Financial globalisation and excess liquidity: monetary policies and new uncertainties
Remarks by Lorenzo Bini Smaghi, Member of the Executive Board of the ECBEuro50-Natixis breakfast seminarWillard Intercontinental Hotel, Washington DC21 October 2007
I would like to start my remarks by distinguishing two different – but related – concepts of liquidity. The first concept of liquidity is related to the easiness with which a certain asset can be converted into cash, which by definition is the most liquid asset. More broadly, it is the easiness with which financial and real assets can be purchased and sold. We can call it “market liquidity”.
In addition to the intrinsic characteristics of the financial instrument, market liquidity is inversely related to the degree of information asymmetry prevailing among economic agents: as shown by Akerlof in his celebrated analysis of the “market for lemons”, a market may altogether disappear (the most extreme form of illiquidity) if information is sufficiently asymmetric. The degree of information asymmetry can vary over time, reflecting both fundamental factors as well as shifts in market sentiment. This is what is happening in the present market turmoil. Liquidity is thus a time-varying variable.
Liquidity has to be distinguished from riskiness. A financial asset can be very risky but at the same time very liquid, if its risk is precisely and broadly understood. Having said this, it is also more likely for a risky asset to be subject to asymmetric information. Therefore, risk appetite and liquidity often go hand in hand. A general re-pricing of risk may be accompanied by shifts in the degree of liquidity of the market.
The second concept of liquidity is the quantity of liquid assets held by households and firms. This reflects, for the most part, portfolio decisions by economic agents in relation to prevailing monetary and financial conditions, the latter linked to, inter alia, the stance of monetary policy. We can call this second concept “macro liquidity”.
Over recent years we have seen a surge in macro liquidity, in tandem with an unusually low level of short and long-term interest rates. In my opinion, and as I have argued elsewhere , financial globalisation has substantially contributed to the creation of global macro liquidity. This has been due to the combination of high savings in developing countries such as China, which have increased the appetite for liquid assets (due to precautionary motives and the willingness to accumulate foreign reserves), and insufficient production of financial liabilities, as a result of the still underdeveloped legal and financial technology. The net result of this process may have been a downward push on real (short-term and long-term) equilibrium interest rates, which explains the apparently paradoxical co-existence of strong global growth and low real interest rates. This has allowed central banks in advanced countries to keep interest rates low without igniting inflationary pressures. However, expansionary monetary policies and carry trades may have contributed to temporarily rising global macro liquidity, and it is not easy to disentangle these temporary phenomena from more long-lasting influences.
The two concepts of global liquidity that I have described are different but related. If financial globalisation has been pushing down expected returns, it might also have affected incentives towards risk-taking in financial markets (not only by households but also by financial intermediaries, especially portfolio managers). This is what is commonly referred to as the “search for yield”. It may also have affected the incentives to collect information in financial markets, which (in the spirit of Grossman and Stiglitz) is a commodity like any other and is influenced by market prices (expected returns in this case). Low interest rates may therefore have directly contributed to creating information asymmetries, sowing the seeds for the liquidity problems that we experience nowadays.
The relationship between market and macro liquidity is not necessarily stable. Indeed, in normal times abundant global macro liquidity tends to be associated with high market liquidity, reflecting low interest rates and spreads. However, at times of financial turmoil, market liquidity may dry out even in the presence of abundant macro liquidity if, as is currently the case, the latter is not exchanged between market participants who want to retain for themselves available financing rather than trading it. Also in this case, in financial markets quantities are not always the mirror image of prices.
What can central banks do?
Central banks can do mainly three things to take into account the impact of changing liquidity conditions on the economy.
First, central banks should monitor both indicators of liquidity. This is important from both a monetary policy and a financial stability perspective. In fact, shocks affecting monetary and credit aggregates and more generally liquidity conditions have the potential, as we are seeing now, to affect asset prices, confidence, credit conditions and ultimately inflationary pressure. This is why it is important to monitor liquidity, in a broad sense, from a monetary policy perspective.
The two-pillar strategy of the ECB is an asset in this respect. Indeed, the monetary analysis pays close attention to trends in monetary and credit aggregates and to the behaviour of the banking sector. In the current market turmoil, it enables the provision of information on several key variables which would not be available under simpler frameworks.
Central banks have to be aware, of course, that financial innovation and globalisation may complicate the monetary analysis and affect the impact of monetary policy on the creation of liquidity by the private sector. In particular, the recent market turmoil may have increased the amount of reserves in central bank money that banks need in order to carry out their intermediation role, leading to a dampening of the money multiplier.
Second, central banks should warn market participants not to take liquidity for granted, especially market liquidity, and to test their portfolio decisions also under stressful conditions. The ECB has repeatedly expressed the concern that buoyant global liquidity and risk appetite could result in an abrupt re-pricing of risk and sudden shifts in liquidity, as we have witnessed in recent months. For example, the June 2007 Financial Stability Review (FSR), prior to the August turmoil, stated: “If history is any guide, liquidity can vanish abruptly from financial markets when investor uncertainty and risk aversion rise… and primary issuers… could struggle to find investors for their securities. Some banks would also face heightened counterparty risks if the institutions they have extended credit to are thrown into financial distress.”
Finally, a central bank should stand ready to ensure the proper functioning of the payment system and the money market, even in case of disruption, so that its monetary policy impulse is adequately transmitted to the economy. The ECB and other central banks have done so since early August, lending funds to market participants with a view to promoting appropriate market liquidity conditions. However, the restoration of normal conditions over the whole maturity spectrum does not hinge only on central bank action but also on the return of confidence and trust by market participants, both in the other participants and in themselves. Financial institutions still fear the risk that some counterparties may face funding problems, as reflected in the high spreads on credit default swaps. They also seem to fear the risk of not being able themselves to access funding in the market, if needed, in particular towards the end of the year when financial accounts will be completed. Financial institutions are thus aggressively bidding for funds and keeping these funds on their balance sheets rather than lending them to other banks, thus taking advantage of the high spreads. Some kind of end-of-the-year fear, similar to the Y2K problem experienced at the start of this century, seems to have developed.
This fear is totally unjustified. Central banks have clearly shown their willingness and availability to intervene in the market to maintain orderly conditions. The ECB, in particular, has recently announced its intention to intensify its actions aimed at reducing the variability of the overnight rate around the MRO rate.  This has partly contributed to reducing the spread on the three-month interbank rate. The ECB will continue this strategy, including around the end of the year, if the need arises. There can be no doubt about this.
There should thus be no Y2K-type fear in the markets. The experience of Y2K itself has shown that central banks are fully equipped to manage this type of situation.
 L. Bini Smaghi (2007): Global imbalances and monetary policy, Journal of Policy Modeling, 29, pp. 711-727.
 MRO stands for main refinancing operation. A press release on 8 October 2007 stated that “The ECB continues to closely monitor liquidity conditions and aims at further reducing the volatility of very short term rates around the MRO minimum bid rate. For this purpose, the ECB will reinforce its policy of allocating more liquidity than the benchmark amount in main refinancing operations to accommodate the demand of counterparties to fulfil reserve requirements early within the maintenance period. The difference between the allotted and the benchmark amount is envisaged to decline gradually in the course of the maintenance period, taking into account the prevailing market conditions. The ECB still aims at balanced liquidity conditions at the end of the maintenance period. The ECB will steer liquidity towards more balanced conditions also during the maintenance period, in a way which is consistent with the objective to keep very short term rates close to the minimum bid rate. The ECB will follow this policy for as long as needed.”