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Economic cycles are driven by financial flows, namely quantities of savings and credits, and not by high street inflation or interest rates. Their sweeping destructive powers are expressed through Global Liquidity, a $130 trillion pool of footloose cash. Global Liquidity describes the gross flows of credit and international capital feeding through the world’s banking systems and wholesale money markets. The huge jump in the volume of international financial markets since the mid-1980s has been boosted by deregulation, innovation and easy money, with financial globalisation now surpassing the peaks of integration reached before the First World War. Global Liquidity drives these markets: it is often determinant, frequently disruptive and always fast-moving. Barely one fifth of Wall Street’s huge gains over recent decades have come from earnings: rising liquidity and investors’ appetite for riskier financial assets have propelled stock prices higher. Similar experiences are shared worldwide and even in emerging markets, such as India, flat earnings have not deterred waves of foreign money and domestic mutual funds from driving-up stock prices. Now with central banks actively pursuing quantitative easing policies, industrial corporations flush with cash and rising wealth levels among emerging market investors, the liquidity theory of investment has never been more important.

International spill-overs of these rapacious cross-border flows sets off capital wars and exposes the unattractive face of liquidity called ‘risk.’ As the world grows bigger, it becomes ever more volatile. From the early 1960s onwards, the world economy and its financial markets have suffered from three broad types of shocks – labour costs, oil and commodities, and global liquidity. Financial markets spin on fragile axes and the absence of liquidity often provides a warning of upcoming troubles.

Global Liquidity is a much-discussed, but narrowly-researched and vaguely-defined topic. This book deeply explores the subject by clearly defining and measuring liquidity worldwide and by showing its importance for investors. The roles of central banks, shadow banking, the rise of Repo and growth of wholesale money are discussed. Additionally, covering the latest developments in China’s increasingly dominant financial economy, this book will appeal to practitioners, policy-makers, economists and academics, as well as those with a general interest in how financial markets work.

Table of Contents

Frontmatter

Chapter 1. Introduction: Capital Wars

Abstract
Capital wars sit alongside trade wars and technology wars as the means for exercising power in the modern World economy. This money power can be expressed through the concept of Global Liquidity, a US$130 trillion pool of fast-moving funds. Its origins go back to research initiated by the US investment bank Salomon Brothers in the 1980s. The effects of Global Liquidity are transmitted through cross-border capital flows. An escalation in the size of these flows often leads to financial crises, notably in Emerging Markets. China herself is too reliant on US dollar flows, and, controversially, the coming decades will likely see the internationalisation of the Yuan.
Michael J. Howell

Chapter 2. Global Money

Abstract
Global Liquidity is a source of funding, defined by the flow of savings and credit and analysed through a flow of funds framework. It can be measured by adding together the money flowing through its three main conduits: (1) Central Bank provision; (2) private sector supply from traditional banks and shadow banks and (3) cross-border capital inflows. The major sources of Global Liquidity are the US, China and offshore pools, such as the Eurodollar markets. Policy-makers and academics put more emphasis on interest rates, i.e. the cost of capital, than balance sheet size and the quantity of liquidity, i.e. the capacity of capital. The cost of capital matters in an economy actively driven by capital spending, but in a World featuring huge debt refinancings, the capacity of capital and, hence, liquidity matter more.
Michael J. Howell

Chapter 3. Synopsis: A Bigger, More Volatile World

Abstract
As the World gets bigger, it seemingly becomes more volatile. The 1989 Fall of the Berlin Wall changed the direction of World capital flows, facilitating a productivity ‘catch-up’ across the Emerging Markets and effectively reversing the polarity of financial systems. These effects were reinforced by a second shock following China’s 2001 entry into the World Trade Organisation (WTO). China significantly increased the use of US dollars through her export-led supply chains. One result was the build-up of vast CICPs (corporate and institutional cash pools). These dominated the wholesale money markets, eclipsing high street banks, demanding collateralised ‘safe’ liquid assets and leading to the rise of the repo. Parallel government austerity policies have constrained the supply of government bonds to use as collateral for these repos.
Michael J. Howell

