Turbocharged liquidity drives turbulence

Turbocharged liquidity drives turbulence

India has to be more vigilant on macro stability.

When a butterfly flaps its wings in New Mexico, it causes a hurricane in China — so goes a popular rendition of chaos theory. In other words, small changes in initial conditions can lead to large changes in the end results. President Donald Trump is not as pretty as a butterfly, but when his policy of aggressive pressure on China waffled and the media reported the likely scaling back of some punitive tariffs on imports from China, the effects were felt in stock markets around the world. The US witnessed the immediate impact of reduced safe-haven demand for the dollar, resulting in a selloff of US Treasuries, depressing bond prices and pushing up yields, even if only by a few basis points. The money leaving bonds redeployed in stocks, in the US and elsewhere. Sentiments also push up stock prices around the world. Such interdependence is a source of potential sorrow as well.

The world is awash in liquidity, thanks to the quantitative easing set in motion by the US Fed, the European Central Bank (ECB), the Bank of Japan and the Bank of England, to ward off a depression in the wake of the global financial crisis. The US Fed alone purchased bonds worth $3.63 trillion, over 2009-15. When a central bank purchases securities, it pushes counterpart liquidity into the system. That sloshes around the world’s financial markets, pushing up asset prices, often beyond those warranted by fundamentals. These global flows of liquidity are vulnerable to mood swings in the countries that generated such liquidity. In October 2017, the US Fed started a programme of lightening its asset load. It kept selling till August 2019, shedding, in all, $0.7 trillion of bonds. Some sudden liquidity problem caused the Fed to start asset purchases again. The ECB has revived asset purchases, after reducing its policy rates further into the negative territory.

If the world economy improves, and central banks sense the leeway to reverse extra accommodation, liquidity could be sucked back and stocks could tumble, instead of celebrating recovery. India has to be ever more watchful on macroeconomic and financial stability.