FINACIALIZATION AND MACRO-LIQUIDITY RISK

LI BAOWEIZHANG YUN

XIE RUOQING

25/9/2014

1

ABSTRACT

Background: Recent financial crisis and macroeconomic volatility show us excess liquidity and liquidity crunch are alternate in China. This paper considers that it is rooted in three reasons: Firstly, in the main developed countries, financial development has become increasingly

independent from the development of the real economy. Increased finance separate from the real economy investment brings about new financial instruments and transactions which are get rid of the shackles of traditional finance, resulting in a significant change in the macroeconomic structure;

Secondly, high liquidity assets with low risk and other financial assets are complexly alternative in financialization process;

Thirdly, lever mechanism is widely used, leading to increasingly significant financial instability.

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Macro-Liquidity; Financialization; Monetary; credit

CO

NTEN

T1. Introduction 2. Review

2.1 Theoretical Studies of Macro Liquidity2.2 Definitions of Liquidity

3. Money, Credit and the Nature of Liquidity4. Financialization and the Produce of Macro Liquidity Risk

4.1 Definitions of Financialization4.2 The produce of Macro Liquidity Risk

5. Study of Liquidity Measurement5.1 Review of Measurement Methods5.2 An Empirical Analysis of China’s Monetary Market

6. Policy Recommendations of Liquidity6.1 Monetary Policy6.2 Macro Prudential

7. Main Conclusions

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1. INTRODUCTION

• June 2013, a "money shortage" reproduction hit China money market. Under the impact of reserve repayment, expectation of foreign exchange holding decline, greater regulation on bond market, money of payment and other factors, the interbank offered rate was climbing, which means short-term liquidity crunch. June 8, Shanghai interbank offered rates rose 231.2 basis points to 8.294%.

• We study the logic of the monetary and credit capital theory from Marx in the development of the foundation, absorb and learn from Minsky's financial instability theory to analyze the current macroeconomic liquidity risk. In this paper, we consider that the national currency is the credit support of the M1 and M2 with deposit insurance protection and other supported by national credit debt assets, equity and financial derivatives markets, such as credit belongs to the support of financial credit assets.

• This is not just arising from a single financial institution but rather reflects the overall financial markets. This paper is intended to depart from the functional currency, study the nature of the mechanism of liquidity, and why liquidity generated in the process of the financial supplemented by empirical analysis to propose appropriate policy recommendations for macroeconomic liquidity risk.

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2.

REV

IEW

2.1 Theoretical Studies of Macro Liquidity

For monetary liquidity stage research and focused on Keynesian and neo-classical economic theory, research scholars around the world in this regard is quite mature.

•Keynes (1936); Tobin (1958) and Kahn (1972);

Minsky (1963); Stanfield (1986)

•Wray(2012)

•Nobuhiro Kiyotaki and John Moore(2002)

•Friedman (1968) and Bruner (1968); Stanfield (1986)

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2.

REV

IEW

2.2 Definitions of Liquidity.

• The most common is the use of financial deepening McKinnon indicator, M2 / GDP measure of liquidity, the index reflects the interaction between the real economy and the financial market level and did not consider the process of money between financial and non-monetary financial assets alternative relationships.

• Kramp define the “liquidity” from three aspects: First, from the due date of assets to define "liquidity", while money is a kind of maturity zero assets, so the money the most, "liquidity" of nature; Second, convenience, the proportion of the stock of money balances and output flows, "liquidity" of the ratio between the size of output; third is the "financial strength" him from the balance sheet of the economy starting to define the "liquidity", namely financial strength is that people hold on government debt and other private sector entities in the market value of debt measure, that "liquidity" is make a financial product conveniently converted to another financial product tools. Definition Kramp to maturity to define liquidity, liquidity is to explain the concept of repetition, does not have real meaning.

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2.

REV

IEW

2.2 Definitions of Liquidity.

We summarized in the definition of the various liquidity that there are three aspects of liquidity meaning that monetary liquidity, institutional liquidity and market liquidity. We believe that monetary liquidity means investors will credit the lower currency conversion process for a higher credit non-monetary financial assets arising from liquidity, when the economy in which people are expected to rise in interest rates, tend to hold money instead of bonds , the greater the demand for money speculative motive, resulting in excess liquidity. Liquidity refers to the institutional bodies prefer to non-monetary financial assets into monetary assets, resulting in conversion value of assets between agencies or institutions and individuals, resulting in liquidity, when lack of funds between institutions, the formation of the money shortage, liquidity risk is generated. Market liquidity is a measure in markets monetary financial assets and monetary assets transaction activity, if market liquidity is high, then the more active trading between assets.

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2.

