Where did all the money disappear? – Liquid Fantasies

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

In the current financial crisis, the quantum of available capital, the munificent resources of central banks and sovereign wealth funds and the 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 still exist, but you have ceased to live”.

Reserve Illusions

In recent years, there has been speculation about the amount of capital or liquidity available for investment globally. The substantial reserves of central banks and, their acolytes, sovereign wealth funds were frequently cited in support of the case for a large pool of “unleveraged” liquidity, that is “real” money. In reality, the available pool of money may be more modest than assumed.

For example, China has close to $2 trillion in foreign exchange reserves. The reserves arise from dollars received from exports and foreign investment into China that are exchanged into Renminbi. The central bank generates Renminbi by printing money or borrowing through issuing bonds in the domestic market. On China’s “balance sheet”, the reserves are essentially “leveraged” using domestic “liabilities”.

In order to avoid increases in the value of the Renminbi that would affect the competitive position of its exporters, China undertakes ” currency sterilisation” operations where it issues bonds to mop up the excess liquidity. China incurs costs – effectively a subsidy to its exporters – of around $60 billion per annum (the difference between the rate it pays on its Renminbi debt and the investment income on it reserves).

The dollars acquired are invested in foreign currency assets, around 60% in dollar denominated US Treasury bonds, GSE paper (such as Freddie and Fannie Mae debt) and other high quality securities. China is exposed to price changes in these investments and currency risk because of the mismatch between foreign currency assets funded with local currency debt.

Deterioration in the US economy and the need to issue additional debt to support the financial sector may place increasing pressure on the US sovereign rating and the dollar. US Government support for financial institutions 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 in losses on investment through falls in the market value of the debt and a weaker dollar. The credit default swap (“CDS”) market for sovereign debt is increasingly pricing in increased funding costs for the US. The fee for hedging against losses on $10 million of Treasuries was about 0.58% pa for 10 years (equivalent to $58,000 annually) in December 2008. 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 the portfolios, it is difficult for large investors like China to rapidly mobilise a large portion of these funds by liquidating their investments and converting them into the home currency without substantial losses. This means that this money may not, in reality, be available, at least at short notice.

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

The position of emerging market sovereign investors with large portfolios of dollar assets is similar to that of a bank or leveraged hedge fund with poor quality assets. China’s Premier Wen Jiabao recently expressed concern: “If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital…” In December 2008, Wang Qishan, a Chinese vice-premier, noted: “We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China’s assets and investments in the US.”

There are other factors affecting the availability of the reserves at central banks and sovereign wealth funds. In recent years, sovereign wealth 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 to support the domestic economy and banking system. For example, South Korea has used a portion of its reserves to provide dollars to banks unable to re-finance short-term dollar borrowings in international money markets.

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

Capital Illusions

The substantial build-up of foreign reserves in central banks of emerging markets and developing countries, as identified by David Roche (see David Roche and Bob McKee (2007) New Monetarism; Independent Strategy Publications), is really a liquidity creation scheme that relies on the dollar’s favoured position in trade and as a reserve currency.

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

Large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements and the historically unimpeachable credit quality of the US sovereign assets facilitated the process. The recycled dollars flow back to the US to finance the spending.

This merry-go-round is a significant source of liquidity creation in financial markets. It also kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going. This process increased the velocity of money and exaggerated the level of global liquidity.

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

The central banks holding reserves were lending the funds used to purchase goods from the country. In effect, the exporter never got paid at least until the loan to the buyer (the vendor finance) was paid off. As the debt crisis intensifies and global growth diminishes with increased defaults, it is increasingly likely that this debt will not be paid back in it entirety.

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

Trade Illusions

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

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

The slowdown in central bank reserve re-circulation affects global trade through the decrease in the availability of financing for purchasers to buy goods and services. This is apparent in the sharp slowdown in consumer consumption in the US, UK and other economies. The availability of cheap finance also helped drive up the prices which, in turn, allowed excessive borrowing against the inflated value of these assets that fuelled consumption.

Weakness in the global banking system (in particular, loan losses, the lack of capital and concerns about counterparty risk between large financial institutions) contributes to restricted availability of trade letters of credit, guarantees and trade finance generally. This exacerbates the problem. The restrictions, in turn, further impact on the level of trade flows and capital re-circulation resulting in a further decrease in trade activity that in turn further slows down international credit creation.

