Asia/Pacific: The Liquidity Conundrum
Andy Xie (Hong Kong)
morganstanley.com
Rapidly rising forex reserves in Asia, low real interest rates everywhere, declining credit spreads and market volatilities suggest amply liquidity in the global economy. However, monetary statistics in major global economies have been turning down for some time.
There are two possible explanations for the paradox. First, commodity-driven inflation is scaring investors out of money into higher risk assets. Hence, liquidity for asset markets could be rising despite a weakening money supply. Second, despite recent deceleration, the levels of monetary aggregates are still high for the current asset prices. Both are probably relevant.
The rising appetite for risk in the global financial system is sustaining strong growth in emerging economies, which fuels commodity inflation. The latter further fans risk appetite in the developed economies through sustaining low real interest rates. As commodity inflation and risk appetite fuel each other, the global financial system sits precariously on overvalued assets. A shock would likely cause a global financial crisis.
Globalization has altered how the global economy works. The globalization of supply has integrated labor surplus in low-cost economies into the global economy. The neutral monetary policy should target lower inflation levels than before. Because monetary authorities have not considered this fact, they have oversupplied liquidity and created the massive global bubble.
It may be too late to prevent a global hard landing. The global economy is amidst the biggest bubble in history with the most froth in big city properties (e.g., New York, London and Shanghai), in my view. It is likely to end with debt deflation. The economies that have most enjoyed this bubble will likely also suffer most.
The Liquidity Conundrum
Money supplies in big developed economies, mainly the US and, to a lesser extent, Euro-zone and Japan, set the tone for liquidity conditions in emerging market economies. There are ample signs of strong global liquidity. Credit spreads and market volatilities have been setting multi-decade lows around the world. Real interest rates are still low everywhere. Property speculation – the best indicator of ample liquidity – is pervasive around the world. In 2004, Asia ex-Japan saw forex reserves up by $369 billion (or 10% of GDP), the biggest increase in history, even higher than the $310 billion increase in 2003. Asian exports, another good indicator of liquidity, have remained quite strong despite 30 months of an above 20% YoY growth rate – a historical record.
On the other hand, the traditional liquidity indicators in the three big economies have been turning down. US money with zero maturity grew by 3.8% last year compared to 7.3% in 2003, Euro-zone’s M1 slowed to 9.3% from 10.7% in 2003, and Japan’s M1 slowed to 4.0% from 7.6%. The marginal changes in the main liquidity suppliers in the world were negative throughout 2004.
Liquidity Levels May Still Be Too High
The levels of money supplies are still extraordinarily high in major global economies. US money with zero maturity declined from the peak of 57.2% in 2002 to 55.5% of GDP last year but is still much higher than the average of 38.2% during 1974-97. Euro-zone M1 reached 38% of GDP compared to an average of 24.5% during 1991-97. Japan’s M1 surged to 73.5% of GDP in 2004 from an average of 27.7% during 1980-97.
The year 1997 was a turning point in the global liquidity condition. The Asian Financial Crisis was a massive deflationary shock to the global economy. As China pushed investment to keep growth up in response to the crisis, the deflationary shock continued with its excess capacity formation. This deflationary pressure allowed the major global economies to keep liquidity levels high without encountering inflationary pressure.
The liquidity buildup in the three major economies (mainly in the US) sparked a property price bubble in Anglo-Saxon economies that has supported strong consumption. That consumption boom has triggered a massive export boom in China. Its boom has attracted massive inflow of hot money, which has created a huge quantity and price bubble in its property market. China’s property bubble has led to strong demand for raw materials that have reflated emerging economies in general. This is essentially the global boom that we are seeing today.
We do not know how long it takes asset markets to fully reach equilibrium with the higher liquidity levels. Thus, even though the marginal changes in liquidity levels may be negative, they still could exert a positive pull on asset markets.
Money Illusion Drives Risk Appetite
Negative real interest rates are increasing risk appetite everywhere. Pension funds, insurance companies, and wealthy individuals are more willing to buy high-risk assets than before. The biggest growth areas in the global financial system are in selling derivative products to hedge funds and private banking customers to chase yield.
The perception of negative real interest rates is a form of money illusion, in my view. Commodities drive inflation at present. Unless the commodity-led inflation triggers a wage-price spiral, the inflation is not sustainable. Globalization has created a global platform in the supply of goods and, increasingly, in services. There is still a massive labor surplus in either unskilled or educated labor in the global labor market. Any push for higher wages in developed economies would push global companies to shift more production to low-cost economies like China or India. Therefore, the current bout of negative real interest rates would not last.
The enhanced risk appetite, however, has decreased the cost of capital for businesses and economies that were starved of capital, and they have taken advantage of the cheaper capital to increase investment. This force continues to push up the prices of natural resources. The resulting inflation further increases risk appetite in the global financial system. As financial investors pile in, commodity prices rise substantially above what real demand would imply. This dynamic is leading to a big commodity bubble.
The End Is Debt Deflation
The global economy is experiencing the biggest bubble ever. The bubble began with the Asian Financial Crisis and went through the tech bubble, the property bubble and, finally, the China bubble. It has been one big and long bubble. The main reason is because the major central banks have been targeting inflation in a fundamentally deflationary environment, releasing too much liquidity into the global economy. How is it going to end?
There are two obvious trends in this bubble: Anglo-Saxon consumers have been borrowing a lot against their rising property values to support consumption, and Chinese companies (actually, government-related entities) have been borrowing a lot to create production capacities. To mirror the surge in liquidity, the indebtedness of Anglo-Saxon consumers and Chinese investors has risen sharply. The current boom, therefore, is debt-funded. Debt levels can continue to rise as long as asset prices keep rising.
Whatever triggers the collapse, it will show up first in declining asset prices. Property is the likely candidate. Property prices in New York, London, and Shanghai could decline at the same time. When property prices begin to decline, it would cause the global economy to weaken. The weakening economy would decrease the cash-flow of property speculators who would have to sell to unwind. The unwinding would lead global asset prices to collapse in general.
The major central banks may try to ease aggressively to fight the unwinding spiral. However, it would be too late to revive money demand. Most speculators who are driving demand for money today would have been cut down already. The global economy is likely to experience a period of debt deflation.
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Bingo
Key points:
1)Unless the commodity-led inflation triggers a wage-price spiral, the inflation is not sustainable. Globalization has created a global platform in the supply of goods and, increasingly, in services. There is still a massive labor surplus in either unskilled or educated labor in the global labor market. Any push for higher wages in developed economies would push global companies to shift more production to low-cost economies like China or India.
2)The enhanced risk appetite, however, has decreased the cost of capital for businesses and economies that were starved of capital, and they have taken advantage of the cheaper capital to increase investment. This force continues to push up the prices of natural resources. The resulting inflation further increases risk appetite in the global financial system. As financial investors pile in, commodity prices rise substantially above what real demand would imply. This dynamic is leading to a big commodity bubble.
3)The End Is Debt Deflation
4)The major central banks may try to ease aggressively to fight the unwinding spiral. However, it would be too late to revive money demand. Most speculators who are driving demand for money today would have been cut down already. |