REV

IEW

2.2 Definitions of Liquidity.

In this paper, a new perspective of Marxist political economics and Keynesian, Post Keynesian monetary theory is based on three basic propositions, first, the currency can be exchanged commodities, currencies can be exchanged, but not the direct exchange of goods commodities, currencies as medium of exchange, the quest for money because of its ability to meet the payment means the role of the exchange; Second, money is debt, record the borrower's debt and lenders as a form of assets, Minsky argued that anyone can through the issuance of notes in the social accounting system to create money; Third, the existence of debt default risk, due to both lenders and borrowers must be willing to "create money" and "holding money" has generated a lending relationship, which produced a liquidity and default risk. Therefore, this article is essentially Post-Keynesian perspective of research money that liquidity is an alternative non-monetary assets and monetary relationships between assets is determined by the entire financial system has shown.

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3. MONEY, CREDIT AND THE NATURE OF LIQUIDITY

• Money supply based on their safety and liquidity in general is divided into four levels of M0, M1, M2, M3, etc. M0 is cash in circulation, the monetary base; M1 individuals and businesses rely on credit, such as bank acceptances; credit M2-dependent agencies and organizations, such as time deposits and other enterprises; M3 institutions in the country and credit support, such as treasury bills, financial bonds, margin deposits, foreign currency deposits.

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3. MONEY, CREDIT AND THE NATURE OF LIQUIDITY

Monetary Financial Assets Security Liquidity Category

M0 Cash currency Max Max

Security

M1 Bank Savings Higher Higher

M2Deposits expect of

Demand DepositsHigh High

M3

Government Bonds High Low

Corporate Bonds Low Low

AssetStock Lower Lower

Derivative Min Min

Table 1 Monetary and non-monetary financial assets safety and liquidity analysis

Source: This article is based on hierarchical division of monetary and non-monetary financial assets finishing 10

3. MONEY, CREDIT AND THE NATURE OF LIQUIDITY

Monetary Assets

Traditional Financial Assets

Financial

Derivatives

National Credit Market Credit

Alternative relations

Real Economy

Figure 1 Figure currency circulation

Source: This article is based on neo-Marxist political economy and the integration of Keynesian theory carding 11

3. MONEY, CREDIT AND THE NATURE OF LIQUIDITY

Based on Post-Keynesian functions for hoarding knowledge, this paper considers that in the process of development in the current financial and monetary savings had gradually as residents of non-monetary financial assets have higher credit support, people chase money that has more value assets resulting liquidity risk. The period of excess liquidity, which means there are more household savings and cash in circulation, with the same time is the lack of financial assets, thereby forming a financial bubble. We believe that the essence of liquidity is the value of a monetary and non-monetary financial assets between the conversions, credit exchange system.

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4.1 DEFINITIONS OF FINANCIALIZATION 4. Financialization

and the Produce of

Macro- Liquidity

Risk

Epstein (2001) on the financialization make the following definition: financialization refers to the domestic and international levels, financial markets, financial institutions and the financial industry elites importance of economic performance and economic management system for continuous improvement process. Paley pointed out the impact of financialization is mainly reflected in the financial sector relative to the real sector to enhance the importance of the transfer of income from the real sector to the financial sector, resulting in the distribution of income. Georgia · R · Kerry Pune (2008) considered an accumulation mode, Arrighi endorse this model that profit through trade and financial channels rather than the production of goods produced here in order to obtain financial means and future interest, dividends and capital gains liquidity supply (or transfer) related activities (Arrighi, 1994). Goldsmith related to financial ratios (Financial Interrelations Ratios, FIR) to measure the relative size of the extent of the financial superstructure and financial deepening. Goldsmith with the "financial development" to define the changes in the financial structure, with "economic financialization" to describe the current situation of financial development.

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4.1 DEFINITIONS OF FINANCIALIZATION 4. Financialization

and the Produce of

Macro- Liquidity

Risk

From an international perspective, we believe that the process of formation of financial time arises from the financial markets, the banking industry can be traced back to the United States in the 19th century, large-scale mergers and acquisitions, and in the late 1970s to become a global trend of financialization, 80 stock era in the United States as the representative of developed countries, bonds, funds market is gradually improving.

