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Liquidity surge: Boon or bane? - Views on News from Equitymaster
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  • Jun 3, 2009

    Liquidity surge: Boon or bane?

    Pros and cons of excess liquidity
    It has been contested and that too with a fair degree of success that the current rally in equities, especially in the emerging markets is a result of a huge surge in liquidity. And this isn't a bad thing at all. Greater liquidity enables credit starved sectors to spring back to life. And when this happens, goods and services are produced at a faster rate, thus leading to a rise in the country's GDP.

    But what is worrisome is the fact that over the past few months, liquidity, that is money supply has grown at a lot faster rate than the real economy can absorb. And the excess liquidity is finding its way into the asset markets, leading to rally in equities and other assets like commodities. As per a leading daily, it is in the nature of such trends that when they recover, they do so by being stronger than ever, thus setting themselves up for a bigger fall in the future.

    Furthermore, by supporting prices of commodities such as oil, the excess liquidity drives up inflation, making real economic growth a rather difficult task. While everyone talks about the global financial crisis, it should be remembered that the previous spike in oil prices was also responsible for hurting GDP growth, especially in the emerging markets. The world is thus confronted with a million dollar question. Will the current surge in liquidity pull the world out of the economic crisis or it will only prolong the pain by giving rise to inflation. Unfortunately, even we don't have an answer to the question. Only time will tell.

    A problem more serious than infrastructure
    Forget infrastructure, if India has to put itself on a sustainable long-term growth path, it will have to take care of this problem first. And if a recent report by the United Nations Children's Fund or UNICEF is to be believed, the problem has only gotten worse in the aftermath of the global financial crisis. We are referring to the number of chronically hungry people in India, which as per the UNICEF stood at 230 m in 2007-08 as opposed to 210 m in 2004-06.

    The report further adds that with marginal groups spending nearly 80% of their total income on food, a 5% rise in food prices makes them vulnerable and forces them to go for cheaper and less nutritious food and also cut back on other areas of spending such as education. And this in turn, lays the seed for the start of a vicious circle. While less nutritious food leads to malnourishment, lack of education hampers their long term progress and ultimately that of the nation.

    And it's not as if the world body has only facts to highlight, it has also offered a simple solution. South Asian nations, where the problem is especially rampant, spend around 10% of their GDP on defence. If they divert a small portion of it towards education, these countries will be a lot better place to live in. We couldn't have agreed more.



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