The proof is in the money market

During the last few weeks I have been advocating the idea that to see the first signs of the next crisis one has to watch the money market rates. I know this is not new especially after 2008. Still, it seems to me that people never learn. While I am confident that at the international level there are many economists drawing attention to this I am not sure that in Romania this issue gets the attention deserved. Moreover, few days ago Fitch suggested as an engine growth for Romania foreign denominated loans. They do say, also, this avenue has to be explored carefully.

At first sight the two issues the money market (i.e. liquidity) story and the foreign denominated loans are not connected. In Romania the money market for RON is managed by the central bank and they can supply as much RON as the market needs (the October 2008 episode will be treated separately). On the other hand the foreign currency loan is a bank decision and as banks are private organizations we assume they are using their resources wisely and with no threat to shareholders.

But history and research shows otherwise. The two markets are highly correlated and directly influenced by the inflow of capital. The research goes deeper and shows the correlation to be very strong for cases when there is a stoppage of capital inflow into a highly dollarized/euroized economy leading to a severe banking sector crisis.

How can such scenario unfold?

As the supply of euro on the Romanian market is ample, the banking sector can go ahead and do what it does best borrow short term to finance illiquid assets in the long term. Enough euro on the market is critical for a euroized economy to function. But the moment something happen to the supply of euro: the government needs euro, external liquidity crisis, or an overvalued exchange rate the banking sector in such an economy is pushed towards collapse. Together with the exchange rate and other asset prices. By now this story should look familiar to Romanian readers as it is the blueprint for October 2008.

But how does the local money market get involved?

There are few channels through which RON is used in such scenario. For example correction of overvalued currency increases demand for RON. Or shortage of euro on the market increases demand for RON as it is used to swap it for euro (in times of crisis it is almost impossible to have direct deposits in euro from foreign counterparties). Or governments needs to borrow more as the financial sector cannot finance short term the real economy. Any one of these increases the demand for RON which can be seen first on the money market rates.

And now I come back to the Fitch comments, First House (Prima Casa) government program and desperate calls from politicians towards banking sector to start lending again irrespective of the currency. The 2008 crisis in Romania has unfolded as predicted by research* but the policies implemented afterwards show that it has been in vain. Today we are about to face the same problem and we are doing the same mistakes. The regulator has still let banks free to lend in any currency (some banks even relaxed measures of market and operational risk or conflict of interests), the government is crowding out private demand in both euro and RON and to my knowledge no tools have been developed to deal with such a particular crisis.

If you are worried about a next crisis in Romania watch the money markets here (Romanian Money Market) and abroad. An increased number of Repos at higher and higher volume are your first clues. This is already happening in the euro area, let’s see if it translates to Romania.

I hope this will help you.  My scope is not to help you scramble for cover once the rain has started. I am here to tell you that there is a storm coming and you better get off the beach.

*Illiquid Banks, Financial Stability, and Interest Rate Policy 

with Douglas Diamond


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