Monitoring the Perception of Future International Liquidity

by Eduardo Petazze Central banks are responsible for providing adequate levels of money supply In fact, since the beginning of the subprime mortgage crisis, and the crisis over sovereign debt levels in some euro area countries, central banks unconventional policy designed as quantitative easing (QE), significantly reducing the impact recessive such events. Although monetary policy objectives of the major central banks (including the U.S. Federal Reserve) has not changed in terms of keeping monetary growth rates above the growth rates of gross domestic product, the ads of possible future reductions rates of monetary expansion (via reduced levels of central banks' investment in secondary markets, or by lower credit support requirements of financial institutions to the central bank) has had and may continue to have a negative impact on perception of economic agents about future levels of international liquidity.

A first effect of this perception on future levels of international liquidity, is the reversal of hot
money flows, as can be seen in the statistics on US-CFTC Commitment of Trades, for positions in International Markets Currency futures contracts for speculative investors . Certainly a deficit in the capital account in a country, caused by an apparent flight to quality, must be offset by a surplus in the current account of the balance of payments, or the sale of its central bank reserves or covered by swap agreements that keep each other major central banks. In the first alternative will increase the volatility of currencies, affecting international trade in goods and services, the second alternative would lead to an unsustainable policy interventions over time or to oppose longer-term trends, the third alternative requires swaps periods significantly exceeding the 1-year-long, in order to build an anti-cyclical mechanism to stabilize international currencies, subject to meet short-term movements.

A second effect of a change in the perception of future levels of liquidity risk is the growth of noncompliance can be monitored through the evolution of the prices of credit default swaps for major credit takers in international markets : countries and international financial institutions. The table on the following page shows a summary of the evolution of the CDS for an average of 60 countries and 18 international financial institutions, during the months of July and August 2013. For the first half of 2013 can be found the following documents: Sovereign Credit Default Swaps (5 Year) - 2Q2013 Pricing Report Global Financial Risk Monitor

Credit default swaps Summary 60 Weekly CDS 5 yr. (bps) sovereigns chg. 1 Jul 13 199.8 -24.8 2 Jul 13 198.1 -17.9 3 Jul 13 205.7 -2.2 4 Jul 13 203.0 -1.0 5 Jul 13 201.4 -1.2 8 Jul 13 202.2 2.4 9 Jul 13 199.6 1.6 10 Jul 13 199.5 -6.3 11 Jul 13 196.4 -6.6 12 Jul 13 193.9 -7.5 15 Jul 13 190.2 -12.0 16 Jul 13 192.2 -7.4 17 Jul 13 191.7 -7.7 18 Jul 13 184.5 -11.9 19 Jul 13 185.9 -7.9 22 Jul 13 181.4 -8.8 23 Jul 13 181.3 -10.9 24 Jul 13 184.5 -7.2 25 Jul 13 187.4 2.9 26 Jul 13 187.0 1.1 29 Jul 13 188.4 7.0 30 Jul 13 189.6 8.3 31 Jul 13 190.9 6.3 1 Aug 13 188.6 1.2 2 Aug 13 187.9 0.9 5 Aug 13 187.1 -1.4 6 Aug 13 188.2 -1.3 7 Aug 13 190.0 -0.9 8 Aug 13 189.5 0.9 9 Aug 13 188.4 0.5 12 Aug 13 187.7 0.6 13 Aug 13 185.3 -3.0 14 Aug 13 187.2 -2.7 15 Aug 13 190.2 0.7 16 Aug 13 192.1 3.6 19 Aug 13 198.4 10.7 20 Aug 13 199.6 14.4 60 Monthly CDS 5 yr. (bps) sovereigns chg. June average 193.2 32.8 July average 192.8 -0.4 August, avg. to date 190.0 -2.8 Provisional estimate data

18 Int. Weekly Banks chg. 161.5 -17.8 159.2 -14.2 166.0 2.6 162.9 3.8 163.2 -0.6 159.9 -1.6 154.2 -5.0 157.5 -8.5 154.1 -8.8 155.6 -7.5 151.3 -8.7 151.8 -2.4 151.1 -6.4 145.0 -9.0 142.1 -13.5 137.5 -13.8 139.7 -12.2 138.4 -12.7 141.5 -3.5 141.7 -0.4 142.5 5.0 140.2 0.5 139.3 0.9 133.9 -7.7 134.0 -7.7 133.8 -8.7 132.7 -7.5 134.1 -5.2 131.1 -2.8 131.3 -2.6 131.4 -2.4 129.2 -3.5 129.5 -4.6 134.7 3.6 136.7 5.4 139.0 7.6 140.3 11.1 18 Int. Monthly Banks chg. 150.5 26.8 150.3 -0.2 133.7 -16.6

Sovereign Weekly Vs. Banks chg. 38.3 -7.1 38.8 -3.7 39.8 -4.9 40.1 -4.8 38.2 -0.6 42.3 4.0 45.4 6.6 42.0 2.2 42.3 2.1 38.2 0.0 39.0 -3.3 40.4 -5.1 40.6 -1.4 39.4 -2.8 43.8 5.6 43.9 4.9 41.6 1.3 46.2 5.5 45.9 6.4 45.4 1.5 45.9 2.0 49.4 7.8 51.5 5.4 54.8 8.9 53.9 8.6 53.3 7.4 55.5 6.1 55.9 4.3 58.4 3.6 57.1 3.2 56.3 3.0 56.1 0.6 57.7 1.9 55.5 -3.0 55.3 -1.8 59.4 3.2 59.3 3.2 Sovereign Monthly Vs. Banks chg. 42.7 6.0 42.5 -0.2 56.3 13.8

The increase in average risk and expanding the spread between countries and between international financial institutions, exacerbating volatility in international capital flows and unnecessarily expensive the cost of servicing the public debt, too difficult for international banks achieve goals capital adequacy established by Basel III. Curiously, financial sector regulators and central banks in the stress tests that monitor for major financial institutions, analyze the additional capital buffer that an entity should be a result of illiquidity risk, a risk that is ultimately decided monetary policy by the central bank itself. (see on this point the recommendations of the Federal Reserve in the paper on capital planning at large bank holding companies Capital Planning at Large Bank Holding Companies (PDF 48 pages) The third effect (not officially recognized) Interest rates have been defined as the price of money, that is affected by supply and demand for money. As in commodities, the spot market prices relate to prices in the futures markets, which in turn are affected by expectations or perceptions of economic agents on the evolution of supply and global demand of that "commodity" If the yield curve represents the expected future supply and demand for money, a change in the expectation (by reduction in the rate of monetary expansion) impact the yield curve increasing the medium and long-term interest rate Eventually such a change could be neutralized by the Fed by an Operation Twist program (sell short-bonds to buy long-bonds), although this has not been too much firepower It has always been a challenge for monetary policy, to establish appropriate mechanisms for transmission of this policy to the market While the inflation rate remains below the inflation targeting central banks, steepening of the yield curve of bonds, further hinder transmission mechanisms of monetary policy. In summary of this point, interest rates of medium and long term could again escape the scope of monetary policy of central banks. Two final comments The encouraging return to a previous situation of normality, when the world has changed, it should not be a dogma. Perceptions do matter and impact (at least in economics). 3