Hard to Define and Measure

Two timely articles appear in the current issue of The Economist. Both take on the subject of "liquidity" - a word that is increasingly used today to describe all sorts of odd goings on with hedge funds, mortgage lending, private-equity, fine art markets, not to mention Wall Street bonuses.

To be sure, the subject of liquidity is both timely and fascinating. The word, however, presents great difficulty in definition and measurement. It will surely compete with "subprime" and perhaps "systemic" when all is said and done in 2007, regardless of whether any progress is made in understanding what it means and how big it is.

The first story($) looks at the nearly unanimous bullishness that augers in the New Year and how liquidity has played a part.

INVESTORS have entered this year in a buoyant mood. After global equities returned 18% in 2006, many stockmarkets have started 2007 either at record highs or close to them.

Two factors have fuelled investors' optimism. The first is the slightly vague notion of liquidity (see next article). There is no universally agreed definition of this concept; best to say you know it when you see it. What is clear is that there is a lot of it about. Investors have felt sufficiently flush with cash to buy high-risk assets, such as junk bonds or commodity futures. Credit has been plentiful for those who need to borrow.
The second factor is corporate profits, which have risen faster and for longer than anyone expected a few years ago. Companies have used their cash to buy back shares, supporting the stockmarket, and the high level of profitability has reduced defaults, helping bonds.

The bullish trends are clearest in the private-equity industry, which has some $300 billion of cash ready to spend, according to Morgan Stanley. Liquidity explains why this business has so much cash; and companies' fat profits (along with low interest rates) explain why private-equity houses are so keen to buy them.

Should anyone be worried that there is too much liquidity? With volatility near all-time lows and investor confidence so high, is there too much complacency?

The creation of new instruments, such as complicated derivatives, probably makes the financial system stronger in the long run, by ensuring risk is better priced and more widely distributed. But some of these instruments have yet to be tested by a severe recession or a big corporate default. If most people have made the same bet (that risky assets will outperform and that volatility will stay low), there could be an almighty scramble for the exits when the trend changes.

Bull markets are remarkably resilient. But it would be surprising if one of those threats did not cause confidence to wobble at some stage in 2007.

The same worries have been expressed over derivatives and various other forms of financial engineering for a half-decade now - the longer things continues with no major melt-downs, the more likely confidence will build, though wobbles persist.

Confidence surely wobbled in May of last year and there is likely to be more wobbling again in the New Year - it's the falling down part that really hurts. With the exception of a few hedge funds and subprime lenders, remarkably, there hasn't been much of that yet - some say this makes any eventual falling down that much more dangerous.

The second story looks at the exchange rate policies that have led to the world as we currently know it - where inflation is low, yet there seems to be a nearly infinite amount of money sloshing around the world.

WHEN Thailand's introduction of capital controls sent its stockmarket plunging a few days before Christmas, you could have been forgiven for thinking, “Here we go again”. It is almost ten years since the start of the Asian financial crisis, when capital flight on a huge scale caused financial markets and economies in the region to collapse. The problem that Thailand and other Asian countries face today, however, is the exact opposite: how to stop capital flowing in.

Worldwide, an abundance of liquidity has lured investors into riskier assets in search of higher returns. Though there is no agreement on how to measure liquidity, using the global supply of dollars as a proxy, The Economist estimates that in the past four years it has risen by an annual average of 18%, probably the fastest pace ever (see chart).

Wow! Eighteen percent a year is pretty good. Some Wall Street fund company ought to start an exchange traded fund that tracks the change in liquidity - the demand would probably be quite strong.

It's natural to wonder what that chart would have looked like earlier in the last century - aside from the two big wars and a number of smaller ones, it was probably pretty tame. Of course the tameness may have helped get those two big wars started - when so many people are getting rich, trying to get rich, or marveling at all the rich people, fewer people are inclined to start wars.

Of course, the case of Weimar Germany makes the opposite argument that too much liquidity has a downside as well.

But today things are different. Computers, research, and learning well the lessons of history have reduced the downside risk to such heady liquidity growth (cross your fingers). The real problem today is what to do with all the U.S. dollars that are piling up in Asian central banks.

The Thai government found out what happens when they try to slow things down - the whole financial system quickly goes kerflooey.

Where's all the stuff coming from anyway?

The deluge of spare cash has two main sources. First, average real interest rates in the developed world are still below their long-term average. Second, America's huge current-account deficit and the consequent build-up of foreign-exchange reserves by countries with external surpluses has also pumped vast quantities of dollars into the financial system. A large chunk of Asia's reserves and oil exporters' petrodollars have been used to buy American Treasury securities, thereby reducing bond yields. In turn, low bond-market returns have encouraged bigger inflows into higher yielding emerging-market bonds, equities and property, especially in Asia. Liquidity has been further boosted by the use of derivatives, and by carry trades (borrowing in currencies with low interest rates, such as yen, to buy higher-yielding currencies).

The spread on emerging-market bond yields over American Treasury bonds fell to another record low last week. Share prices in emerging economies have risen by 243% on average from their trough in 2003. That still leaves the average price/earnings ratio below its historical average and less than that in developed countries, so for most markets it is premature to talk about bubbles. But if asset prices continue to climb at their recent pace, central bankers will become increasingly nervous.

Well, the money's got to go somewhere - as long as it doesn't go into consumer prices, things will probably turn out OK (cross your fingers).