Comment

The sun might just shine again in 2012, on the back of artificial liquidity provided by central banks.

Borrowing costs for Spain fell sharply on December 20, with yields on six-month bonds falling to 2.4% from around 5.2% seen a month ago. Spain was able to raise $7.3 billion at lower yields as banks invested in Spanish bonds to take advantage of the unlimited funds offered by the European Central Bank (ECB) to banks.

ECB has offered unlimited funds for three years at an interest rate of 1% to European banks for them to tide over the liquidity crunch and enable them to buy sovereign bonds.

The ECB move gives banks a huge arbitrage opportunity. They can subscribe to bonds of countries like Italy, Spain, Ireland and Portugal, where yields range between 3.5% and 8%, and earn the carry (difference between borrowing and lending costs). What’s more, banks need not worry on default of these countries as the European Union (EU) is committed to protect these indebted nations from default.

The fact is, instead of directly buying government bonds, the ECB is making banks buy government bonds in exchange for unlimited liquidity.

On its part, the US Federal Reserve (Fed) has committed to keep interest rates at under 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 of 8.6%.

Bank of Japan has been running an ultra loose monetary policy for a while, given the strong yen — which has rallied more than 7% over the last one year — and due to the destruction caused by the tsunami in early 2011.

China, too, cut reserve ratios for banks by 50 basis points (bps) this month to 21%. A 50 bps cut will free around $61 billion of liquidity for Chinese banks. China cut the reserve requirement in the face of worries over growth on the back of the euro zone crisis.

China is expected to cut the reserve requirement further to release more liquidity into the system as growth worries take hold.

Nearer home, the Reserve Bank of India (RBI) signalled in its policy review this month that its next policy move will be of rate cuts.

The cash reserve ratio (CRR) is at 6% and the repo rate at 8.5%, and the RBI has room to cut these rates in the face of falling growth expectations. A 1% CRR cut will release around $11 billion (around 58,300 crore) 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 the Fed, and in the face of liquidity easing measures by central banks across the globe, including China, 2012 looks to be a year of cheap liquidity for the system.

Cheap liquidity usually flows into risky assets to earn extra carry. Such assets 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 euro zone 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 can cause havoc in the markets if withdrawn. However, till such time 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.

The writer is editor, www.investorsareidiots.com, a website for investors