Evans-Pritchard - Fears of global liquidity crunch haunt Davos elites

The Telegraph
by Ambrose Evans-Pritchard
20 January, 2016

The International Monetary Fund is increasingly alarmed by signs that market liquidity is drying up and may trigger an even more violent global sell-off if investors rush for the exits at the same time.

Zhu Min, the IMF's deputy director, said the stock market rout of the last three weeks is just a foretaste of what may happen as the US Federal Reserve continues to raise interest rates this year, pushing up borrowing costs across the planet.

He warned that investors and wealth funds have clustered together in crowded positions. Asset markets have become dangerously correlated, amplifying the effects of any shift in mood.

"The key issue is that liquidity could drop dramatically, and that scares everyone," he told a panel at the World Economic Forum in Davos.

"If everybody is moving together we don't have any liquidity at all. We have to be ready to act very fast," he said.

Zhu Min said the worry is that policy-makers still do not understand the complex interactions in the global financial system, where vast sums of money can move across borders at lightning speed.

What the IMF has observed is that market correlations are near an historic peak, with aligned positions in the US equity markets four times higher than the average since 1932. This is a recipe for trouble when the Fed is tightening.

"When rates go up, market valuations have to adjust," he said.

Harvard professor Kenneth Rogoff said the fear in the markets stems from a dawning realisation that the Chinese authorities are not magicians after all, and that this time the Fed may stand back and let the blood-letting run its course.

"What is driving this is that the central banks are not coming to the rescue," he said, speaking at a Fox Business event hosted by Maria Bartiromo. Rates are already zero or below in Europe and Japan, and quantitative easing is largely exhausted, leaving it unclear what they could do next if the situation deteriorates.

Prof Rogoff said these deep anxieties are causing companies to hold back investment, entrenching a slow-growth malaise. The Fed may be forced to halt its tightening cycle and even cut rates again if the wild sell-off continues for much longer.

Prof Rogoff said the events of the last year had demolished the myth that China is a "perpetual growth machine" and could somehow escape the curse of the business cycle. It is the last domino of the "debt supercycle" to fall and the scale of it is the haunting spectre now hanging over the global economy.

Nariman Behravesh, chief economist for IHS, said capital flight from China has reached $1 trillion since the mid-2015. "It has been massive. They have offset it by running down reserves but doing this is a form of monetary tightening. So what are they going to do now?"

There is a risk that we could see a 20pc devaluation of the Chinese currency, and that really would push the world economy into recession

Mr Behravesh said China is trapped by the "Impossible Trinity", unable to manage the exchange rate without losing control over internal monetary policy within a context of (partially) free capital flows. They are likely to opt for draconian capital controls as the lesser of evils, he said.

But the danger for the world is that capital flight spins out of control and forces Beijing to abandon its defence of the yuan.

"This all reminds me of the ERM crisis in Europe in the early 1990s. There is a risk that we could see a 20pc devaluation of the Chinese currency, and that really would push the world economy into recession," he said.

Paul Singer, head of Elliott Management, said central banks have corrupted global assets markets with $15 trillion of bond and equity purchases over the last seven years, creating a total dependency on monetary largesse that must inevitably be all the more painful when it ends.

The bond markets - supposedly safe - have become the epicentre of risk.

"Things could be very disorderly. There is the potential for a tectonic shift if investors lose confidence in central banks," he said.