‘Silent killer’ liquidity crisis will stalk global financial system in 2023

Few people seem aware as a liquidity crisis offers few clearly visible symptoms until it begins to affect the internal organs of the financial system
It could be that the potential risks involved will not crystallise on a scale that threatens the financial system, but past crises offer little reassurance

Anthony Rowley

Published: 11:00pm, 31 Dec 2022

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As we enter the new year, it might seem that fate can have nothing worse in store than what it inflicted upon the world in 2022: Russia’s invasion of Ukraine and its economic fallout, surging prices and interest rates, climate crises and the Covid-19 emergency in China. That is not the case, however.

There is another potential threat waiting in the wings to seize centre stage, and that is the risk of a liquidity crisis in the global financial system. As with high blood pressure, such a threat is hard to detect until it is too late and can likewise be seen as a “silent killer”.

One hidden threat is the vast amount of off-balance-sheet foreign exchange swap positions held by banks, which the Bank for International Settlements (BIS) said in December had reached more than US$80 trillion. This is a scary liability for 2023 as foreign exchange rates swing ominously.

A potential stock market crisis is evident from plunging share prices, a bond market crisis from yield volatility or a currency crisis from sharp swings in exchange rates. A liquidity crisis offers few such symptoms until it begins to affect the internal organs of the financial system.

What does such a crisis look like? The CFA Institute describes a “breakdown of an entire system rather than of individual parts. In a financial context, it denotes the risk of a cascading failure in the financial sector, caused by linkages within the system, resulting in a severe economic downturn”.

Financial history is littered with such crises, such as the great stock market crash and economic depression after 1929, the Asian financial crisis in 1997 and the global financial crisis in 2008, to name but a few. Relatively soon after the last of those, we now face the threat of another crisis.

Yet, it is remarkable how few people seem to be aware of this danger. As my former colleague John Plender noted recently in the Financial Times, “Recent monetary policy mistakes may in part reflect a collective generational memory loss.”

Pastries are on display at a bakery in Berlin on December 28. Energy-intensive businesses such as bakeries have suffered most due to the increase in the prices of gas and wheat. Photo: AFP

For example, witness the relatively sudden change in monetary policy. It has gone from a decade and a half of historically low interest rates and low inflation, which encouraged high borrowing and risk-taking, to rapid monetary tightening, surging interest rates and an economic slowdown.

Such swings take a visible toll in the form of rising prices and wage demands plus declining demand and investment, but their initially invisible toll is more insidious. This is the damage done to myriad financial institutions that are vital to the functioning of the system.

Banks are at risk, especially those in emerging markets, while the lightly regulated nonbank financial sector – insurance firms, venture capitalists, currency exchanges and so on – represents a possibly greater risk. Despite being little-known, nonbank institutions are vital to the safety of the financial system.

Other institutions ranging from building societies to business corporations are also vulnerable at a time of rapidly rising interest rates and potential loan defaults. Yet, such problems are overlooked by many who choose to ignore the lasting legacy of monetary policy laxity.

To quote a recent International Monetary Fund (IMF) blog, “Measures of market liquidity have worsened across asset classes, especially in recent weeks, as heightened uncertainty about the economic outlook and monetary policy left investors with much less risk appetite.” This, it said, “may pose risks to financial stability”.

The IMF has also said “key gauges of systemic risk, such as dollar funding costs and counterparty credit spreads, have risen. There is a risk of a disorderly tightening in financial conditions that may interact with pre-existing vulnerabilities.” This is about the closest institutional economists come to warning people to watch out.

07:32

BIS chief Carstens: High interest rates to stay even if a US recession might be 'avoided' in 2023

The problem is that for savers, investors and other users of the financial system in one form or another, vigilance is in vain if you do not know what you’re looking for or are supposed to be on guard against. It’s a case of “let the buyer beware”, and in finance that can be lethal.

For example, the most recent BIS Triennial Central Bank Survey showed shifts in trading patterns and market structure in foreign exchange and over-the-counter interest rate derivatives markets. It warned of “risks deserving attention”. Foreign exchange swap positions “point to over US$80 trillion of hidden US dollar debt, reported off-balance sheet” while the “volume of daily foreign exchange turnover subject to settlement risk remains stubbornly high despite mechanisms to mitigate such risks”.

As Plender observed, the US$80 trillion of “hidden” US dollar debt – related to foreign exchange swaps, forward transactions and currency swaps – by banks exceeds the stock of dollar US Treasury bills, repurchase agreements and commercial paper available to meet such liabilities.

It could be that potential risks involved in these short-term and maturity-mismatched transactions will not crystallise, at least on a scale that poses a threat to the financial system. But past crises such as the subprime mortgage crisis in 2008 offer little reassurance on this point.

Perhaps it is best to accept what is sometimes referred to as “Murphy’s law”, which states that “anything that can go wrong will go wrong.” Watch out for trouble in the global financial system in the new year.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs