Home' Trinidad and Tobago Guardian : October 22nd 2015 Contents OCTOBER 22 • 2015 www.guardian.co.tt BUSINESS GUARDIAN
THE ECONOMIST | BG21
When the financial system teetered on the
brink of collapse in 2008, the biggest problem
was a lack of liquidity. Banks were unable
to refinance themselves in the short-term
debt markets. Central banks had to step in
on a massive scale to offer support. Calm
eventually was restored, but not without enormous economic dam-
Has the underlying problem of liquidity gone away, though? A
research note from Michael Howell of Crossborder Capital argues
that, in the modern financial system, central banks no longer are the
only, or even the main, providers of liquidity. Instead the system looks
much like that of the Victorian era, with banks dependent on the
wholesale markets for funding. Back then the trade bill was the key
asset for bank financing. Now it is the mysteriously named "repo"
A repurchase, or repo, agreement involves a borrower selling a
bunch of securities for cash and agreeing to buy them back later for
a higher price. The difference between the two prices represents the
interest payment. The market is huge: A survey by the International
Capital Market Association estimated that, in June 2015, European
repo agreements were worth US$6.4 trillion.
To borrow in the repo market, banks need assets to pledge against
the loans---collateral, in other words. Howell argues that it is the
supply of, and demand for, collateral that determines liquidity in the
The problem is that not all collateral is treated equally. Lenders
worry that, if the borrower fails to repay, the securities they are left
holding may not sell for their face value. So they apply a discount,
or "haircut," to the collateral, depending on its perceived riskiness.
At times of stress lenders get nervous and apply bigger discounts
than before. This is what happened during the financial crisis.
Bigger haircuts mean that borrowers need more collateral than before
in order to fund themselves.
"When market volatility jumps," Howell writes, "funding capacity
drops in tandem and often substantially."
The result, a liquidity squeeze at the worst possible moment, is a
template of how the next crisis may occur, although regulators are
trying to reduce banks reliance on short-term funding.
Viewed in this light, global liquidity should not bemeasured merely
by the size of central banks balance sheets but also by the availability
of acceptable collateral. By Howell s calculations, global collateral shot
up in the aftermath of the financial crisis, but grew much more slowly
from 2012 onward. This may explain why global growth has been so
Traditional quantitative easing may do little to help.
"Simply expanding the central-bank balance sheet by buying in
Treasuries from the private sector is robbing Peter to pay Paul," Howell
writes, since otherwise the bonds could have been used as collateral
for repo transactions.
Given that funding conditions resemble those in Victorian times,
Howell thinks that central banks should return to the policies favored
by Victorian economist Walter Bagehot and focus, above all, on the
smooth running of the credit markets. If they do not, the risk is that
a shortage of collateral may induce another funding squeeze. Low as
they are, government-bond yields may then fall even further as banks
scramble to get hold of them for funding purposes.
This view is an interesting contrast with a popular investment theme
of the moment, the idea of "quantitative tightening." Central banks are
slowing their pace of asset purchases and China has been offloading
some foreign-exchange reserves. Since many people think that cen-
tral-bank purchases have been propping up the financial markets, their
fear is that QT may cause bond yields to rise in the absence of cen-
These differing interpretations point to the difficulty of analysing a
broad concept such as "global liquidity." It is reminiscent of the problem
of defining the money supply during the heyday of monetarism in the
late 1970s and early 1980s. Everyone can agree that notes and coins
are money, but the wider the definition, the greater the scope for dis-
agreement. Use the wrong measure, and the monetary signals may
completely mislead. A fast-changing financial system makes things
even harder: How do bitcoins fit into global-liquidity calculations?
Such complexity makes the withdrawal of monetary stimulus by
central banks even more difficult. In a 2014 paper, the International
Monetary Fund warned that "central banks exit strategy needs to be
mindful of disruptions to the financial plumbing."
Even if they manage that trick, Howell surely is right: One day the
financial headlines will be dominated by worries about a collateral
shortage. The Economist
"Sinking" might be a better description than "floating"
when it comes to many of the world s currencies.
