Economist John Maynard Keynes had spoken of a unique situation called the ‘liquidity trap’ which was applicable during the depression of 1930s when there was no demand for money; and hence even when supply increased it had little impact.
Money supply was increased by central banks to lower rates to make it attractive for borrowers. However, few were willing to borrow because of truncated demand for goods and services. His suggestion, therefore, was that the only way to move out was to have higher government expenditure.
Japan for long now has interest rates close to zero, yet remains in a rescission for years. Following the financial crisis, the Fed not just brought its policy rate close to zero but also started buying back bonds from banks so that liquidity was provided.
The idea was that as the crisis was all about toxic assets and banks stopped trusting one another, the best way to provide funds was directly through buyback of bonds. This worked. The ECB has also started on a policy of quantitative easing for a sum of €1.1 trillion over 18 months till September 2016 which Draghi now says will carry on till March 2017. The idea is to provide funding to banks for on lending purposes.
The ECB now has its policy rate at 0.05% which is the equivalent of our repo rate that has been brought down to close to zero. A more innovative tool used to dissuade banks from holding cash was to lower the interest rate on deposits kept by them with the ECB to the negative territory.
The ECB has lowered this deposit rate further to -0.30%. This means if banks have surplus liquidity which they are not deploying for credit, then they will have to pay the central bank to hold the funds. Will this work?
The ECB has said that it has been effective so far which has pushed the GDP growth to 1.5% for 2015 which will reach 1.9% in 2017. It is also confident that inflation will move towards 2%, even though it is at 0.1% presently. Hence the monetary stimulus has worked to a large extent though the story across all countries has been different.
Two interesting questions need to be addressed. The first is whether this is the right route. The problem in the euro region is that the sovereign debt crisis has promoted stringent conditions to be imposed especially on the government debt levels and fiscal deficits to maintain stability in a system where there is single cut back heavily on spending which affected their progress to begin with. But things have turned around now with growth being fairly broad based in the region even though the absolute level is still low. Almost all the countries in this block are expected to grow by a positive rate with inflation also being non-negative.
The second question is why India has not followed this policy if monetary expansion is the route to a recovery. Logically if easing of money to ensure that funds available to all and sundry is the solution for low growth, an economy like ours which is growing at 7% plus could also logically be propelled. But so far the RBI has not been doing anything on the funding side. This is interesting because in a system where there is less demand for funds, buying back bonds through open market operations should also logically stimulate the economy.
There are three reasons why this is not happening. First, why banks are not lending is not because they do not have money but because there is less demand for funds on account of lackluster demand conditions. Investment is not taking place due to surplus capacity and other extraneous issues with infrastructure projects. Therefore, providing funds to banks will be counterproductive; and more likely the response will be negative.
The other is that the banking system is still saturated with high levels of stressed assets including NPAs and restructured assets. There is, hence, to some degree, unwillingness to lend to companies as stressed assets are 10% plus of advances and the risk taking appetite has come down.
Last, when QE has been pursued in countries inflation has been very low and the idea is to reflate the economy too. Draghi has spoken in the latest policy of the need to push inflation up gradually as this is an incentive for enterprise to invest. In India we already have inflation at 5% caused on the supply side which is moving upwards. At this stage reflating the economy through credit creation could add demand pull forces and exacerbate the situation. Therefore, pursuing QE is not an option when inflationary tendencies are already there.
Therefore, monetary easing through infusion of funds has to be understood against the context of countries. Japan has been a perfect example where there has been a much muted response. Growth in the last quarter was negative even as the Bank of Japan has been aggressive in buyback of assets in an era of close to zero interest rates. The government has limited fiscal space with the deficit being 6.8% of GDP. In fact, if the yen was not an anchor currency, such deficits would not have been tolerated by the rating agencies.
Also it must be remembered that QE has worked in the US after almost 7 years to bring it out of the morass and the euro region has also taken similar time to move up with growth still being uneven as the Greece crisis has been popping up off and on.
Therefore, QE and monetary easing, though a good option for countries in a deep recession is not appropriate for countries like India where one has to fine tune monetary policy depending on both the growth potential as well as inflationary forces. For us, instead of the RBI, it is the government which can be more effective in stimulating demand.
The author is chief economist, CARE Ratings. Views are personal
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Updated Date: Dec 06, 2015 10:42:05 IST