Some MPC members warn high liquidity may become opium for markets

MPC members Professor Jayanth R. Varma and Dr. Mridul K. Saggar highlighted concerns in the minutes of the MPC’s August policy meeting, that could arise on the financial stability front because of the exorbitant surplus liquidity currently prevalent in the banking system.

The central bank had introduced a gush of liquidity to the financial market back in March 2020, and in subsequent policy meetings, to stabilize the market affected by the pandemic and smoothen the process of price discovery that had been affected by the large withdrawal of liquidity caused by the financial market meltdown in March.

At the time the central bank’s action was in alignment with other global central banks who had taken similar measures to ensure that financial markets did not fail as a result of the panic that struck investors due to the onset of the pandemic.

Since March 2020, Indian benchmark stock indices have more than doubled their value while broad market indices have risen more than 200 per cent in the same period. At the same time, credit spreads for corporate debtors in the corporate bond market are among the narrowest in years.

“Averting markets becoming opiated to slush liquidity designed as a temporary crisis measure is critical to facilitate unwinding when the time comes,” said Saggar. Saggar suggested that gradual adjustments to the central bank’s liquidity policy that are non-disruptive are possible within the accommodative stance adopted by the rate-setting panel currently.

Saggar, however, voted in favour of keeping the repo rate at 4 per cent and sticking with the accommodative stance on monetary policy.

Meanwhile, Professor Jayanth Varma questioned the effectiveness of the current easy liquidity policy of the central bank in the face of rising inflationary pressures and rising evidence that the pandemic may no longer be a short-term event.

Varma argued that the impact of the pandemic is increasingly becoming narrower on the economy as contact-intensive sectors are bearing the brunt of the economic loss while others are even recovering to their pre-pandemic levels.

“Monetary policy is much less effective than fiscal policy for providing targeted relief to the worst affected segments of the economy. Indeed, monetary accommodation appears to be stimulating asset price inflation to a greater extent than it is mitigating the distress in the economy,” Varma said in his remarks recorded in the minutes.

Varma dissented against the rate-setting panel’s decision to keep monetary policy stance unchanged at accommodative, while he voted to keep the repo rate unchanged at 4 per cent.

The impact of the extraordinary liquidity pumped by global central banks on financial markets has been a matter of intense debate over the past six months given signs of exuberance visible in various segments of the financial landscape. In India, investors have pointed to the sky-high demand for initial public offerings that have seen 36 companies raise more than Rs. 72,000 crore this year.

To be sure, the central bank has already taken initial steps to contain the surplus liquidity in the system through enhanced variable rate reverse auctions that the RBI will conduct between August 13 and September 24.

However, the RBI Governor Shaktikanta Das stressed that the market should not interpret this as a sign of normalization of its liquidity policy and that overall system-wide liquidity will still remain in surplus of more than Rs. 4 lakh crore.