Venkat, an investment banker, and Nikhil Akali, a senior executive in a captive BPO, both college mates, meet for dinner at one of their favourite restaurants. Nikhil doesn’t seem to be in his usual cheerful mood. Venkat enquires, “You appear bit dull today, what’s the matter?”
Nikhil speaks in a hazy voice, “It’s about the dollar-rupee thing again, with one going down and the other going up. Everybody in my industry is worried and all kinds of horror stories such as salary cuts and slow growth are floating around…I am not sure what’s happening.”
“I think this is something we must learn to live with. Today countries are so closely united and one man’s meat is becoming another man’s poison,” Venkat says philosophically.
The reserve currency
“The world adopted dollar as the reserve currency because of its ability to withstand any kind of onslaught, but suddenly why is it in trouble? Why is it giving nightmares for everybody?” Nikhil asks.
Venkat says nonchalantly, “That’s because the US is running a historically high trade deficit (it imports more than what it exports) and economists see this as the single most important factor affecting the value of the dollar. It’s simple — bigger the trade deficit faster will be the dollar’s decline.”
“But why is the US’ trade deficit widening,” Nikhil grows restive.
“Its due to pathological consumption,” Venkat continues, “If a country borrows to invest, it will be on the road to prosperity, but if it borrows to spend it will lead to despair.”
“Hey I am not getting a hang of it, can you explain,” Nikhil asks.
Borrowing binge
“The average US consumer has become a buyer instead of a seller. The consumption is not financed from the profits of the business but from borrowing. It goes like this: The US central bank (Fed) borrows from other countries such as India and China. Then the banks in the US borrow from the Fed and lend the money to consumers at ‘ultra’ low interest rates.
“This lower interest rates resulted in high credit demand, which were utilised for consumption, housing and financial speculation. Corporate credit demand for investment purpose remains weak as they have been borrowing heavily for mergers, acquisitions and stock buybacks and not for productive investment.
“The rest of the money was used to buy goods ranging from computer chips to potato chips that are made in China and India. As a result, Asian countries have been experiencing an influx of dollars and the US, an outflow of dollars. Most of the Asian countries found this game exciting and started lending more money to the US to keep their own export machines running.
“This acted as a double-whammy. While, on the one hand, the US wealth was getting transferred to other countries in the form of imports (remember when the US imports, exporting countries earn foreign exchange), financial speculation was slowly giving way to bubbles in the stock markets and the realty sector.
Rising bubbles
“Just imagine this situation, if the speculative money grows into the stock markets, companies in the US must make productive investments, which are simply not happening. So the stocks will not live up to expectations and will eventually fall to retrace their underlying values. On the other hand, when people borrow to finance their new houses, there must be sufficient creation of new jobs and salaries should be rising.
“Again, this has not been happening as the US has been shifting more and more jobs offshore and their own unemployment levels have been rising. So just remember any financial crisis arising out of realty or stock markets will further plunge the value of the dollar.
“While it is the high trade deficit that was depreciating the dollar, the appreciation the rupee is just the other side of the coin. India has been earning a lot of dollars and its foreign exchange reserves have been swelling.”
“But if you say if India has been earning a lot of dollars, why are our exporters, especially in the IT industry, feeling threatened?” Nikhil asks rather curiously.
“Unfortunately India is suffering from symptoms of Dutch disease,” rues Venkat.
The Dutch connection
“Hey I know Chikungunya and bird flu, but when did this new disease start,” Nikhil exclaims.
“The Netherlands during the 1960s discovered natural gas in their country. It started exporting the oil and earned a lot of foreign exchange. It resulted in its currency appreciating vis-À-vis other countries, which made their exports less competitive. And this is what happening to India also.
“India with its talented IT manpower started exporting software services. The country’s IT exports, starting from a few million dollars in the early 1990s, have now touched $40 billion and account for 65-70 per cent of the global off-shoring pie. It is one of the fastest growing sectors in the world.
“Apart from software, India is also emerging as a hi-tech manufacturing hub. So India has been earning a lot of foreign exchange and the IT/ITeS industry became a victim of its own success,” Venkat concludes as they both prepare to leave the restaurant after a lot of food for thought.