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4.2 THE PRODUCE OF MACRO LIQUIDITY RISK 4. Financialization

and the Produce of

Macro- Liquidity

Risk

Since the 1990s, increasing the degree of financial deepening, lack of supervision

caused serious consequences in the 2008 financial crisis. In response to the financial

crisis, the Fed lender of last resort to save the city's identity, non-performing assets

acquired companies, the introduction of credit facilities, direct way to supplement the

lack of liquidity. Former financial regulatory reform, like CDO (bonds backed

securities) and CDS (credit default swaps) such complex financial derivatives and hedge

funds are not subject to regulation. And later in 2009, the United States launched a

comprehensive reorganization of financial markets, 2012 Financial Supervisory

Authority referred 692 cases involving potential financial fraud to the United States

Securities and Exchange Commission and other law enforcement agencies, including

347 with insider trading related to a strong complement to the Government supervision

of the securities industry.15

4.2 THE PRODUCE OF MACRO LIQUIDITY RISK 4. Financialization

and the Produce of

Macro- Liquidity

Risk

Stage Process Impact Characteristics

1929-1938

1929 -1938 Establish Federal Home Loan Bank Committee (FHLBB)

the Federal Home Loan Bank membership organization established

to strengthen the supervision

system And promote the

development

1933 promulgated the "Glass - Steagall Banking Act"

prohibits the payment of interest to banks, demand deposits, prohibiting commercial banks underwriting securities company

1940-1979

1940 Enacted "Investment Company Act" (ICA) and the "Investment Advisers Act" (IAA)

regulate investment

securities and investment

banking business

regulation

Early 80-90s

982 Securities and Exchange Commission allows companies to provisions in Section 415 "Securities Act" for all securities under a one-time two years after the issuance of the registration program

to improve the efficiency of the stock and bond registration process, the formation of the shelf registration system, to facilitate the issuance and investment bankers tender

deregulation

Since the

1990s

1999, pass "Financial Services Modernization Act,"

allows the bank holding company operating a variety of financial services, including deposits and loans, securities brokerage, underwriting, advisory and other

Financialization and greater

financial regulation

Table 2 U.S. Financial Policy Act process of sorting table

Source: Based on [America] Alan • Stuttgart forward, Chen Yulu, Wang Zhijie, Cai Ling translation: "Control, relax and re-regulation", Economic Science Press, 1999 edition and U.S. recently news 16

4.2 THE PRODUCE OF MACRO LIQUIDITY RISK4. Financialization

and the Produce of

Macro- Liquidity

Risk

Stage

Process of financialization Features

1992-2001

1995 "Banking Law" was promulgated on the People's Bank of duties and obligations of commercial banks, responsibility, business rules, financial regulation

financial accounting system requirements. Financial regulation is becoming systematic, mixed.

1995 pass the "Commercial Bank Law" and other conditions for the establishment of commercial banks and business to regulate.  1995 promulgated the "Insurance Law", 2002 amended 2009 amendments. 1995 promulgated the "law", provides a ticket, bill of rights and obligations of people and transfer.

Since 2001 to now

2001 the "Trust Law" on the subject of rights and obligations, such as the termination of the Trust to change the trust industry norms.

Financial markets while strengthening security in the open financial markets, better adapted to China's national conditions and systematic development.  

2003 "Securities Investment Fund Law" was promulgated on closed-end funds and open-end funds to regulate, fund manager duties, fund raising, supervision and management regulations; small foreign currency deposit interest rate controls to reduce currency, interest rate floor open.

Table 3 China's financial institutions and interest rate liberalization bill

Source: Beijing University Legal Information Network 17

5. STUDY OF LIQUIDITY MEASUREMENT

5.1 Review of Measurement

Methods

a. Balance Sheet Analysis

b. Spread volatility analysis

c. Scenario analysis and stress

testing

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5. STUDY OF LIQUIDITY MEASUREMENT

5.2 An Empirical Analysis of China’s Monetary Market

our empirical analysis of this paper, money market as an object, examine the

performance of the macro liquidity risk result that the volatility of the overnight

interest rate that results from the start, through the analysis and indicators of the

monetary authorities and other depository institutions balance sheets observations,

to explore the reasons behind volatility liquidity risk generated by the current

balance sheet structure within a reasonable forecast range for the foreseeable

future.

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5. STUDY OF LIQUIDITY MEASUREMENT

5.2 An Empirical Analysis of China’s Monetary Market

A. measure of liquidity fluctuations in the currency market

Interbank lending rate refers to the short-term inter-bank lending rate is used, the

reflection of the degree of market shortage and excess liquidity, Shibor by China 16

commercial banks offer, as China's interbank lending market benchmark interest rate

. Paper selected since October 8, 2006, since Shibor started running to date data

March 31, 2014, the establishment of ARCH models to measure fluctuations Shibor,

thus reflecting the tightness of the liquidity situation.

