THE LIQUIDITY PIPES REMAIN CLOGGED / THE FINANCIAL TIMES COMMENTARY & ANALYSIS

The liquidity pipes remain clogged



By Gillian Tett

Published: August 6 2009 17:10

A decade ago, I was working as a reporter in Tokyo when I was asked to investigate the impact of Japanese-style quantitative easing. Back then, the Bank of Japan was pouring gazillions of yen into the money markets and politicians were angrily exhorting the Japanese banks to lend.

Indeed, at one point, the Tokyo government even created quotas, which stipulated that banks should make a certain level of loans to worthy small enterprises to combat a pernicious credit crunch.

But, when I examined what the Japanese banks were actually doing, the results were almost comical. In public the banks claimed they were lending to small enterprises; in reality some were only meeting the targets by lending to subsidiaries of Toyota.

Faced with a political order to lend, in other words, Japanese banks were ducking round the rules – and the liquidity was notably not ending up where politicians (or central bankers) had hoped.

Sound familiar? I am increasingly tempted to think so. In the last six months, European and US central banks have poured dizzying sums into the money markets and politicians have put pressure on the banks to lend. Last week, for example, Alistair Darling, UK chancellor declared his readiness to “get tough” with banks that were failing to lend. On Thursday, the Bank of England triggered surprise by announcing an expansion of its quantitative easing scheme.

But as I look at these endeavours, what springs to my mind is a vision of a plumber trying to force water into a domestic waterflow system whose pipes are badly clogged, if not broken. To be sure, liquidity is entering the banking pipes. Some is also trickling out at the end: banks still seem willing to lend to big, reputable companies (the Western equivalent of Toyota, as it were.)

However, numerous small or risky corporate ventures in the west currently complain that they cannot get loans. Consumers are facing rising borrowing charges too. Thus, in the West, as in Japan a decade ago, the liquidity is still not necessarily flowing to those who need it most. Those pipes remain clogged, even as water is forced in.

That, in turn, raises a fascinating question for investors and policy makers: where will all that “backflow” of unusued liquidity, as it were, go? Right now, some seems to be sitting in a quasi stagnant pool, deposited into reserve acounts with central banks.

Much also seems to be leaking into the government bond markets, or moving directly there (as in the case of the British central bank’s direct purchase of gilts). That is helping to keep long-term yields low, echoing the pattern seen previously in Japan.

However, the backflow may now be creating other side effects. Right now, most banks seem unwilling to use spare liquidity to engage in activity that regulators or shareholders might deem risky, in the lending or capital markets arena. At a meeting of securities analysts in New York this week, for example, there was discussion about the fact that Wall Street banks will not even use their spare funds to take short trading positions in the US treasury market anymore, for fear that this looks too “risky.”

But, while banks sit on their hands in some arenas, in other corners of the markets, a feeding frenzy is breaking out. Last month, for example, there was an extraordinary scramble to buy €1bn bonds issued by Deutsche Postbank, with some $9.2bn of its offers received in just 10 minutes. (Ironically, it seems that many investors now consider bank debt to be one of the safest instruments on the planet, since the governments can ill afford to let large banks collapse.)

This week an equally crazed scramble erupted when EADS, the giant aerospace group, sold bonds. That was doubly remarkable since normally August is an utterly dead market; indeed, so extraordinary that some bankers are already using the “b” word – bubble – in relation to these seemingly safe, vanilla assets.

Perhaps that is no bad thing. If government bond yields remain low, and companies such as EADS find it easy to raise cash, that should support recovery. At any rate, it may do no harm. That, at least, appears to be one finding of a fascinating paper from the International Monetary Fund this month. This suggests that while there is little evidence that quantitative easing has eased UK credit conditions yet, there is also little sign of harm.

But the longer that the banking pipes remain partly or fully clogged and the governments keep pouring water into the system, the more that investors and policy makers need to watch what this liquidity “backflow” might do; and not just in the gilts market, but other, less obvious corners of the global asset markets too.

Copyright The Financial Times Limited 2009