Monday, February 18, 2008
Monday, February 4, 2008
Ben raises interest in rate cuts
Wiggins, Rogers, Prof Williams and Daisy are engaged in an animated conversation in their college corridor over US Fed Chief Ben Bernanke’s decision to lower interest rates for the second time in quick succession.
Wiggins begins the conversation inquiringly: “Why is there so much euphoria over Bernanke’s decision to lower interest rates? Why is everybody keenly watching what he is doing?”
Rogers answers nonchalantly: “It’s simple, he is trying to ward off recession.”
Daisy, a bit unsure about what the term means, asks: “First, tell me what is the difference between recession and depression?”
“Yup, there is a widespread misconception that recession and depression are the same. Actually they are not. Depression means a major slowdown in the economy that lasts more than a year. Whereas, recession means two consecutive quarters of negative growth that may even last several months, after which the economy is expected to revive,” Wiggins looks at Prof Williams for his approval.
Daisy gets more curious: “Okay, how can interest rates help ward off a slowdown in the economy?”
“Bernanke is trying to raise stock prices by lowering risk premiums. Lower risk premiums cause consumers to trim their precautionary savings, which, in turn, leads to more spending by households. The increased spending gets amplified through the Keynesian multiplier and kick-starts the economic activity, which remains subdued till now,” Prof Williams turns towards Daisy, “Is that clear?” he asks.
Helicopter money
Rogers appears unconvinced by Prof Williams’ reply, who goes on, “For instance, in 2001, the Fed aggressively lowered the rate target from 6.5 per cent in December 2000 to 1.75 per cent by December 2001, but that doesn’t seem to have revived the fortunes of the economy.”
“You are right. That is why many economists don’t buy the logic that lowering rates would improve the fortunes of the US economy. It all depends on how one looks at it,” Prof Williams goes on to explain, “Bernanke thinks that helicopter money can save the economy from falling into recession.”
“Professor, I am very sorry to interrupt you, what did you say ‘helicopter money’?” Wiggins asks.
“Yes, Fed chiefs believe that lower interest rates and tax cuts would drop cash in the hands of consumers, as if from a helicopter. On the other hand, economists have been arguing that lower interest rates have wider ramifications. The lower interest rate has resulted in cheap long-term mortgage as housing became affordable for many. Economists also feel that the interest rates are kept deliberately low, that is, below the inflation rate. A lot of consumers have taken loans at low interest and, once the Fed raises its rates, there will be more defaults.
“Once the bubble bursts, people might realise that too many houses were built too soon and the expected demand is not there, as there cannot be an endless new demand for new houses. This problem will worsen for those who buy property at artificially high prices, encouraged by lower interest rates. They will find the going tough when the interest rate rises along with the fall in the buying power of the dollar,” Prof Williams said, concluding his mini lecture on interest rates.
“Prof, If I have understood it right, the Fed chiefs are expecting the lower interest rates to help the companies to expand, but the whole thing is resulting in credit-based spending without any real productivity, right?” Rogers asks.
“Exactly,” Prof Williams continues, “If the Fed continues to lend at below inflation rates, it stands to lose money, thereby affecting the economy too in the process. Housing and mortgage will be the first victims.”
Arbitrage opportunity
Wiggins becomes restless, “How can somebody lend below the inflation rate? It’s like somebody selling a product below its cost price?”
“That’s right, it is similar to how we calculate real interest rates. When we deposit money in the bank, our real interest rate is arrived at by reducing the inflation rate from the interest rate offered by the bank.
“That is, if our deposits earn 10 per cent and if the inflation is at 5 per cent, it means our money in the bank earns only 5 per cent. In the same way, if the Fed lends at 3 per cent, when the consumer price index is at, say, 4.2 per cent, the Fed will lose 1.2 per cent for every dollar that it lends.
“Moreover, when interest rates are low, people in the US try to take advantage of the interest rate arbitrage and try to invest in countries such as India, where their money earns more interest. So the dollar flows out of the US to developing countries, where they get handsome returns for their money,” Prof Williams looks at the others and asks, “Is that clear?”
