Central banks have been pumping liquidity into markets worldwide and the Reserve Bank of India (RBI) is no exception. The accompanying chart compares the year-on-year growth in money supply with the y-o-y growth in quarterly GDP. Notice how, for the quarter ended March 2009, the growth in money supply was around 10 percentage points higher than that in nominal GDP (or GDP numbers not adjusted for inflation). The excess liquidity, or the liquidity that isn’t being used to turn out goods and services, goes into supporting asset prices.
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But first, a bit of history. The chart shows how liquidity was relatively abundant during the March 2008 quarter, when nominal GDP grew at 14.8% y-o-y while M3 (the total amount of money available in the system) growth was 20.7%—that’s a difference of almost 6 percentage points. In the quarter ended June 2008, that
cushion had been squeezed to 4 percentage points. But notice how liquidity evaporated in the September 2008 quarter—while GDP grew by 19.3% y-o-y during the period, money supply growth was 19% y-o-y at end-September. The cushion between the GDP growth rate and the money supply growth rate was wiped out. That’s when RBI started to loosen its purse strings, with the result that the difference between the M3 and nominal GDP growth rates widened to over 5 percentage points by the end of December 2008. And by the end of March 2009, that difference was at least 10 percentage points. Given the increase in money supply and the lack of avenues in the real economy for using the money, it’s no surprise that banks are awash with liquidity. What is happening in India is being seen worldwide. While central banks are increasing money supply and printing money, the growth in output of goods and services has remained very low and in many countries has contracted. Naturally, there’s “excess liquidity” available, which is being channelled into the asset markets. This is the source of the funds now flooding the stock markets.
Morgan Stanley economists Manoj Pradhan and Joachim Fels have drawn attention to this sudden increase in global liquidity. In their note, The Global Liquidity Cycle revisited, they say, “Back in January, the available data indicated that the new liquidity cycle was only in its infancy. Our favourite metric for excess liquidity—the ratio of money supply M1 (assets that strictly adhere to the definition of money; a smaller number than M3) to nominal GDP (aka the “Marshallian K”)—had only started to tick up slightly for the G5 advanced economies (the US, euro area, Japan, Canada and UK) and was still declining for the Brics (Brazil, Russia, India, China) aggregate. Now, our updated metrics, which include data up to March 2009, confirm that a powerful liquidity cycle is under way, with excess liquidity surging to a new record-high both in the advanced and the emerging economies. Thus, the jump in excess liquidity over the past two quarters has more than fully reversed the preceding decline in excess liquidity, which had foreshadowed the credit crisis.”
The rise in global “excess liquidity” has been reinforced by the return of risk appetite. The shock wave that followed the collapse of Lehman Brothers led to investors fearing we were on the brink of another Great Depression. The panic led to a rush to the perceived safe haven of US government bonds and to the US dollar. But as the credit markets have thawed and as the economic data gets better, that safe haven trade is being reversed and some of the money locked up in US money market funds is coming out again. Emerging market bond spreads have come down considerably in recent weeks, although they’re still higher than where they were a year ago. Emerging equity markets have done much better than markets in the developed world.
The chart shows how liquidity was relatively abundant during the March 2008 quarter, when nominal GDP grew at 14.8% y-o-y while M3 (the total amount of money available in the system) growth was 20.7%—that’s a difference of almost 6 percentage points. Ahmed Raza Khan / Mint
There’s also another, more fundamental reason for the rise in emerging market assets. Countries such as India, China and Indonesia are some of the very few places that are growing instead of contracting. Doug Noland, senior portfolio manager of the Federated Prudent Bear Fund, writes in his weekly commentary Credit Bubble Bulletin that “the dynamic of powerful Core to Periphery flows has resumed. Moreover, it is the nature of this type of dynamic that if such a trend recovers it will likely resume stronger-than-ever (think technology stocks post-LTCM reflation or mortgages post-tech Bubble reflation). This analysis is supported by the Periphery’s recent dramatic economic and market outperformance relative to the Core.”
LTCM (Long Term Capital Management) was a hedge fund that went bust in the late 1990s. There is, though, a worm in the bud, a snake in this reflated Eden—higher commodity, especially energy, prices. The “excess liquidity” need not go into stocks alone, but also into other asset classes such as commodities. Merrill Lynch economists say the current recession was caused, not by the credit crisis alone, but also by surging oil prices, which killed consumer demand. A Merrill Lynch note points out that it was the oil prices spike that killed emerging markets growth and that “it is important to consider whether increased liquidity can solve the credit crisis without spurring another energy crisis.”
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org