Mideast equity market crash portends global asset price shocks

However, we should not overlook the possibility that excess liquidity can vanish rather rapidly. How so? In the case of the Middle Eastern oil producers liquidity began to shrink for three principal reasons.

When stock markets turned down in late 2005, marginal and highly leveraged investors had to sell equities in order to meet margin calls. This pushed prices lower and triggered further margin calls, which pushed prices even lower.

Then, the stock market boom was also accompanied by a huge real estate boom. Condos and houses were bought off plans and as construction progressed, the buyers had to meet the payments for their properties.

Mideast realty boom

This drained money from the financial market into the real economy and put additional pressure on equities, which were then liquidated to meet the installments for the purchased properties. At the same time, the OPEC countries went on a spending binge and imported an increasing quantity of goods and services.

Because after late 2005 oil prices and oil production no longer increased and OPEC revenues leveled off, a more than doubling of imports to an annual rate of close to $350 billion since 2004 meant that the OPEC governments' surpluses diminished rapidly and led to overall tighter liquidity in the system. I am mentioning the Middle Eastern experience for several reasons.

Rising asset markets always lead to increased liquidity because it allows the speculators to leverage up - that is as asset prices increase the loan value of these assets also increases, and additional loans can be obtained against the rising asset values.

Conversely when asset prices decline (and we had a taste of it in the April/May 2006 sell-off), leveraged positions are reduced, liquidity immediately shrinks, and volatility increases.

Tighter liquidity

Therefore, I believe that the pundits who are looking at signs from the real economy of money becoming tighter, which will in turn bring down asset markets, will be disappointed.

It is the asset markets, which when they begin to decline will provide the first sign of excess liquidity shrinking. In the US, we have the first symptom of liquidity getting tighter in the real estate market. The value of sub-prime loans has recently collapsed. A second symptom of tighter liquidity is evident from a slowdown in debt growth among US households.

By itself a slowdown in household borrowings does not imply a decline in asset markets because a lower rate of debt growth by households can be offset by higher corporate borrowings and higher leverage of the asset shufflers who believe that low volatility is here to stay.

However, it indicates an increasingly fragile financial house of cards, which is vulnerable to a shock from wherever it may come.