Some economists say the central bank is getting antsy over the surfeit of liquidity in the banking system. But too much of it could stoke macro imbalances such as inflation and a wider trade deficit, eventually hurting the very recovery it was meant to support," wrote Bhandari. To start with, governor Shaktikanta Das has highlighted several times that equity markets are divorced from economic fundamentals.

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This indicates he may be worried about a liquidity-fuelled inflation of asset prices. The central bank has been buying dollars in the forward market in order to stagger the accretion in rupee liquidity. Also, it has done liquidity-neutral Operation Twists, instead of outright purchase of government bonds.

The so-called Operation Twist makes it easier to flatten the yield curve without adding to liquidity. When the Indian central bank buys dollars from the foreign exchange market, it releases rupees to banks. This would add to the existing large liquidity surplus.

RBI also accumulates foreign currency assets on its balance sheet as it invests the dollars bought into financial assets. There is a cost to carrying a large quantum of forex reserves considering the exposure to several risks, including credit and market risks. That said, a change in tactical policy towards the foreign exchange market does not entirely resolve the issue of liquidity.

As such, dollar flows are finding their way into Indian equities, a primary reason for the pricey valuations.

Meanwhile, the rise of the rupee could bring its own set of issues such as a hit on export realizations and even mild losses on forex hedges. Click here to read the Mint ePaper Mint is now on Telegram. Join Mint channel in your Telegram and stay updated with the latest business news. Looks like you have exceeded the limit to bookmark the image. Remove some to bookmark this image. First, private debt increases much more than public debt throughout the whole period compare the left hand axis with the right hand axis.

The latest boom period of stands out with yearly additions to private debt amounting on average to 35 percentage points of GDP. During these boom periods, public debt growth drops to 1 to 2 percentage points of GDP. The opposite occurs during bust years. Private debt growth slows down and public debt growth accelerates. The following picture emerges. During boom years, the private sector adds a lot of debt. This was spectacularly so during the boom of Then the bust comes and the governments pick up the pieces.

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They do this in two ways. In the past few days, the scenarios discussed in the media have been changing so rapidly and dramatically that for many it may be hard to grasp the reason behind them. But in emergencies such as the one we are currently experiencing, the way to escape the worst-case scenarios and find an exit strategy is to stick to clear-headed thinking. First, as the economy is driven into a recession, government revenues decline and social spending increases.

Second as part of the private debt is implicitly guaranteed by the government bank debt in particular the government is forced to issue its own debt to rescue private institutions. Thus, the driving force of the cyclical behaviour of government debt is the boom and bust character of private debt. This feature is particularly pronounced during the last boom- bust cycle that led to unsustainable private debt growth forcing governments to add large amounts to its own debt. Financial markets now ask the question of whether the addition of government debt is sustainable.

Clearly the rate of increase of the last two years is unsustainable.

Rupee hits 73.57 against dollar; Indian bonds gain as Fed move raises RBI rate-cut hopes

So, while the Eurozone as a whole is no closer to a debt crisis than is the US, some of its member states have been moving closer to such a crisis. Is it conceivable that a debt crisis in one member country of the Eurozone triggers a more general crisis involving other Eurozone countries? My answer is that yes, it is conceivable, but that it can easily be avoided. Financial markets are nervous and the most nervous actors in the financial markets are the rating agencies. One thing one can say about these institutions is that they systematically fail to see crises come.

And after the crisis erupts, they systematically overreact thereby intensifying it. This was the case two years ago when the rating agencies were completely caught off guard by the credit crisis. It was again the case during the last few weeks. Having failed so miserably in forecasting a sovereign debt crisis, they went on a frantic search for possible other sovereign bond crises.

They found Greece, and other Eurozone countries with high budget deficits, and started the process of downgrading. Add to this that the ECB is still using the ratings produced by the same agencies to accept or refuse collateral presented by banks in the Eurozone, and one can see that all the elements are in place to transform a local crisis into a crisis for the system as a whole.

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It does not have to be that way, however. A systemic crisis can be avoided. Although an outright default by the Greek government remains a remote possibility, it is good to think through what the other Eurozone countries can and will do in that case. They can easily bail out Greece.

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It does not cost them that much. Greek bail-out itself is affecting negatively the fiscal position of Portugal, Spain, and Italy. This too may have contributed to weaken confidence in their ability to service the debt. Thus, much depends on the amount of public debt coming to maturity in the next months. This in turn depends on the maturity structure of the public debt. If public debt mainly has a long-term maturity, then the amount of debt to be rolled- over in a certain time interval is small and the burden of a high interest rate might be sustainable.

In these cases, the risk of a fiscal crisis is ruled out. If instead the debt has mainly a short-term maturity so that the amount to be rolled over is large, then a fiscal crisis can occur, as illustrated in my paper with Francesco Giavazzi Giavazzi and Pagano, Fifth, in the last few days, we have witnessed the sudden depreciation of the euro. Why is the euro depreciating? A possible answer is that as the crisis spreads to other large Eurozone countries, the risk of monetization of the public debt becomes more concrete.

Even if Greece can be bailed out by other countries in the Eurozone, this would not be feasible for the much larger public debts of Italy, Spain, and Portugal. In the scenario of a widespread crisis, the possibility that the ECB will monetize the debt of weak Eurozone countries exists, and fear of the implied inflation can explain the depreciation of the euro.

However, a massive monetization is an unlikely scenario, as it would eventually undermine price stability in the Eurozone and imply a substantial transfer of resources from strong to weak Eurozone countries. An alternative explanation for the depreciation of the euro is the fear of a breakdown of the single currency itself, a scenario that was unthinkable even a few months ago.

In order to avoid having to bail-out weak Eurozone countries through debt monetisation, the strong countries might push the weak ones outside the Eurozone. Obviously, this would be a dramatic scenario, as redrawing the borders of the common currency could hardly happen without generating a financial earthquake.

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Meanwhile, such a crisis could degenerate into the insolvency on the public debt of several Eurozone countries, with devastating effects on the global economy. Given that the public debt of these countries is massively present in the balance sheets of banks and insurance companies all over the world, and in the Eurozone in particular, instability would spread throughout the financial system. Contagion would become really global. In comparison, the sub-prime crisis would almost pale into insignificance. This explains why last week stock exchanges collapsed and why governments on both sides of the Atlantic are very concerned.

And we all contribute to determine market outcomes, even when we decide to abstain from participating in them. Rather than blaming them, governments have to demonstrate that speculators and markets got their forecasts and bets wrong. This implies a significant limitation on the fiscal sovereignty of member states, which comes on top of their delegation of monetary sovereignty to the ECB. But much more is needed than the fragile discipline imposed by the Maastricht treaty and by the stability pact, such as binding constraints on budget laws of member states and institutions able to enforce them.