What a difference a month can make! Economists, that till a month ago were forecasting gloom and doom, are now predicting that the recession is over. The stock markets have zoomed ahead and there is a sense everywhere that the worst is behind us. Is it really so?
For economies to grow, people have to spend. When customers spend more, factories produce more goods and services, and hire more people - thus generating more employment, which further increases spending. This leads to a virtuous cycle. The stunning growth experienced by India, for example, has been lead in large parts by the Indian middle class spending more. China is the chief exporter to the US, and the American customers spending beyond their means has been the key reason for China's growth.
When consumer spending goes down, it can lead to a recession like we are seeing now. During these times, the government increases its spending to compensate for the drop in consumer spending. Government can take up huge infrastructure projects like building dams and ports, constructing roads and rail, etc. The hope is that by doing so the consumer spending will pick up, and the government can then go back to its normal spending levels.
We have seen the increase in government spending thus far in 2008 - 09, with governments across the world coming up with billions of dollars of bailout packages. However, there is a chance that this may not result in the expected increase in consumer spending, especially in the US.
There were three key reasons for the huge US spending:
1. Home prices were going up making people ‘feel’ rich. Also people could get more loans against their higher home prices. Consequently they ended up spending more.
2. The stock market rally had led to a huge increase in ‘perceived wealth’ for investors, who went ahead and spent more.
3. The credit card companies, in their race to growth, gave away cards to all and sundry, leading to a huge spending.
Now with the recession, all these factors have been reversed. However, what compounds the problem is the fact that 'baby boomers' are retiring. They are suddenly finding out that their net-worth has been severely depleted. They will have to save a lot more, to make sure that they have a comfortable retirement.
This is a serious long term trend that seems to mirror something that happened in Japan 20 years ago. As a large portion of the Japanese population approached retirement, they started saving more, which exacerbated the recession and worsened it into the ‘lost decade’. As the baby boomers retire, it may prolong the recovery from recession for the world in general and US in particular. We may still have a recovery, but it will be a slow grinding process, rather than a quick one.
Sunday, June 14, 2009
Tuesday, April 28, 2009
The new carry trade?
What is carry trade? Carry trade essentially means borrowing at a place where the borrowing costs are low and investing in another place where the rate of return is high. Carry trade became very popular in the last decade, when Japanese interest rates were close to zero. It came to be known as the Yen carry trade.
Let us look at how investors benefited from the near-zero interest rate in Japan and the high interest rate in other countries (like the US) in the past few years. In 2006, the interest rate in Japan was 0.1%. Let us say an investor borrowed a sum of 115,000 Yen in the Japanese market for one year. At the end of the year the investor will have to return 115,115 Yen (original amount of 115,000 + interest for one year which is 115,000 *0.1%).
In 2006 the interest rate in US was 5.25% and the currency exchange rate was around 1$ = 115 Yen. Suppose the investor converted his Yen to Dollars, he then got $1,000 (for his 115,000 Yen). If he then proceeded to invest his $1,000 in the US market, at the end of the year he would have $1,052.5 (original amount of $1,000 + interest for one year which is $1,000 * 5.25%).
If the currency exchange rate stayed the same, he would then get 121,037.5 Yen ($1,052.5 * 115) when he converts his Dollars to Yen. After repaying the amount due he will be left with 5,922.5 Yen (121,037.5 - 115,115). That is a neat profit considering the fact that all the investor had to do was borrow in one country and invest in another.
(the profit percentage is 5,922.5/115,000 = 5.15%, which is also equal to the difference in the interest rates of US and Japan)
The only risk the investor faces is that of the currency movement. The above calculation assumes that the Yen:Dollar exchange rate stays the same at the end of the year. However, if the Yen appreciates by more than 5.15%, then the investor effectively makes a loss (because he will have to pay more Dollars to get the Yen at the time of repayment).
Due to a host of reasons, the Yen has appreciated considerably in the past year with respect to the Dollar (refer figure). Thus the Yen:Dollar carry trade has come to an abrupt halt. Another reason that has hampered the carry trade is that the interest rates in US is also close to zero now (effectively there is no difference in interest rates in Japan and US).
Hence investors have now started borrowing from countries like Japan and US (where the interest rate is close to zero) to invest in countries where the interest rate is still high (Brazil and India). In Brazil, the interest rate is 11%, so an investor can potentially make twice as much as the Yen:Dollar trade in 2006! The assumption, of course, is that these currencies do not appreciate against the Dollar and the Yen.
Let us look at how investors benefited from the near-zero interest rate in Japan and the high interest rate in other countries (like the US) in the past few years. In 2006, the interest rate in Japan was 0.1%. Let us say an investor borrowed a sum of 115,000 Yen in the Japanese market for one year. At the end of the year the investor will have to return 115,115 Yen (original amount of 115,000 + interest for one year which is 115,000 *0.1%).
In 2006 the interest rate in US was 5.25% and the currency exchange rate was around 1$ = 115 Yen. Suppose the investor converted his Yen to Dollars, he then got $1,000 (for his 115,000 Yen). If he then proceeded to invest his $1,000 in the US market, at the end of the year he would have $1,052.5 (original amount of $1,000 + interest for one year which is $1,000 * 5.25%).
If the currency exchange rate stayed the same, he would then get 121,037.5 Yen ($1,052.5 * 115) when he converts his Dollars to Yen. After repaying the amount due he will be left with 5,922.5 Yen (121,037.5 - 115,115). That is a neat profit considering the fact that all the investor had to do was borrow in one country and invest in another.
(the profit percentage is 5,922.5/115,000 = 5.15%, which is also equal to the difference in the interest rates of US and Japan)
The only risk the investor faces is that of the currency movement. The above calculation assumes that the Yen:Dollar exchange rate stays the same at the end of the year. However, if the Yen appreciates by more than 5.15%, then the investor effectively makes a loss (because he will have to pay more Dollars to get the Yen at the time of repayment).
Due to a host of reasons, the Yen has appreciated considerably in the past year with respect to the Dollar (refer figure). Thus the Yen:Dollar carry trade has come to an abrupt halt. Another reason that has hampered the carry trade is that the interest rates in US is also close to zero now (effectively there is no difference in interest rates in Japan and US).
Hence investors have now started borrowing from countries like Japan and US (where the interest rate is close to zero) to invest in countries where the interest rate is still high (Brazil and India). In Brazil, the interest rate is 11%, so an investor can potentially make twice as much as the Yen:Dollar trade in 2006! The assumption, of course, is that these currencies do not appreciate against the Dollar and the Yen.
Tuesday, April 7, 2009
Auto Companies: to save or not to save?
After the US government warned General Motors (GM) and Chrysler to shape up or go bankrupt, there has been a huge uproar from many people. The argument goes that if the US government is ready to spend hundreds of billions of dollars to save the banks, then why not spend a few billion dollars to save the auto companies? Although the argument may sound convincing, there are some key reasons as to why the US government should not bail out the auto companies.
The fundamental difference between a bank and any other company is in the service that they provide. A bank’s basic function is to take money from the government (or the Federal Reserve in the US) and loan it out to people and companies. This money forms the basis of all economic activity. Without the banks, corporations will not get money to perform their day-to-day activities. People will not be able to buy things on loan. Companies will not be able to expand their business. The economy will simply collapse.
The auto industry on the other hand, is not as critical to the economy. The industry does employ a lot of people, and also supports a lot of auto-ancillary factories (which in turn employ even more people). However, in case a GM goes bankrupt, there are other car makers (especially efficient companies like Honda and Toyota) which will keep producing cars. Employees from GM can potentially find jobs at other car makers (assuming aggregate demand for cars does not drop sharply).
When the economy was booming; GM, Ford and Chrysler kept on making bigger and more petrol-consuming cars. People were readily getting loans and they kept on buying. As oil prices shot up and the economy went down, the demand for big cars disappeared. The US auto companies suddenly found themselves at a huge disadvantage to companies like Toyota, which had successfully invested in electric and hybrid technology.
The US auto makers are also struggling with huge costs of employees and labor unions, which are a big drag on profits. With falling demand, these companies cannot re-size the workforce as needed.
The simple truth about the US auto makers is that they make more cars than there is demand for, and most of the foreign car makers make better cars at lower cost.
One of the benefits of an economic downturn is that it allows good companies to flourish and destroys uncompetitive companies. As long as uncompetitive companies are allowed to fail, there will be other leaner and better companies taking their place and the economy as a whole will be better off. The best course of action for the US government would be to allow the auto companies to fail. If the government keeps providing these companies with cash, it will promote unhealthy competition (with other countries like UK, Canada, France, Italy, etc. also being forced to subsidize their auto companies).
The fundamental difference between a bank and any other company is in the service that they provide. A bank’s basic function is to take money from the government (or the Federal Reserve in the US) and loan it out to people and companies. This money forms the basis of all economic activity. Without the banks, corporations will not get money to perform their day-to-day activities. People will not be able to buy things on loan. Companies will not be able to expand their business. The economy will simply collapse.
The auto industry on the other hand, is not as critical to the economy. The industry does employ a lot of people, and also supports a lot of auto-ancillary factories (which in turn employ even more people). However, in case a GM goes bankrupt, there are other car makers (especially efficient companies like Honda and Toyota) which will keep producing cars. Employees from GM can potentially find jobs at other car makers (assuming aggregate demand for cars does not drop sharply).
