Liquidity crisis – central banks, SWFs and global moral hazard
In the last few days every major newspaper had a cover page story on global credit crunch, on funds suspending withdrawals, on funds reporting major losses (20-30 percent or more). There are many stories suggesting that a global crisis may lie ahead and that global economy will experience a recession.
It is important to understand what is going on, and the story seems very simple. Some funds, banks and other institutions suffered heavy losses, so unhappy investors want their remaining back. But we all know that liquidity is a coward it runs away on the first sign of a trouble. Because investors expect prices to decline further they do not want to buy, so those who face redemptions and cannot sell amid no bids have to borrow to remain liquid or have to suspend redemptions. In the absence of new credit more and more institutions will be unable to meet client withdrawal demands, eventually they will be forced to sell at any price and major asset price collapse and recession will follow.
This scenario may lie ahead, but there are two ways to prevent it from happening. Firstly, and this is already happening, major central banks inject liquidity into the world financial system, so funds do not have to continue selling their assets. Secondly, and here we have no knowledge amid lack of transparency, the Sovereign Wealth Funds and the world central banks which are largest reserve holders may start buying now much cheaper assets to stabilize market situation. Under the assumption of markets returning to normal functioning, current spread levels may seem attractive enough for those institutions to step in, buy cheaply, stabilize situation and make large profits at the same time.
This is an unprecedented situation, unseen in the 20th century. The global stability lies in the hands of central banks in the developed world which are supplying liquidity (old story), AND in the hands of central banks and SWFs from the emerging world, which may be providing bids at times when private sector is unwilling to do it.
If both channels are operating now, the markets will calm, sooner or later. But in such case the result could be the biggest ever moral hazard in financial markets, the global one. According to some commentators the Greenspan put (Fed willingness to bail out troubled US financial institutions) is one of the factors behind the current turmoil. It is easy to imagine the future investors behavior if the global bail out takes place. So any action should carefully balance short-term stability goal with a long-term one.