GLOBAL LIQUIDITY

Quantitatively, private liquidity dominates official liquidity. Most global liquidity today is privately created through cross border operations by both bank and non-bank financial institutions. From a financial stability perspective, understanding the determinants of private liquidity is of particular importance. Private global liquidity displays both an increasing trend and a strong cyclical component. The increasing trend is a result of deeper financial integration between countries and financial innovation. But private global liquidity is also highly cyclical because it is driven by divergences in growth rates, monetary policies and above all risk appetite.

REUTERS/Jo Yong-Hak

Private liquidity can give rise to international spillovers as many financial institutions provide liquidity both domestically and in other countries. The creation and destruction of private liquidity is closely related to leveraging and deleveraging by private institutions. Hence globally, private liquidity is linked to the dynamics of gross international capital flows including cross-border banking or portfolio movements. This international component of liquidity can be a potential source of instability because of its own dynamics or because it amplifies cyclical movements in domestic financial conditions and intensifies domestic imbalances.

There is some interaction between official and private liquidity. In normal times and particularly in boom periods, the supply of global liquidity will be largely determined by international banks (either directly or through financial markets). In times of stress, the supply of global liquidity will depend crucially on the private sector’s access to official liquidity.

Policy responses to global liquidity call for a consistent framework that considers all phases of global liquidity cycles, countering both surges and shortages.  Such a framework should rest on three lines of defense.

The first line of defense is the prevention of excessive liquidity surges through strengthened regulatory frameworks. The current Bank for International Settlement (BIS) reform agenda clearly goes in the right direction. It will limit the probability and frequency of liquidity disruptions by increasing the resilience of global financial intermediation. It will also dampen the amplitude of global liquidity cycles by limiting the intrinsic pro-cyclicality of financial systems.

Domestic policies are a second line of defense. They include macro-prudential measures and central bank liquidity provision. One issue is the extent to which individual countries will want to insure themselves against liquidity shocks by building sufficiently large stocks of foreign reserves. The accumulation of reserves, which has been an increasing trend, entails some negative externalities as well as operational challenges.

There are many factors at play in terms of domestic policy: insuring against a run on domestic financial systems; providing foreign currency liquidity to domestic corporates and financial institutions; and influencing market sentiment and risk premia. These same factors may also explain why there is a reluctance to use reserves in times of stress. This raises the question of whether and to what extent other sources of foreign currency liquidity could substitute for the accumulation of precautionary reserves, thus helping to limit some of the costs and externalities imposed by large foreign exchange reserves holdings.

Cooperative measures for the provision of liquidity in crisis situations provide the third line of defense. There is a well known tradeoff between ex ante clarity and the risk of moral hazard. Existing precautionary facilities have worked well but it is important to preserve the current level of conditionality. Swap arrangements between central banks have played a crucial role in crisis’s, which has shown that truly global liquidity shocks necessitate direct interventions in amounts large enough to break downward liquidity spirals. Central banks’ ability to elastically supply potentially very sizeable amounts of foreign currency liquidity at short notice can thus successfully assure credibility among financial market participants. This advantage has to be balanced, however, by the necessity of avoiding moral hazard, preserving monetary policy autonomy, and controlling financial risks for the liquidity-providing central bank.