The liquidity tide

The US Federal Reserve last week announced that it would modify its “secondary market corporate credit facility” — its corporate bond-buying programme — to buy up to $250 billion of (BBB or higher) corporate bonds directly as well as bond exchange-traded funds. This suggests that, in the developed world, the liquidity taps are nowhere near being turned off. Global equity markets raced higher in response. Importantly from the point of view of India and other emerging markets, the action of the central banks of the developed world has helped reverse the near-catastrophic outflows of capital, which were visible in the early weeks of the pandemic. According to the Institute of International Finance, emerging economies raised more than $83 billion on the global bond markets since the early weeks of April. Emerging market sovereign yields have come down. Overall, the MSCI emerging markets equity index, up 32 per cent from March, may have its best quarter since 2009 — also a global liquidity-fuelled run.

On the one hand, as signs that there is no immediate risk of a freeze-up in trans-national credit or liquidity, these are hopeful indicators. But emerging market policymakers must be wary of the medium- and long-term effects of the Fed and others keeping the money printers going. While the current liquidity backstop has stabilised not just bond markets but also sovereign yields and even currencies, over the longer term this can lead to instability instead. Such was the experience in the years following the financial crisis of 2008, and the co-ordinated monetary stimulus and quantitative easing that was unleashed. India endured a series of negative effects from that period. Commodity price inflation globally led to domestic inflation expectations becoming unmoored. Asset prices, including of real estate, shot up. Cheap liquidity led to a bad loan bonanza that the regulator and the banks are still trying to unwind.

It is important, therefore, to keep this negative impact in view. This is not a simple debate about the possibility of inflation in a broadly deflationary environment. Of course money printing will lead to inflationary pressure; and of course the pandemic and the lockdown combine with existing overcapacity to create deflationary pressure. The question of which winds up being stronger is not yet settled. But inflation is not a single point, even if the various indices encourage observers to think that it is. In the post-2008 period, asset price inflation hit real estate prices, commodities, and so on. A similar process might well play out in the coming months, though with different assets. The stock market, having come apparently unmoored from earnings expectations, is both an illustration and a consequence of this dynamic. Equities are usually the first pipeline through which global liquidity floods the economy; eventually similar trends may be observed in other asset prices. Thus, the monetary authorities in India and other emerging markets should watch broader indicators of inflation than just their respective consumer price indices. The other danger, of steadily increasing default rates as the liquidity binge wears off, is even more pressing, given that India has still not emerged from its existing non-performing asset problem. While the regulators cannot stop excess liquidity from washing up on India’s shores, they must nevertheless be alive to the warning signs of overindulgence.

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