The world is witnessing an unusual era of Liquidity.The central banks have pumped in over 5 trillion dollars of Liquidity in the market.This is almost double the GDP of India.This overdose of liquidity has led to blitzkrieg in stock market.The assets are inflating as if the world is set to witness high growth rate.The reality , however, is very different. Covid-19 is going to drastically impact certain sectors to such an extent that they can even grapple for their survival.Tourism, mass transportation and aviation will have a tough time till covid clouds keep on looming.Further, the recent data suggests that India’s imports have decreased by whopping 45 percent which shows that India’s demand is plunging.In the midst of such grim reality, Liquidity which was supposed to be pain reliever is now doing the work of intoxication.
Let us be very clear that financial institutions have to confront three major types of financial risk- the credit risk, the default risk and the liquidity risk.The central bank’s liquidity injection can only prevent ‘liquidity risk’ but not the other two.The sectors which are deeply impacted by covid-19 can procrastinate the tough situations by availing low interest loans and loan-moratorium but cannot escape default if the covid 19 doesn’t recede by the end of this year.The only question is who will bear the loss of default- the banks or the corporations.Perhaps both because the capital structure of most of such corporations is having elements of both equity and debt.However, the biggest problem apart from default is of a moral hazard this liquidity is trying to create.
The moral hazard is that it is not differentiating between the impact of covid and non covid factors and thus, resulting in equal treatment of both whereas the requirement is of having a very calibrated approach towards various sectors.The sectors which are impacted more need to get more attention than those which are relatively insulated.For example, US Fed has recently bought 30 year bonds of corporations like Google, Facebook and Apple whereas it is questionable whether these IT giants need relief.Similarly, the availing of loan moratorium by those whose income is relatively steady is again not a very healthy sign.The governments are trying to make people feel happy in painful times by giving a blanket relief but how far they can stretch it remains to be seen
Another major issue related to liquidity is that it is stopping the much required asset re-valuation in the economy.The asset prices in post-covid regime cannot be the same as pre-covid and any attempt to do so will only create a bubble.The government should prod the economy to revisit the cost-structure and do the asset revaluation so that the activity in the economy picks up.In absence of asset revaluation, the economy will slow down as people would not like to take extra-ordinary risk in an uncertain future.The demand growth , thus, needs asset revaluation and not liquidity.Apart from this, there is need to create virtual markets and e-platforms to move sectors to online mode to create a continuity in the markets.
The most important side-effect of liquidity is inflation.The recent data shows that food inflation is over 6 percent much above the level RBI would expect it to be.High inflation can be catastrophic for a country like India where majority of people live in poverty.Many experts are saying that we are heading towards deflation.Yes, we are heading towards deflation but not because of oversupply of goods and services but because we are witnessing plummeting demand for non-food products where as the liquidity is heating up the food prices.This is because, at this time, the liquidity is going to food , stock markets or deposits. As a result, food prices are heating , stock market is on rampage and deposits are on record high.All the three phenomenon can be counterproductive.
Deposits without lending will further bleed the financial institutions who are already witnessing a credit slowdown and run a major risk of defaults.The market rampage is making mad rush of investors who without analyzing fundamentals of the companies are buying shares in order to make short-term profits.On the other hand, big corporations are seeing this an opportunity to sell their equity to muster some cash from market. One must realize that no one sells equity until unless one feels that one will not get a better price in future.Thus, the intelligent corporations are taking exactly the opposite position to that of investors.However,in the world of liquidity and uncertainty, everything seems to be possible.
It is high time that financial regulators along with governments work on nuanced policy of providing relief through liquidity rather than creating a delusion of normalcy.And most importantly, there is no normal until the covid-19 does not get controlled.The rising cases of covid can push the corporations to bankruptcy and no matter who bears the cost of such bankruptcies , the ultimate loser will be the society.The result will be high unemployment and high food inflation contrary to what has been general philosophy in economics.Thus, there is a need to better understand the current situation and give a holistic response rather than working on over-dose of liquidity.
Like most of the articles on economics/ finance, this article also presupposes a direct cause and effect in an economy. I fail to subscribe to this idea of close relationship between monetary/ fiscal action and their immediate effect, may be because I am a grey haired person not belonging to any school.
My view is that since “ceteris paribus” does not exist in complex/ advanced
and educated economies the nexus between cause and effect takes a very long time to play out. This plays havoc with the idea and practitioners of short term prescriptive economics.
The second problem is the understanding that Governments are omniscient, omnipresent and omnipotent. This premise is problematic and still more so in large democracies like US and India.
Economic prescriptions and direction have to be long term with minor adjustments for calamities like Covid or Indo China War.
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Sir,your insights are always a source of valuable learnings.
Your views on excess liquidity are gaining ground in public discourse. As a generalist, I am of the opinion that nuanced policy approach is very much required. Having said that , liquidity push has kept the economy breathing. It was neeeded as first response to the situation to keep financial markets stable and not go into panic mode. Recalibration is an ongoing exercise and must be in minds to decision makers. Fiscal stimulus is required to push demand. Monetary and fiscal policy need to be in tandem.
Regarding food inflation…pre monsoon it’s generally high and behaves subsequently as per vagaries of monsoon. Monsoon they say will be great this time though I never believe in models they use it for saying so 😀
Let’s keep our thinking hats on
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