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Business News/ Opinion / Is the sudden return of liquidity a good sign?
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Is the sudden return of liquidity a good sign?

Is the sudden return of liquidity a good sign?

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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.

Also Read Manas Chakravarty’s earlier columns

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

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 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 capitalaccount@livemint.com

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Published: 02 Jun 2009, 09:44 PM IST
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