Chapter 4. The Liquidity Model

Abstract
We use the discipline of flow of funds accounting to define liquidity algebraically from the standard budget constraint. By rearranging the expression for the private sector’s net acquisition of financial assets, we derive a formula for gross flows that splits out aggregate sources from the uses of liquidity. The model aligns with existing analyses of inside and outside money. It also shows that the main focus of traditional monetarism, namely bank deposits, is a use of funds rather than a source of funds. We argue that the aggregate inside plus outside money determines the size of maturity spreads, whereas the differential between inside and outside money flows determines credit spreads and the value of the exchange rate.
Michael J. Howell

Chapter 5. Real Exchange Adjustment

Abstract
The exchange rate is a main transmission channel for liquidity. Liquidity and productivity shocks can both affect the real exchange rate. This leads to some combination of nominal exchange rate change and relative price change. Because more and more economies are international price-takers, the bulk of the relative price adjustment is channelled through asset prices, particularly when nominal exchange rates are fixed or targeted by policy-makers, such as in the Eurozone and between the US and China. Asset price booms often characterise the Emerging Market economies, which often currency target the US dollar. Equally, the desire to maintain the collateral values of domestic assets force many financially dominant economies, such and Britain and the US, to devalue their currencies rather than allow their asset prices to fall.
Michael J. Howell

Chapter 6. Private Sector (Funding) Liquidity

Abstract
The gross measure of funding liquidity is distinguished from the net credit supply using the financial sector balance sheet. This embraces shadow banks as well as traditional high street banks. The growth of US and World shadow banking is enumerated. Cash-rich wholesale markets lie behind the recent rise of shadow banking, and these are being fed by CICPs (corporate and institutional cash pools) and explain the rise of the repo as a key financial instrument. The greater use of collateral and access to unregulated, offshore pools of money in the Eurodollar markets have reduced Central Bank control over liquidity creation, leading to a collapse in the traditional money multiplier. The alternative concept of the shadow money base is introduced.
Michael J. Howell

Chapter 7. The Central Banks: Don’t Fight the Fed, Don’t Upset the ECB and Don’t Mess with the PBoC

Abstract
The US Federal Reserve; the People’s Bank of China (PBoC) and, to a lesser extent, the European Central Bank (ECB), are the dominant global players. The US Federal Reserve and the ECB have recently seen monetary control badly shaken, whereas the PBoC’s liquidity multiplier has remained remarkably stable. The Federal Reserve operated through three channels following the 2007–2008 Global Financial Crisis (GFC)—liquidity provision, maturity transformation and credit enhancement. The policies of other Central Banks are less definitive. The PBoC still focuses on quantitative policies to provide liquidity, with their domestic monetary operations becoming far more important since the disruption to foreign exchange reserve accumulation in 2015. The ECB has struggled to maintain liquidity provision since the GFC and has lately been forced to focus increasingly more on credit enhancement policies.
Michael J. Howell

Chapter 8. Cross-Border Capital Flows

Abstract
Violent shifts in cross-border flows are associated with international financial crises. Cross-border financial markets operating out of global money centres, such as New York and London, can act as amplification mechanisms through carry trades and currency-swaps. These flows tend to move anti-cyclically and expand alongside a weak US dollar. They are often hard to track because experts traditionally focus on net capital flows rather than gross flows. Emerging Markets tend to be large buyers of ‘safe’ assets in the US and Europe, but they are also large borrowers of dollars from Western banking systems, thereby incurring both currency and maturity mismatches between their assets and liabilities. These mismatches can trigger financial crises.
Michael J. Howell

Chapter 9. China and the Emerging Markets

Abstract
Emerging Markets’ financial markets are often fuelled by cross-border capital inflows. There is a tight linkage between Emerging Markets’ foreign exchange reserves and their domestic credit cycles. Capital inflows are driven both by ‘pull’ as well as by ‘push’ factors. China is a major driver of these capital flows, evidenced by the close correlation between the Chinese liquidity cycle and broader cross-border capital flows into the Emerging Markets. Chinese liquidity is dominated by the State-owned banks (SoBs), although around one-third of liquidity is sourced from highly cyclical shadow banks. China remains financially immature, as shown by the comparative underdevelopment of her gross international balance sheet. China re-exports US dollars when she should export Yuan. The development of a Yuan-based trade credit market and greater international access to Chinese domestic bonds are needed.
Michael J. Howell

