World economy confronted by liquidity paradox
Saturday, 25 August 2007
Krishna Guha in Washington
There is a paradox of liquidity in the world economy today. In large parts of the financial system market liquidity is in scarce supply.
The supply of credit is tightening and the price of risk is going up. But at the macroeconomic level, liquidity remains abundant. The world is still awash with savings as it has been for several years. One striking example of this: the giant current account surpluses of the oil exporters, China and other emerging markets, which represent surplus national savings.
In the short term this structural "global savings glut" is no guarantee against further market turmoil.
But at some point it is likely to act as a moderating force, containing the ultimate extent of the increase in the price of risk reflected, for instance, in credit spreads, and helping to restore market liquidity.
To some extent the liquidity paradox is an illusion, deriving from the fact that we use the word liquidity to describe several distinct ideas.
As investors have discovered in recent days, macro liquidity (plenty of savings) does not guarantee cheap and available credit, or micro liquidity (ease of buying and selling in markets). Kevin Warsh, a Federal Reserve governor, argued in a speech in March that micro liquidity was largely a product of confidence - a commodity that is in short supply now.
But Ken Rogoff, a professor at Harvard and former chief economist of the International Monetary Fund, says: "There is clearly a link between macro liquidity and micro liquidity."
Before the latest crisis broke, analysts often talked about how a wave of global liquidity was driving down the price of risk and making it easy to buy and sell in the markets. This story sometimes came in over-simplified form. But it has economic logic behind it.
When savings are abundant and global interest rates low, default rates tend to be low, meaning credit spreads should be low too.
Low interest rates may encourage investors to take on more risk in order to meet required rates of return. They also put pressure on financial institutions to seek higher yield, promoting innovation that in turn makes it easier to buy and sell securities.
Indeed the link between interest rates and credit conditions is such that Mr Rogoff says it is possible that the credit market turmoil was triggered by the short-lived move up in global interest rates earlier this summer.
In the first seven months of the year, China's trade surplus - the main driver of its current account surplus - rose 81 per cent, according to Thomson Financial.
Thomson calculates that the combined current account surplus tracked by the Economist Intelligence Unit is forecast to be $116bn (€86bn, £58bn) this year, only a fraction lower than last year. Actual surpluses could come down if the US economy slows, but the structural drivers of high global savings remain intact.
"Global liquidity is strong," says Raghu Rajan, a professor at Chicago and, a former chief economist of the IMF. "There is still in some sense an excess of desired saving over investment."
He says the problem is not supply of savings, but the fact that market dysfunction is making it hard to reallocate these savings.
"This certainly is one of the differences from 1998" - when there appeared to be a global shortage of savings - says Mr Rajan.
Some sketch out a scenario in which the sovereign wealth funds that invest some of the world's excess savings could ride to the rescue of troubled markets. This is unlikely, as these funds are risk-averse.
The IMF says co-ordinated intervention of this kind is not under discussion.
Still, the savings have not gone away, and once markets stabilise this should help to moderate any long-term increase in the price of risk and decline in market liquidity. Throw in a strong global economy and cash-rich corporate balance sheets as well, says Mr Rogoff, and it is "an extremely soft cushion on which to land".
There is a paradox of liquidity in the world economy today. In large parts of the financial system market liquidity is in scarce supply.
The supply of credit is tightening and the price of risk is going up. But at the macroeconomic level, liquidity remains abundant. The world is still awash with savings as it has been for several years. One striking example of this: the giant current account surpluses of the oil exporters, China and other emerging markets, which represent surplus national savings.
In the short term this structural "global savings glut" is no guarantee against further market turmoil.
But at some point it is likely to act as a moderating force, containing the ultimate extent of the increase in the price of risk reflected, for instance, in credit spreads, and helping to restore market liquidity.
To some extent the liquidity paradox is an illusion, deriving from the fact that we use the word liquidity to describe several distinct ideas.
As investors have discovered in recent days, macro liquidity (plenty of savings) does not guarantee cheap and available credit, or micro liquidity (ease of buying and selling in markets). Kevin Warsh, a Federal Reserve governor, argued in a speech in March that micro liquidity was largely a product of confidence - a commodity that is in short supply now.
But Ken Rogoff, a professor at Harvard and former chief economist of the International Monetary Fund, says: "There is clearly a link between macro liquidity and micro liquidity."
Before the latest crisis broke, analysts often talked about how a wave of global liquidity was driving down the price of risk and making it easy to buy and sell in the markets. This story sometimes came in over-simplified form. But it has economic logic behind it.
When savings are abundant and global interest rates low, default rates tend to be low, meaning credit spreads should be low too.
Low interest rates may encourage investors to take on more risk in order to meet required rates of return. They also put pressure on financial institutions to seek higher yield, promoting innovation that in turn makes it easier to buy and sell securities.
Indeed the link between interest rates and credit conditions is such that Mr Rogoff says it is possible that the credit market turmoil was triggered by the short-lived move up in global interest rates earlier this summer.
In the first seven months of the year, China's trade surplus - the main driver of its current account surplus - rose 81 per cent, according to Thomson Financial.
Thomson calculates that the combined current account surplus tracked by the Economist Intelligence Unit is forecast to be $116bn (€86bn, £58bn) this year, only a fraction lower than last year. Actual surpluses could come down if the US economy slows, but the structural drivers of high global savings remain intact.
"Global liquidity is strong," says Raghu Rajan, a professor at Chicago and, a former chief economist of the IMF. "There is still in some sense an excess of desired saving over investment."
He says the problem is not supply of savings, but the fact that market dysfunction is making it hard to reallocate these savings.
"This certainly is one of the differences from 1998" - when there appeared to be a global shortage of savings - says Mr Rajan.
Some sketch out a scenario in which the sovereign wealth funds that invest some of the world's excess savings could ride to the rescue of troubled markets. This is unlikely, as these funds are risk-averse.
The IMF says co-ordinated intervention of this kind is not under discussion.
Still, the savings have not gone away, and once markets stabilise this should help to moderate any long-term increase in the price of risk and decline in market liquidity. Throw in a strong global economy and cash-rich corporate balance sheets as well, says Mr Rogoff, and it is "an extremely soft cushion on which to land".