The huge rally in the equity markets, especially in Asia, has once again led to fears whether we’re seeing another bubble in the making. A recent paper by Deutsche Bank AG’s Sebastian Becker, Is the next global liquidity glut on its way?, tries to answer that question.
Becker provides a precise definition of “excess liquidity”, which is simply that if money supply expands faster than nominal gross domestic product (GDP), excess liquidity will be created. In other words, excess liquidity is the percentage year-on-year (y-o-y) money supply growth minus the percentage y-o-y growth in nominal GDP. There are problems with the precise definition of money supply and the assumption is that there are no changes in the velocity of money. Nevertheless, Becker says that “global liquidity has indeed grown much faster than global nominal GDP since 1996. In particular, since 2000-01, both the narrow and broad money stocks have clearly outpaced nominal GDP. Especially, between 2001 and 2003, when world growth weakened and central banks started to inject massive amounts of liquidity into the financial system, our excess liquidity creation indicators jumped to around 6 pp (percentage points) for broad money and more than 10 pp for narrow money, respectively”.
That’s more or less the received wisdom, but what does Becker have to say about current liquidity conditions? He agrees that credit growth is yet to pick up in the advanced economies, but asserts that according to Deutsche Bank’s indicators, excess liquidity creation is currently higher than it was in the early 2000s. Becker says, “By now, global excess liquidity creation has risen to 12 pp.” The difference, though, is that while the jump in excess liquidity creation in the early 2000s was primarily a result of strong money growth, excess money creation now stems to a large extent from falling nominal GDP.
Excess liquidity in the early 2000s did not lead to a boom in equity prices for several years after the dotcom bust. Paras Jain / Mint
But is it necessary that excess liquidity will have to pour into equity markets? After all, excess liquidity in the early 2000s did not lead to a boom in equity prices for several years after the dotcom bust. Becker argues that as long as investors’ risk aversion (gauged by the VIX implied volatility index, for example) was high due to increased economic uncertainty, excess liquidity did not pour into equity markets. The strong acceleration of global broad money growth between 2001 and 2003 had no immediate impact. In short, the message is to watch the VIX.
What about other much-touted source of global liquidity, the “carry trade”? Becker says that “as long as financial market volatility remains high and interest rate differentials between funding and target currencies low, one should not expect a major boost to global liquidity from carry trades. However, should financial markets and the world economy stabilize again and interest rate gaps widen, then cheap money from Japan may start spilling over again to the rest of the world.”
Won’t all that excess liquidity lead to higher inflation? Not so long as there’s excess capacity and a sluggish recovery, which is why the report says that the odds are currently in favour of asset price inflation. The Deutsche Bank analysis echoes an earlier research piece by HSBC Holdings Plc. economist Frederic Neumann, Blowing Bubbles, in which he said a bubble is forming in Asia. He presents another side of the picture—the excess savings of Asian economies are unlikely to be mopped up totally by government borrowing and with private industry not keen on adding capacity, those savings, too, could spill over into equities. Neumann also says that “successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble and, more often than not, policy makers are reluctant to step up for fear of bringing down the house.”
Are we then on the threshold of another bubble? In the week to 29 July, EPFR Global-tracked equity funds posted collective inflows of $9.52 billion (around Rs45,900 crore)—the highest weekly tally since mid-June 2008. In China, the frenzy in the equity markets is back, with stock-trading accounts being opened at the fastest pace in 18 months. Initial public offerings, or IPOs, are listing at huge gains to already inflated issue prices. Some estimate that a substantial part of the lending spree by state-owned Chinese banks is finding its way to the stock market.
The Chinese authorities have already tried to clamp down on the practice.
In South Korea, the government is now trying to cool real estate prices. In Vietnam, the central bank is trying to curb lending against shares and for buying real estate. Back home in India, the central bank governor has unequivocally said that “the Reserve Bank will maintain an accommodative stance until demand conditions improve and credit flow takes hold, but reversing the expansionary policies is definitely on the agenda on the way forward”.
But what matters for Asian asset prices is not so much local monetary policy as capital inflows from the West. Because a loose monetary policy is necessary to mend the exceptionally weak financial and housing markets in the West, the effect is that countries that are not so badly affected will be the recipients of that increase in liquidity, fuelling asset bubbles there. That doesn’t mean there won’t be shocks along the way. Neumann points out: “This is a multi-year process rather than a short-term call on the direction of financial markets. As history shows, bubbles develop only gradually and include occasional corrections (which actually make it possible for the run-up to be sustained for quite a long period).” And finally, he argues that the precipitous drop in Asian equity markets in 2008 may have been just a pause, a hiatus in a continuing bubble.
Neumann says, “From a broader perspective, the recent sell-off may be regarded as a temporary setback in a longer bubble run that started in the second half of 2006 across Asia. The post-Lehman plunge in asset markets, from this perspective, helped to prolong the bubble that was already under way: first by correcting asset values for a short while and thus reshuffling investor participation, and second because it loosened monetary policy across the globe, re-energizing Asia’s bubble.”
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