When the economy was booming; GM, Ford and Chrysler kept on making bigger and more petrol-consuming cars. People were readily getting loans and they kept on buying. As oil prices shot up and the economy went down, the demand for big cars disappeared. The US auto companies suddenly found themselves at a huge disadvantage to companies like Toyota, which had successfully invested in electric and hybrid technology.
The US auto makers are also struggling with huge costs of employees and labor unions, which are a big drag on profits. With falling demand, these companies cannot re-size the workforce as needed.
The simple truth about the US auto makers is that they make more cars than there is demand for, and most of the foreign car makers make better cars at lower cost.
One of the benefits of an economic downturn is that it allows good companies to flourish and destroys uncompetitive companies. As long as uncompetitive companies are allowed to fail, there will be other leaner and better companies taking their place and the economy as a whole will be better off. The best course of action for the US government would be to allow the auto companies to fail. If the government keeps providing these companies with cash, it will promote unhealthy competition (with other countries like UK, Canada, France, Italy, etc. also being forced to subsidize their auto companies).
Sunday, April 5, 2009
Housing sees an uptick: should we rejoice?
The boom and bust in the housing market has been the trigger for throwing the world economy in recession. Many pundits believe that for the economy to recover, the housing market should first stabilize. Of late, there are signs that the housing market might be seeing a turnaround. It there a cause for celebration?
In the UK, the Nationwide Building Society reported the first monthly rise in house prices since October 2007. Housing prices which have fallen 17.6% since the start of the crisis, actually rose 0.9% in March!
In the US, the housing prices were down 29% from their peak with home sales going down steadily. However, in February, home sales rose unexpectedly. In Nevada, which with California, Florida, and Arizona was the epicenter of the boom and bust, fourth quarter sales were more than double their level a year earlier.
So what are the causes for this turnaround in the housing sector? One reason is that the house prices have gone down substantially, which makes it a good opportunity for bargain hunters. However, the bigger cause is that interest rates are at an all time low. The government interest rates in the US and UK are as low as 0 - 0.5%! In other parts of the world, interest rates are at or near historic lows. The low rate of interest is making a lot of people jump into the housing market. This includes first time buyers also. However, the only lesson we learn from history is that we do not learn from history.
Just because interest rates are low now, it doesn’t mean they will be low in a few years time. This was the exact same mistake made by house buyers in the US in 2003-05. When interest rates dropped from a high of 6.5% in 2000 to 1% in 2003, many people bought houses using loans. But when interest rates rose again to more than 5% in 2006, many people found out that they could no longer afford to make the monthly payments on their home loans. This lead to defaults and foreclosures, eventually leading to a global crisis.
As the economy recovers in the next couple of years, interest rates will invariably go up from the current historic lows (to counter inflation). People who are buying houses now, must be sure they can afford their house loans even if the cost rises significantly. It is not clear that people are thinking about that.
In the UK, the Nationwide Building Society reported the first monthly rise in house prices since October 2007. Housing prices which have fallen 17.6% since the start of the crisis, actually rose 0.9% in March!
In the US, the housing prices were down 29% from their peak with home sales going down steadily. However, in February, home sales rose unexpectedly. In Nevada, which with California, Florida, and Arizona was the epicenter of the boom and bust, fourth quarter sales were more than double their level a year earlier.
So what are the causes for this turnaround in the housing sector? One reason is that the house prices have gone down substantially, which makes it a good opportunity for bargain hunters. However, the bigger cause is that interest rates are at an all time low. The government interest rates in the US and UK are as low as 0 - 0.5%! In other parts of the world, interest rates are at or near historic lows. The low rate of interest is making a lot of people jump into the housing market. This includes first time buyers also. However, the only lesson we learn from history is that we do not learn from history.
Just because interest rates are low now, it doesn’t mean they will be low in a few years time. This was the exact same mistake made by house buyers in the US in 2003-05. When interest rates dropped from a high of 6.5% in 2000 to 1% in 2003, many people bought houses using loans. But when interest rates rose again to more than 5% in 2006, many people found out that they could no longer afford to make the monthly payments on their home loans. This lead to defaults and foreclosures, eventually leading to a global crisis.
As the economy recovers in the next couple of years, interest rates will invariably go up from the current historic lows (to counter inflation). People who are buying houses now, must be sure they can afford their house loans even if the cost rises significantly. It is not clear that people are thinking about that.
Tuesday, March 24, 2009
Why are the markets happy?
Stock markets the world over surged after the US Treasury announced its latest plan. The Dow jumped almost 500 points, its biggest one-day point gain since November 21. What makes this plan so different, and why are the markets so happy?
One of the key learning from the Japanese lost decade was that 'Zombie Banks' prolonged the crisis. Towards the end of the last century, the Japanese real-estate and stock market bubble burst. The country was faced with a situation which is similar to what the US economy is facing right now. It had a lot of banks had made huge loans, and the loans were going sour pretty fast (as customers and businesses failed to make monthly repayments). One of the biggest mistakes that Japan made was that it helped these banks survive.
The banks had so much bad loans on their book that their total liabilities exceeded their assets. Thus they were very reluctant to make more loans. As banks reduced making newer loans, other industries became starved of cash to run their business and people could not finance their big-ticket purchases. This caused massive problems within the economy.
In any economy, the only way governments can give money to the businesses and consumers is though banks. Hence the Japanese government reacted by giving more money to the banks (hoping that the banks would lend it to businesses and consumers). The banks, on their part, were very happy to take the money and keep it with themselves - to improve their reserves (i.e., make sure they have enough money - in case more loans go bad)!
These banks came to be known as 'Zombie Banks'. They were practically insolvent and the Japanese government fed them money to keep them 'alive'. However these banks just hoarded up the money and did not plough it into the economy. This ended up prolonging the crisis for many more years.
In the US, there were fears of banks like Citibank and Bank of America becoming 'Zombie Banks'. The fears were primarily because these banks have huge portfolio of bad loans. They are also hoarding up government money and not lending out as much as they should. The situation is very similar to that in Japan few years ago.
Hence, the announcement by the Treasury is very important. The announcement basically says that the bad loans that these banks have will be bought over by the Treasury. Once banks become free of their bad loans, they will again start lending out to businesses and consumers. This will help get the economy moving again. Consumers will be able to buy more goods, factories will increases production, and more people will get jobs.
But as with any other plan, implementation will be the key. If the Treasury is successful in implementing this plan, it will have effectively averted one of the biggest mistakes that led to the Japanese lost decade.
One of the key learning from the Japanese lost decade was that 'Zombie Banks' prolonged the crisis. Towards the end of the last century, the Japanese real-estate and stock market bubble burst. The country was faced with a situation which is similar to what the US economy is facing right now. It had a lot of banks had made huge loans, and the loans were going sour pretty fast (as customers and businesses failed to make monthly repayments). One of the biggest mistakes that Japan made was that it helped these banks survive.
The banks had so much bad loans on their book that their total liabilities exceeded their assets. Thus they were very reluctant to make more loans. As banks reduced making newer loans, other industries became starved of cash to run their business and people could not finance their big-ticket purchases. This caused massive problems within the economy.
In any economy, the only way governments can give money to the businesses and consumers is though banks. Hence the Japanese government reacted by giving more money to the banks (hoping that the banks would lend it to businesses and consumers). The banks, on their part, were very happy to take the money and keep it with themselves - to improve their reserves (i.e., make sure they have enough money - in case more loans go bad)!
These banks came to be known as 'Zombie Banks'. They were practically insolvent and the Japanese government fed them money to keep them 'alive'. However these banks just hoarded up the money and did not plough it into the economy. This ended up prolonging the crisis for many more years.
In the US, there were fears of banks like Citibank and Bank of America becoming 'Zombie Banks'. The fears were primarily because these banks have huge portfolio of bad loans. They are also hoarding up government money and not lending out as much as they should. The situation is very similar to that in Japan few years ago.
Hence, the announcement by the Treasury is very important. The announcement basically says that the bad loans that these banks have will be bought over by the Treasury. Once banks become free of their bad loans, they will again start lending out to businesses and consumers. This will help get the economy moving again. Consumers will be able to buy more goods, factories will increases production, and more people will get jobs.
But as with any other plan, implementation will be the key. If the Treasury is successful in implementing this plan, it will have effectively averted one of the biggest mistakes that led to the Japanese lost decade.
Saturday, March 14, 2009
The Indian Rupee (Part II: The Fall)
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Continuation of the previous post: The Indian Rupee (Part I: The Rise)
***
The very same factors, that led to the rise of the Rupee, reversed rapidly in 2008. This led to a huge fall in the Rupee. However, there are a couple of more factors which accelerated this cycle:
Vicious cycle of stock market returns and currency depreciation: The returns for global financial institutions investing in India depend on the performance of the stock market and the currency exchange rate. Let us take the case of a firm that had invested 100$ in India in early 2008 (when the currency rate was 40Rs./$). Using the 100$ they got 4,000 Rs. and let us assume that the firm invested the money in stocks. Now in 2009, with the stock market down let us assume the value of the stocks that the company owned has come down by 50%. The value of the investment now is 2,000 Rs. However, it would be wrong to say that the loss of the firm is just 50%. If the firm wants its money back, it will have to convert the Rupees into Dollars. Now, if the exchange rate is at 50Rs./$ in 2009, then the company will get only 40$ (2,000/50). Thus the ‘true return’ for the firm will not be negative 50% but will now be negative 60%. Due to the double whammy of stock market decline and depreciating Rupee, global financial institutions are pulling money out in droves. To exit India, they sell Rupees - thus increasing the supply of Rupees. This drives down the Rupee further, which leads to even worse ‘true returns’ which further causes more financial institutions to exit India. India’s stock market dropped more than the US and other developed countries in 2008. Hence financial institutions that had invested in India, started to exit, leading to this vicious cycle - which has been one of the key factors driving the fall of the Rupee.
