A recent report from the Bank for International Settlements titled “Financial stability risks: old and new” suggests that the real risks for the interconnected global economy of the 21st century are not from central banks, but from asset managers. Author Hyun Song Shin highlights that the financial industry has changed dramatically since the 2007-2008 financial crisis, and that policy makers and investors are not fully aware of just how much financial intermediation has changed and how closely linked the financial sector and non-financial corporate sector really are today.

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Stronger dollar results in a “global tightening”

Hyun Song Shin points out that from a global perspective, the U.S. dollar is the dominant currency of finance and is the global unit of account in debt contracts. He argues from a macroeconomic perspective that this means that a stronger dollar in essence constitutes a tightening of global financial conditions.

He also notes that this “tightening” will inevitably have an impact on global growth, and, moreover, this will also put further upward pressure on the dollar.

Liquidity freeze up could lead to “distress loop” exacerbated by asset managers

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The Bank of International Settlements report also hypothesizes the possibility of a liquidity freeze leading to a “distress loop” in the future. Hyun Song Shin offers a five-step breakdown of the process.
“1. Steepening of local currency yield curve
2. Currency depreciation, corporate distress, freeze in corporate CAPEX, slowdown in growth
3. Runs of wholesale corporate deposits from domestic banking sector
4. Asset managers cut back positions in EME corporate bonds citing slower growth in EMEs
5. Back to Step 1, and repeat.”
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The report concludes with with a warning and by posing questions for future consideration.

Hyun Song Shin reminds us that asset managers rather than banks are at the heart of transmission mechanism in the current second phase of global liquidity, and that their actions as a group have the potential to destabilize international financial markets.

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He highlights the conundrum: “Textbooks say long-term investors are benign, not a force for destabilization

How do we adjust to the new world?”

Asset Managers