.) There have been many false alarms. The credit gap flashed red almost continuously in Chile in 1993-2002, reaching over 24%, but no crisis followed. It was also persistently large in the Czech Republic in 2007-14 and in Hungary in 2000-10 without any great trauma ensuing. The indicator successfully predicted the “Asian flu” in Indonesia, Malaysia and South Korea in the late 1990s, but only after sounding a false alarm in all three countries in the 1980s.
What about China? Paul Samuelson, a Nobel-prize winning economist, once joked that the stockmarket had predicted nine out of America’s last five recessions. Similarly, the credit gap predicted at least three out of China’s last zero crises. It rose above 9% in mid-2003, mid-2009 and mid-2012, where it has stayed since. China’s comeuppance may still arrive. But the gap is now closing rapidly. It has decreased from almost 29% in the first quarter of 2016 to less than 13% at the end of last year, according to The Economist’scalculations.
One obvious explanation for China’s resilience is that its credit is mostly home-grown, extended by domestic banks and other Chinese lenders. By contrast the crisis-struck emerging economies mostly relied on inflows of foreign capital to finance their current-account deficits with the rest of the world. Looking at both current-account gaps and credit gaps may provide better predictions, says Michael Spencer of Deutsche Bank. He calculates that China’s risk of a financial crisis this year is less than 8% (assuming a credit gap of under 13%) partly because it runs a current-account surplus of about 1.4% of GDP. If China’s government keeps credit stable as a share of GDP this year, this crisis-risk could fall to about 5%.
On that day of infamy in 1941, Mr Elliott took the radar blip far more seriously than his fellow operator did, despite being less experienced. Perhaps this should not be surprising. After less than three months of radar-watching, Mr Elliott was not yet jaded by routine. If a financial crisis eventually strikes China, many people will be caught out—not because of a lack of warnings, but because of too many.
A lose-lose trade war looms between America and China
If China cannot placate Donald Trump, it will fight him instead
Mar 15th 2018| SHANGHAI
PRESIDENT DONALD TRUMP has not yet started a global trade war. But he has started a frenzy of special pleading and spluttered threats. In the week since he announced tariffs on steel and aluminium imports, countries have scrambled to win reprieves. Australia, the European Union and Japan, among others, have argued that, since they are America’s allies, their products pose no risk to America’s security. If these appeals fail, the EU has been most vocal in vowing to retaliate, in turn prompting Mr Trump to threaten levies on European cars.
In China, ostensibly the focus of Mr Trump’s actions, the public response has been more restrained. Officials have said the two countries should strive for a “win-win outcome”, a favourite bromide in their lexicon. As a rival to America, China knows that an exemption from the tariffs is not on offer. It also knows that it needs to conserve firepower. If this is the first shot in a trade war, it is, for China, small bore. Its steel and aluminium exports to America amount to roughly 0.03% of its GDP, not even a rounding error.
It is two shots to come that have China more worried. Mr Trump has asked China to slash its $375bn bilateral trade surplus by as much as $100bn, a nigh-impossible task. And an investigation into China’s intellectual-property practices is almost over. Mr Trump wants to punish China for the alleged theft of American corporate secrets. Reportedly he will seek to place tariffs on up to $60bn of Chinese imports, focused on technology and telecommunications (see Briefing).
Until recently, Chinese officials thought they had the measure of Mr Trump. During a state visit to China in November, he was treated to a lavish banquet and signing ceremonies for $250bn in cross-border deals. He still speaks fondly of the dinner, but the glow faded quickly on the deals, many of which were restatements of previous commitments. The tariffs on steel and aluminium, though negligible in their impact on China, signalled that hawkish advisers to Mr Trump were in the ascendancy. So behind their mask of calm, Chinese officials are searching for ways to fight back.
The demand that China cut its trade surplus by $100bn is, in a technical sense, risible. As Mei Xinyu, a researcher in a Chinese commerce-ministry think-tank, observes, America complains that China is not a market economy, but asks for a hard target that only a planned economy could hit. The true bilateral trade gap is smaller than reported, since Chinese exports contain many inputs from elsewhere. Add in services, including Chinese students in America, and it is smaller still.
Politically, the demand has helped focus China’s thinking. “There is a sense that they need to give Mr Trump a win, and that the win must be in the form of a big round number that he can tout,” says Eswar Prasad, an economist at Cornell University, who has spoken with Chinese trade officials. One possibility is that China might buy more of its oil and gas from America, and perhaps even make a hefty down payment on future purchases.
But if America imposes stiff penalties in the intellectual-property case—along with stinging tariffs, it might also place new restrictions on Chinese investment and travel visas—China will take a much harder line. A government adviser in Beijing says that regardless of the economic consequences, Xi Jinping, China’s president, will want to show that he is no pushover. Counter-measures will be varied, says David Dollar, America’s former treasury representative in Beijing. China will buy more soyabeans from Brazil instead of from America. It will buy more Airbus planes instead of Boeings. It will tell its students and tourists to go to other countries. It will drag its feet on approvals for American companies in China.
Worryingly, each side thinks that in a trade war of attrition, it would have the advantage. America calculates that China has the bigger surplus, and thus more to lose. But China’s exports to America are less than 3% of its GDP—large but not critically so. China, for its part, thinks Americans would object to paying higher prices for manufactured goods from toys to televisions. But much low-end production is migrating from China to other developing countries and, in a pinch, American consumers might rally round the flag. To invert China’s much-loved win-win motto, this has all the makings of a lose-lose battle.
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