Uncertain future: We all know that the American consumer has taken on excessive debt. In India, this role has been taken over by the government. Of the major economies, India has one of the greatest debt burden. This essentially means that the government is borrowing a lot of money to finance its huge expenses (salary hike for government service employees, loan waiver for the farmers, stimulus packages, etc.). The debt levels have risen to alarming levels, leading to a downgrade by rating agencies. Elections are round the corner, and people are predicting a hung parliament. The lack of a single party government will ensure that strong polices will not be enacted to reduce the debt burden. The hung parliament will also be an impediment to reforms (which as desperately needed at such times). To top it all, if India has a bad monsoon this year, things could get really bad. Hence companies are shying away from investing in India, thus reducing demand, and driving down the Rupee further.
Looking ahead, all these factors are not expected to reverse in a hurry. The Rupee will likely go down further, as the year goes along.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Continuation of the previous post: The Indian Rupee (Part I: The Rise)
***
The very same factors, that led to the rise of the Rupee, reversed rapidly in 2008. This led to a huge fall in the Rupee. However, there are a couple of more factors which accelerated this cycle:
Vicious cycle of stock market returns and currency depreciation: The returns for global financial institutions investing in India depend on the performance of the stock market and the currency exchange rate. Let us take the case of a firm that had invested 100$ in India in early 2008 (when the currency rate was 40Rs./$). Using the 100$ they got 4,000 Rs. and let us assume that the firm invested the money in stocks. Now in 2009, with the stock market down let us assume the value of the stocks that the company owned has come down by 50%. The value of the investment now is 2,000 Rs. However, it would be wrong to say that the loss of the firm is just 50%. If the firm wants its money back, it will have to convert the Rupees into Dollars. Now, if the exchange rate is at 50Rs./$ in 2009, then the company will get only 40$ (2,000/50). Thus the ‘true return’ for the firm will not be negative 50% but will now be negative 60%. Due to the double whammy of stock market decline and depreciating Rupee, global financial institutions are pulling money out in droves. To exit India, they sell Rupees - thus increasing the supply of Rupees. This drives down the Rupee further, which leads to even worse ‘true returns’ which further causes more financial institutions to exit India. India’s stock market dropped more than the US and other developed countries in 2008. Hence financial institutions that had invested in India, started to exit, leading to this vicious cycle - which has been one of the key factors driving the fall of the Rupee.
Uncertain future: We all know that the American consumer has taken on excessive debt. In India, this role has been taken over by the government. Of the major economies, India has one of the greatest debt burden. This essentially means that the government is borrowing a lot of money to finance its huge expenses (salary hike for government service employees, loan waiver for the farmers, stimulus packages, etc.). The debt levels have risen to alarming levels, leading to a downgrade by rating agencies. Elections are round the corner, and people are predicting a hung parliament. The lack of a single party government will ensure that strong polices will not be enacted to reduce the debt burden. The hung parliament will also be an impediment to reforms (which as desperately needed at such times). To top it all, if India has a bad monsoon this year, things could get really bad. Hence companies are shying away from investing in India, thus reducing demand, and driving down the Rupee further.
Looking ahead, all these factors are not expected to reverse in a hurry. The Rupee will likely go down further, as the year goes along.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
The Indian Rupee (Part I: The Rise)
The past few years have seen a monumental see-saw in the value of the Rupee. After hovering in the 44-46Rs./$ range for a long time, the Rupee gained in value and rose more than 15% in 2006-07. Then during 2008-09 it fell from around 39Rs./$ to nearly 52Rs./$ (a fall of more than 30%)!! What led to such wild swings in the value of the Rupee, and what does the future hold?
At the heart of the matter is the fundamental rule of economics at work: demand-supply. During 2006-07 the demand for the Rupee was rising, due to a host of interrelated factors:
Global companies come to India: The world suddenly discovered that the Indian economy was growing at 8-9% every year. The huge, and growing, middle class was a big potential market. Everybody and their dog wanted to part of the ‘India story’. Companies all over the world started coming to India. Now, when a company wants to set up shop in India, they need to buy land (by paying in Rupees) pay salaries to Indian workers (in Rupees), etc. Thus all these companies started buying Rupees to fund their operations (leading to a rise in demand for Rupees).
Rise of IT and BPO: After the Y2K success, India emerged as a premier destination for IT offshoring. The Indian BPO industry also picked up steam. IT and BPO companies from all over the world started expanding rapidly in India. Again, to pay their employees, they needed Rupees (thus increasing the demand for Rupees)
Stock Market: While all this was happening, the Indian stock market was breaking one record after the other. Global financial institutions started investing in the Indian stock market (again fueling the demand for Rupees).
The huge demand for the Rupee, led to its sharp rise. As more and more companies needed Rupees, India ended up with a huge foreign exchange surplus (which at its peak was close to 300 billion Dollars).
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
At the heart of the matter is the fundamental rule of economics at work: demand-supply. During 2006-07 the demand for the Rupee was rising, due to a host of interrelated factors:
Global companies come to India: The world suddenly discovered that the Indian economy was growing at 8-9% every year. The huge, and growing, middle class was a big potential market. Everybody and their dog wanted to part of the ‘India story’. Companies all over the world started coming to India. Now, when a company wants to set up shop in India, they need to buy land (by paying in Rupees) pay salaries to Indian workers (in Rupees), etc. Thus all these companies started buying Rupees to fund their operations (leading to a rise in demand for Rupees).
Rise of IT and BPO: After the Y2K success, India emerged as a premier destination for IT offshoring. The Indian BPO industry also picked up steam. IT and BPO companies from all over the world started expanding rapidly in India. Again, to pay their employees, they needed Rupees (thus increasing the demand for Rupees)
Stock Market: While all this was happening, the Indian stock market was breaking one record after the other. Global financial institutions started investing in the Indian stock market (again fueling the demand for Rupees).
The huge demand for the Rupee, led to its sharp rise. As more and more companies needed Rupees, India ended up with a huge foreign exchange surplus (which at its peak was close to 300 billion Dollars).
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Friday, March 13, 2009
Mortgage Foreclosures: To help or not to help?
As the subprime crisis deepens in the US, more and more people are finding it difficult to make payments for their home loans (mortgages). As a result, banks are re-possessing their houses to sell them off and recover the loan amount. As many people are being forced out of their houses (foreclosure), there is increasing pressure on the US government to help these people. However, there are some side-effects to this which need to be considered.
Economic cycles are inevitable and booms are followed by bursts and vice-versa. During a burst, demand goes down. Hence prices decrease rapidly. Thus demand picks up again and this sows the seed for future growth. There is always a danger in stopping or slowing down the price decrease - as this can prolong the burst.
The US government has put pressure on banks and lending institutions to help mortgage borrowers avoid foreclosure. When this happens, banks come up with arrangements that help borrowers retain their houses for some more months. However, finally once the arrangement ends, people end up foreclosing anyway.
What the temporary arrangement ends up doing, though, is that it delays the whole process of price reduction. As people stay in houses longer than they should, they reduce supply and price reduction is hampered. For a good recovery to begin, markets have to adjust to natural equilibrium level. The US government’s efforts to keep prices artificially elevated will delay this process, prolonging the pain for the rest of the economy. When a person can buy a house and rent it out and generate a positive cash flow, houses will be reasonably priced. Till then buyers will shy away from buying.
Another side effect is future borrowers are faced with a restricted supply of houses and hence higher prices. On top of that interest rates on loans are sky-high, because banks needed to compensate for the fact that they will not be able to re-posses and sell houses for bad loans. Thus new buyers are penalized.
Given the state of the US economy there is every need to help the people impacted by the crisis. However, the US government needs to weigh the benefit of helping people who took on loans they did not deserve, versus prolonging the crisis and affecting people who had nothing to do with this in the first place.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Economic cycles are inevitable and booms are followed by bursts and vice-versa. During a burst, demand goes down. Hence prices decrease rapidly. Thus demand picks up again and this sows the seed for future growth. There is always a danger in stopping or slowing down the price decrease - as this can prolong the burst.
The US government has put pressure on banks and lending institutions to help mortgage borrowers avoid foreclosure. When this happens, banks come up with arrangements that help borrowers retain their houses for some more months. However, finally once the arrangement ends, people end up foreclosing anyway.
What the temporary arrangement ends up doing, though, is that it delays the whole process of price reduction. As people stay in houses longer than they should, they reduce supply and price reduction is hampered. For a good recovery to begin, markets have to adjust to natural equilibrium level. The US government’s efforts to keep prices artificially elevated will delay this process, prolonging the pain for the rest of the economy. When a person can buy a house and rent it out and generate a positive cash flow, houses will be reasonably priced. Till then buyers will shy away from buying.
Another side effect is future borrowers are faced with a restricted supply of houses and hence higher prices. On top of that interest rates on loans are sky-high, because banks needed to compensate for the fact that they will not be able to re-posses and sell houses for bad loans. Thus new buyers are penalized.