A plunge in commodity prices has hit producers of natural
resources hard. Weak oil prices, in particular, have under-
mined the current-account position of oil exporters. The
Economist Intelligence Unit expects the Norwegian current
account to have deteriorated by 3.3 percentage points between
2013 and 2015. Many currencies have followed oil prices
down. Since June 2014 the Norwegian krone has declined
by 26 per cent, the Brazilian real by 40 per cent and the
Russian ruble by 45 per cent against the greenback.
Those who believe that competitive exchange rates boost
economic growth should be pleased. Not every country is
willing to let its currency freely adjust, however. The Inter-
national Monetary Fund s annual review of currency regimes,
published this month, revealed that, at the beginning of
2015, only 35 per cent of member countries let their currencies
float and only 16 per cent intervened rarely enough for the
IMF to classify them as "free floating." The rest, from Hong
Kong s ironclad peg to the dollar to the stumbling Nigerian
naira, are managed with a tighter grip.
This penchant for pegs can make sense. Many big oil
exporters peg their exchange rates to the dollar because oil
is priced in that currency. Anchoring a country s exchange
rate to another, stable currency allows a weak central bank
to latch onto the credibility of a stronger institution and
thus keep inflation expectations steady. Ask a Zimbabwean
whether he or she prefers the old regime---when 175
quadrillion Zimbabwean dollars exchanged for US$5--- or
the new, hard-currency one.
Pegs come with strings attached, however. In a free
market a shock such as a collapse in the value of exports
would boost relative demand for foreign exchange, which
in turn would cause the domestic currency to depreciate.
The danger of a peg is that, rather than allowing the exchange
rate to adjust gradually, imbalances build up. Speculators
spot the problem and attack the currency. If the country
has to push up interest rates to defend the peg, that hurts
the underlying economy, but devaluing brings potential
ruin to companies that have borrowed in foreign curren-
cy.If the exchange rate does not adjust to a shock, then
something else has to shift instead. Some places, such as
Hong Kong, have enough flexibility to cope --- its strong
peg to the dollar works because workers wages can go
down as well as up. Not everywhere is so nimble, though.
An alternative approach is to build huge reserves to ward
off speculators, as Saudi Arabia has done. According to
estimates from Jadwa Investment, a Saudi Arabian fund
manager, the government has amassed enough reserves to
cover a comforting 48 months of imports. Few seem to
think that the Saudi peg will fall soon.
Other pegs have been buckling under global pressures.
Both the Kazakh tenge and the Vietnamese dong have seen
their pegs break in the wake of the recent Chinese deval-
uation. The Kazakhs had little choice, even though a similar
move in February 2014 led to street protests as imported
luxuries were lifted out of the reach of ordinary people.
The country also has had to cope with a fall in the Russian
ruble, a big trading partner. Maintaining the dollar peg
would have left Kazakh exporters painfully uncompetitive.
Other oil producers have adopted strategies that risk
doing more harm than good. The Nigerian naira and Angolan
kwanza have depreciated by 19 per cent and 27 per cent
respectively against the dollar since June 2014, as their
central banks have allowed them to drop in a series of steps.
According to Yvonne Mhango of Renaissance Capital, an
emerging-market investment bank, both still have some
way to go.
Rather than getting the pain over with, the Nigerian gov-
ernment is trying to shock the economy into plugging the
gap between import and export revenues. In June the Central
Bank of Nigeria produced a list of 41 items that cannot be
bought using foreign exchange, including rice, rubber, tooth-
picks and private jets. According to Mhango, these import
restrictions are causing a recession in its manufacturing
sector, which cannot get access to the raw materials it
"There is nothing to suggest that the gap in supply that
has been created by the import ban can be filled," she said.
"In the short term the prices of those goods are just increas-
The government is creating the very problem it is trying
Venezuela also is in a fix. The falling price of oil is expected
to turn its current account from a surplus to a deficit. With
enough reserves for only three months of imports, it has
clamped down on access to foreign exchange. The IMF
expects it to be one of this year s worst economic performers.
The inflation rate is widely estimated to be in triple dig-
its.For countries such as these, burning through central-
bank reserves is a short-term solution to defending a
currency and restricting trade is self-defeating. Angola and
Nigeria already have devalued more than once, and investors
sense that there is further to go. The only question is what
will force the move --- outside speculators or economic
pressure from within? The Economist
Pegs under pressure
The next bank crisis?
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