Where did all the money disappear? – Liquid Fantasies

Where did all the money disappear? – Liquid Fantasies

Satyajit Das | Dec 9, 2008


In recent years, money was cheap and other assets were expensive. Aseach of the global economy’s credit creation engines breaks down andsystemic leverage reduces, money becomes scarce and expensivetriggering adjustments in asset prices in a reversal of this process.

In the current financial crisis, the quantum of available capital, themunificent resources of central banks and sovereign wealth funds andthe globalisation 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 stillexist, but you have ceased to live".

Reserve Illusions

In recent years, there has been speculation about the amount of capitalor liquidity available for investment globally. The substantialreserves of central banks and, their acolytes, sovereign wealth fundswere frequently cited in support of the case for a large pool of"unleveraged" liquidity, that is "real" money. In reality, theavailable pool of money may be more modest than assumed.

For example, China has close to $2 trillion in foreign exchangereserves. The reserves arise from dollars received from exports andforeign investment into China that are exchanged into Renminbi. Thecentral bank generates Renminbi by printing money or borrowing throughissuing bonds in the domestic market. On China’s "balance sheet", thereserves are essentially "leveraged" using domestic "liabilities".

In order to avoid increases in the value of the Renminbi that wouldaffect the competitive position of its exporters, China undertakes "currency sterilisation" operations where it issues bonds to mop up theexcess liquidity. China incurs costs – effectively a subsidy to itsexporters - of around $60 billion per annum (the difference between therate it pays on its Renminbi debt and the investment income on itreserves).

The dollars acquired are invested in foreign currency assets, around60% in dollar denominated US Treasury bonds, GSE paper (such as Freddieand Fannie Mae debt) and other high quality securities. China isexposed to price changes in these investments and currency risk becauseof the mismatch between foreign currency assets funded with localcurrency debt.

Deterioration in the US economy and the need to issue additional debtto support the financial sector may place increasing pressure on the USsovereign rating and the dollar. US Government support for financialinstitutions is already approaching 6% of GDP compared to less than 4%for the Savings and Loans crisis.

Deterioration in the credit quality of the United States results inlosses on investment through falls in the market value of the debt anda weaker dollar. The credit default swap ("CDS") market for sovereigndebt is increasingly pricing in increased funding costs for the US. Thefee for hedging against losses on $10 million of Treasuries was about0.58% pa for 10 years (equivalent to $58,000 annually) in December2008. This is an increase from 0.01% pa ($1,000) in 2007 and 0.40% pa($40,000) in October 2008.

It is also not easy to tap this liquidity pool. Given the size of theportfolios, it is difficult for large investors like China to rapidlymobilise a large portion of these funds by liquidating theirinvestments and converting them into the home currency withoutsubstantial losses. This means that this money may not, in reality, beavailable, at least at short notice.

If the dollar assets lose value or cannot be accessed then China muststill service its liabilities. It can print money but will suffer theeconomic consequences including inflation and higher funding costs.

The position of emerging market sovereign investors with largeportfolios of dollar assets is similar to that of a bank or leveragedhedge fund with poor quality assets. China’s Premier Wen Jiabaorecently expressed concern: "If anything goes wrong in the U.S.financial sector, we are anxious about the safety and security ofChinese capital…" In December 2008, Wang Qishan, a Chinesevice-premier, noted: "We hope the US side will take the necessarymeasures to stabilise the economy and financial markets as well asguarantee the safety of China’s assets and investments in the US."

There are other factors affecting the availability of the reserves atcentral banks and sovereign wealth funds. In recent years, sovereignwealth funds have also suffered losses on some of their investments,most notably in US and European financial institutions.

Some central banks have been forced to utilise some of the reserves tosupport the domestic economy and banking system. For example, SouthKorea has used a portion of its reserves to provide dollars to banksunable to re-finance short-term dollar borrowings in internationalmoney markets.

Russia has similarly used a significant portion of its reserves tosupport financial institutions and also its domestic markets. Russia’sreserves, which rank third after China’s and Japan’s reserves in size,have fallen $122.7 billion, or 21 percent, since August 2008. Thereserves, including oil funds that exclusively act as a safety cushionfor the budget, stood at $475.4 billion on November 2008.

