Liquidity expansion in the period before the crisis

The Federal Reserve’s increases in policy rates in 2004 encouraged speculation as private investors borrowed lower interest rate yen to invest in higher-yielding dollar assets. The build-up in international liquidity continued in 2005 for the fourth consecutive year with an excessive inflow into the US that prompted outflows for investment in higher-yielding emerging market assets. Many emerging economies bought dollar inflows to prevent inflation and falling exchange rates. But by investing these new reserves in dollar assets, they re-exported the problem back to the US and fueled another round of capital outflows that would make the same round-robin trip to emerging markets and back to the US. The search for yield also spurred demand for euro-denominated government debt to back borrowing and for credit derivatives such as credit default obligations to boost returns. In the spring of 2006, the International Monetary Fund and Bank for International Settlements warned that borrowing for speculation had come to dominate cross-border transactions.