The shortage of liquidity in the inter-bank market in China has sparked off a fear of "monetary famine". This seems rather odd when the national savings rate is 50 per cent of GDP and even though growth is slowing, it is still one of the fastest growth rates in the world.
What is happening?
We have to go back to the 1959 Radcliffe Committee on the Working of the Monetary System in the UK for the controversial view at that time that it was the liquidity of the system that determined spending behaviour, rather than the interest rate. The Radcliffe Committee also held the view that the central bank can influence the state of liquidity.
In other words, it is not the quantity of money that determines spending, but the velocity of turnover of money, which the central bank should influence. Since then, the debate has raged between different tools that the central bank can deploy to influence the real economy, through price intervention (interest rate or exchange rate), through quantitative intervention, or intervening in liquidity of the system as a whole.
One lesson of the recent crisis is better understanding that there is a difference between individual institution liquidity and system liquidity. Individual liquidity does not add up to system liquidity.
There was a puzzle in the run up to the current crisis.
In 2007, despite adequate capital levels, many banks experienced difficulties in obtaining liquidity because according to the Basel Committee on Bank Supervision (BCBS) analysis, "they did not manage their liquidity in a prudent manner."
In 2008, the BCBS issued guidelines on "Principles for Sound Liquidity Risk Management and Supervision" and issued two minimum standards for measuring liquidity.
The first Liquidity Coverage Ratio (LCR) seeks to promote short-term ability of a bank to have sufficient liquid assets to survive a period of liquidity stress. The LCR measures the value of unencumbered high quality liquid assets against the expected net cash outflows over the next 30 calendar days. The final definition of LCR was agreed in January 2013 with implementation to begin in 2015.
The second standard tries to promote incentives for banks to fund their activities with more stable sources of long-term funds. The Net Stable Funding Ratio (NSFR) is defined as the amount of available stable funding to the amount of required stable funding, which must be greater than 100 per cent. "Stable funding" is defined as the equity and debt financing available over a one-year time horizon under conditions of extended stress.
The definition is quite controversial because different banks want different types of assets to be included as liquid and stable, because what is liquid may not be stable. To date, there is no final definition, and the minimum standard is expected to be implemented only in 2018.
These liquidity requirements only deal with liquidity of individual institutions, not system liquidity. There are two types of system liquidity, real sector liquidity and financial sector liquidity. The former is measured in terms of the velocity concept of money - how much broad money turns over relative to GDP, the proxy for the real sector.
Today, there may be four to eight times the transactions between different financial institutions before there is one trade with a non-financial customer.