Capital Illusions

The substantial build-up of foreign reserves in central banks ofemerging markets and developing countries, as identified by David Roche(see David Roche and Bob McKee (2007) New Monetarism; IndependentStrategy Publications), is really a liquidity creation scheme thatrelies on the dollar's favoured position in trade and as a reservecurrency.

Many global currencies are pegged to the dollar at an artificially lowrate, like the Chinese Renminbi to maintain export competitiveness.This creates an outflow of dollars (via the trade deficit that isdriven by excess US demand for imports based on an overvalued dollar).Foreign central bankers are forced to purchase US debt with dollars tomitigate upward pressure on their domestic currency.

Large, liquid markets in dollars and dollar investments capable ofaccommodating the very large investment requirements and thehistorically unimpeachable credit quality of the US sovereign assetsfacilitated the process. The recycled dollars flow back to the US tofinance the spending.

This merry-go-round is a significant source of liquidity creation infinancial markets. It also kept US interest rates and cost of capitallow encouraging further borrowing to finance consumption and imports tokeep the cycle going. This process increased the velocity of money andexaggerated the level of global liquidity.

The large build-up in reserves in oil exporters from higher oil pricesand higher demand from strong world growth was also re-cycled into USdollar debt. The entire process was reminiscent of the "petro-dollar"recycling of the 1970s.

The central banks holding reserves were lending the funds used topurchase goods from the country. In effect, the exporter never got paidat least until the loan to the buyer (the vendor finance) was paid off.As the debt crisis intensifies and global growth diminishes withincreased defaults, it is increasingly likely that this debt will notbe paid back in it entirety.

This liquidity circulation process supported, in part, the growth inglobal trade. This too may have been an illusion as the underlyingprocess is a gigantic vendor financing scheme.

Trade Illusions

An accepted article of economic faith is that failure of economicco-operation and resurgent nationalism in the form of tradeprotectionism (for example, the Smoot-Hawley Act) contributed to theglobal financial crisis of the 1930s.

The stock market crash of 1929 and the subsequent banking crisis causeda collapse in financing and global demand resulting in a sharp of theUS trade surplus. Smoot-Hawley was passed in 1930 to deal with theproblem of over-capacity in the U.S. economy through higher tariffsdesigned to increase domestic firms’ market share. The higher UStariffs led to retaliation from trading partners affecting global trade.

The slowdown in central bank reserve re-circulation affects globaltrade through the decrease in the availability of financing forpurchasers to buy goods and services. This is apparent in the sharpslowdown in consumer consumption in the US, UK and other economies. Theavailability of cheap finance also helped drive up the prices which, inturn, allowed excessive borrowing against the inflated value of theseassets that fuelled consumption.

Weakness in the global banking system (in particular, loan losses, thelack of capital and concerns about counterparty risk between largefinancial institutions) contributes to restricted availability of tradeletters of credit, guarantees and trade finance generally. Thisexacerbates the problem. The restrictions, in turn, further impact onthe level of trade flows and capital re-circulation resulting in afurther decrease in trade activity that in turn further slows downinternational credit creation.

It is not easy to fix the problem. Redirection of capital held incentral banks and sovereign wealth funds to domestic economies affectsthe global capital flows needed to finance the debtor countries, suchas the US and re-capitalise the banking system. Maintenance of thecross border capital flows to finance the debtor countries budget andtrade deficits slows down growth in emerging countries and alsoperpetuates the imbalances.

Trade has become subordinate to and the handmaiden of capital flows. Ascapital flows slow down, global trade follows. Indirectly, thecontraction of cross border capital flows and credit acts as a barrierto trade. In each case, de-leveraging is the end result.

This opens the way to "capital protectionism". Foreign investors maychange their focus and reduce their willingness to finance the US. WenJiabao, the Chinese Prime Minister, indicated that China’s "greatestcontribution to the world" would be to keep it’s own economy runningsmoothly. This may signal a shift whereby China uses its savings toinvest in the domestic economy rather than to finance US needs.

