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The formidable challenge of reversing a liquidity glut

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Monetary policy measures

Mains level : Paper 3- Dealing with the excess liquidity

The article highlights the challenge in dealing with the excess liquidity in the economy after the central banks injected liquidity by persuing unorthodox policies.

Overview of policies adopted during 2008 financial crisis

  • Days after the crash of Lehman Brothers, the United States Congress approved an emergency bailout package of $700 billion in September 2008.
  • The amount was used to buy off mortgage-backed securities from banks, hedge funds and pension funds to avert further Lehman-type bankruptcies.
  • As a result, fresh money was injected into the banking system for it to resume normal credit operations and clean up balance sheets.
  • Subsequent actions of the US government and Federal Reserve blurred the distinction between fiscal and monetary policy.
  • ‘Quantitative easing’  was a term coined to describe unorthodox measures like a central bank buying off mortgages and loans, and thus taking credit risk onto its balance sheet.
  • So, quantitative easing was pursued by all the major central banks of the developed world.
  • Central banks embarked upon an aggressive money-printing spree. Assets on their books ballooned.

Monetary response during pandemic subsequent liquidity glut

  • During the pandemic year more than a decade after the 2008 crisis, the West’s monetary spigots have been opened even more.
  • A liquidity glut has ensued.
  • While the rate of monetary expansion over this period has been healthy, neither employment nor economic output grew by even a fraction of that rate.
  • Central bank finds itself in the maze.

RBI in a similar situation

  • The Reserve Bank of India (RBI) too finds itself in a similar predicament, where the way out of its liquidity glut is hazy.
  • Due to purchases of foreign exchange externally and of government bonds domestically, RBI’s balance sheet has ballooned by more 30% by August last year.
  • RBI has injected liquidity through long-term repo operations, which essentially provide long-term money at low overnight rates.
  • The Indian central bank has also provided implicit liquidity support to mutual funds.
  • However, the RBI has not quite ventured into taking credit risk onto its books, nor has it signalled a readiness to buy toxic assets.

Liquidity glut and challenges associated with it

  • As a result of India’s liquidity glut, money is flowing in and out of the central bank to the tune of 7 trillion on a daily basis.
  • This has resulted in an anomaly: market lending rates have gone below RBI’s reverse repo rate, which is supposed to be the de facto floor.
  • Cheap money encourages to do foolish and risky things, which, if done widely and voluminously enough, can spell disaster for financial stability.
  • But, any hint of reducing the rate of money expansion threatens to cause panic and burst the bubble it blew.
  • So, when RBI tentatively tried to move market rates higher by announcing a reverse repo auction,the market reaction was one of panic all the same, and there was a spike in interest rates.
  • This caused the central bank to rethink its strategy.
  • To calm nervous bond traders, the governor has categorically said that liquidity support will continue as long as necessary.

Way forward

  •  We need to plan an exit from the current glut.
  • One way out could be loan 5 trillion to the central government against shares of public sector undertakings, at a low rate of 3% for a period of five years to fund its huge deficit.
  • That will bypass markets and not cause any disruption to interest rates.

Consider the question “Why the challenges posed by liquidity glut caused by the unorthodox policies adopted by the central bank in the aftermath of the pandemic? What are the challenges in reducing the liquidity?” 

Conclusion

Whatever the way out of this whirlpool of liquidity, it’s not going to be easy.

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