Since 2009, the key driver of financial markets has been low rates and abundant liquidity which has boosted all asset prices. The total amount of money pumped into global money markets is around US$10-12 trillion, enough to buy each person on earth a widescreen flat TV.
In the great reflation, according to one estimate, over 80 percent of equity prices are supported in some way by quantitative easing (“QE”). In Australian both real estate prices and share markets have been underpinned by the global flow of money. Today, as much as US$200-250 billion in new liquidity each quarter may be needed globally to simply maintain asset prices. However, the world is entering a period of asynchronous monetary policy, with divergences between individual central banks which has the potential to destabilise asset markets
The discussion around the possible first increase in US interest rates, beginning the process of reversing the emergency zero interest rate policies implemented to combat the 2008 crisis kisses an essential point. The US Federal Reserve is scaling back, terminating purchases of government bonds and mortgage backed securities (“MBS”), which at their peak provided over US$1 trillion a year in new funds to markets. While new purchases have ceased, the Fed does not plan to sell its portfolio of around US$4 trillion of securities. It will continue to reinvest principal payments from its holdings of MBS and roll over maturing Treasury bonds.
The combination of maintaining its balance sheet at sizable levels and low official interest rates will keep financial conditions loose. But the Fed will not add significantly to liquidity. The withdrawal of Fed support will be offset, many have assumed, by the European Central Bank (“ECB”) and Bank of Japan (“BoJ”).
The ECB plans to expand its balance sheet by over US$ 1 trillion over the next 18 months, through a mixture of purchases of government bonds, asset backed securities and loans to banks. Based on its current plans, the BoJ plans to purchase Japanese government bonds at an annual rate of over US$700 billion. At 16 per cent of gross domestic product (“GDP”), the Japanese program is much larger than the corresponding US Fed’s QE measures adjusted for relative size of the two economies.
The balance sheets of the BoJ and ECB should expand by a total of a minimum of US$2.5 trillion by the end of 2016 at current exchange rates. This is comparable to the US$3.6 trillion expansion in the Fed’s balance sheet since 2008.
A wild card is the People’s Bank of China (“PBOC”) which is also loosening money supply. Initially, this appeared to be to mitigate the sharp tightening in liquidity resulting from the increasing controls on China’s shadow banking system. More recently, it has been targeted at supporting falling the stock market and slowing economic activity.
But there are differences between the liquidity programs. The US Fed and BoJ primarily purchase government bonds. The ECB also lends to banks. The PBoC acts almost exclusively through the banking system. The crucial difference between the actions of individual central banks is that the ECB, BoJ or PBOC cannot directly supply the dollars crucial to global markets.
The importance of dollar liquidity is driven by several factors. First, the US dollar remains the most important global reserve currency. The US debt markets, at around US$60 trillion, are the largest in the world and larger than Europe and Japan combined. Second, the US dollar plays a crucial benchmark role with a number of currencies formally or de facto linked to the dollar. US rates influence the pricing of assets globally. Third, the largest amount of foreign currency debt, especially that issued by emerging market borrowers, is denominated in US dollars.
According to the Bank of International Settlements (“BIS”) as at the end of Q3 2014, US dollar credit to non-bank borrowers outside the US totalled US$9.2 trillion, comprising 46 percent debt securities and 54 percent bank loans. The total has increased over 50 percent since end-2009. Emerging market borrowers have borrowed US$5.7 trillion in foreign currency, comprising US$2.6 in securities and US$3.1 trillion in bank loans. Around 75 to 80 percent of this debt is estimated to be dollar denominated.
Cross border borrowings, mostly in US dollars, by Chinese banks and companies have reached US$1.1 trillion. It is around US$450 billion for Brazil, US$380 billion in Mexico and over US$700 billion for Russia. It is unclear what proportion of these liabilities is protected against currency risk by US dollar income or derivative hedges.
Tightening of available dollar liquidity, a rising US dollar and anticipated increases in American interest rates will result in losses on these borrowings. In turn, this will create repayment difficulties for over-indebted borrowers, in turn triggering a new financial crisis. The risk is exacerbated by domestic weaknesses in many emerging markets.
Low commodity prices compound the problems. It reduces the US dollar denominated revenue available to meet debt obligations of exporters, increasing potential exposures to currency fluctuations.
It also reduces global dollar liquidity. Since the first oil shock, petro-dollar recycling, the surplus revenues from oil exporters, has been an essential component of global capital flows providing financing, boosting asset prices and keeping interest rates low. A prolonged period of low oil prices will reduce petrodollar liquidity and may necessitate sales of foreign investments.
Emerging market foreign currency reserves are also falling, led by substantial falls in Chinese reserves due to a combination of weaker trading conditions, capital flight and (suspected) liquidation to release capital to support the domestic economy and share markets.
Declines in global liquidity driven by falling petrodollar liquidity and emerging market currency reserves affect asset prices and interest rates globally. It will increase interest costs and affect the ability of borrowers to gain access to needed dollars.
Since around March 2015, the price of risk has been adjusting around the world. Yields on 10-year German government bonds (known as Bunds) have reached above 1 percent, up from near zero a few months ago. French, Italian, and Spanish yields have also risen by similar amounts. The bellwether 10-year US Treasury yield has risen around 0.60 percent. Equivalent Australian government bond rates are up around 0.80 percent. Rates have jumped in emerging markets: 1.75 percent in Indonesia, 1.60 percent in South Africa, 1.50 percent in Turkey and 1.30 percent in Mexico.
The interest rate moves have been accompanied by large changes in currency markets. Volatility in currency and interest markets, in particular, has increased. Shares markets have been affected but not nearly as much. Like the early tremors that indicate the heightened risk of the big one, these large moves may signal a major adjustment.
The position is eerily similar to 1997/98, when falling commodity prices, especially oil, a stronger US dollar, rising US interest rates and emerging market debt and weaknesses led to the Asian monetary crisis, the Russian default and the collapse of hedge Long Term Capital Management. For the world’s many economies addicted to foreign capital, the threat of instability in international money markets is serious. This is so especially when other pressures such as the end of the commodity boom, weak domestic activity in many economies and inflated asset markets are considered. . The risk to financial stability is rapidly increasing.
© 2015 Satyajit Das
Satyajit Das is a former banker and author. His latest book A Banquet of Consequences has been published in Australia. It will be released in the UK/ Europe and in the US (as The Age of Stagnation) in February 2016