Given the state of the US economy there is every need to help the people impacted by the crisis. However, the US government needs to weigh the benefit of helping people who took on loans they did not deserve, versus prolonging the crisis and affecting people who had nothing to do with this in the first place.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Sunday, March 8, 2009
The curious case of VolksWagen
The global financial crisis is having strange implications across the globe. Courtesy of the crisis, VolksWagen (a car manufacturer) suddenly found itself as the most valuable company on the planet! VolksWagen (VW) is normally less than third the size of market cap leaders like ExxonMobil . However, a string of strange events shaped up to make it the most valuable company for a short time.
Since the subprime crisis erupted, the fortunes of car companies worldwide have been in decline, due to lack of consumer demand, shortage of credit, etc. Most stock traders and hedge funds were 'shorting' auto stocks. Short selling or shorting is the practice of selling a share that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the share at a lower price. Short-sellers attempt to profit from an expected decline in the price of the share. In essence, you borrow a share and sell it now, and then buy it later (to return the borrowed share) when the share price has gone down.
Hedge funds and traders had shorted the VW stock to the extent of 13%, which means they had effectively sold off 13% of the total shares (and were expecting to buy them in the future at a cheaper price).
VW was owned 43% by Porsche and 20% by Lower Saxony. One fine day Porsche announced that they had increased their stake in VW by 31% to 74%. Now this meant that only 6% (100 - 74 - 20) of the VW shares were out in the market! Hedge funds and traders were left scrambling - they had to buy 13% shares, but now only 6% were available! As demand outstripped supply, the share price went through the roof. VW’s market cap went up from $100B prior to Porsche’s announcement to $376B (easily surpassing ExxonMobil which was at $343B).
There were other effects of this phenomenal rise. VW is a component of the German share index – DAX. Now at a time when global markets were falling, DAX rose 11.3%, thanks to the ‘VW effect’. People who were shorting the DAX or fund managers who benchmarked their fund performance to the DAX were left hopping mad. There were widespread calls to boot VW out of the DAX index.
Finally Porsche managed to ‘help’ the hedge funds and traders by selling some of its shares (and making a huge profit in the bargain). Just goes to show that the global financial crisis is leading to some strange events, and some companies are making a ton of money from it!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Since the subprime crisis erupted, the fortunes of car companies worldwide have been in decline, due to lack of consumer demand, shortage of credit, etc. Most stock traders and hedge funds were 'shorting' auto stocks. Short selling or shorting is the practice of selling a share that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the share at a lower price. Short-sellers attempt to profit from an expected decline in the price of the share. In essence, you borrow a share and sell it now, and then buy it later (to return the borrowed share) when the share price has gone down.
Hedge funds and traders had shorted the VW stock to the extent of 13%, which means they had effectively sold off 13% of the total shares (and were expecting to buy them in the future at a cheaper price).
VW was owned 43% by Porsche and 20% by Lower Saxony. One fine day Porsche announced that they had increased their stake in VW by 31% to 74%. Now this meant that only 6% (100 - 74 - 20) of the VW shares were out in the market! Hedge funds and traders were left scrambling - they had to buy 13% shares, but now only 6% were available! As demand outstripped supply, the share price went through the roof. VW’s market cap went up from $100B prior to Porsche’s announcement to $376B (easily surpassing ExxonMobil which was at $343B).
There were other effects of this phenomenal rise. VW is a component of the German share index – DAX. Now at a time when global markets were falling, DAX rose 11.3%, thanks to the ‘VW effect’. People who were shorting the DAX or fund managers who benchmarked their fund performance to the DAX were left hopping mad. There were widespread calls to boot VW out of the DAX index.
Finally Porsche managed to ‘help’ the hedge funds and traders by selling some of its shares (and making a huge profit in the bargain). Just goes to show that the global financial crisis is leading to some strange events, and some companies are making a ton of money from it!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Sunday, February 15, 2009
Why bailouts are not working?
With governments all around the world announcing bailout packages totaling trillions of dollars, the questions remains - why is the global economy not recovering? The answer lies in understanding the concept of ‘velocity of money’.
Let us take a simple case in which there are only two people in a given country - Mr. A, who sells clothes and Mr. B, who sells food. Suppose Mr. A has $100 and buys food worth $100 from Mr. B every month. Mr. B then spends the $100 buying clothes from Mr. A every month. Thus the total value of transactions each month is $200. Hence the annual GDP (gross domestic product) for the country is $2,400.
As can be seen, with just $100 worth of money in the economy, the GDP can be as high as $2,400. The reason is - velocity of money - or in simple terms how fast does money flow from one person to the other. In this case the velocity of money is 24.
Now let us consider another case in which both Mr. A and B suddenly have a millions of dollars each. However, they decide to keep all their extra money in mattresses and still carry out transactions like they were doing before. Consequently the GDP for the country will still be $2,400. Even though there is millions of dollars worth of money in the economy, the GDP is still $2,400!
As can be seen, the amount of money does not really matter if it is idle. The money in the mattress is non-existent for all practical economic purposes. If people decide not to spend money, the velocity of money goes down.
This is exactly what is happening right now. Even though governments all over the world are pumping in huge amounts of money into the economy, people and companies are taking in the money and not spending it. As in the above example, the money is going into the ‘mattress’ and hence is not having any material impact on the economy.
As can be seen from the graph below, the velocity of money goes down significantly during recessions (years highlighted in grey). This is the reason why the numerous bailouts all over the world do not seem to be having any effect.
Let us take a simple case in which there are only two people in a given country - Mr. A, who sells clothes and Mr. B, who sells food. Suppose Mr. A has $100 and buys food worth $100 from Mr. B every month. Mr. B then spends the $100 buying clothes from Mr. A every month. Thus the total value of transactions each month is $200. Hence the annual GDP (gross domestic product) for the country is $2,400.
As can be seen, with just $100 worth of money in the economy, the GDP can be as high as $2,400. The reason is - velocity of money - or in simple terms how fast does money flow from one person to the other. In this case the velocity of money is 24.
Now let us consider another case in which both Mr. A and B suddenly have a millions of dollars each. However, they decide to keep all their extra money in mattresses and still carry out transactions like they were doing before. Consequently the GDP for the country will still be $2,400. Even though there is millions of dollars worth of money in the economy, the GDP is still $2,400!
As can be seen, the amount of money does not really matter if it is idle. The money in the mattress is non-existent for all practical economic purposes. If people decide not to spend money, the velocity of money goes down.
This is exactly what is happening right now. Even though governments all over the world are pumping in huge amounts of money into the economy, people and companies are taking in the money and not spending it. As in the above example, the money is going into the ‘mattress’ and hence is not having any material impact on the economy.
As can be seen from the graph below, the velocity of money goes down significantly during recessions (years highlighted in grey). This is the reason why the numerous bailouts all over the world do not seem to be having any effect.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Saturday, February 14, 2009
Saving is bad for the economy!
We have all been taught the virtues of saving money. Indian children are routinely reminded by their parents about spending less and saving more and schools teach stories extolling the virtues of thrift. In times of global economic crisis, most Indians, willingly or unwillingly, have started doing this. However, the impact of this on the Indian economy could be devastating indeed.
The basic reason is that – what is right for an individual may not be right for the economy as a whole. In difficult economic times, individuals are worried about their jobs and hence cut down on spending and start saving more. This is indeed good for the individual as it gives him a buffer in case he actually loses his job. However, imagine a scenario in which all individuals start saving more and spending less!
Less spending will lead to less purchase of goods and services. Hence factories will cut down on production and / or lay off workers. This will lead to further fall in demand leading to further layoffs. Eventually this vicious cycle will lead to deflation .
Hence, if everyone starts saving more, the economy will most certainly go down the drain. So what is the Indian government doing to induce people to save less and spend more? Typically governments have three major tools in their armory:
Reduce Interest rates: If interest rates on bank deposits fall, savers have less incentive to save. Also individuals will get cheaper loans to buy cars and houses. Companies will also find it easier to raise capital to build more factories.
Reduce Tax: Reducing tax on goods and services makes them cheaper, hence people buy more. Also reducing income tax means people have more money to spend. Alternatively, increasing salaries of government employees can have the same effect.
Increasing Government expenditure: Building new roads, bridges, upgrading ports, etc. can result in a huge increase in employment, leading to an increased spending.
India’s phenomenal growth in the last 5-6 years has been driven by a 300 million strong middle class, which was out on a spending spree. Now, with the middle class feeling the pinch of the economic crisis, they are starting to save more and cut back on their spending. The Indian government has already reduced interest rates, cut taxes selectively, and increased salaries to government employees. However, the results have been far from encouraging. The government will have to act forcefully and decisively before things start getting worse.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
The basic reason is that – what is right for an individual may not be right for the economy as a whole. In difficult economic times, individuals are worried about their jobs and hence cut down on spending and start saving more. This is indeed good for the individual as it gives him a buffer in case he actually loses his job. However, imagine a scenario in which all individuals start saving more and spending less!
Less spending will lead to less purchase of goods and services. Hence factories will cut down on production and / or lay off workers. This will lead to further fall in demand leading to further layoffs. Eventually this vicious cycle will lead to deflation .
