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Photo: Bloomberg
Photo: Bloomberg

India is vulnerable to a liquidity trap of its own

Gita Gopinath of the IMF has called for a fiscal push across the world as the rescue plans of central banks lose efficacy. The rationale she offers is applicable to the Indian economy too

Now that most big central banks across the world have exhausted their monetary firepower in response to the covid crisis, dropping their real policy rates of interest—adjusted for inflation—to negligible levels, the global economy is caught in a “liquidity trap". So observed Gita Gopinath, chief economist of the International Monetary Fund (IMF), who flagged the problem in an oped for The Financial Times. In its classic form, this Keynesian term refers to a situation where economic agents find their incentive to lend overcome by a preference for hanging on to cash. Simply put, if the price of money—which is what an interest rate is—remains too low to cover its loss of purchasing power over time, at the very least, then there is no commercial motive to loan it. Of course, a government or central bank can bear losses to pump an economy up on credit, which is why negative real rates exist at all. In this sort of scenario, however, further lending could get harder to count on, and so easy money would lose its stimulus potency. Gopinath’s concern was aimed chiefly at advanced economies with inflation so low that zero-charge loans cannot be made any cheaper in real terms, leaving this approach a spent force and thus fiscal spending their only resort. Yet, even an inflation-prone economy like ours is vulnerable to a version of this trap.

“For the first time, in 60 per cent of the global economy… central banks have pushed policy interest rates below 1 per cent," wrote Gopinath. “In one-fifth of the world, they are negative. With little room for further rate cuts, central banks have deployed unconventional measures." These, though, were limited in their ability to stoke demand, she argued, flagging the risks of asset price inflation and a currency war in the trade arena sparked by exchange rates sliding in the wake of excess money supply all around. Low global rates, though, also allow less-indebted countries with high growth prospects to take on debt for fiscal expansion that would have a multiplier effect on incomes, and that is what she would have them do. Over-indebted nations would have to restrict their bills and restructure loans, she added, calling for a “global synchronised fiscal push" to lift everyone’s prospects.

We should pay heed. This is not just because the second-order effects of our lockdown could later see demand slump again to drag India’s economy down. We also risk slipping into a liquidity trap should inflation fail to fall below 6% within a quarter or so, as projected by the Reserve Bank of India (RBI). Its main policy rate, at which it lends money to lenders, has been slashed to 4%. Negative real rates prevail across swathes of the economy. Not just bank depositors, even bond investors grumble about financial repression. If retail price stability proves elusive, then RBI’s apparent effort to cap yields on government bonds at 6% would look flaky. This could throw banks’ treasury operations into a flap. In general, lenders would demand higher risk premia on loans, credit terms would tighten across business sectors, and both deposits and advances might droop. While RBI can be expected to act against such an eventuality, our overall policy framework must minimize the odds of India’s debt market suffering a sustained distortion. A shift from credit mechanisms to direct government expenditure is what we need right now. The case for Stimulus 3.0 remains strong.

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