(Bloomberg Opinion) -- Since the beginning of the trade war between China and the U.S., most economists have warned that rising protectionism would trigger an economic slowdown. A few years into this conflict, the evidence suggests that a deceleration is indeed taking place.
This week, the International Monetary Fund warned that global growth will fall to 3% this year, the lowest rate since the financial crisis, as the tit-for-tat between Washington and Beijing takes its toll on confidence and investment.
There may be an equally dangerous threat that economists so far have neglected: this slowdown, combined with a decade of ultra-loose monetary policy, could cause a wave of defaults among corporations. This double whammy could threaten the world’s financial stability.
The recent deceleration in the world economy has already prompted many central banks around the world to stop bringing monetary policy back in line with pre-financial crisis norms. From the U.S. Federal Reserve to the European Central Bank, central bankers have instead chosen to cut interest rates again and restart asset purchases. They now say that interest rates are bound to stay low — or even negative — for an extended period of time. This message is bound to push investors in search of higher returns to take on more risk.
The trouble is that while monetary policy can have a mitigating effect on an economic slowdown, it cannot solve it. The IMF estimates that the U.S.-China trade war has shaved 0.8 percentage points off global growth, while the response from central banks has only added back half a percentage point.
Monetary policy can help assuage the impact trade conflicts have on demand, but can do very little for the damages to supply — including dislocations in the production process. As the IMF has warned in its Global Financial Stability Report, companies and banks risk finding themselves overstretched, just as the global economy is hitting the brakes hard.
A blunt response would see central banks lift interest rates and immediately stop their asset purchases. But such a sudden tightening of monetary policy would only worsen the slowdown and possibly cause a market panic. So central bankers have little choice but to continue pumping money into the economy, keeping financial conditions as loose as possible for consumers and businesses.
Still, regulators should be mindful of the risks that are accumulating in the financial system. According to the IMF, were the global economy to face a slowdown half as severe as the financial crisis, the corporate debt at risk (that is, debt owed by companies that are unable to cover their interest payments with their earnings) would jump to nearly 40% of total corporate debt in major economies. This is above the level it hit during the financial crisis.
Central bankers can answer to this possibility with a better use of fiscal policy, especially in the countries that can afford it. But regulators should also start acting more forcefully with their macroprudential kit to ensure that banks don’t take on excessive risk — for example, they might take some risk out of the system by setting higher loan-to-value ratios for mortgages. As they seek ways to proceed, regulators should be particularly mindful of the so-called shadow banking system, which is where much of the risk landed after supervisors clamped down on lenders.
Of course, the best outcome would be for the U.S. and China to sign a sustainable trade truce. This would help to restore confidence among investors and allow central banks to resume lifting interest rates. Unfortunately, this appears unlikely: It is increasingly clear that Democrats, too, are skeptical of striking a deal with China that would take the world to the pre-trade war status quo.
So global regulators would be wise to get ready to deal with the financial consequences of protectionism. The costs of tariffs could prove higher than just an economic slowdown.
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Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.
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