Chapter 10. The Liquidity Transmission Mechanism: Understanding Future Macro-valuation Shifts

Abstract
Concept of an active financial cycle introduced. This can amplify macro-economic dislocations. Global Liquidity is shown to determine World financial asset prices, including real estate values. Global Liquidity leads movements in the real economy by up to 20 months. Transmission occurs through portfolio rebalancing using the concept of the price-to-money ratio (P/M), which parallels the traditional price-earnings ratio. Treasury bond term premia are positively determined (Granger caused) by the overall flow of liquidity, in contrast to the conclusions from narrower Central Bank and academic event studies. Exchange rates are determined by the quality mix of liquidity between private and public sources. Equity returns depend on the positioning of liquidity within portfolios. We evidence that large holdings of liquidity are associated with greater future equity returns.
Michael J. Howell

Chapter 11. Financial Crises and Safe Assets

Abstract
‘Safe’ assets are defined. The structural shortage of safe assets is evidenced. This shortage forces down Treasury term premia and so distorts government bond yields. Greater demand for safe assets comes from a combination of the secular growth of CICPs (corporate and institutional cash pools); tighter regulation and the liquidity shortages that result from Central Bank quantitative tightening. The excess demand for safe assets spillsover into higher quality US credit markets, allowing an increase in new issuance. These proceeds find their way back to Wall Street through share buy-backs, highlighting yet another liquidity transmission channel. A solution to the shortage is to issuance more longer duration bonds, even 50-year and 100-year tenors.
Michael J. Howell

Chapter 12. The Financial Silk Road: Globalisation and the Eastwards Shift of Capital

Abstract
The World economy is remorselessly shifting Eastwards. Capital is following, especially foreign direct investment (FDI). This forms part of the Financial Silk Road. The Fall of the Berlin Wall precipitated economic reforms and the privatisation of State assets in other regions, notably Latin America. Actions of German capital also evidences this Eastwards shift. More than half of German FDI holdings were located in the West in the year 2000, but this has since fallen dramatically, with Eastern Europe, Russia, Central Asia and China the beneficiaries. Germany is effectively channelling surplus funds earned from Southern Europe into these Eastern regions, and so starving her poorer EU neighbours of capital. These capital shifts will exacerbate the existing economic and social divisions between Northern and Southern Europe, further raising geopolitical tensions.
Michael J. Howell

Chapter 13. Measuring Liquidity: The Global Liquidity Indexes (GLI)

Abstract
The CrossBorder Capital Global Liquidity Indexes (GLIs) are defined and analysed, as a case study. The GLI are regularly published indexes of liquidity covering around 80 economies Worldwide. These indexes are split into three sources—Central Bank provision; private sector supply from traditional banks and shadow banks and cross-border flows. They are built-up, starting from raw data, using factors, expressed as z-scores, to create diffusion-like indexes. US Federal Reserve Liquidity and Emerging Market Liquidity Indexes are shown as examples.
Michael J. Howell

Chapter 14. Conclusion: A High-Water Mark?

Abstract
The developing rivalry between American and Chinese capital likely compromises the future development of Global Liquidity. This threat could result in a new focus on regionalism that defines exclusive areas of US and Chinese influence. The demise of the Bretton Woods system, paradoxically, has resulted in greater use of the US dollar in the international economy. China’s weakness is that she leans too heavily on the US unit and now badly needs to internationalise the Yuan. China’s financial underdevelopment is a risk for World financial markets, which have become hugely procyclical, partly as a result. The deindustrialisation of the West has emphasised the capital distribution and refinancing dimensions of financial markets, where the capacity of capital outweighs the cost of capital. Consequently, Central Bank liquidity provision and safe asset are critical for further financial stability. Is this Peak Liquidity?
Michael J. Howell

Backmatter

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