Global Liquidity and Financial Stability

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

In the wake of the global financial crisis, global liquidity has become a key focus of international policy debates, yet the term continues to be used in a variety of ways. For the purposes of this analysis, the focus is primarily on the financial stability implications of global liquidity conditions; it should be understood as the “ease of financing” in the international financial system.

Experience shows that very low-cost funding in global financial markets can contribute to the build-up of financial system vulnerabilities in the form of leverage, regional imbalances and large mismatches across currencies and maturities.  These are some of the issues that by Jaime Caruana, of the BIS, Assessing global liquidity from a financial stability perspective in a recent speech (Nov. 22^nd) and summarized in this column.

So, what creates global liquidity? Ultimately, it is trust, the root meaning of credit, expressed through private sector activity in which central banks play an important role.

The monetary policy stance, whether implemented by conventional or unconventional means, is best understood as the precursor of private liquidity creation. The central bank influences financing conditions by determining benchmark interest rates and the amount of funds available to settle payments. Ultimately, the generation of private liquidity depends on the capacity and willingness of market participants to supply funding or to trade in securities markets. This activity hinges on their perceptions of risk, risk appetite and broader macroeconomic conditions. Ex post, any build-up of vulnerabilities therefore arises from interactions of market participants within the private sector and with monetary authorities.

The key questions when assessing global liquidity assessments are therefore: how tight are ex-ante financing conditions, do they spur credit creation and how are they transmitted internationally? These considerations suggest that measures of global liquidity should capture actions by central banks and the private sector, particularly by bank and non-bank financial institutions and their cross-border and/or cross-currency operations.

In addition, it is important to distinguish between indicators for the ease of funding conditions per se and for their materialization in bank financing and other forms of credit. Indicators for ease of funding include broad measures of investor risk appetite and the availability of funding for financial institutions. Indicators for results include private sector credit growth, which, when rapid, can signal the emergence of financial vulnerabilities.

This suggests that no single indicator can capture all the various dimensions of global liquidity. Instead, the monitoring of global liquidity requires a mix of measures, such as global credit aggregates and price- and quantity-based indicators that capture the monetary policy stance, financial conditions and risk appetite.

Growth in international credit seems to indicate more benign global liquidity conditions in comparison to past