China and other emerging countries with large reserves were motivatedto build surpluses in response to the Asian crisis of 1997-98. Reserveswere seen as protection against the destabilising volatility of shortterm capital flows. The strategy has proved to be flawed.

It promoted a global economy based on "vendor financing" by theexporting nations. The strategy also exposed the emerging countries tothe currency and credit risk of the investments made with the reserves.Significant shifts in economic strategy are likely. Zhou Xiaochuan,governor of the Chinese central bank, commented: "Over-consumption anda high reliance on credit is the cause of the US financial crisis. Asthe largest and most important economy in the world, the US should takethe initiative to adjust its policies, raise its savings ratioappropriately and reduce its trade and fiscal deficits." More ominouslyChinese President Hu Jintao recently noted: "From a long-termperspective, it is necessary to change those models of economic growththat are not sustainable and to address the underlying problems inmember economies."

There is also the risk of "traditional" trade protectionism. The end ofthe current liquidity cycle, like the one in the 1930s, may cause asharp fall in exports. Exporting countries, seeking to maintaindomestic growth may try to boost exports by devaluation of the currencyor subsidies. Import tariffs are less effective unless there is a largedomestic market. Recently the governor of the Chinese central bank,Zhou Xiaochuan, did not rule out China depreciating its currency.

The change in these credit engines also distorts currency values and the patterns of global trade and capital flows.

The current strength in the dollar particularly against the Euroreflects repatriation of capital by investors and the shortage ofdollars from the slowdown in the dollar liquidity re-circulationprocess. It is also driven by the reliance on short-term dollarfinancing of some banks and countries and the need for re-financing.This is evident in the persistence of high inter-bank dollar rates anddollar strength.

The strength of the dollar is unhelpful in facilitating the requiredadjustment in the current account and also financing of the US budgetdeficit.

The slowdown in the credit and liquidity processes outlined may havelong-term effects on global trade flows. As Mark Twain also observed:"History not repeat but it rhymes."

End of "Candy Floss" Money

Gillian Tett of the Financial Times coined the phrase (see "ShouldAtlas still shrug?" (15 January 2007) Financial Times) "candy flossmoney". New financial technology spun available "real" money into anexaggerated bubble that, like its fairground equivalent, collapsesultimately.

The global liquidity process was multi-faceted. There was traditionaldomestic credit creation system built on the fractional reserve systemthat underpins banking. The leverage in the system was pushed toextreme levels. Losses and renewed regulation are forcing this systemof credit creation to shut down.

The foreign exchange reserve system was another part of the globalcredit process. Dollar liquidity re-circulation has also slowed as aresult of reduced trade flows (driven by falls in US consumption andimports), losses on dollar investments, domestic claims on reserves andthe inability to readily mobilise large amount of reserves.

Another credit process - the export of Yen savings via the Yen carrytrade and acquisition of foreign assets by Japanese investors) - hasalso slowed.

The focus of the November 2008 G-20 meeting was firmly on financialsector reform. Stabilisation of global capital flows in the short termand addressing global imbalances over the medium to long term barelymerited a mention. It may well come to be seen in coming weeks andmonths as a major missed opportunity to address these issues.

Markets placed great faith in the volume of money available to supportasset prices and assist in alleviating shortages of liquidity. Theperceived abundance of liquidity was, in reality, merely an illusioncreated by high levels of debt and leverage as well as the structure ofglobal capital flows. As the financial system de-leverages, it isbecoming clear, unsurprisingly, that available capital is more limitedthan previously estimated.

As Sigmund Freud once observed: "Illusions commend themselves to usbecause they save us pain and allow us to enjoy pleasure instead. Wemust therefore accept it without complaint when they sometimes collidewith a bit of reality against which they are dashed to pieces."

There is an apocryphal story about a disgraced rock star who ended upin bankruptcy court. When asked what happened to his fortune of severalmillion dollars, he responded: "Some went in drugs and alcohol, Igambled some of it away, some went on women and the rest I probablywasted!" Financial markets have "wasted" a staggering amount of moneythat ironically probably did not exist in the first place.

© 2008 Satyajit Das

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).