Hence, if everyone starts saving more, the economy will most certainly go down the drain. So what is the Indian government doing to induce people to save less and spend more? Typically governments have three major tools in their armory:
Reduce Interest rates: If interest rates on bank deposits fall, savers have less incentive to save. Also individuals will get cheaper loans to buy cars and houses. Companies will also find it easier to raise capital to build more factories.
Reduce Tax: Reducing tax on goods and services makes them cheaper, hence people buy more. Also reducing income tax means people have more money to spend. Alternatively, increasing salaries of government employees can have the same effect.
Increasing Government expenditure: Building new roads, bridges, upgrading ports, etc. can result in a huge increase in employment, leading to an increased spending.
India’s phenomenal growth in the last 5-6 years has been driven by a 300 million strong middle class, which was out on a spending spree. Now, with the middle class feeling the pinch of the economic crisis, they are starting to save more and cut back on their spending. The Indian government has already reduced interest rates, cut taxes selectively, and increased salaries to government employees. However, the results have been far from encouraging. The government will have to act forcefully and decisively before things start getting worse.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Friday, January 23, 2009
Good time to buy stocks???
Ever since the markets fell a few months ago, experts have been advising people that it is a good time to buy stocks with a long term horizon. But should we really buy stocks, and what exactly is ‘long term horizon’?
The current economic downturn is the worst since the great depression. The current market crash has been pretty similar to the ‘Great Crash of 1929’ which led to the great depression. In both the cases stocks fell almost 50% within a very short period of time. A look at the Dow Jones Industrial Average (stock market index for the US) shows a pretty similar pattern in both cases.
July, 1929 - December, 1929
July, 2008 - December, 2008
However, what is not common knowledge is that the ‘Great Crash of 1929’ was just the beginning. The 50% fall is stocks looks like a tiny fall, compared to what happened after that. The markets recovered briefly after the great crash, but thereafter they kept going down for a long time. Eventually, the market lost close to 90% of its value!
July, 1929 - August, 1932
The two major reasons for the fall were the collapse of global trade (due to the Hawley-Smoot Tariff bill) and deflation. While there is a remote possibility of a global trade war happening today, there is a very real danger of deflation. If it happens, the stocks could head lower than the levels we have seen in 2008.
After the great crash of 1929, experts may have told the people - it is a good time to buy stocks with a ‘long term horizon’. However, people who would have taken that advice would have had to wait for a quarter of a century just to break even!!!
July, 1929 - May, 1955
The current economic downturn is the worst since the great depression. The current market crash has been pretty similar to the ‘Great Crash of 1929’ which led to the great depression. In both the cases stocks fell almost 50% within a very short period of time. A look at the Dow Jones Industrial Average (stock market index for the US) shows a pretty similar pattern in both cases.
July, 1929 - December, 1929
July, 2008 - December, 2008
However, what is not common knowledge is that the ‘Great Crash of 1929’ was just the beginning. The 50% fall is stocks looks like a tiny fall, compared to what happened after that. The markets recovered briefly after the great crash, but thereafter they kept going down for a long time. Eventually, the market lost close to 90% of its value!
July, 1929 - August, 1932
The two major reasons for the fall were the collapse of global trade (due to the Hawley-Smoot Tariff bill) and deflation. While there is a remote possibility of a global trade war happening today, there is a very real danger of deflation. If it happens, the stocks could head lower than the levels we have seen in 2008.
After the great crash of 1929, experts may have told the people - it is a good time to buy stocks with a ‘long term horizon’. However, people who would have taken that advice would have had to wait for a quarter of a century just to break even!!!
July, 1929 - May, 1955
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Sunday, January 18, 2009
Buy Indian only???
With the global economic crisis worsening, there have been mails / posts about how Indians can help their country by buying Indian goods. The argument is that if Indians buy only Indian goods and boycott foreign goods and brands, India will be able to save a lot of foreign exchange. But will reducing the consumption of foreign goods actually help India? Let us see what history tells us...
In the 1910s and 1920s, global production capacity was increasing at a phenomenal rate, due to widespread use of mass production and huge efficiency gains brought on by the use of farm tractors in agriculture. The US was fearful that products and foodgrains from other countries will flood the US market and lead to job losses in US industries and farms. With the intention of protecting the US farmers and industries, the US government passed a law called the Smooth-Hawley Tariff Act.
Smooth-Hawley Tariff Act: The Act raised US tariffs on over 20,000 imported goods to record levels. It imposed an effective tax rate of 60% on more than 3,200 products and materials imported into the US, almost quadrupling previous tariff rates. In essence, it made imports of many products into the US uncompetitive.
Global reaction: Following the act, there was a huge global outrage, and countries all over the world took steps to counter this. Canada preemptively imposed new tariffs on 16 products that altogether accounted for around 30% of U.S. exports to Canada. Other countries in Europe and elsewhere also raised tariffs or banned US goods altogether.
Result: U.S. imports from Europe declined from a 1929 high of $1,334 million to just $390 million in 1932, while U.S. exports to Europe fell from $2,341 million in 1929 to $784 million in 1932. Overall, world trade declined by around 66% between 1929 and 1934. Unemployment which was at 7.8% in 1930, jumped to 16.3% in 1931, 24.9% in 1932, and 25.1% in 1933.
In the 1910s and 1920s, global production capacity was increasing at a phenomenal rate, due to widespread use of mass production and huge efficiency gains brought on by the use of farm tractors in agriculture. The US was fearful that products and foodgrains from other countries will flood the US market and lead to job losses in US industries and farms. With the intention of protecting the US farmers and industries, the US government passed a law called the Smooth-Hawley Tariff Act.
Smooth-Hawley Tariff Act: The Act raised US tariffs on over 20,000 imported goods to record levels. It imposed an effective tax rate of 60% on more than 3,200 products and materials imported into the US, almost quadrupling previous tariff rates. In essence, it made imports of many products into the US uncompetitive.
Global reaction: Following the act, there was a huge global outrage, and countries all over the world took steps to counter this. Canada preemptively imposed new tariffs on 16 products that altogether accounted for around 30% of U.S. exports to Canada. Other countries in Europe and elsewhere also raised tariffs or banned US goods altogether.
Result: U.S. imports from Europe declined from a 1929 high of $1,334 million to just $390 million in 1932, while U.S. exports to Europe fell from $2,341 million in 1929 to $784 million in 1932. Overall, world trade declined by around 66% between 1929 and 1934. Unemployment which was at 7.8% in 1930, jumped to 16.3% in 1931, 24.9% in 1932, and 25.1% in 1933.
Although the act was passed after the stock-market crash of 1929, some economic historians consider the political discussion leading up to the passing of the act a factor in causing the crash, the recession that began in late 1929, and its eventual passage a factor in deepening the Great Depression.
As can be seen, banning imports or raising tariffs can cause similar reactions from other countries, leading to a reduction in overall trade. In such a case everyone is worse off. Hence banning foreign products and using only Indian products may not be such a good idea.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Tuesday, January 13, 2009
India’s 7% growth rate?
Even though the International Monetary Fund (IMF) is predicting a global recession in 2009, India’s growth rate is expected to be at 7% . In a world where most economies will shrink or grow marginally, 7% is a stunning growth rate. However, is this a realistic prediction? There are a host of factors that could derail India’s growth in 2009.
Consumers: The biggest risk to India’s growth comes from the consumers! The Indian consumers, till a couple of decades back, primarily believed in saving money and living within their means. But as the Indian economy opened up, the Indian consumer started spending more. Consequently the economy benefited. Credit card off-take increased, malls and multiplexes came up everywhere, and spending began in right earnest. Just when it seemed like this would never end, the global economic crisis began. This has led to a fear of job losses and uncertainly, leading to a fall in consumer demand.
Housing: A house is the single biggest purchase for most middle class Indians. Housing also drives a host of other industries and products like, paints, consumer durables, furniture, etc. Also, when the house price goes up, people ‘feel’ rich and end up spending more. With many houses bought in 2007 and 2008 now quoting below their purchase price, consumers in India are learning the hard way that property prices can actually go down!
The key reason why India was supposed to do well, despite the global gloom, was that the Indian economy is driven by internal consumption. But the biggest risk now is that the Indian consumer, who had just started to spend, may cut back on spending and start to save more. If this continues for a long period of time, it could potentially lead to deflation .
Businesses: Many Indian businesses have also been guilty of borrowing heavily when the times were good, and are clearly under-prepared for this downturn.
Government: The government has been slow to react to the global financial crisis. Till some time back the government was still fighting inflation, by keeping interest rates high, when there was a clear case to reduce rates to boost growth. The two stimulus packages were too little too late to help the economy in any meaningful way.
Elections and Monsoon: The two jokers in the pack are elections and monsoon. A government with Left’s support or an inadequate monsoon could be the last thing the Indian economy needs in 2009.
Given all these factors, it will be very difficult for India to maintain a 7% growth rate in 2009. The growth rate could actually go down to as low as 4%-5% over the next few quarters. Lets hope the Indian consumer keeps spending...
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Consumers: The biggest risk to India’s growth comes from the consumers! The Indian consumers, till a couple of decades back, primarily believed in saving money and living within their means. But as the Indian economy opened up, the Indian consumer started spending more. Consequently the economy benefited. Credit card off-take increased, malls and multiplexes came up everywhere, and spending began in right earnest. Just when it seemed like this would never end, the global economic crisis began. This has led to a fear of job losses and uncertainly, leading to a fall in consumer demand.
