- Nomura has created a model that has reliably signalled at least two-thirds of the past 50 financial crises in 30 countries monitored.
- Right now, the model says Hong Kong is in the “danger zone” for a potential financial crisis.
- China’s risk is also elevated, but Nomura isn’t increasing its warning for the moment.
Investor sentiment has taken a turn for the worst in October.
Stocks have slumped, bond yields have risen while concerns surrounding Italy, Saudi Arabia and China have all increased, albeit for different reasons.
It’s easy to understand why some investors may be on edge, especially given the increased frequency of sharp and sudden bouts of market volatility in 2018, adding to the view that it’s all looking a little “late cycle”.
Well, here’s something else for you to worry about, courtesy of Nomura.
According to the bank’s early warning indicators (EWIs), a model that has reliably signalled at least two-thirds of all financial crises that have occurred since the early 1990s, the risks of such an outcome is growing in Asia, in particular, Hong Kong.
Before we get to why Hong Kong looks vulnerable to a financial crisis, Rob Subbaraman and Michael Loo, Economists at Nomura, explain how the EWI works:
Drawing from the historical results, we have devised Nomura’s 3-30 rule: when a country has 30 or more EWIs flashing (there have been 17 countries in total since the early 1990s), it typically experiences a financial crisis (14 out of 17) and/or a sharp drop in domestic demand (12 of the 17) in the next three years.
The model uses five specific financial metrics: private credit-to-GDP, private debt-service ratios, real effective exchange rates (REER), real property prices and real equity prices to look for unusual deviations from historic trends. When they breach a predefined level, they trigger an early warning indicator for a potential financial crisis within three years.
So, back to Hong Kong. Why should be concerned?
According to Subbaraman and Loo, its EWI is in the “danger zone”.
“For Hong Kong, 50 warning signals were given over the past 12 quarters out of a maximum of 60, the highest of all the 30 economies in our sample,” they say.
“For the latest quarter of Q1 2018, all five of our EWI combinations are flashing warning signs… reflecting Hong Kong’s high credit-to-GDP ratio, real property prices, debt-service ratio, and real effective exchange rate (REER), all of which are above their long-run trends.”
Ominous, right? Akin to Hong Kong’s black rainstorm signal in terms of warning levels.
The news is not much better for Hong Kong’s neighbour to the north with China’s EWI also sitting in warning territory, an even bigger concern given its a substantially larger economic reach.
Thankfully, Nomura says that despite sitting at elevated levels, the risks don’t appear to be getting worse. For now.
“Encouragingly for China, the number of warning signals has declined from 35 in Q2 2017 to 32 in Q1 2018, which is unchanged from Q4 2017,” says Subbaraman and Loo.
So are the warning signals generated from the EWI’s worth paying attention to?
This chart may help you to decide.
It shows Nomura’s “3-30 rule”, tracking individual nations that recorded 30 or more EWIs in the past and comparing the subsequent change in domestic demand three years after it was triggered compared to the three years before.
Those with red markings indicate that a financial crisis occurred.
Right now, China’s EWI doesn’t appear all that extreme compared to other nations in the past. Hong Kong, on the other hand, will be creating history if it is to avoid a financial crisis, at least based on the model.
It’s little wonder why Subbaraman and Loo deem it to be in the “danger zone”.
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