Reason behind the asset bubble

M3 growth in a year should normally be equal to nominal GDP, but the numbers show it has been way above, especially in the last two years

by Manas – HT Mint

Not only has money supply (M3) been rising in recent years, but it has also gone up sharply as a proportion of nominal gross domestic product (GDP). Here’s the data: The annual increase in M3 as a proportion of GDP in that year was 9.1% in FY02; 9.0% in FY03; 11.1% in FY04; 10.1% in FY05; 12.4% in FY06 and as much as 15.7% last fiscal.
M3 growth in a year should normally be at least equal to the increase in goods and services plus the rise in the prices of these goods and services, which is nothing, but nominal GDP. But as the numbers show, M3 growth has been well above the growth in nominal GDP, especially in the last two years.

The increase in money supply has been boosting asset prices

What does this trend indicate? Says Ajit Ranade, chief economist of the Aditya Birla Group: “Part of it is the result of financial deepening, as the use of money becomes more and more widespread.” But the extra liquidity could also be spilling over into higher asset prices. The rise in goods and services is captured by nominal GDP, but the rise in asset prices is not.

Gaurav Kapur, senior economist with ABN Amro Bank, says that rapid M3 growth is a reflection of the sharp rise in bank credit. “Bank credit as a proportion of nominal GDP too has gone up,” he says, ”partly because banks have discovered retail lending.” Kapur also agrees that part of the M3 increase, beyond that required for the real economy, has been boosting asset prices.

This fiscal, the Reserve Bank of India wants M3 growth to decelerate to 17-17.5%, while real GDP growth is pegged at 8.5% and inflation at 5%, giving a nominal GDP growth rate of 13.5%. That will mean the M3/nominal GDP ratio will be 13.8% in FY08, well below last fiscal’s 15.7%.

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