Exploring the Dynamics of Global Liquidity. By Sally Chen, Philip Liu, Andrea Maechler, Chris Marsh, Sergejs Saksonovs, and Hyun Song Shin
IMF Working Paper WP/12/246
JEL Classification Numbers: G01, G15, G18, G32, C23
Keywords: Liquidity, core and noncore financial liabilities, shadow banking, growth
Recent financial crises in the U.S. and Europe have brought the impact of liquidity on economic and financial stability into sharp relief. Much of this impact has long been documented. Domestically, liquidity has been seen as having important implications for the real economy and the financial system (for example Friedman and Schwarz, 1963). It can drive up asset prices and encourage risk-taking, with negative consequences for financial stability (Borio and Zhu, 2008). Globally, the allocation liquidity affects macroeconomic and financial developments in ways that are not directly under the control of national policymaker (a theme of recent GFSR and spillover reports, see IMF, 2011a; IMF, 2011b; IMF, 2011c; IMF, 2011d; also Matsumoto, 2011; and Darius and Radde, 2010).
At the most basic level, liquidity can be described as the amount of funding readily available to finance domestic and cross-border asset purchases. Liquidity reflects both the ability and willingness of parties to engage in financial transactions, including intermediation, as well as the capacity of financial markets to absorb temporary fluctuations in demand and supply without undue dislocations in prices. In part because of the many purposes liquidity serves, there is no straightforward way to assess developments in global liquidity conditions.
One challenge in measuring liquidity is that it is largely endogenous and highly cyclical, contributing to the build-up of risks to financial stability and be affected by them in return. While central bank injection of base money plays an important role in liquidity creation, flows in global liquidity are also driven by growth differentials, financial innovation, and market participants’ risk appetite (CGFS, 2011). For example, the recent explosion of collateralized market-based borrowing, where funding expands or contracts depending on the market value of the underlying collateral, has introduced a significant source of endogeneity (IMF, 2011e, 2011f, 2011g). Similarly, if for some reason, private agents become unwilling to transact, much of the liquidity can disappear and the same amount of liquidity as measured by quantity aggregates may go from being abundant to scarce, with attendant price increases, while exacerbating the potentially volatile nature of liquidity.
The case for monitoring global liquidity conditions is not straightforward. While there is conflicting evidence whether national monetary aggregates contain useful information about the business cycles, and possible asset price misalignments, the value of aggregating national monetary aggregates is particularly questionable given their differences. Domestic quantity measures of money aggregates have fallen out of fashion in some countries, such as the United States, because of the lack of empirically-stable relations between money aggregates and macroeconomic variables. At the same time, the global financial crisis has made clear that traditional monetary aggregates on a national level may not capture the full range of liquidity-creating instruments nor the full impact of the activities of large cross border financial intermediaries, which play an increasingly important role in globally integrated capital markets. In particular, the source of funding—whether via deposit funding or wholesale funding—matters. The crisis has also highlighted that financial structure does matter—especially in times of stress, in sharp contrast to the frictionless financial market hypothesis underlying modern monetary theory (Tirole, 2011).
Approaches to liquidity measurement generally fall along two lines: the asset side or the liability side. From the asset side, efforts involve measuring the amount of global credit extended to the private sector, providing valuable insights about the liquidity cycle through the private sector balance sheet expansion. The liability side approach, adopted in this paper, focuses on the funding available to expand financial institutions’ balance sheets and the risks associated with sudden funding reversals, as manifested during the global financial crisis. Put differently, “liquidity” as measured here, is the degree to which institutions can borrow—as measured by the liability side of the balance sheets—and to expand and contract balance sheets through increases in leverage or consolidation based on collateral valuations. A key advantage of the current funding-based approach is that it aims at capturing not only bankbased financial intermediation but also the broader range of wholesale intermediation, something which has proven difficult to do on the credit side.
The use of price and quantity measures together can help better understand developments in liquidity conditions. Quantity indicators, which reflect the size of the risk exposure, tend to be slow-moving, making them ill-suited as forward-looking indicators of crises. Similarly, price indicators are coincident indicators, spiking only when the crisis is already underway, making them equally poor early warning indicators. Combining the behavior of prices and quantities provides a richer framework of analysis. It sheds light on the paradox of risk management, where risk (as reflected by the size of exposures) is often at its highest when its perception (as reflected by the price of funding) is at its lowest. Additionally, analyzing price and quantity measures together helps disentangling the pull- and push-factors driving the behavior of liquidity. Persistent increases in liquidity supply—for example, driven by financial innovations—would result in growing liquidity (quantity) and falling interest rates (prices). By contrast, higher demand for liquidity—driven by rising risk appetite and expectations of higher returns—would result in increases in both price and quantity measures.
Important caveats are in order. First and foremost, there is no theoretical framework to determine an optimal level of global liquidity, nor do we know how global liquidity should behave to promote sound, sustainable global growth with financial stability. Second, financial markets are undergoing rapid transformation, the underlying reality that these indicators try to capture is therefore constantly evolving, at a rapid pace. Finally, serious data shortcomings remain—for example, only a few countries compute flow of funds data while cross-country reporting consistency is still lacking. Thus, any policy conclusions from our measurement exercises should depend on a thorough analysis of the underlying developments. More research is needed to improve the measurement of liquidity and develop a theoretical basis for understanding its economic and financial implications.