Housing: A house is the single biggest purchase for most middle class Indians. Housing also drives a host of other industries and products like, paints, consumer durables, furniture, etc. Also, when the house price goes up, people ‘feel’ rich and end up spending more. With many houses bought in 2007 and 2008 now quoting below their purchase price, consumers in India are learning the hard way that property prices can actually go down!
The key reason why India was supposed to do well, despite the global gloom, was that the Indian economy is driven by internal consumption. But the biggest risk now is that the Indian consumer, who had just started to spend, may cut back on spending and start to save more. If this continues for a long period of time, it could potentially lead to deflation .
Businesses: Many Indian businesses have also been guilty of borrowing heavily when the times were good, and are clearly under-prepared for this downturn.
Government: The government has been slow to react to the global financial crisis. Till some time back the government was still fighting inflation, by keeping interest rates high, when there was a clear case to reduce rates to boost growth. The two stimulus packages were too little too late to help the economy in any meaningful way.
Elections and Monsoon: The two jokers in the pack are elections and monsoon. A government with Left’s support or an inadequate monsoon could be the last thing the Indian economy needs in 2009.
Given all these factors, it will be very difficult for India to maintain a 7% growth rate in 2009. The growth rate could actually go down to as low as 4%-5% over the next few quarters. Lets hope the Indian consumer keeps spending...
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Saturday, January 10, 2009
Low oil price bad for the economy?
For all of us who fill in our vehicles at the petrol pumps, the recent drop in oil prices is a welcome relief. However, looking at the macro picture, the recent drop in global oil prices (from the highs of around $150 per barrel last year to the current price of $40) may turn out to be a bad thing. Lets see how...
The soaring price of oil in the initial part of 2008, had lead to a spike in the cost of petrol, diesel, etc. It also led to an increase in the cost of virtually everything (all goods have to be transported, and an increase in oil price increases this cost). This obviously hurts the consumers, and since consumers are also voters, governments all over the world started thinking about tackling the oil crisis.
The focus was largely on two things:
Alternatives : Governments seriously started thinking about ways to reduce dependence on oil. This led to an increase in investment into alternatives like wind energy, solar energy, etc. The cost of alternatives was historically higher than oil, however with oil hitting $150, the alternatives suddenly started looking cheap!
New oil exploration : There are huge unexplored oil reserves in non-traditional places like the oil sands of Canada , oil shale in Western US , and deep water oil . At $150 a barrel, companies started exploring these options, as the price of oil was more than the cost of production from these non-traditional places.
Now at $40 a barrel, experts believe that oil has gone below the marginal cost of production! Governments and companies have suddenly shifted their focus away from alternatives and new oil exploration. On an average the marginal cost of production is around $65. It simply doesn’t make sense to invest millions of dollars at drilling new wells when oil futures are selling for $40 or $50. French oil company Total’s CEO recently warned that at $60 oil, a lot of new projects would be delayed.
China currently uses 8 million barrels of oil per day, as against 3.5 million in 1997. China consumes 2 barrels per person, versus 24 barrels per person in the US. The US has 220 million cars for 305 million people, versus 32 million cars for 1.3 billion people in China. There are a host of other countries where the standard of living is rising. Thus; demand for oil will continue to grow in the future.
Adding new oil supply can take decades due to the nature of oil exploration and extraction business. By taking the focus away from alternatives and new oil exploration governments and companies are taking a decidedly short term view. Once the global economy gets on track and the pent-up demand catches up, people will suddenly realize that there is limited supply. This will lead to an oil-shock that will make $150 seem like a bargain! Till then, lets all hope, governments and companies continue to invest and explore more alternatives.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
The soaring price of oil in the initial part of 2008, had lead to a spike in the cost of petrol, diesel, etc. It also led to an increase in the cost of virtually everything (all goods have to be transported, and an increase in oil price increases this cost). This obviously hurts the consumers, and since consumers are also voters, governments all over the world started thinking about tackling the oil crisis.
The focus was largely on two things:
Alternatives : Governments seriously started thinking about ways to reduce dependence on oil. This led to an increase in investment into alternatives like wind energy, solar energy, etc. The cost of alternatives was historically higher than oil, however with oil hitting $150, the alternatives suddenly started looking cheap!
New oil exploration : There are huge unexplored oil reserves in non-traditional places like the oil sands of Canada , oil shale in Western US , and deep water oil . At $150 a barrel, companies started exploring these options, as the price of oil was more than the cost of production from these non-traditional places.
Now at $40 a barrel, experts believe that oil has gone below the marginal cost of production! Governments and companies have suddenly shifted their focus away from alternatives and new oil exploration. On an average the marginal cost of production is around $65. It simply doesn’t make sense to invest millions of dollars at drilling new wells when oil futures are selling for $40 or $50. French oil company Total’s CEO recently warned that at $60 oil, a lot of new projects would be delayed.
China currently uses 8 million barrels of oil per day, as against 3.5 million in 1997. China consumes 2 barrels per person, versus 24 barrels per person in the US. The US has 220 million cars for 305 million people, versus 32 million cars for 1.3 billion people in China. There are a host of other countries where the standard of living is rising. Thus; demand for oil will continue to grow in the future.
Adding new oil supply can take decades due to the nature of oil exploration and extraction business. By taking the focus away from alternatives and new oil exploration governments and companies are taking a decidedly short term view. Once the global economy gets on track and the pent-up demand catches up, people will suddenly realize that there is limited supply. This will lead to an oil-shock that will make $150 seem like a bargain! Till then, lets all hope, governments and companies continue to invest and explore more alternatives.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Thursday, January 8, 2009
Is the US government really doing the right thing?
The US government has been praised for the way it has reacted to the current financial crisis. The US government has acted quickly on both monetary (reducing interest rates) and fiscal (providing stimulus packages and tax rebates) fronts. However the basic question remains, is the US government really doing the right thing?
Consider the analogy of a person who falls ill. The doctor can give the patient a medicine which takes a week to take effect and will cure the person completely. Thus the patient will slowly get better in a week. Alternatively, the doctor can give the patient steroids, which will make him feel better within a day, however it will only suppress the disease. The person, in this case, feels better in a day, goes to work the next day and is generally happy. Till after a couple of months - the disease comes back with renewed force...
Let us look back at what happened in the US in 2000-2001. Events like the dot com burst and 9/11 raised the possibility of a US economic recession. The response of the US Federal Reserve (or the Fed) was to reduced interest rates drastically (from 6.5% to 1%), in its bid to spur the economy. This acted like a steroid and sure enough the economy picked up.
However, the question remained – did the Fed cut interest rates too low? Should it have let the economy go through a slow recovery rather than try to artificially stimulate it? To deal with the dot com bubble, had the Fed sown seeds for a bigger mortgage bubble?
As with the patient example, the economy has now tanked even more badly after 5 years. In order to prevent a minor downturn then, the Fed has inadvertently led the country to a major downturn.
An economic downturn is not necessarily bad. It is one half of the overall economic cycle of boom and burst. A downturn in the US would lead to the demise of old, uncompetitive companies so that new, competitive companies can take hold. By bailing out these companies (for example the big 3 in automobiles) the US government is trying to keep alive uncompetitive, value destroying companies. A downturn also leads to stability in prices and acts as a balance for the inflation during a boom period. The current downturn is actually helping genuine buyers find homes, after the steep correction in house prices. A downturn also leads to a drop in currency which should help boosts exports and correct the balance of trade crisis – which the US so desperately needs. However if a downturn is not allowed to run its course, it can have nasty consequences.
The Fed response to the current downturn has been the same as 2002 – if anything, much swifter. It has rapidly reduced interest rated from 5.25% to almost zero. It has also used big fiscal measures like the income tax rebate program and stimulus package. Again the Fed is using the equivalent of steroids – lots of it. In doing so, it is doing exactly what it did last time – only on a much larger scale. The result may be the same. In order to prevent a huge crisis today, the Fed is sowing seeds of a catastrophic crisis in 2015...
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Consider the analogy of a person who falls ill. The doctor can give the patient a medicine which takes a week to take effect and will cure the person completely. Thus the patient will slowly get better in a week. Alternatively, the doctor can give the patient steroids, which will make him feel better within a day, however it will only suppress the disease. The person, in this case, feels better in a day, goes to work the next day and is generally happy. Till after a couple of months - the disease comes back with renewed force...
Let us look back at what happened in the US in 2000-2001. Events like the dot com burst and 9/11 raised the possibility of a US economic recession. The response of the US Federal Reserve (or the Fed) was to reduced interest rates drastically (from 6.5% to 1%), in its bid to spur the economy. This acted like a steroid and sure enough the economy picked up.
However, the question remained – did the Fed cut interest rates too low? Should it have let the economy go through a slow recovery rather than try to artificially stimulate it? To deal with the dot com bubble, had the Fed sown seeds for a bigger mortgage bubble?
As with the patient example, the economy has now tanked even more badly after 5 years. In order to prevent a minor downturn then, the Fed has inadvertently led the country to a major downturn.
An economic downturn is not necessarily bad. It is one half of the overall economic cycle of boom and burst. A downturn in the US would lead to the demise of old, uncompetitive companies so that new, competitive companies can take hold. By bailing out these companies (for example the big 3 in automobiles) the US government is trying to keep alive uncompetitive, value destroying companies. A downturn also leads to stability in prices and acts as a balance for the inflation during a boom period. The current downturn is actually helping genuine buyers find homes, after the steep correction in house prices. A downturn also leads to a drop in currency which should help boosts exports and correct the balance of trade crisis – which the US so desperately needs. However if a downturn is not allowed to run its course, it can have nasty consequences.