It is not easy to fix the problem. Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance the debtor countries, such as the US and re-capitalise the banking system. Maintenance of the cross border capital flows to finance the debtor countries budget and trade deficits slows down growth in emerging countries and also perpetuates the imbalances.

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

This opens the way to “capital protectionism”. Foreign investors may change their focus and reduce their willingness to finance the US. Wen Jiabao, the Chinese Prime Minister, indicated that China’s “greatest contribution to the world” would be to keep it’s own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance US needs.

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

It promoted a global economy based on “vendor financing” by the exporting nations. The strategy also exposed the emerging countries to the 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 and a high reliance on credit is the cause of the US financial crisis. As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.” More ominously Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

There is also the risk of “traditional” trade protectionism. The end of the current liquidity cycle, like the one in the 1930s, may cause a sharp fall in exports. Exporting countries, seeking to maintain domestic growth may try to boost exports by devaluation of the currency or subsidies. Import tariffs are less effective unless there is a large domestic 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 Euro reflects repatriation of capital by investors and the shortage of dollars from the slowdown in the dollar liquidity re-circulation process. It is also driven by the reliance on short-term dollar financing of some banks and countries and the need for re-financing. This is evident in the persistence of high inter-bank dollar rates and dollar strength.

The strength of the dollar is unhelpful in facilitating the required adjustment in the current account and also financing of the US budget deficit.

The slowdown in the credit and liquidity processes outlined may have long-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 “Should Atlas still shrug?” (15 January 2007) Financial Times) “candy floss money“. New financial technology spun available “real” money into an exaggerated bubble that, like its fairground equivalent, collapses ultimately.

The global liquidity process was multi-faceted. There was traditional domestic credit creation system built on the fractional reserve system that underpins banking. The leverage in the system was pushed to extreme levels. Losses and renewed regulation are forcing this system of credit creation to shut down.

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

Another credit process – the export of Yen savings via the Yen carry trade and acquisition of foreign assets by Japanese investors) – has also slowed.

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

Markets placed great faith in the volume of money available to support asset prices and assist in alleviating shortages of liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows. As the financial system de-leverages, it is becoming clear, unsurprisingly, that available capital is more limited than previously estimated.

As Sigmund Freud once observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”

There is an apocryphal story about a disgraced rock star who ended up in bankruptcy court. When asked what happened to his fortune of several million dollars, he responded: “Some went in drugs and alcohol, I gambled some of it away, some went on women and the rest I probably wasted!” Financial markets have “wasted” a staggering amount of money that 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).

20 Responses to "Where did all the money disappear? – Liquid Fantasies"

  1. Zeus   December 8, 2008 at 6:41 pm

    So what does it all mean?

  2. r0tiNeK   December 8, 2008 at 7:13 pm

    It means there is currently a vacuum sucking enormous volumes of money out of the real economy (i.e. DELEVERAGING) – and this process is WELL underway (already sucked enormous volumes of money out of the system – just look at the Dow Jones or the Oil price).http://www.nakedcapitalism.com/2008/07/has-deleveraging-even-begun-not-for.htmlWe're now in Deflation and we’ll be lucky not to experience a prolonged period – just like Japan has gone through.If you’ve got plenty of Cash & no Debt. You’re laughing : )

    • Rick Metzger   December 10, 2008 at 1:09 am

      I have plenty of cash and no debt. Nevertheless, I am too humble and too risk-averse to be laughing, though this is not meant to diminish your accurate point. Each night when I try to sleep, I count the ways the government and its financiers will try to screw me, so even all my cash and debt-free status are of insufficient consolation. It remains “the man behind the curtain” that worries me.

      • Gunther Steinberg   December 12, 2008 at 8:50 am

        Quite right. Eventually the US is going to inflate its debt away,since no one feels like paying more taxes. The result is the same, either way. The savers loose. The profligate consumers either spend and enjoy or walk away from debt. The government will mess us up in the end.

  3. fresno dan   December 9, 2008 at 4:47 am

    confirms what I thought about the “savings glut” – of course, I don’t have nearly the intellect or insights of Das, but still nice to have some validation. But really, at a basic level, wasn’t it obvious that money was being created out of thin air? I find it astounding that regulators are surprized by this.

  4. CLS   December 9, 2008 at 2:21 pm

    Really good article. Thanks for your insights.

