Global liquidity is currently shrinking at an alarming rate, and the cause of this situation is not the collapse of the banking system like the 2007-2008 crisis, but the excessive tightening policies of central banks.

For example, in the United States, although the Federal Reserve has only raised interest rates 9 times during this cycle, including balance sheet reduction and other operations, the effect is actually equivalent to 10 additional interest rate hikes.

If the U.S. Federal Reserve and other major central banks do not change course, a global liquidity crisis will break out with disastrous consequences.

As we entered 2019, global liquidity shrank sharply at a pace not seen since the 2007-2008 financial crisis.

Investors once again began to painfully realize that low nominal interest rates do not necessarily mean that monetary conditions are truly loose.

Against the background of tight liquidity, economic slowdown and even possible recession, risky assets have hit a wall.

The future is particularly bleak for economies, companies and industries that have muddled along over the past decade, dragging their feet on resolving their debt problems or even worsening them.

For these highly indebted entities to refinance, high liquidity is an essential condition.

If these debts cannot be rolled over any longer, systemic risks will erupt.

Chart 1 shows the scale of the recent contraction in global liquidity.

The liquidity here refers to financing liquidity rather than market liquidity, although the two are actually closely related.

Since the end of January 2018, global private sector liquidity has decreased by approximately US$3 trillion, about two-thirds of which occurred in developed countries. At the same time, global central bank liquidity has also decreased by US$1.1 trillion, with two-thirds of it occurring in developed countries.

Emerging markets have experienced massive losses in foreign reserves.

Taken together, global liquidity fell by more than $4 trillion to $124.1 trillion.

Comparing this 3% decrease with the "normal" trend of a 7% increase is even more shocking.

In other words, after a brief recovery, global liquidity has once again fallen to about 25% below the long-term trend.

The chart shows recent weekly actions by key central banks, with only the People's Bank of China still expanding its balance sheet.

In U.S. dollar terms, global central bank funds have decreased at an annual rate of nearly 10% in the past three months.

Objects of Concern When monitoring global liquidity, there are three channels that need to be paid close attention to, namely liquidity injected by the central bank, liquidity provided by the private sector, and cross-border flows of capital.

The first refers to so-called quantitative easing and other central bank currency, repo and bond market operations.

The second is all cash generated by the private sector, including credit.

The third accounts for all net investments.

Central bank liquidity and cross-border capital flows serve as primary liquidity, while banks and shadow banks provide secondary liquidity.

Although liquidity is closely related to interest rates, it is never a simple correspondence. This is especially obvious in the post-2008 era.

A similar story holds true for the relationship between bank reserves, currency and liquidity.

The central bank has super influence in the non-regulated part of the financial system, where deposits are not the only source of financing. The most important thing here is the ability to refinance existing debt, and when the situation is desperate, the central bank is the last liquidity provider.

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In other words, in a crisis, liquidity is the most indispensable, so central bank intervention is also necessary.

Given that liquidity supply is far more important for refinancing existing debt than for financing new projects, the size of central bank balance sheets is often much more important than the impact of interest rates themselves.

Therefore, the relationship between interest rates and liquidity supply is almost never a simple correspondence.

In the modern financial system, the central bank's decisive position in financing liquidity is increasingly consolidated, and it often directly affects market liquidity.

Chart 2 shows the dramatic expansion of the U.S. dollar money market since 1980 and the decisive role played by the Federal Reserve in the process.

These markets have become increasingly important and, after the 2007-2008 crisis, have become almost as valuable as bank deposits.

There are two types of players in the money market: traditional banks and shadow banks. The difference is that the former have deposits to rely on and are more flexible in lending.

Shadow banking is different. Its operation must rely on a more complex chain. For example, A lends money to B, and B lends money to C.

In the process, they will provide other stored value instruments, such as asset-backed bonds.

However, shadow banks are actually engaged in the repackaging and recycling of existing savings to a large extent, which means that they are often mainly related to wholesale financing in the brokerage chain and do not create much new lending.

Shadow banking increases the flexibility of the traditional banking system, thereby pushing up credit multipliers.

There is always a good appetite for speculative loans, seemingly unaffected by interest rates.

But if that were the case, the shadow banking system, which itself relies on bank credit, would not have ballooned in the run-up to the 2007-08 crisis.

The fragility of this wholesale funding model based on short-term repos drives up systemic risk because it is a mortgage-based market that is extremely ahead of the normal cycle, and also has a negative impact on the operations of traditional banks.