Capital Scarcity Makes Capital Optimization the Driver of Financial Transformation

Is History Repeating Itself? Lessons from the Tapering and Beyond The financial markets are experiencing instability, a predictable outcome as the Federal Reserve begins to taper its quantitative easing program. This withdrawal of liquidity makes risky assets less appealing, marking the initial phase of normalizing monetary policy. The critical question, however, is the ultimate depth of the consequences. Perhaps we can glean insights from recent history. The Echoes of 2007 The Subprime Crisis, which began in February 2007, offers a stark parallel. As interest rates edged up, some borrowers struggled to refinance, leading to a moderate decline in housing prices. At the time, the economy seemed robust, credit flowed freely, and the stock market quickly rebounded. The crisis was largely dismissed as a "storm in a teacup." Yet, a mere year and a half later, the financial system faced its most severe crash since the Great Depression. There are striking similarities between February 2007 and the events unfolding now. Over the past few years, central banks worldwide—including the Bank of England, the Federal Reserve, and the Bank of Japan—have injected massive amounts of liquidity into the system. This has drastically lowered interest rates, fueling "carry trade" strategies that have channeled excess liquidity into emerging economies, significantly increasing their external debt. Consider Brazil, for example, whose external debt surged from $200 billion to $312 billion in just six years, with much of this capital flowing into real estate and consumption. As economic activity increased, credit ratings improved, and local banking systems extended more loans, boosting leverage. Again, a substantial portion of this capital gravitated towards real estate, inflating property valuations. Adding another layer of complexity, shadow banking has exploded in some countries, notably China, making it incredibly difficult to gauge the true scale of potential problems. This situation bears an unsettling resemblance to the challenges in estimating the size of the Collateralized Debt Obligations (CDO) problem during the U.S. Subprime Crisis. Historically, such conditions have been the root cause of credit and real estate bubbles, with devastating consequences. Global Ripples and Emerging Market Vulnerability, Including Chinas Unsettled State Many emerging economies rely heavily on commodity exports.4 During periods of monetary expansion, commodity prices tend to rise. As this cycle concludes, commodity prices drop, widening trade deficits in these nations. In our interconnected global economy, capital can flow in and out of countries at lightning speed.5 We've witnessed this in recent weeks, with significant impacts on foreign exchange markets. For instance, the Turkish Lira depreciated by 10% in the last two weeks of January and nearly 30% over the preceding six months. In an attempt to stem capital flight, some central banks have raised interest rates, a move likely to slow down their economies and increase the risk of bursting existing credit bubbles. China, despite its overall growth targets, faces significant domestic challenges that contribute heavily to global economic uncertainty.6 Its property market has been in a severe downturn since 2021, with prices falling significantly in many cities and numerous private developers facing insolvency.7 While government interventions aim for a "controlled landing," weak consumer confidence and surging household debt continue to weigh on the sector. This property crisis, coupled with persistent weak domestic demand and industrial overcapacity, is contributing to deflationary pressures within China. The opaque nature and past rapid growth of its shadow banking system further amplify concerns, as the true extent of hidden liabilities remains difficult to ascertain, echoing the CDO problem of the U.S. Subprime Crisis. These internal imbalances within China, a major global economic player, add a considerable layer of risk and uncertainty to the international financial landscape, impacting trade, commodity markets, and overall global growth. The Debt Situation in Key G7 Nations: A Closer Look The current global financial landscape is also significantly shaped by the debt situations of major developed economies. Among the G7 countries, the United States, France, the United Kingdom, Japan, and Italy all present unique, yet interconnected, fiscal challenges. United States: The U.S. stands out among large economies for its high debt-to-GDP ratio, exceeding 120% in 2023 and projected to remain high. This reflects decades of persistent budget deficits, driven by rising entitlement spending, an aging population, and increased interest costs. The U.S. is currently running some of the largest fiscal deficits among advanced economies.8 Japan: Japan holds the unenviable position of having the highest debt-to-GDP ratio among advanced economies, reaching approximately 235-250%. This is a result of decades of fiscal deficits and slow growth. However, a significant portion of Japan's government debt is held domestically, which, coupled with ultra-low interest rates, has historically mitigated immediate financial instability concerns.9 Italy: Italy also carries a very high debt-to-GDP ratio, consistently above 130% and projected to be around 135-138% in 2024-2025. This has been a long-standing challenge for the Eurozone, raising questions about its fiscal sustainability and sensitivity to interest rate changes. France: France's public debt has continued to rise, reaching around 113% of GDP in 2024 and expected to be around 116% by the end of 2025. The country's deficit was 5.8% of GDP in the previous year, one of the highest in the Eurozone. France faces the challenge of reining in its ballooning debt through spending cuts without resorting to significant tax increases.10 United Kingdom: The UK's public sector net debt reached approximately 96.3% of GDP by June 2025, a level not seen since the early 1960s. Rising interest payments on government debt are contributing to increased borrowing. Five of the G7 nations have government debt-to-GDP ratios well over 95%. While the reasons for these high debt loads vary—from expansive social safety nets in France and Italy to large stimulus measures during crises in the U.S. and