An article of faith is that the failure of economic cooperation, resurgent nationalism and trade protectionism contributed to the global financial crisis of the 1930s.
The slowdown in central bank reserve recirculation affects global trade through the decrease in the availability of financing for purchasers to buy goods and services. This is apparent in the sharp slowdown in consumer consumption in the US, the UK and other economies. The availability of cheap finance also helped drive up the prices, which, in turn, allowed excessive borrowing against the inflated value of these assets that fuelled consumption.
Weakness in the global banking system contributes to restricted availability of trade letters of credit, guarantees and trade finance generally. This exacerbates the problem.
It is not easy to fix this problem. Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance debtor countries such as the US and recapitalize the banking system. Maintenance of cross-border capital flows to finance debtor countries’ budget and trade deficits slows growth in emerging countries and perpetuates imbalances.
Trade has become subordinate to and the handmaiden of capital flows. As capital flows slow, global trade follows. Indirectly, the contraction of global capital flows and credit acts as a barrier to trade. In each case, deleveraging results.
This opens the way to capital protectionism. Foreign investors may change their focus and reduce their willingness to finance the US. Wen Jiabao, the Chinese Prime Minister, indicated that China’s “greatest contribution to the world” would be to keep it’s own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance the US needs.
China and other emerging countries with large reserves were motivated to build surpluses in response to the Asian crisis of 1997-98. Reserves were seen as protection against destabilizing volatility of short term capital flows. The strategy has proved to be flawed.
It promoted a global economy based on vendor financing by exporting nations. The strategy also exposed emerging countries to currency and credit risks of the investments made with the reserves. Shifts in economic strategy are likely. As Chinese President Hu Jintao recently said: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”
The change in these credit engines also distorts currency values and the patterns of global trade and capital flows.
The current strength in the dollar, particularly against the euro, reflects repatriation of capital by investors and the shortage of dollars from the slowdown in the dollar liquidity recirculation process. It is also driven by the reliance on short-term dollar financing of some banks and countries and the need for refinancing. This is evident in the persistence of high inter-bank dollar rates and dollar strength.
The strength of the dollar is unhelpful in facilitating the required adjustment in the current account and also financing of the US budget deficit. The slowdown in the credit and liquidity processes outlined may have long-term effects on global trade flows. As Mark Twain also observed: “History does not repeat but it rhymes.”
End of candyfloss money
Gillian Tett of the Financial Times coined the phrase (see Should Atlas still shrug? in the 15 January 2007 issue of the newspaper) candyfloss money. New financial technology spun available “real” money into an exaggerated bubble that, like its fairground equivalent, collapses ultimately.
The global liquidity process was multifaceted. There was traditional domestic credit creation system built on the fractional reserve system that underpins banking. The leverage in the system was pushed to extreme levels. Losses and renewed regulation are forcing this system of credit creation to shut down.
The foreign exchange reserve system was another part of the global credit process. Dollar liquidity recirculation has also slowed as a result of reduced trade flows (driven by falls in US consumption and imports), losses on dollar investments, domestic claims on reserves and the inability to readily mobilize large amount of reserves.
Another credit process—the export of yen savings via the yen carry trade and acquisition of foreign assets by Japanese investors—has also slowed.
The focus of November’s G-20 meeting was firmly on financial sector reform. Stabilization of global capital flows in the short term and addressing global imbalances over the medium to long term barely merited a mention. It may well come to be seen in coming weeks and months as a major missed opportunity to address these issues.
Markets placed great faith in the volume of money available to support asset prices and assist in alleviating shortages of liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows. As the financial system deleverages, it is becoming clear, not surprisingly, that available capital is more limited than previously estimated.
As Sigmund Freud once observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives ( 2006, FT-Prentice Hall ).
This is the second and final part of a series on the financial crisis.