In recent years, money was cheap and other assets were expensive. As each of the global economy’s credit creation engines breaks down and systemic leverage reduces, money becomes scarce and expensive, triggering adjustments in asset prices in a reversal of this process.
In the current financial crisis, the quantum of available capital, the munificent resources of central banks and sovereign wealth funds and the globalization of capital flows may be some of the accepted “facts” that are revealed to be grand illusions. As Mark Twain once advised: “Don’t part with your illusions. When they are gone you may still exist, but you have ceased to live”.
In recent years, there has been speculation about the amount of capital or liquidity available for investment globally. The substantial reserves of central banks and, their acolytes, sovereign wealth funds were frequently cited in support of the case for a large pool of “unleveraged” liquidity, that is “real” money. In reality, the available pool of money may be more modest than assumed.
For example, China has close to $2 trillion in foreign exchange reserves. The reserves arise from dollars received from exports and foreign investment into China that are exchanged into renminbi. The central bank generates renminbi by printing money or borrowing through issuing bonds in the domestic market. On China’s “balance sheet”, the reserves are essentially “leveraged” using domestic “liabilities”.
The dollars acquired are invested by central banks in foreign currency assets, around 60% in dollar-denominated US treasury bonds, GSE paper (such as Freddie and Fannie Mae debt) and other high quality securities. Deterioration in the credit quality of the US results in losses on investment through falls in the market value of the debt and a weaker dollar.
It is also not easy to tap this liquidity pool. Given the size of the portfolios, it is difficult for large investors such as China to rapidly mobilize a large portion of these funds by liquidating their investments and converting them into the home currency without big losses. This means that this money may not in reality be available, at least at short notice.
The position of emerging market sovereign investors with large portfolios of dollar assets is similar to that of a bank or leveraged hedge fund with poor quality assets. China’s Premier Wen Jiabao recently expressed concern: “If anything goes wrong in the US financial sector, we are anxious about the safety and security of Chinese capital…”
There are other factors. Sovereign wealth funds have suffered losses on some investments, most notably in the US and European financial institutions. Some central banks, South Korea and Russia, have been forced to utilize reserves to support the domestic economy and banking system.
The substantial build-up of foreign reserves in central banks of emerging markets and developing countries, as identified by David Roche (see David Roche and Bob McKee (2007) New Monetarism; Independent Strategy Publications), is really a liquidity creation scheme that relies on the dollar’s favoured position in trade and as a reserve currency.
Many global currencies are pegged to the dollar at an artificially low rate, such as the Chinese renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency.
Large liquid markets in dollars and dollar investments capable of accommodating very large investment requirements and the historically unimpeachable credit quality of the US sovereign assets facilitated the process. The recycled dollars flow back to the US to finance the spending.
This merry-go-round is a significant source of liquidity creation in financial markets. It also kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going. This process increased the velocity of money and exaggerated the level of global liquidity.
Central banks holding reserves were lending funds used to purchase goods from the country. In effect, the exporter never got paid at least till the loan to the buyer was paid off.
As the debt crisis intensifies and global growth diminishes with increased defaults, it is increasingly likely that this debt will not be paid back in its entirety.
This liquidity circulation process supported, in part, the growth in global trade. In reality, this too may have been an illusion as the underlying process is a gigantic vendor-financing scheme, where the seller is lending the buyer the money to purchase the goods.
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 first in a two-part series on the financial crisis.