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Excess global liquidity may be here for some time

Mon, Nov 6 2006, 15:16 GMT
by Trevor Williams

Lloyds TSB Financial Markets  |  View company's profile

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Fast growth in the world economy combined with low inflation is driving global liquidity

Global economic growth is robust and the relationship between the developed economies and the emerging markets is changing rapidly. This is causing a shift in the global growth axis away from the developed economies to places like Asia but also to commodity exporters, like Brazil and Russia. This process is helping to keep down global inflation and is contributing to buoyant global liquidity via low interest rates. In turn, this is also leading to high levels of debt and big imbalances between countries in terms of current account deficits and within countries in terms of high personal debt levels and big government fiscal deficits.

An historical shift in the world economy is currently underway...

The global economy is going through an historical shift – in short, a tremendous structural or paradigm change is taking place, led by the emerging markets. The trend rate of global economic growth is rising, see chart a, due to the very fast growth of the emerging markets being so much higher than that of the developed economies (almost four times faster, see chart b) and by a rise in the share of the emerging economies out of total world gdp. But the effect is more profound than that; the dynamics of global growth is shifting to high population economies that use their labour supply to increase growth. But, as they industrialise, the demand for global commodities is pushing up the growth rate of a host of other smaller economies that are supplying the materials and resources necessary for the industrialisation of the larger emerging market economies.

...and is driving low inflation and low interest rates, so boosting liquidity and asset markets

Moreover, with better governance and a greater spread of best practices around the world, some of the smaller emerging economies are also pursuing policies of diversification and of using receipts from exports and inward investment to develop alternative industries. All of these trends are driving global growth in the developing economies, but are also keeping down global price inflation, see chart c.

The impact of this process is being reflected in a shift in global capital flows and investment trends. Investment isflowing to the faster growing economies; either directly in the form of investment in plant and machinery or indirectly by using financial instruments that allow a position to be taken that benefits investors from growth in these markets. This is via equity or investment instruments structured to raise returns from these markets. Low inflation is helping to keep real interest rates low, see chart d, and so increase the search for returns and push up asset prices, increasingly now seen in commodities as well.

High liquidity due to low interest rates and a search for yield

Moreover, global liquidity is high, as shown in chart e, partly down to low interest rates, which in turn is down to low global inflation. Low global inflation is itself a function of the increasing share of global output accounted for by the lower cost emerging market economies. Of course, there is also an overlay of new technology and productivity gains that also support faster growth and low inflation that have contributed to this process but the increased share of the trade taking place between low cost areas and higher cost areas that is accruing to the former is exerting downward pressure on global prices.

The end result: imbalances persist and eventually lead to crisis

We are currently in this process of rapid change as described and so are seeing bigger current account deficits and surpluses than ever before. This is partly sustainable because in a world of plentiful liquidity and financial instruments seeking higher returns when high prices have driven the latter down, debt is more easily financed. This process has lengthened economic cycles and means that the imbalances that typically lead to boom and bust may carry on for longer before they cause a major problem. Where will this process end and when? The answer is no one really knows, we are in a new environment of historical growth dynamics not seen before with a population of a combined 3 billion people or so now industrialising at the same time, but it may continue for many more years, with an attendant risk of a very messy ending

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Published on  Mon, Nov 6 2006, 15:20 GMT

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