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Storm Cloud at the Global Bazaar?

By Robert Samuelson

WASHINGTON -- Global finance is mysterious, exciting and sometimes reckless. A specter now haunts it -- the specter of excess "liquidity.'' Will this prove a passing anxiety or, as in 1997 and 1998 with the Asian financial crisis, will it threaten the stability of the entire global economy? Good question.

First, a vocabulary lesson.

"Liquidity'' is a common, but confusing, economic metaphor. Financial markets (say, stock and bond markets) are said to be "liquid'' when it's easy to buy and sell. Transactions flow smoothly. By contrast, either buyers or sellers are scarce in an "illiquid'' market. Prices move sharply, up or down. Markets can also have too much liquidity: investors may take increasingly large risks to put their abundant funds to use. "Bubbles'' can form. Losses may follow.

We now have evidence of that.

Just recently, HSBC -- a major bank holding company -- announced more than $10 billion in losses on so-called "subprime'' home mortgages. Representing about 20 percent of new mortgages in 2006, subprime loans go to weaker borrowers with shakier credit histories. Because borrowers are less credit-worthy, their loans carry higher interest rates. Hence, the appeal to lenders. Now, losses are emerging.

What's unclear is whether the subprime losses are an isolated event or a harbinger of wider investment blunders.

In the past quarter-century, points out economist Richard Berner of Morgan Stanley, the financial system -- the way that savings are channeled into investments -- has changed in three fundamental ways.

First is "securitization.'' Banks, savings and loan associations (S&Ls) and insurance companies have retreated as direct lenders. In 1980, for example, S&Ls and banks made and held most home mortgages. Now, most mortgages are bundled into bond-like securities and sold to institutional investors -- pension funds, endowment funds, insurance companies as well as banks. The same thing has happened to credit card debt, auto loans and business loans. About 53 percent of U.S. nonfinancial debt is now "securitized''; in 1980, that was 28 percent.

Second is the explosion of financial institutions -- hedge funds, mutual funds, private equity funds. The channels for savings have multiplied. Hedge funds, for instance, are large pools of loosely regulated money from wealthy individuals and institutional investors. These funds control more than $1 trillion.

Finally, finance has gone global. In 1980, most countries (one exception: the United States) restricted or prohibited their citizens from investing abroad -- and foreigners from investing in their countries. Since then, governments have relaxed or removed most of these "capital controls.'' Cross-border investments now exceed $6 trillion annually, reports the McKinsey Global Institute.

It's a global money bazaar. An American hedge fund with European investors can put their money into U.S. subprime mortgages -- or into Brazilian stocks. This can be a good thing. Theoretically, savings go to the most productive investments. In some ways, investing has become safer. Since the 1980s, business cycles have become less turbulent. Many "emerging market'' countries (Brazil, China, India) are doing better than a decade ago. Still, all the changes are unsettling.

The concerns over "excess liquidity'' stem mainly from the low interest rate policies adopted by the United States, Europe and Japan after 2000. The aim was to avert a deep recession. The Federal Reserve cut its overnight rate to 1 percent; the European Central Bank got down to 2 percent, and the Bank of Japan actually went to zero. With low short-term rates, investors have poured money into longer-term securities with higher interest rates -- government bonds, mortgages, "junk'' corporate debt, bonds from emerging market countries -- and into stocks. Often, these investments are financed by short-term loans at low interest rates.

One big worry now is the "yen carry trade.'' Investors (speculators?) borrow at 1 percent or 2 percent in yen, convert the yen into other currencies (say, Brazilian reals or Turkish lira) and reinvest the funds in those countries at much higher interest rates. For Brazil and Turkey, three-month rates are roughly 13 percent and 19 percent. Low interest rates on Swiss franc loans have also inspired a sizable "carry trade,'' says Grant's Interest Rate Observer. The danger is that a sharp shift in exchange rates (either the borrowing or lending currency), or higher interest rates in the lending country, could make these appealing trades unprofitable. A panic might ensue as investors sought to escape. Historically, "excess liquidity'' often evaporates through losses.

Global finance is a dark hole. There are more investors in more countries moving more money into more securities in more other countries than ever before. Herd behavior sometimes overwhelms the natural tendency of markets to self-correct, often harmlessly to everyone but overeager investors. Large losses in one market could trigger selling in others. Confidence and spending could weaken. What's unnerving about the global money bazaar is not what we know; it's what we don't know.

(c) 2007, The Washington Post Writers Group

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