Who doesn’t know that our markets are most influenced by foreign institutional investor flows? That a surfeit of global liquidity led to the boom of 2003-07 is also common knowledge.
What’s new is that the International Monetary Fund (IMF) now says so in its latest Global Financial Stability Report. What’s important is the question it asks: Are capital flows into receiving economies primarily driven by the countries’ strong economic fundamentals and, therefore, likely to remain stable over the medium to long term, or are they primarily driven by the abundant global liquidity?
The study finds that rising liquidity in the G-4—Japan, the euro zone, the UK and the US—spills over to emerging markets and is associated with rising equity returns and declining real interest rates there. What’s more, the impact of global liquidity is five times as large as that of domestic liquidity.
More specifically, a 10% decline in global liquidity growth is associated with a 2% decline in the equity returns of what they call the liquidity-receiving economies, which are essentially emerging markets.
They also found no link between housing prices and global liquidity, although they caution that the sample size is small. Domestic liquidity is more important for house prices.
IMF says, however, that for economies with a more flexible foreign exchange rate, the statistical link between global liquidity and domestic asset valuation declines and it suggests that economies that are facing large capital inflows could opt for a more flexible exchange rate policy—which is easier said than done.
Also, global liquidity was not found to be positively correlated with foreign direct investment, portfolio bond investment and cross-border bank lending.
The analysis implies that global liquidity is the single most important factor for equity prices in emerging markets. That has been vividly demonstrated in the past year, when a combination of zero interest rates and quantitative easing has led to a surge of liquidity to emerging markets, pushing up equities by more than 100%.
The study defines global liquidity as money supply (M2) growth in the G-4 countries, or reserve money growth, or growth in excess liquidity, described in turn as “the difference between broad money growth and estimates for money demand in the G-4”.
In short, perhaps these are the metrics that need to be tracked most closely to enable us to forecast equity prices in emerging markets.
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