The financial crisis of 2008  was a result of the bursting of the housing bubble in the US market when unregulated and reckless subprime mortgage lending led to a crash of mortgage‐backed securities. This sudden shortage of cash to refinance debts sent banks and corporate investors into bankruptcy and ushered in the Great Recession that affected various economies globally.

The market collapse, known as a Minsky Moment, occurs after a period of excess speculative risk-taking during a bull market when the financial market crashes due to the inability of the investors to recover enough capital to refinance their debt. It is a major example of how the aggregate sum of unrestricted cash and marketable securities in the world’s biggest economies is important for the stability of the global financial markets.

Understanding Global Liquidity

Liquidity is the state of easy access to financial capital for investment and market activities in an economy. Liquidity has many facets, from market liquidity (the extent a financial market allows for quick trading of assets) to accounting liquidity (the ability of a company to easily convert its assets to cash).

In the context of the global economy, liquidity is the measure of the credit and financing conditions across major economies that have the potential to impact international capital supply. The concept of global liquidity comes from the understanding that financial conditions have a cross-border effect. Research has shown there is an international spillover of credit cycles, asset price movements, and cash flow. This means that an economic crisis like the shortage of liquidity in the US for example can result in a corresponding effect on foreign markets.

What Drives the State of Liquidity in the Global Economy

While global liquidity conditions are a result of a mix of quantifiable and more nuanced factors, macroeconomic conditions, financial policies, and the risk appetite in global financial centers such as the United States, the United Kingdom, China, and the Euro region play a major role in regulating the abundance of international financing in the global economy. The financial markets in the listed countries currently have significant control over global cash supply to open markets across other advanced economies and emerging markets.

Monetary Policies

Domestic monetary policies in individual countries such as central bank interest rates, reserve requirements, and interbank rates determine the credit growth and overall funding availability in an economy and so the extent of international capital flow.

International Financing Policies

Cross-border cash flow is dependent on the presence of policies that ease foreign lending in global economies, as well as the existence of infrastructure for financial integration like cross-border payment settlement. Foreign exchange policies can also impact international cash flow. For example, a stable currency exchange rate can encourage cross-currency lending as it minimizes risk to investors.

Risk Appetite

The private sector acts alongside public monetary policies to provide liquidity to the economy. As a result, domestic and international risk considerations can influence investors’ liquidity preference and their level of willingness to provide funding.

Global Liquidity Implications on Financial Markets

When global liquidity conditions are in excess or at a shortage, they can give rise to adverse market conditions affecting asset valuation, credit growth, and investor risk appetite.

Credit Market Disruption

The primary impact of a liquidity crisis is a shortage of available credit for business financing. As cash flow becomes tighter, financial institutions and lenders are aware of the increased credit risk in the market causing short-term interest rates to rise. These institutions might also decide to hoard their liquid assets to finance their debt repayments, making credit not only expensive but scarce. Excess liquidity, on the other hand, leads to reckless borrowing and predatory lending in the credit market.

Asset Price Valuation

When liquidity is loose, it can lead to a surge in asset prices above what is reasonable for their fundamentals. This happens because, during abundant liquidity, investors can become over-optimistic about the financial market conditions, leading to miscalculations of the risks associated with an asset. On the other hand, a global liquidity shortage can lead to diminished investor confidence and a decline in stock prices.

Investor Risk Appetite

Excessive capital flow can result in investment misallocation, and excessive risk-taking as abnormally low market volatility causes investors to make poor and speculative portfolio decisions. Tight liquidity also creates big problems for investors, diminishing risk appetite due to the lack of capital flow.

Managing Global Liquidity Risk For Your Portfolio

Understanding how global liquidity affects international markets can help you hedge your portfolio from possible risks. Three important indicators to watch as a standard for measuring the level of liquidity in the global economy include:

1. Central bank liquidity across advanced economies

2. Private cash supply in form of monetised household and corporate savings and deposits

3. Cross-border cash flow through foreign exchange, cross-border lending, payments, and settlement.

As liquidity levels in the international financial market vary throughout the economic cycle, it is important to know when to restructure your global asset allocation. In times of critical liquidity conditions, it can be beneficial to identify individual country markets with the most stable macroeconomics, as well as sectors that tend to outperform following easing liquidity policies.

Reinforce your liquidity risk analysis for your global asset allocation by leveraging the Anahit platform. Our expert investment research tools utilise artificial intelligence to assess real-time market conditions to help you make smarter decisions.

Learn more today at anahit.ai/about_us.