TOKYO -- The escalating trade tussle between the U.S. and China is fueling uncertainty about the future of the global economy. And if history is any guide, it shows that worldwide economic unrest often starts in financial markets.
If the world is hit by a full-blown economic crisis, the financial resilience of many emerging economies will be put to the test.
Major economic policy shifts often trigger changes in the flow of money. In early July, the Thai currency market experienced this firsthand. The Thai baht soared against the dollar, prompting the Bank of Thailand -- the country's central bank -- to step in to curb inflows of speculative capital chasing short-term profits. The surge of "hot money" came after the central bank decided to keep interest rates unchanged despite an expected rate cut by the U.S. Federal Reserve.
Another factor was the U.S. Treasury Department adding Thailand in May to a list of trading partners whose currency policies it reviews. Although Thailand was not placed on the Treasury's list to monitor for currency manipulation, the decision was notable. Preceding it, the Treasury had reviewed all U.S. trading partners whose trade surplus with the U.S. in 2018 exceeded $20 billion. Thailand met this criterion and thus received added scrutiny from U.S. President Donald Trump.
Betting that the Bank of Thailand would be less active about intervening in the currency market to curb the baht's appreciation, speculators aggressively bought the unit.
The U.S. rate cut has precipitated a race among countries to ease monetary policy, revealing weaknesses in some that have up to now remained concealed. But even if these countries weather the changes now sweeping global credit markets, they may face serious financial risks when the U.S. resumes tightening credit.
Hiroshi Morikawa, senior economist at the Institute for International Monetary Affairs, stresses "the need to reevaluate the financial resiliency of countries by using the latest data without being influenced by outdated perceptions."
The International Monetary Fund publishes its own assessment on the adequacy of foreign reserve holdings. This is based on not just a country's ability to pay back short-term debt, but also on the risks posed by a sudden decline in exports that decreases foreign capital inflows while increasing the vulnerability of capital flight and outflows of securities investment.
The IMF recommends that countries maintain foreign reserves totaling at least 100% to 150% of the combined value of these factors.
The latest IMF data, however, shows that not all countries are following this guidance. For example, foreign reserves held by Russia and Thailand -- both hit by currency crises in the past -- are at 324% and 202%, respectively, adequately shields against the risk of future crashes. But for China, the figure stands at 85%, while Argentina is at 86% and Turkey at 75%.
Many feel that the Chinese yuan is largely insulated from the risk of a full-fledged currency crisis. This is based on a number of facts. First, China has over $3 trillion in foreign currency reserves, more than any other country. Second, it runs a significant current-account surplus. Third, the yuan is increasingly being regarded as a major international currency.
But this landscape is rapidly changing. China's foreign reserves fell below the recommended levels in 2017, according to IMF data. The country's foreign reserves ballooned 430% from 2004 to 2015. But its money supply and short-term debt increased even faster, growing 860% and 780%, respectively, over the same term.
If foreign capital starts fleeing China, sending the yuan sharply lower, there will be little room for Beijing to use foreign reserves to prop up the currency.
The Chinese economy has expanded at a torrid pace since 2000, pushing up per capita income. But growth is now slowing as rising labor costs erode the country's global competitiveness.
To reverse the trend, Beijing announced its "Made in China 2025" initiative, which aims to turn the country into a high-tech powerhouse by 2025. The Trump administration -- fearful of losing technological dominance -- is trying to thwart the plan, as seen by the sanctions Washington has slapped on Huawei Technologies, China's top telecommunications equipment maker.
If Trump's tariffs on Chinese goods and the exodus of foreign manufacturers from China combine to further shrink the country's trade surplus, some predict that China will start running a current-account deficit.
Meanwhile, large Chinese commercial banks have become more dependent on the greenback. The Bank of China's dollar-denominated debt stood at 2,213.6 billion yuan ($314 billion) at the end of 2018, up 12% on year, according to the bank's annual report. But its dollar assets remained unchanged at 1,677.1 billion yuan, sending the dollar-debt to dollar-asset gap surging 81% to 536.5 billion yuan.
If Chinese commercial banks have difficulty raising dollars, and if China's foreign reserves do not provide an adequate buffer, what steps can Beijing take in the event of a crisis?
One lesson learned from the 2008 global financial crisis is that a misguided policy response could make the situation dramatically worse.
In 2007, Europe experienced the BNP Paribas shock -- a subprime disruption in financial markets caused by the same factors that pushed Lehman Brothers into bankruptcy in 2008. The European Central Bank responded by flooding European financial institutions with euros.
The action proved effective, but failed to address the core problem, which was a shortage of dollars that made it difficult to refinance existing debt to avoid defaulting on dollar-denominated securities backed by subprime loans.
Immediately after the failure of Lehman Brothers, the U.S. Federal Reserve agreed with the ECB and the Bank of Japan on a scheme to provide dollars directly to the central banks through currency swaps.
But in a similar financial emergency, will the Fed and the People's Bank of China, the country's central bank, be able to arrange the same kind of deal to cope with a crisis?
The lack of mutual trust between Washington and Beijing casts serious doubt on this happening.