Understanding global liquidity

May 2, 2014

A new IMF policy paper defines global liquidity as the ease of funding in global financial markets. The concept is useful for understanding the commonality in global financial conditions, with four large financial centers dominating the world’s institutional funding. In the 2000s banks have been the main conduit of financial shock propagation, but asset managers may play a greater role in the 2010s (see also posts here, here and here).

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An ECB review of forward guidance

April 21, 2014

The ECB has reviewed its own forward guidance in a global context. Forward guidance uses communication [i] to add monetary accommodation at the zero bound for policy rates and [ii] to contain interest rate volatility. The ECB sees its own version as ‘form of qualitative guidance conditional on a narrative’. It is a commitment to keep policy rates very low over a flexible horizon, based on a wide array of indicators supporting a subdued inflation outlook over the medium term. This is different from the Federal Reserve or the Bank of England, which use more quantitative outcome-based forward guidance.

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Global public finances: basic facts and numbers

April 18, 2014

The latest IMF fiscal monitor underscores progress in global fiscal consolidation. The structural government deficit in the developed world has been reduced by 1.2%-points to below 4% of GDP in 2013, while the public debt stock inched lower to 107% of GDP. Fiscal tightening is now becoming less aggressive in most countries, with the notable exception of Japan. Fiscal risks remain globally elevated though, due to low inflation, historically debt levels (view link here), and sizable unfunded pension liabilities.

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The trouble with (sterilized) FX interventions in emerging markets

April 5, 2014

Large foreign exchange interventions are common in emerging markets, typically in response to capital flows. What is less well understood is the expansionary (contractionary) impact of FX purchases (sales) on local credit, even if the transactions are sterilized. Sterilization securities mostly end up on banks’ balance sheets, where they function as substitutes for bank reserves, serve as collateral, and encourage banks to expand their loans-to-securities ratios.

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The structural vulnerability of local EM assets

April 4, 2014

The rapid growth in local-currency bond markets in emerging countries has transferred foreign exchange risk from local borrowers to global institutional investors and mutual funds. Gross capital inflows have soared, magnifying the dependence of flows on mutual fund holdings, particularly on volatile open-ended fixed income funds. In the wake of these changes the “beta” of local emerging market assets has risen and the tendency towards herding has increased.

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An overview of financial crisis theories

March 29, 2014

Daniel Detzer and Hansjoerg Herr deliver a superb summary of timeless economic theories of financial crisis. The main focus is on (i) escalatory inflation and deflation dynamics caused by monetary policy, (ii) boom and bust investment cycles caused by herding and inefficient expectation formation, and (iii) speculative bubbles related to cognitive behaviour that is inconsistent with efficient markets.

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The vulnerability of modern dealer bank financing

March 28, 2014

Modern dealer bank financing relies largely on collateralized transactions. In order to achieve collateral efficiency institutions engage in rehypothecation, for example through matched-book transactions, internalizing trading activities, and re-pledging of margin collateral. A New York Fed article suggests that this funding structure faces risks from rollover, credit rating downgrades, and reputational considerations.

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How banks have adjusted to higher capital requirements

March 23, 2014

Capital regulation reform requires banks to hold a much higher ratio of core capital to risk-weighted assets, taking some toll on lending and economic activity. An empirical analysis by the BIS suggests that the process is well under way. Mathematically, most of the adjustment has been achieved through retained earnings. However, in developed countries also lending spreads have increased, credit growth growth has slowed, trading assets have declined, and the share of higher risk-weighted assets has fallen.

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How real money funds could destabilize bond markets

March 16, 2014

A paper by Feroli, Kashyap, Schoneholtz and Shin illustrates how unlevered funds can become a source of asset price momentum due to peer pressure and redemptions. Regulatory reforms that impair bank intermediation could compound negative escalatory dynamics. This raises the risk of dislocations in fixed income markets if and when extraordinary monetary accommodation is being withdrawn.

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