Unknown unknowns

Risk of a global shock will increase with higher rates

Indian policymakers may be underestimating the risk posed to the Indian economy by global macro conditions that have turned sharply adverse. A recent paper in the Reserve Bank of India monthly bulletin argued that in the case of adverse shocks to volatility or spreads of a magnitude on a par with historical evidence, capital outflows from India would average 3.2 per cent of gross domestic product. A “black swan” event that puts several adverse shocks together might lead to an exit of capital that would be more than double that. In the former case, at least, there may be no destabilisation on the external account given ample reserves. But the broader impact of such events on capital costs, investment, the markets and growth would clearly be negative.

Signs that such a storm is building up are easy to discern. The United States Federal Reserve last week raised the federal funds rate by 75 basis points. Also last week, the Bank of England took its base rate to 1.25 per cent; it has not been higher than 0.75 per cent for more than a decade, but some predict it will reach 3 per cent by the end of next year. The global economy is facing multiple stresses: Escalating prices of food and fuel, driven by real on-the-ground factors, especially the Russian invasion of Ukraine; an unsustainable build-up of sovereign debt in the emerging world; and overstretched post-pandemic balance sheets in the developed world. There will have to be a response, which will likely feature a return to low-risk behaviour and a general increase in interest rates.

But it is always the case that, when the easy money retreats, those who have over-indulged collapse. The question is: How many sectors and geographies do they bring down with them? This usually depends upon two factors: First, how effectively they have hidden risky behaviour from investors and counterparties; and second, how integrated they are with other sectors and geographies. The real estate market in the United States and Europe prior to the 2008 crisis satisfied the first criterion perfectly and the second reasonably well. The 1907 banking crisis was caused by hidden risks in well-connected New York non-banking financial “trusts” — but sparked by a real-world commodity crisis, the San Francisco earthquake and the sudden drying up of gold supply as a consequence.

It is not certain what the leading sector in the next crisis will be. Perhaps sovereign debt? Once again, spreads between southern and northern European bonds are opening up. Start-ups are risky — but are they systemically integrated?  One likely sector is private equity or perhaps “family” investing, which has both hidden and unregulated risk and is increasingly dominant in multiple other financial and real sectors. In the United States, private equity has $4.1 trillion of assets under management (AUM), while it is estimated that even less regulated private family offices have AUM close to $6 trillion. The nature of the leading sector in the next crisis will determine the degree of splashback across sectors, and how much exposure India will have in the initial stages. But crises raise the costs of accessing capital markets for everyone, and create further headwinds for economic growth in India that is already facing headwinds. In the famous phrase, the source of the next financial crisis is a “known unknown”, but its trajectory and effect is the most important “unknown unknown”.