Since 2009, all asset prices have been affected by the central banks’ attempted reflation through a massive injection of liquidity. The total amount of money is around $10-$12trn (£6-£7.5trn), enough to buy each person on earth a flat-screen TV. Today, as much as $200-$250bn in new liquidity each quarter may be needed simply to maintain asset prices.
Equity and real estate prices are supported in some way by quantitative easing. However, the world is entering a period of asynchronous monetary policy, with divergences between individual central banks which has the potential to destabilise the asset market.
The US Federal Reserve is scaling back, having already terminated purchases of government bonds and mortgage-backed securities, which at their peak provided more than $1trn a year in new funds to markets. Currently, the Fed does not plan to sell its portfolio of about $4trn of securities. It continues to reinvest principal payments from its holdings of mortgage-backed securities and roll over maturing Treasury bonds. 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 and Bank of Japan. The ECB plans to expand its balance sheet by more than $1trn 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 Bank of Japan plans to purchase Japanese government bonds at an annual rate of more than $700bn. At 16 per cent of GDP, the Japanese programme is much larger than the corresponding US Fed’s quantative easing measures, adjusted for relative size of the two economies.
A wild card is the People’s Bank of China, which is also loosening money supply. But this may be to mitigate the sharp tightening in liquidity resulting from the increasing controls on China’s shadow banking system.
The crucial difference between the actions of individual central banks is that the European, Japanese and Chinese central banks cannot directly supply the dollars essential 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 $60trn, are the largest in the world and larger than Europe and Japan combined. Second, the 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 dollars.
According to the Bank of International Settlements as at the end of March 2014, US dollar credit to non-bank borrowers outside the US totalled $9.2trn, comprising 46 per cent debt securities and 54 per cent bank loans. The total has increased over 50 per cent since 2009. Emerging market borrowers have borrowed $5.7trn in foreign currency. Around 75 to 80 per cent of this debt is estimated to be dollar denominated.
Cross-border borrowings, mostly in dollars, by Chinese banks and companies have reached $1.1trn (around $450bn for Brazil, $380bn in Mexico and over $700bn for Russia). Tightening of available dollar liquidity, a rising dollar and anticipated increases in American interest rates will result in losses on the borrowings. This will create repayment difficulties for over-indebted borrowers, triggering a new crisis. The risk is exacerbated by domestic weaknesses in many emerging markets.
Low commodity prices compound the problems. It reduces the dollar-denominated revenue available to meet debt obligations of exporters, increasing potential exposure 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. A prolonged period of low prices will reduce available liquidity, pushing up the dollar and increasing interest costs, affecting the ability of borrowers to gain access to needed dollars. In the first few months of 2015, Saudi Arabia’s large foreign exchange reserves fell by an unprecedented 15 per cent, consistent with tightening liquidity.
The position is eerily similar to 1997-98, when falling commodity prices, a stronger dollar, rising US interest rates and emerging market debt and weaknesses led to the Asian monetary crisis, the Russian default and the collapse of the Long-Term Capital Management hedge fund. The risk to financial stability and global asset prices is rapidly increasing.
Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’Reuse content