Figure 2 is October 8, 2006 to March 31, 2014 Overnight Shibor fluctuations, we

can see the interest rates have smooth, and therefore do Shibor time sequence

diagram. 20

5. STUDY OF LIQUIDITY MEASUREMENT

0

2

4

6

8

10

12

14

2006 2007 2008 2009 2010 2011 2012 2013 2014

IR

Figure 2 2006.10.8-2014.03.31Shibor overnight call rate fluctuations map Source: People's Bank of China statistics

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5. STUDY OF LIQUIDITY MEASUREMENT

Through the overnight lending rate of the

relevant diagrams and partial correlation

chart analysis, we have established three

AR lag time series models are as follows:

we can get the LM test result is greater than

253.25, P (F (2,2724) ) = 0.0000, so we come

to the square of the residual presence of two

order autocorrelation sequence, that sequence

is present regression model error conditional

heteroskedasticity: 22

5. STUDY OF LIQUIDITY MEASUREMENT

Both test results are considered models exist autoregressive

conditional heteroskedasticity should be established in AR

GARCH basis (3) mean equation on (1,1) model.

Mean equation is:

After ARCH LM Test test results are as follows in table:

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5. STUDY OF LIQUIDITY MEASUREMENT

F-statistic 3.14833

3

Prob. F(1,2726) 0.0761

Obs*R-squared 3.14700

8

Prob. Chi-Square(1) 0.0761

Source: EViews 7.0 software fitting results

Table 3 GARCH (1,1) model ARCH LM test results table

Description Value statistics fall null hypothesis accepted domain, there is no autoregressive conditional heteroskedasticity in the error term, the prediction of IR, get the overnight lending rate March 31, 2014 was (1.29-1.51,1.29 + 1.51 ).

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5. STUDY OF LIQUIDITY MEASUREMENT

-6

-4

-2

0

2

4

6

8

10

2006 2007 2008 2009 2010 2011 2012 2013 2014

RESIDB. Spread volatility analysis

Source: People's Bank of China overnight lending rate data processing

We can observe fluctuations in interest rates four

large range of overnight disassemble: October

2007, February 2011, July 2011 and June 2013.

We can observe Correspondingly, 2008 financial

crisis occurred in 2007 within a certain time

after fluctuations in liquidity indicators, the

paper from October 2006 to February 2014 the

monetary authorities and other depository

institutions' balance sheets analysis were

calculated monthly security assets, or assets and

liabilities of safety, or the ratio between debt. 25

5. STUDY OF LIQUIDITY MEASUREMENT

    Sample Mean

Standa

rd

Deviati

on

Min Max

Monetar

y

authoriti

es

illiquid assets / liabilities

security89 1.27 0.16 1.04 1.52

Security Assets / Total

Liabilities89 0.90 0.06 0.73 0.95

Safety Assets / Assets 89 11.35 4.44 2.76 18.13

Other

deposito

ry

instituti

ons

illiquid assets / liabilities

security89 1.18 0.03 1.12 1.25

Security Assets / Total

Liabilities89 0.25 0.03 0.20 0.29

Safety Assets / Assets 89 0.34 0.05 0.25 0.42

Source: People's Bank of China Monthly Data Report

Table 4 monetary authorities and other depository institutions' balance sheets multivariate analysis

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5. STUDY OF LIQUIDITY MEASUREMENT

  Monetary authorities other depository institutions

 

Illiquid

assets /

liabilities

safe

assets /

total

liabilities

security

assets /

liabilities

illiquid

assets /

liabilities

security safe

assets / total

liabilities

security

assets /

liabilities

 

The

correlatio

n

coefficien

t

-0.68 0.36 0.53 0.09 -0.56 -0.56

Table 5 monetary authorities assets and other depository institutions balance sheet variables of relevance compared

with Shibor

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5. STUDY OF LIQUIDITY MEASUREMENT

Set monetary authorities than illiquid assets and liabilities of safety, other depository institutions than

illiquid assets and liabilities of safety, y = the last day of each month Shibor rates for regression of y

resulting regression equation as follows:

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6. Policy

Recommendatio

ns of Liquidity

Monetary Policy

Macro-prudential Policy

Market Rate

CreditMortgage Rates

Risk of Banks’ Balance Sheets

Price Stability

Financial Stability

Figure 4 monetary policy interaction with macro-prudential policy

Source: Grant Spencer: <Coordination of monetary policy and macro-prudential policy>,

at the Credit Suisse Asian Investment Conference, HongKong, 27 March 2014. 29

7. Main

Conclusions

In this paper, starting from the functional currency, liquidity is to explore the

nature of the monetary deemed credit assets in the financial trend, investors

are more willing to higher levels of credit held by non-monetary financial

assets, resulting liquidity risk. It is liquidity risk and excessive amplification

alternating the role of credit in which reflects financial leverage played, when

credit expansion bubble burst, then there was an economic crisis. Based on

empirical analysis of China's currency market, the use of time-series model

and balance sheet analysis, results in the future China will be in for some

period of illiquidity, which made policy recommendations, by establishing a

broader currency policies to control the flow of the system and the

establishment of macro-prudential regulatory framework to strengthen

liquidity management, and promote economic stability and development.30

THE END

LI BAOWEIZHANG YUN

XIE RUOQING

25/9/2014

31