The possibility that the sun will shine again in 2012 on the back of artificial liquidity provided by central banks cannot be ruled out.
Borrowing cost for Spain fell sharply on the 20th of December 2011 with yields on six month bonds falling to 2.4% from levels of 5.2% seen a month ago. Spain was able to raise USD 7.3 billion at lower yields as banks invested in Spanish bonds to take advantage of the unlimited funds offered by the ECB (European Central Bank) to banks. ECB has offered unlimited funds for three year at an interest rate of 1% to European banks for them to tide over liquidity crunch and to enable them to buy sovereign bonds.
The ECB move to offer unlimited funds to banks at 1% for a period of three years is giving banks a huge arbitrage opportunity. Banks can subscribe to bonds of countries like Italy, Spain, Ireland and Portugal, where yields range between 3.5% to 8% and earn the carry (difference between borrowing and lending costs). Banks need not worry on default of these countries as the EU (European Union) is committed to protect these indebted nations from default.
The fact is that the ECB instead of directly buying government bonds is making banks buy government bonds in exchange for unlimited liquidity.
The US Federal (Fed) Reserve has committed keep interest rates at 0% to 0.25% for the next two years and has committed liquidity to the system in order to spur a flagging economy that is seeing unemployment rates at 8.6% levels
Bank of Japan has been running an ultra loose monetary policy for a while given the strong Yen, which has rallied by over 7% over the last one year and due to the destruction caused by the Tsunami in early 2011.
China cut reserve ratios for banks by 50bps this month to take the bank reserve requirements to 21% from 21.5%. A 50bps cut will free around USD 61 billion of liquidity for Chinese banks. China cut the reserve requirement in the face of worries over growth on the back of the Eurozone crisis. China is expected to cut reserve requirement further to release more liquidity into the system as growth worries gain hold.
India’s RBI signaled in its policy review in December 2011 that its next policy move will be of rate cuts. The CRR (Cash Reserve Ratio) rate is at 6% and the repo rate is at 8.5% and RBI has room to cut these rates in the face of falling growth expectations. A 1% CRR cut will release around USD 11 billion of liquidity into the system.
Central banks across the world including Brazil, Australia, South Korea, Indonesia and Thailand have all pledged to bring down rates and release more liquidity into the system in the face of falling global growth expectations. All the central banks mentioned above have started the process of easing monetary policy.
In the face of unlimited liquidity committed by the ECB and Fed and in the face of liquidity easing measures by central banks across the globe including China, the year 2012 looks to be a year of cheap liquidity for the system. Cheap liquidity usually means that it flows into risk assets to earn extra carry. Risky assets for cheap liquidity are in the form of high yielding currencies (like the Indian Rupee where interest rates are much higher than US interest rates), equities and high yielding bonds (bonds of Eurozone nations and other countries where yields are attractive).
High global liquidity infused through central banks is not an ideal scenario as the liquidity is artificial and if withdrawn can cause havoc in markets. However till such time as the liquidity is being provided, markets will tend to use it for speculation and that would mean rising asset prices. India will be one of the beneficiaries of this liquidity.