A tsunami of liquidity

Source: Mint

We’ve heard a lot about how the credit crunch in the Western financial markets is affecting liquidity. Huge losses have punched a hole in the balance sheets of US and European banks and till such time they are able to repair their net worth, their ability to lend will remain impaired. That has hurt liquidity. But there’s a flip side to the story.

High oil prices have led to windfall gains by oil exporters. That money has to go somewhere. So far, what seems to be happening is that countries in the Persian Gulf region that have their currencies pegged to the dollar, are seeing a big rise in inflation as their central banks mop up dollars and release the local currency into their money markets. Foreign exchange reserves held by these countries are rising.

Moreover, the magnitude of the rise in dollar gains is truly staggering. According to a research note from Morgan Stanley, A Petrodollar Tsunami Warning by Stephen Jen and Charles St-Arnaud, the market value of annual cross-border oil flows is around $2 trillion (Rs80 trillion), evenly split among Gulf Co-Operation Council (GCC), non-GCC and non-Opec oil ­exporters.

While part of the oil receipts—Morgan Stanley’s estimate is 10%—will be invested by these countries within their borders, in infrastructure and the like, the bulk of the windfall will find its way into global financial markets. The note says that about half of it is likely to be invested by sovereign wealth funds, with the rest being direct investments in financial assets. The note ends with the dramatic flourish: “A tsunami is coming.”

At the moment, much of the money is going either into US bonds or, through sovereign wealth funds, into US financial institutions. But with the slowdown in the US and a falling dollar, it makes sense to diversify holdings. Indian markets should benefit, just as Indian engineering firms are already profiting from the boom in West Asia.

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