The Indian money supply growth (year-on-year) last week hit a decade high of 23.8%, vis-a-vis the target of 17-17.5% set by the Reserve Bank of India.
Devendra Nevgi
The Indian money supply growth (year-on-year) last week hit a decade high of 23.8%, vis-a-vis the target of 17-17.5% set by the Reserve Bank of India.
One of the major source of money supply growth has been “Net Foreign Exchange Assets of Banking sector” which has contributed around 25-30%.
This money flood is not restricted to India, it’s a global phenomenon. The euro zone money supply growth (yoy) sky rocketed to 12.30% in October, an historic high. This rise came in due to a 41.8% rise in bank deposits. The growth in loans to households and firms remained strong too. The UK money supply growth has almost tripled in the last decade.
The US Federal Reserve was one step ahead. It discontinued disclosing its money supply (M3 figures) from March 2006, the reason being, it does not convey any additional information and the cost of collecting the same outweighs the benefits. Thus the Fed can now print money as much as it wants.
Money supply (M3) is a broad measure of liquidity in the financial system. In India, M3 is broadly the currency held by public, time and demand deposits with banks and other deposits with RBI. The process of money creation takes place when fresh currency is issued or through the money multiplier, where banks lend to each other after retaining a portion of there deposits as “statutory reserves”
Globally, why is the money supply rising?
Because of the recent subprime and housing problems in the US that have plagued financial markets and made lenders risk averse.
The cost of credit, which is the oil that lubricates the economy, has risen sharply, threatening economic growth rates and financial stability. A recent Goldman Sachs report puts the total losses on account of defaults on mortgages at $400 billion, which can result into a scale-back of lending to the extent of $2 trillion.
And how are Central Banks the world over responding to the credit crisis?
Pumping liquidity into the financial markets and cutting interest rates is perceived to be a panacea for all the credit problems. World over, most of the central banks led by the Fed are infusing massive liquidity in the banking system, leading to a runaway money supply growth. The Bank of England had offered to provide a safety net to depositors of the beleaguered mortgage house, Northern Rock. The European Central Bank as well as the Bank of Canada pumped billions of euros and dollars in the financial system to ease the credit squeeze.
And what does this higher money supply do?
If more amount of money chases the same amount of assets, the result is higher asset prices, specially the risky ones. Excess liquidity also tends to increase the risk appetite of investors and encourages them to leverage. Another consequence of excess liquidity is creeping inflation, which most of the Central banks dread. Often banks tend to dilute there lending standards in an excess liquidity scenario. And free flow of capital across borders ensures that the ill effects of excess liquidity are felt all round the world, including in India.
Indian stock markets have benefited from the global liquidity glut. The year to date (2007) net FII inflows have been over $16.50 billion. In that period, Indian markets have returned almost 40%. The Reserve Bank of India has been buying US dollars to stem the rupee’s appreciation (10.14% ytd), in turn infusing liquidity in the system. Such liquidity, if not sterilised, leads to incessant money supply growth.
A thumb rule on adequacy of the money supply growth is that, it should be equal to: Real GDP growth rate + Inflation. In the Indian context, RBI has been projecting a real GDP growth rate of 8.5% and an inflation of around 5%. RBIs target on money supply growth recently has been 17-17.5% (including the money velocity effect).
The current rate of money expansion of 23.80% is much ahead of the RBIs target. This is likely to compel RBI to keep the short interest rates higher by using various tools of sterilisation such as CRR hikes, MSS, LAF etc since higher money supply impacts financial & price stability and ultimately the real economy.
The author is CEO, Quantum Asset Management Company Pvt Ltd.
Email: devendra@QuantumAmc.com
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