The Fed response to the current downturn has been the same as 2002 – if anything, much swifter. It has rapidly reduced interest rated from 5.25% to almost zero. It has also used big fiscal measures like the income tax rebate program and stimulus package. Again the Fed is using the equivalent of steroids – lots of it. In doing so, it is doing exactly what it did last time – only on a much larger scale. The result may be the same. In order to prevent a huge crisis today, the Fed is sowing seeds of a catastrophic crisis in 2015...
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Great Indian Businesses?
A lot has been said and written about the Indian businesses - how they were growing at a scorching pace, how they were making global acquisitions, etc. However, for all the hype surrounding the Indian businesses, the fact still remains that they had a plethora of factors going for them until some time ago:
- Huge liquidity in the global financial system
- Increasing Foreign Direct Investment (FDI) in India
- Booming economy
- Prevalence of the decoupling theory
Now with most of these factors gone or reversed, the Indian businesses leaders and their business models are being severely tested:
Tata Motors: The acquisition of a luxury brand like Jaguar while the global economy was facing a threat of recession was a questionable move. On top of that, the acquisition was done by borrowing a lot of money. The stock-holders of Tata Motors have paid a heavy price for that mistake. There are talks Jaguar and Land Rower now being bailed out by the UK government.
DLF: That the DLF stock tanked was not a surprise. However, the move on part of DLF to buy back shares definitely was. The company was losing cash on its core operations. The company was sustaining its operations though IPO money raised a year ago, fresh borrowing, and raising capital by selling equity in various special purpose vehicles. This made a strong case for cash conservation. However, the DLF management it seems was more interested in making sure that their share price remained high – and was not too worried that their operations were in a bad shape. The buy-back done with the sole intention to raise the share price was an ill timed and unwise move.
Reliance Power: The Reliance Power IPO marked the zenith of business optimism and absurd valuations. No surprise that with the economy going downhill, the stock went substantially below its IPO price.
Satyam: As if the failed Maytas acquisition was not bad enough, the financial fraud by Raju has now severely exposed the vulnerability of Indian businesses in this downturn!
To be fair, over the last two decades India has produced some very good businesses, a case in point being Bharti (Airtel) which has been a very innovative business generating tremendous value for its shareholders. However the sad fact remains that like the Indian stock market, the Indian businesses also benefited a lot by the tremendous liquidity of the past few years. The great investor Warren Buffet once stated, "Only when the tide goes out do you discover whose been swimming naked". Now that conditions have become much more challenging globally, we will find out which Indian businesses have good sustainable business models.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
- Huge liquidity in the global financial system
- Increasing Foreign Direct Investment (FDI) in India
- Booming economy
- Prevalence of the decoupling theory
Now with most of these factors gone or reversed, the Indian businesses leaders and their business models are being severely tested:
Tata Motors: The acquisition of a luxury brand like Jaguar while the global economy was facing a threat of recession was a questionable move. On top of that, the acquisition was done by borrowing a lot of money. The stock-holders of Tata Motors have paid a heavy price for that mistake. There are talks Jaguar and Land Rower now being bailed out by the UK government.
DLF: That the DLF stock tanked was not a surprise. However, the move on part of DLF to buy back shares definitely was. The company was losing cash on its core operations. The company was sustaining its operations though IPO money raised a year ago, fresh borrowing, and raising capital by selling equity in various special purpose vehicles. This made a strong case for cash conservation. However, the DLF management it seems was more interested in making sure that their share price remained high – and was not too worried that their operations were in a bad shape. The buy-back done with the sole intention to raise the share price was an ill timed and unwise move.
Reliance Power: The Reliance Power IPO marked the zenith of business optimism and absurd valuations. No surprise that with the economy going downhill, the stock went substantially below its IPO price.
Satyam: As if the failed Maytas acquisition was not bad enough, the financial fraud by Raju has now severely exposed the vulnerability of Indian businesses in this downturn!
To be fair, over the last two decades India has produced some very good businesses, a case in point being Bharti (Airtel) which has been a very innovative business generating tremendous value for its shareholders. However the sad fact remains that like the Indian stock market, the Indian businesses also benefited a lot by the tremendous liquidity of the past few years. The great investor Warren Buffet once stated, "Only when the tide goes out do you discover whose been swimming naked". Now that conditions have become much more challenging globally, we will find out which Indian businesses have good sustainable business models.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Is Deflation a possibility in India?
Indian people are all too familiar with rising prices. Over the past few years, inflation had been steadily climbing upwards making almost everything expensive. It’s a relief to see inflation begin to cool off recently. But that raises a question - is deflation a possibility for India?
Deflation is the opposite of inflation. During inflation prices go up. During deflation prices come down. Things start becoming cheaper! Now this may sound very good, but economists try to avoid deflation like plague. There are very good reasons too. Consider a classic deflation scenario, in which prices are coming down:
Customers postpone purchase: Customers tend to postpone further purchases - especially big ticket purchases, apart from basic necessities (a good example of this is the real estate sector in India - most customers are waiting for prices to fall further).
Aggregate demand falls: As more and more customers postpone purchases, the aggregate demand goes down. When this happens, two things happen simultaneously: Price cuts and Production cuts.
Prices cuts: Some producers reduce prices to spur demand. As producers reduce prices, it reinforces the customer mentality that prices will go down further. Thus they postpone purchase further!
Production cuts: Some producers start cutting down on production. As producers cut down production, it results in layoffs or pay cuts. Both scenarios lead to a fall in aggregate demand.
Cycle repeats: As aggregate demand falls further, producers again respond in the two ways above... and thus a vicious cycle starts.
As expected, the fallout of deflation is that economic activity slows down, unemployment increases, and stock markets languish. History has shown that once deflation has set in, it is very difficult to reverse . A classic example is Japan , whose economy has been severely hit by deflation in the recent past.
So, is deflation a threat to the Indian economy? The Indian economy is already seeing deflationary pressures in some sectors (like real estate and to an extent automobile). A full-fledged economic deflation, though, is a remote possibility. However, if the global financial crisis drags on for another six months, then the Indian economy will face a very real threat of deflation. Let us hope things don’t come to that!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Deflation is the opposite of inflation. During inflation prices go up. During deflation prices come down. Things start becoming cheaper! Now this may sound very good, but economists try to avoid deflation like plague. There are very good reasons too. Consider a classic deflation scenario, in which prices are coming down:
Customers postpone purchase: Customers tend to postpone further purchases - especially big ticket purchases, apart from basic necessities (a good example of this is the real estate sector in India - most customers are waiting for prices to fall further).
Aggregate demand falls: As more and more customers postpone purchases, the aggregate demand goes down. When this happens, two things happen simultaneously: Price cuts and Production cuts.
Prices cuts: Some producers reduce prices to spur demand. As producers reduce prices, it reinforces the customer mentality that prices will go down further. Thus they postpone purchase further!
Production cuts: Some producers start cutting down on production. As producers cut down production, it results in layoffs or pay cuts. Both scenarios lead to a fall in aggregate demand.
Cycle repeats: As aggregate demand falls further, producers again respond in the two ways above... and thus a vicious cycle starts.
As expected, the fallout of deflation is that economic activity slows down, unemployment increases, and stock markets languish. History has shown that once deflation has set in, it is very difficult to reverse . A classic example is Japan , whose economy has been severely hit by deflation in the recent past.
So, is deflation a threat to the Indian economy? The Indian economy is already seeing deflationary pressures in some sectors (like real estate and to an extent automobile). A full-fledged economic deflation, though, is a remote possibility. However, if the global financial crisis drags on for another six months, then the Indian economy will face a very real threat of deflation. Let us hope things don’t come to that!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Wednesday, January 7, 2009
Is Capitalism really to be blamed for the Subprime Crisis?
Not a day passes by when we do not read or hear about the failures of capitalism in the US and how it led to the subprime crisis (which in turn went on to become a global financial crisis). But is capitalism really to be blamed? Or was it poor political intervention that led to all this? Lets see:
Historically it was observed in the US that low-income people and minorities were not granted sufficient home loans (mortgages) due to their poor ability to repay those loans. However repeated policy interventions over the years have altered this, leading to dangerous consequences.
Intervention # 1: The government decided to enact the Community Reinvestment Act (CRA) in 1977, which basically forced the banks and other regulated mortgage lenders to lend more to the low income and minority mortgage applicants. As it did not make a lot of economic sense lending to the poor, banks complied reluctantly to avoid regulatory scrutiny. Hence mortgages to the poor (subprime mortgages) remained a small portion of the overall mortgage market and did not pose a systemic risk.
Intervention # 2: To counter this, in 1992, the Department of Housing and Urban Development set targets for Fannie Mae and Freddie Mac to purchase low-income loans for sale into the secondary market. With Government Sponsored Enterprises (GSE) like Fannie and Freddie ready to buy up their subprime loans, banks started lending out enthusiastically.
Intervention # 3: As if this was not enough, an amendment to the CRA was passed in 1995 - permitting securitization of these loans. This changed everything. Securitization basically meant that these subprime loans could be bundled together with virtually anything and sold off to other investors. From the late 1990s into 2005, the subprime share of mortgage lending exploded from about 5-6% to over 20%.
