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The Grand Illusion of Global Liquidity, Part 1


Capital flow, global trade growth were actually houses of cards.

Editor's Note: This is Part 1 of a 2-part series. Part 2 can be found here.

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 globalization 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."

The dollars acquired are invested by the central banks in foreign currency assets, around 60% in dollar denominated US Treasury bonds, GSE paper (such as Freddie Mac (FRE) and Fannie Mae (FNM) debt) and other high quality securities. 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.

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 mobilize 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 not on short notice.

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 US financial sector, we are anxious about the safety and security of Chinese capital."

There are other factors affecting the availability of the reserves at central banks and sovereign wealth funds. Sovereign wealth funds have also suffered losses on some of their investments, most notably in US and European financial institutions. Some central banks, South Korea and Russia, have been forced to utilize some of the reserves to support the domestic economy and banking system.
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