  5. r0tiNeK   December 9, 2008 at 7:53 pm

    Good point, fresno dan. The reality of the situation is that “The Powers That Be” knew full well what was going on. Even Greenspan, who was the Loved Fed Governor is highly responsible for the asset bubble which came to be. Your “Regulators” turned a blind eye to the CDO’s (which didn’t exist in 2002) and allowed the money supply to be blown to the schiezen-housin because it gives the ILLUSION that the economy is on steroids. But any Professional bodybuilder who’s retired & who’s body has sh!t itself & they now have the testosterone levels of a 12yr old girl can tell you… this sort of thing has consequences.The Deflationary collapse which is now unfolding is a process of Equilibrium. When you blow the money supply to the moon like they did, then you get a Japan like Deflation to bring REALITY back into the picture. It has to happen and is part of the credit cycle. The reason it’s going to be so bad is because we printed WAY hard for WAY too long.

  6. AP   December 9, 2008 at 11:34 pm

    Great insights, but one quibble… the apocryphal rockstar quote is actually from footballer George Best: “I spent 90% of my money on women, drink and fast cars. The rest I wasted.”http://news.bbc.co.uk/sport2/hi/football/4312792.stm

  7. Demand Side   December 10, 2008 at 12:33 pm

    Very good. Thank you. It seems to me the only long-term stability will arise when goods are traded for goods through the medium of money and the currency is not manipulated to facilitate “export economies.”In the short term, the “illusions” generated a great deal of real building, manufacturing and production of services. The real capacity to do this did not disappear, but the illusion that the dollar is a store of value may be crumbling. The dollar’s future and the financial structure that has been built around it seems to require the U.S. and its trading partners to reverse the merry-go-round.This would seem to necessitate a growth in the U.S. export sector, i.e., manufacturing, and a new exchange regime that will eliminate the need to hoard dollars against volatility in short-term capital flows.

  8. wtt1011   December 10, 2008 at 5:53 pm

    So does it mean we will at the least have sever dis-inflation/deflation or that the value of the dollar will decline dramatically and the rest of the world stops buying our Treasuries(financing our debt) and we face inlation/hyperinflation??

    • Guest   December 12, 2008 at 1:42 pm

      First one, then the other.

  9. Anonymous   December 11, 2008 at 2:14 am

    “This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance US needs.” ?One of the basic problems in our culture is the dishonesty to call wishes “needs”.

  10. Jupiter   December 12, 2008 at 11:55 am

    What if some one in the US or EU develop some radical technology or thing such as Internet etc that could be sold to every one else for a huge profit. Does this reverse this whole process. In my opinion US didn”t benefit enough from the Computer/Internet Technology it developed.I wish an alternate energy or something else that is cool come out of this. All though over 90% of the population in the west and especially US are slobs, I still haven’t given up on the rest of the 10%.What do you guys think.

  11. Hal   December 12, 2008 at 3:13 pm

    Basic question:Just why would we want to ‘go back’ to the big spending ways?Seems that letting the deleveraging work itself out — and encouraging savings is a better long term plan/I’m more interested in sustainability than quick profit.AND I believe most people in the country are too.It only seems to be Wall Street and Big Business that want things differently.All these arguments ASSUME that everyone is interested in ‘big money’ — NOT TRUE.GREED IS STUPID — AND SICK.

  12. Lockey   December 14, 2008 at 10:46 am

    I have a simple view. Chinese accumulation of dollars represents a debt of USA to Chinawhich can only be repaid in goods or services. This is an unwinding of the Chinese madegoods sent to the USA. The debt is measured in dollars and you can be sure there will bevery careful monitoring (by China) of any manipulation which may reduce what is owed in realterms i.e. goods or services. This is why currency exchange rates are so important. EventuallyUSA should have to repay the debt.

    • Pierre   December 17, 2008 at 12:09 am

      You’re right! Your view is simple. Please reread Das and try to get the macro picture. China stands to loose more than any other player. China today represents the US post 1929. US today represents Europe post 1929. Europe reflated, especially Germany and did quite well by mid 1930s.

      • Kiers   January 2, 2009 at 10:28 pm

        Interesting! But if China loses, then it’s over for the $. Which again is bad for U$A. China could demand the ONLY thing that the world wants from the US at this point….export of High tech weaponry. or else…We’ve never had a “guns vs butter” debate like THAT before!