UK—the cumulative effect of this global debt burden adds another layer of vulnerability to the financial system. High debt levels can constrain future government spending, increase interest costs, and potentially crowd out private investment, all of which can hinder economic growth.11 The Looming Capital Scarcity Crisis and Weak Global Growth Prospects Adding to these concerns, major international organizations like the OECD, IMF, and World Bank are painting a picture of weak global growth prospects for the coming years.12 The World Bank, in its June 2025 Global Economic Prospects report, projects global growth to slow to just 2.3% in 2025, marking the slowest pace since 2008 outside of outright recessions.13 They noted that growth forecasts have been cut for nearly 70% of all economies.14 Developing economies, in particular, are expected to experience their weakest long-term growth outlook since 2000, with per capita income growth insufficient to recover pandemic-related losses or reduce extreme poverty.15 Similarly, the OECD's latest Economic Outlook, published in June 2025, projects global growth slowing from 3.3% in 2024 to 2.9% in both 2025 and 2026. This slowdown is concentrated in major economies like the United States, Canada, Mexico, and China.16 The OECD highlights "substantial barriers to trade, tighter financial conditions, diminishing confidence, and heightened policy uncertainty" as adverse impacts on growth.17 The IMF's World Economic Outlook, with updates through January and April 2025, also points to a slowdown.18 While January's update saw global growth projected at 3.3% for both 2025 and 2026, subsequent assessments emphasize intensified downside risks. The April 2025 report described a "critical juncture amid policy shifts" and a slowdown as downside risks intensify.19 Persistent inflation, escalating trade tensions, and increased policy uncertainty are all factors complicating the outlook and raising the prospect of higher-for-longer interest rates. These organizations collectively emphasize that prolonged weak investment, rising protectionism, geopolitical uncertainty, and high public debt burdens are significant headwinds to a robust global recovery. This leads us to a crucial and often overlooked point: excess debt, at its highest levels in history both in absolute value and as a percentage of GDP, is consuming capital at an unprecedented pace. At the same time, weaker economic growth is slowing down the generation of new capital. If capital is over-consumed and not sufficiently regenerated through economic growth, it inevitably becomes scarce. Capital is not just a resource; it is the most important resource of the financial system, and indeed, of the entire economic system—which is precisely why it's called capitalism. This growing scarcity of capital poses a fundamental threat to the stability and functionality of our global economy. The Persistent Cycle of Bubbles and Busts Expansionary cycles characterized by low interest rates and abundant liquidity invariably inflate economic bubbles. As these bubbles grow, positive investor sentiment keeps interest rates low, encouraging higher leverage and pushing market valuations skyward. Even when spreads widen, signaling the end of the expansionary cycle, the true size of the bubble remains unknown until the correction is complete—a process that can span months, or even years. As in 2007, the prevailing sentiment is that this is not that serious. The U.S. economy appears healthy, and the Chinese real estate crisis, while acknowledged, is often seen as containable.20 However, we are in a globalized economy, and what affects one part of the system inevitably impacts the whole. While different economies may manifest crises in unique ways, the underlying cause—capital scarcity—remains common, demanding a coordinated global solution. The Role of Margin Debt and Systemic Risk A telling symptom in developed economies is the record-high level of margin debt, which hit $451 billion last January. Margin debt, the value of securities purchased on credit, is a clear indicator of leverage and investor sentiment.21 When investors are optimistic about market trends, they increase their leverage by buying securities on margin. If market perception shifts, perhaps triggered by rising interest rates, this enormous margin debt could lead to a cascade of margin calls, intensifying selling pressure and bursting the bubble. The 2008 subprime crisis was fueled by a prolonged period of low interest rates. When the bubble burst, central banks slashed interest rates and injected massive amounts of liquidity into the financial system, aiming to avert a global depression.22 However, injecting liquidity to prevent a depression is an outdated solution. It worked when capital was abundant, but today, we face an era of capital scarcity—a new challenge demanding new strategies. In a capital-scarce environment, injecting liquidity to prevent a debt-induced depression only magnifies the debt crisis. What central banks have done during the last five years could be likened to trying to extinguish a global fire with gasoline. These liquidity injections have merely delayed a depression and inflated a new bubble. When this new bubble inevitably bursts, it will become painfully clear that capital is even scarcer than it was five years ago. Therefore, the main conclusion is undeniable: it is mandatory to transform the financial system from a model predominantly based on debt expansion to one fundamentally built on capital optimization. Capital is, and will continue to be, scarce. This represents a new structural environment that necessitates a strategic transformation of the financial system to ensure its long-term stability and effectiveness. Connect and Stay Informed: Join the Conversation: Connect with fellow professionals in the SAP Banking Group on LinkedIn. https://www.linkedin.com/groups/92860/ Stay Updated: Subscribe to the SAP Banking Newsletter for the latest insights. https://www.linkedin.com/newsletters/sap-banking-6893665983048081409/ Explore More: Visit the SAP Banking Blog for in-depth articles and analyses. https://sapbank.blogspot.com/ Connect Personally: Feel free to send a LinkedIn invitation; I'm always open to connecting with like-minded individuals. ferran.frances@gmail.com I look forward to hearing your perspectives. Kindest Regards, Ferran Frances-Gil