By Ian Fraser
The wild swings in global liquidity that continue to distort economies around the world might, if left unchecked, trigger the end of open capital markets and free trade, Bank of Canada governor Mark Carney warned in a recent speech. Carney, named head of the G20’s Financial Stability Board on November 4, suggested that this is a monster he intends to tame.
In a lecture titled 'Global Liquidity', given to the Canada-United Kingdom Chamber of Commerce in London on November 8, Carney described liquidity as the “Keyser Söze” of international finance (in the 1995 film The Usual Suspects, Söze is a shadowy crime lord whose ruthlessness and influence have acquired a legendary, even mythical, status among police and other criminals). Carney said that, just like Söze, liquidity has:
“no agreed definition and, as a consequence, there has been no coherent policy approach to tame its more violent tendencies.”
Carney – who gained kudos after standing up to hectoring over enhanced capital rules from Jamie Dimon, chief executive of JPMorgan Chase (NYSE:JPM), in September – said a key determinant of private liquidity is the willingness of the financial sector to provide cross-border financing.
This, in turn, depends on the preparedness of market participants to provide the underlying funding. As a result, Carney said private liquidity is highly cyclical. In good times there's an over-abundance, which feeds through the banking system and corporate bond markets, fuelling general exuberance and inflating asset price bubbles.
Carney said that central banks, through their own actions, can exacerbate such cyclicality. He cited the massive, predictable reserve built up by Asian central banks as having “dampened longer-term interest rates, promoted carry trades and fed global liquidity creation.”
Carney went on to say that economic downturns are exacerbated by deleveraging, with market participants offloading riskier assets, often at firesale prices, in order to raise liquidity. Such sales spark a generalized decline in asset prices, said Carney, which is self-perpetuating since it further raises investors’ funding liquidity risk through margin calls.
“In the extreme, widespread uncertainty about the viability of banks can lead to a total drying up of private funding, with significant adverse effects on the financial system and the broader economy.”
Carney said the peaks and troughs of the liquidity cycle have been further exaggerated by globalization (as cross-border funding is so mobile), which Carney said "amplifies the cyclical dynamics of domestic credit and asset prices." He said what had happened in Ireland in the years up to the crisis illustrated this.
“A huge surge in cross-border liquidity led to a massive increase in domestic debt and unsustainable growth in house prices and housing sector activity."
Carney said that, globally, cross-border bank credit, including interbank funding, grew rapidly between 2003 and 2007, reaching annual growth rates of 20% on the eve of the crisis. He said the surge fed the build-up of large currency mismatches, particularly for European banks in US dollars. After the onset of the crisis, cross-border interbank lending fell sharply, reducing funding liquidity, forcing asset fire sales and further reducing overall private liquidity. He said the current liquidity crunch, partly caused by the drying up of US interbank funding for European banks, risks tipping Europe into recession.
Carney suggested a number of policy options for addressing this:
- Limit scale of deleveraging
- Asian authorities should draw on official reserves to offset the withdrawal of private liquidity.
- European banks should sell US-dollar assets.
- European banks should be required to meet at least part of their requirements by raising private capital, including high-trigger contingent capital.
- Introduce co-operative measures to provide foreign currency liquidity.
- Central banks should stand ready to activate domestic facilities, if required.
- Country-specific or regional liquidity shocks to be addressed, where possible, through IMF facilities.
- Adjust monetary policy if the outlook for economic activity and inflation warrant, for example through direct provision of additional official liquidity through quantitative easing.
The 46-year-old central banker added:
“Global liquidity has fluctuated wildly over the past five years, and we are on the cusp of another retrenchment. There are steps that can be taken to mitigate, but not eliminate, the negative effects of the current wave. How European banks choose to delever will determine which ones authorities around the world need to take.”
Over the medium term, Carney warned that the continuation of wild liquidity swings may threaten the future of open capital markets and free trade. To avoid this he proposed:
- Countercyclical capital buffers
- The implementation of more-resilient financial market infrastructure
- Reductions in the variability of repo margins
- Other macroprudential policies such as loan-to-value ratios in property markets
Leslie Levesque, senior economist with IHS Global Insight, a US economics consultancy, believes Carney was providing a foretaste of what he intends to do during his tenure at the FSB. She said:- “I’m sure he’s looking back at the liquidity crunch that came out of the 2008 crisis, and hoping to avoid something similar.”
Carney, named “Canada’s Banking rock star” in a recent CTVNews profile, last month described the Occupy Wall Street movement as “entirely constructive", since it has made the extreme challenges that the global economy is facing "tangible". He said the Occupy protests demonstrate that the world must deliver on financial reform.