The problem with the liquidity push

  • IASbaba
  • May 26, 2020
  • 0
UPSC Articles
Print Friendly, PDF & Email

ECONOMY/ GOVERNANCE

Topic: General Studies 3:

  • Indian Economy and issues relating to planning, mobilization, of resources 
  • Government policies and interventions for development in various sectors 

The problem with the liquidity push

Context: The government’s relief-cum-stimulus amounting to 10% of GDP has relied heavily on measures aimed at pushing credit to economy.

The Liquidity push

  • In the wake of economic crisis unleashed by COVID-19, Union Government’s agenda of “self-reliant India” has identified land, labour, laws and liquidity as focus areas.
  • In economic and business parlance, liquidity refers to ease of access to money.
  • In periods of crisis, individuals, small businesses, firms, financial institutions and even governments tend to experience a liquidity crunch
  • Relaxing that liquidity crunch is a focus of the government’s crisis-response package.

Why the need for pushing credit?

  • The thrust is to get RBI and other public financial institutions to infuse liquidity and increase lending by the financial system
  • This would ensure that businesses big and small, use borrowed funds to lend to others, make pending payments and compensate employees 
  • Also, this would increase the money in the hands of consumers driving demand
  • Thus, increased liquidity addresses both demand and supply side of economic cycle, reviving demand, investment and expenditure
  • Enhancing liquidity is thus considered as productive as direct transfers to the poor.

What is the focus area of liquidity transmission?

  • The main intermediaries being enlisted for the task of transmitting liquidity are the banks, with NBFCs constituting a second tier
  • Among the first steps taken by the RBI was the launch of special and ‘targeted’ long term repo operations (TLTROs)
  • First round of such operations, called for investment of the cheaper capital in higher quality investment grade corporate bonds, commercial paper, and non-convertible debentures. This allowed big business access to cheap capital
  • The second round was geared to saving NBFCs, whose balance sheets were under severe stress even before the COVID-19 strike
  • The COVID-19 package identified more intermediaries like SIDBI, NABARD, NHB that could increase liquidity in different sectors
  • Also, in some instances the government offered them partial or full credit guarantees in case their clients defaulted

Challenges with liquidity transmission

  • Ineffective: There is little evidence to suggest that first round of RBI’s TLTROs aimed toward big business triggered new investment decisions. This is because they used the cheap capital to substitute for past high-cost debt or finance ongoing projects
  • Practical Challenges: Given the circumstances, the liquidity push, even if partially successful, would only culminate in eventual default, as borrowers use the debt to just stay afloat in the absence of new revenues.
  • Banks were reluctant about lending to NBFCs/MFI, because of fears that their clients could default in repayments due to weak business cycle. Ex: Franklin Templeton issue 
  • Weak Transmission: Those who can access credit would either not borrow or only do so to protect themselves and not use the funds either to pay their workers or buy and stock inputs, due to grim economic outlook
  • Medium term issue: Even after the lockdown is lifted, the compression of demand resulting from the loss of employment and incomes would be considerable. 
  • Inadequate Fiscal Measures: Demand decline would be aggravated by the fact that spending by a government would fall sharply because of a collapse in revenue collections.

Way Ahead

  • New and additional transfers to people in cash and kind
  • Increased wage subsidies and enhanced spending on employment programmes
  • Debt financed spending by the government, with borrowing at low interest rates from the central bank or a “monetisation” of the deficit

Connecting the dots:

  • Taper tantrum by US Fed in the wake of post-2009 financial crisis
  • Keynesian Economics in the wake of Great Depression

Search now.....

Sign Up To Receive Regular Updates