Did RBI tightening contribute to the domestic credit crunch?

The accompanying chart plots the y-o-y growth in money supply (M3) with the growth rate in quarterly GDP at current prices in India. The difference between them can be taken as a measure of “excess liquidity”.

That’s not too different from the way Morgan Stanley measures excess liquidity on a global basis—the difference is that it takes a narrower measure of money supply (M1).

The chart clearly shows that excess liquidity clearly drained away in the Sept 08 quarterleading to a severe credit squeeze. But the impact of the collapse of Lehman Brothers Holdings Inc. was felt only in the Dec 2008 quarter.

That raises the question whether the credit crunch in the fourth quarter of 2008 was due entirely to international factors or whether local factors such as the restrictive monetary policy then being used to fight inflation also played a role. The chart also shows how the extraordinary steps taken by the RBI to infuse liquidity in the fourth quarter of 2008 bore fruit, with “excess liquidity” increasing phenomenally.

Earlier, “excess liquidity” spiked in the Dec 2007 quarter, which was also the quarter that saw the stock market run up sharply higher and also led to a big rise in property prices.Domestic liquidity conditions were very different when the economy was coming out of the last recession in 2003.

In 2003-04, M3 growth at the end of every quarter ranged between 11.4% and 15.8%, while “excess liquidity” was much lower. Simply put, we’re currently going into a recovery with a huge monetary overhang, which means the scope for asset price inflation is much higher. Of course, stock prices in India are primarily dependent on global liquidity.

Morgan Stanley economists Spyros Andreopoulos, Joachim Fels and Manoj Pradhan, in a recent report, say that excess liquidity has risen to a new high both in the G5 (France, Germany, Japan, the UK and the US) and the Bric (Brazil, Russia, India, China) economies. They point out that “with rates in the major economies unchanged for some time to come and QE (quantitative easing) still ongoing, we see no early end in sight for the global liquidity bonanza”.

For RBI, though, this could be a serious headache, as capital inflows lead to a rise in the rupee. Tightening policy too soon could only lead to a further rise in the currency, as seen from what happened to the Aussie dollar after the Reserve Bank of Australia raised its policy rate. On the other hand, intervening in the currency markets to buy dollars, as is being done by several Asian central banks, will only add to the liquidity glut and fuel inflationary pressures.

Source: Mint

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