This was all good till home prices were going up and interest rates were low. But once both these things reversed in 2007, people started defaulting on subprime mortgages and with subprime mortgages now being a big part of the overall mortgage market, this posed a systemic risk to the whole economy.
In a capitalist system it is difficult to see how mortgages would be given to people who cannot afford them. However, combine capitalism with political intervention and you have the perfect ingredients for a crisis. As the famous economist Milton Friedman said - just about every economic and social ill that confronts the US could be traced to misguided federal policies and their unintended consequences.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Historically it was observed in the US that low-income people and minorities were not granted sufficient home loans (mortgages) due to their poor ability to repay those loans. However repeated policy interventions over the years have altered this, leading to dangerous consequences.
Intervention # 1: The government decided to enact the Community Reinvestment Act (CRA) in 1977, which basically forced the banks and other regulated mortgage lenders to lend more to the low income and minority mortgage applicants. As it did not make a lot of economic sense lending to the poor, banks complied reluctantly to avoid regulatory scrutiny. Hence mortgages to the poor (subprime mortgages) remained a small portion of the overall mortgage market and did not pose a systemic risk.
Intervention # 2: To counter this, in 1992, the Department of Housing and Urban Development set targets for Fannie Mae and Freddie Mac to purchase low-income loans for sale into the secondary market. With Government Sponsored Enterprises (GSE) like Fannie and Freddie ready to buy up their subprime loans, banks started lending out enthusiastically.
Intervention # 3: As if this was not enough, an amendment to the CRA was passed in 1995 - permitting securitization of these loans. This changed everything. Securitization basically meant that these subprime loans could be bundled together with virtually anything and sold off to other investors. From the late 1990s into 2005, the subprime share of mortgage lending exploded from about 5-6% to over 20%.
This was all good till home prices were going up and interest rates were low. But once both these things reversed in 2007, people started defaulting on subprime mortgages and with subprime mortgages now being a big part of the overall mortgage market, this posed a systemic risk to the whole economy.
In a capitalist system it is difficult to see how mortgages would be given to people who cannot afford them. However, combine capitalism with political intervention and you have the perfect ingredients for a crisis. As the famous economist Milton Friedman said - just about every economic and social ill that confronts the US could be traced to misguided federal policies and their unintended consequences.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Exemplary regulation in India!
Talk of regulation in India, and people generally think of red-tape and outdated rules. However, in recent times there has been an instance of exemplary regulation in India that should serve as a good example for the other countries of the world to emulate.
The regulator for the Indian banking system is the Reserve Bank of India ( RBI ). Dr. Y. V. Reddy was the governor of RBI from 2003 to 2008. Regulators can detect the building up of bubbles in the economy and make sure they are dealt with early on. Or they can provide support to the economy once the bubble has burst. Most regulators globally have been very good with the second aspect. However, in India’s case the regulator correctly detected a build up of the housing bubble and took corrective action, thus making sure the second stage wasn’t necessary.
By 2006-07 the Indian housing market (like the Indian stock market) was going through the roof. Dr. Reddy and the RBI detected the housing bubble early on and used a slew of policy measures to control it:
Banned the use of bank loans for the purchase of raw land: Land prices were going through the roof and if prices collapsed, banks would then end up with huge non performing assets. Hence RBI stopped banks from making these loans.
Increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of reserve capital: Banks were made to put aside extra capital for every loan made. Anticipating a liquidity crisis, the RBI was mandating banks to plan for it ahead of time.
Severely limited securitization: Banks in India were not allowed to simply bundle up their home loans and sell them off to a third party. Thus, banks ended up holding onto the loans they made to customers. Banks, in this case, had a high incentive to make sure the loans were repaid. Hence the lending standards were not relaxed to absurd levels and also the down-payment requirements were conservative.
Pushed interest rates up: Last but not the least, the RBI pushed key interest rates up early on to prick the housing bubble before it could get out of control.
The housing market did crash in 2008; however, thanks to the early actions of the banking regulator, the Indian banks did not have to write down huge amounts of money. Neither did any Indian bank fail, or require the kind of emergency injections of capital that Western banks have needed. What a huge difference good regulation can make!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
The regulator for the Indian banking system is the Reserve Bank of India ( RBI ). Dr. Y. V. Reddy was the governor of RBI from 2003 to 2008. Regulators can detect the building up of bubbles in the economy and make sure they are dealt with early on. Or they can provide support to the economy once the bubble has burst. Most regulators globally have been very good with the second aspect. However, in India’s case the regulator correctly detected a build up of the housing bubble and took corrective action, thus making sure the second stage wasn’t necessary.
By 2006-07 the Indian housing market (like the Indian stock market) was going through the roof. Dr. Reddy and the RBI detected the housing bubble early on and used a slew of policy measures to control it:
Banned the use of bank loans for the purchase of raw land: Land prices were going through the roof and if prices collapsed, banks would then end up with huge non performing assets. Hence RBI stopped banks from making these loans.
Increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of reserve capital: Banks were made to put aside extra capital for every loan made. Anticipating a liquidity crisis, the RBI was mandating banks to plan for it ahead of time.
Severely limited securitization: Banks in India were not allowed to simply bundle up their home loans and sell them off to a third party. Thus, banks ended up holding onto the loans they made to customers. Banks, in this case, had a high incentive to make sure the loans were repaid. Hence the lending standards were not relaxed to absurd levels and also the down-payment requirements were conservative.
Pushed interest rates up: Last but not the least, the RBI pushed key interest rates up early on to prick the housing bubble before it could get out of control.
The housing market did crash in 2008; however, thanks to the early actions of the banking regulator, the Indian banks did not have to write down huge amounts of money. Neither did any Indian bank fail, or require the kind of emergency injections of capital that Western banks have needed. What a huge difference good regulation can make!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Advantage US?
There is a lot of talk about how the US economy is in a bad shape. Many big corporations have been bailed out by the government or have got government funding. The US investment banking business has been badly hit and now the big-3 carmakers are facing the heat. The economy is in a recession and unemployment is rising. The trade deficit is ballooning. Some people are even predicting the end of US economic dominance.
However, given all the bad news, there is one fact that is firmly favoring the US – the US dollar.
The global financial crisis has caused a massive liquidity crunch (shortage of money) and there is a real threat of deflation (deflation is the opposite of inflation – i.e. prices going down, although this may sound good; deflation is in reality very bad). The way to address both these issues is to pump liquidity in the economy, or in other words to print and distribute more money. Ben Bernake, the Federal Reserve Chairman is nicknamed ‘Helicopter Ben’ because he had once said that the way to deal with deflation would be to simply print money and drop it from a helicopter.
Normally when a country increases money supply, the value of the country’s currency goes down. If any other country printed money at the rate at which US is doing, other countries will sell the currency in haste. This will lead to a dramatic fall in the country’s currency and effectively ruin its economy.
So how will the US be able to print more money and get away with it? The dollar happens to be the global reserve currency. At the end of 2007, more than 60% of the identified official foreign exchange reserves in the world were held in US dollars. China has it $2 Trillion of foreign exchange reserves and any significant drop in dollar will lead to a huge erosion of wealth for China. Similarly for Japan’s $1 trillion reserves and India’s $250 million. Oil is traded primarily in dollars, and a fall is dollars, will effectively lead to skyrocketing of oil prices and another oil-shock like 1973.
Thus the entire world has a vested interest in making sure that the dollar does not lose value. Hence even though the US keeps printing dollars, the value of the dollar does not go down.
All this is not to say that US can go on printing money forever. Eventually, there could be an alternate global currency that could replace the dollar - maybe the Euro or the Yen. How soon that happens is anyone's guess. But till then US will be the only country in the world that will not have to worry about printing more money to deal with the financial crisis.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
However, given all the bad news, there is one fact that is firmly favoring the US – the US dollar.
The global financial crisis has caused a massive liquidity crunch (shortage of money) and there is a real threat of deflation (deflation is the opposite of inflation – i.e. prices going down, although this may sound good; deflation is in reality very bad). The way to address both these issues is to pump liquidity in the economy, or in other words to print and distribute more money. Ben Bernake, the Federal Reserve Chairman is nicknamed ‘Helicopter Ben’ because he had once said that the way to deal with deflation would be to simply print money and drop it from a helicopter.
Normally when a country increases money supply, the value of the country’s currency goes down. If any other country printed money at the rate at which US is doing, other countries will sell the currency in haste. This will lead to a dramatic fall in the country’s currency and effectively ruin its economy.
So how will the US be able to print more money and get away with it? The dollar happens to be the global reserve currency. At the end of 2007, more than 60% of the identified official foreign exchange reserves in the world were held in US dollars. China has it $2 Trillion of foreign exchange reserves and any significant drop in dollar will lead to a huge erosion of wealth for China. Similarly for Japan’s $1 trillion reserves and India’s $250 million. Oil is traded primarily in dollars, and a fall is dollars, will effectively lead to skyrocketing of oil prices and another oil-shock like 1973.
Thus the entire world has a vested interest in making sure that the dollar does not lose value. Hence even though the US keeps printing dollars, the value of the dollar does not go down.
All this is not to say that US can go on printing money forever. Eventually, there could be an alternate global currency that could replace the dollar - maybe the Euro or the Yen. How soon that happens is anyone's guess. But till then US will be the only country in the world that will not have to worry about printing more money to deal with the financial crisis.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
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