Page 4 of 5 Liquidity boom and looming
crisis By Henry C K Liu
Fed
Funds Rate to an all-time high of 19.75% on
December 17, 1980, to curb stagflation caused by a
rising trade deficit. Five years later, in 1985,
Volcker engineered the Plaza Accord to force the
Japanese yen up against the dollar to curb the US
trade deficit with Japan, promptly pushed the
Japanese economy into sharp deflationary
depression from which Japan has not yet fully
recovered. Volcker's victory
over US inflation was won by forcing deflation on
Japan.
Global liquidity boom sourced by
dollar supply increase The fountainhead of
the global liquidity boom is in the vast increase
of the supply of US dollars, both as a result of
Fed monetary policy and of dollar-denominated
structured finance under dollar hegemony. This
liquidity boom has helped create demand through
inflating asset markets.
The wealth effect
of property inflation produced both producer and
consumer spending power released by debt.
Commodity inflation has given producer economies,
such as oil states, windfall incomes to invest in
the advanced economies. Declining cost of capital
fueled a new wave of financial expansion through
private-equity and hedge-fund acquisitions
financed with high leverage.
What is
liquidity and how is a liquidity boom created?
Liquidity is affected by a monetary
environment created by central-bank policies and
actions.
Lowering interest rates increases
liquidity. Easing money-supply measures relative
to growth in nominal economic activity also
increases liquidity. The level of liquidity in
corporate or individual balance sheets relates to
cash and credit positions with which to invest or
spend. But availability of money alone does not
create liquidity, which requires a market in which
assets can be bought and sold without regulatory
restrictions or causing fundamental shifts in
price levels.
The demand for assets
relative to their supply also affects liquidity.
Market confidence fundamentally affects liquidity,
which depends on states of mind of market
participants relating to appetite for risk-taking.
Hedge funds contribute significantly to
the increase of liquidity by enlarging investor
appetite for risk-taking. Collateralized debt
obligations and credit derivatives have acted to
expand liquidity in the credit markets through
disintermediation and innovation. Banks have moved
from the traditional "buy and hold" mode to the
"originate and distribute" mode, whereby they
distribute portfolios of credit risks and assets
to other market players through securitization.
Banks also act increasingly as suppliers of
revolving credit independent of their deposits as
they obtain additional credit protection through
credit derivatives.
A liquidity boom
requires the continuing confluence of all these
factors, an even slight change in any of which can
have an unraveling effect that puts a sudden end
to it. A precipitous fall in the US dollar could
trigger market sell-offs, as it did after the
Plaza/Louvre Accords of 1985 and 1987, first to
push down and later push up the dollar, which
contributed to the 1987 crash.
Another
cause of the 1987 crash was a threat by the US
House of Representatives Ways and Means Committee
to eliminate the tax deduction for interest
expenses incurred in leveraged buyouts. Still
another cause was the 1986 US Tax Act, which while
sharply lowering marginal tax rates, nevertheless
raised the capital gains tax to 28% from 20% and
left capital gains without the protection against
inflated gains that indexing would have provided.
This caused investors to sell equities to avoid
negative net after-tax returns and contributed
significantly to the 1987 crash.
The
danger of a liquidity bust Today, any one
factor out of a host of interconnected factors,
such as new regulation on hedge funds, or sharp
changes in the yuan exchange rate against the US
dollar, or an imbalance between tradable assets
and available credit, etc, could bring the current
liquidity boom to a screeching halt and turn it
into a liquidity bust.
With finance
globalization and the dominance of derivative
plays by hedge funds and private-equity firms, any
minor disruption could turn into a financial
perfect storm that makes the collapse of Long Term
Capital Management look like a tempest in a
teacup.
William Rhodes, chairman,
president and CEO of Citibank North America and of
Citicorp Holdings Inc, wholly owned subsidiaries
of Citigroup Inc, of which Rhodes is senior vice
chairman, wrote in March:
During the last big adjustment that
started in July 1997 in Thailand and spread to a
number of Asian economies including South Korea,
followed by Russia in 1998 - and led ultimately
to the bailout of Long Term Capital Management,
the US hedge fund - a number of today's large
market operators were not yet in the mix. Today,
hedge funds, private equity and those involved
in credit derivatives play important, and as yet
largely untested, roles.
The primary
worry of many who make or regulate the market is
not inflation or growth or interest rates, but
instead the coming adjustment and the possible
destabilizing effect these new players could
have on the functioning of international markets
as liquidity recedes. It is also possible that
they could provide relief for markets that face
shortages of liquidity. Either way, this clearly
is the time to exercise greater prudence in
lending and in investing and to resist any
temptation to relax standards.
The
five-year global growth boom and four-year secular
bull market may simple run out of steam, or become
oversaturated by too many late-coming imitators
entering a very specialized and exotic market of
high-risk, high-leverage arbitrage. The liquidity
boom has been delivering strong growth through
asset inflation (property, credit spreads,
commodities, and emerging-market stocks) without
adding commensurate substantive expansion of the
real economy. Unlike real physical assets, virtual
financial mirages that arise out of thin air can
evaporate again into thin air without warning. As
inflation picks up, the liquidity boom and asset
inflation will draw to a close, leaving a hollowed
economy devoid of substance.
Massive fund
flows from the less experienced non-institutional,
retail investors into hot-concept funds such as
those focusing on opportunities in BRIC (Brazil,
Russia, India and China) or in commodities, or in
financial firms involved in currency arbitrage and
carry trades, have caused a global financial mania
in the past five quarters that has defied gravity.
It will all melt away in a catastrophic unwinding
some Tuesday morning.
Inflationary
pressure in the US and other OECD economies makes
a cyclical bear market inevitable and an orderly
unwinding unlikely. Central banks cannot ease
because of a liquidity trap that prevents banks
from being able to find creditworthy borrowers at
any interest rate. Banks could be pushing on a
credit string and global liquidity could decline,
causing asset-risk valuations to contract suddenly
and sharply. A liquidity trap can also occur when
the economy is stagnant and the nominal interest
rate is close or equal to zero, and the central
bank is unable to stimulate the economy with
traditional monetary tools because people do
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