Capital Illusions

The substantial build-up of foreign reserves in the central banks of emerging markets and developing countries, as identified by David Roche (see his 2007 book New Monetarism, coauthored by Bob McKee), is really a liquidity creation scheme that relies on the dollar's favored 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, which 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 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 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 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. In reality, this too may have been an illusion, as the underlying process is a gigantic vendor-financing scheme, where the seller is lending the buyer the money to purchase the goods.