The three students nod their heads in unison and reply: “Yes, we even read reports that the dollar inflow into India has been causing a lot of headaches for those people, rendering their exports less competitive as the dollar has depreciated against the rupee.”
“So, now you know why everybody is watching the Fed’s moves very closely?” Prof Williams concludes with a smile.
Wiggins begins the conversation inquiringly: “Why is there so much euphoria over Bernanke’s decision to lower interest rates? Why is everybody keenly watching what he is doing?”
Rogers answers nonchalantly: “It’s simple, he is trying to ward off recession.”
Daisy, a bit unsure about what the term means, asks: “First, tell me what is the difference between recession and depression?”
“Yup, there is a widespread misconception that recession and depression are the same. Actually they are not. Depression means a major slowdown in the economy that lasts more than a year. Whereas, recession means two consecutive quarters of negative growth that may even last several months, after which the economy is expected to revive,” Wiggins looks at Prof Williams for his approval.
Daisy gets more curious: “Okay, how can interest rates help ward off a slowdown in the economy?”
“Bernanke is trying to raise stock prices by lowering risk premiums. Lower risk premiums cause consumers to trim their precautionary savings, which, in turn, leads to more spending by households. The increased spending gets amplified through the Keynesian multiplier and kick-starts the economic activity, which remains subdued till now,” Prof Williams turns towards Daisy, “Is that clear?” he asks.
Helicopter money
Rogers appears unconvinced by Prof Williams’ reply, who goes on, “For instance, in 2001, the Fed aggressively lowered the rate target from 6.5 per cent in December 2000 to 1.75 per cent by December 2001, but that doesn’t seem to have revived the fortunes of the economy.”
“You are right. That is why many economists don’t buy the logic that lowering rates would improve the fortunes of the US economy. It all depends on how one looks at it,” Prof Williams goes on to explain, “Bernanke thinks that helicopter money can save the economy from falling into recession.”
“Professor, I am very sorry to interrupt you, what did you say ‘helicopter money’?” Wiggins asks.
“Yes, Fed chiefs believe that lower interest rates and tax cuts would drop cash in the hands of consumers, as if from a helicopter. On the other hand, economists have been arguing that lower interest rates have wider ramifications. The lower interest rate has resulted in cheap long-term mortgage as housing became affordable for many. Economists also feel that the interest rates are kept deliberately low, that is, below the inflation rate. A lot of consumers have taken loans at low interest and, once the Fed raises its rates, there will be more defaults.
“Once the bubble bursts, people might realise that too many houses were built too soon and the expected demand is not there, as there cannot be an endless new demand for new houses. This problem will worsen for those who buy property at artificially high prices, encouraged by lower interest rates. They will find the going tough when the interest rate rises along with the fall in the buying power of the dollar,” Prof Williams said, concluding his mini lecture on interest rates.
“Prof, If I have understood it right, the Fed chiefs are expecting the lower interest rates to help the companies to expand, but the whole thing is resulting in credit-based spending without any real productivity, right?” Rogers asks.
“Exactly,” Prof Williams continues, “If the Fed continues to lend at below inflation rates, it stands to lose money, thereby affecting the economy too in the process. Housing and mortgage will be the first victims.”
Arbitrage opportunity
Wiggins becomes restless, “How can somebody lend below the inflation rate? It’s like somebody selling a product below its cost price?”
“That’s right, it is similar to how we calculate real interest rates. When we deposit money in the bank, our real interest rate is arrived at by reducing the inflation rate from the interest rate offered by the bank.
“That is, if our deposits earn 10 per cent and if the inflation is at 5 per cent, it means our money in the bank earns only 5 per cent. In the same way, if the Fed lends at 3 per cent, when the consumer price index is at, say, 4.2 per cent, the Fed will lose 1.2 per cent for every dollar that it lends.
“Moreover, when interest rates are low, people in the US try to take advantage of the interest rate arbitrage and try to invest in countries such as India, where their money earns more interest. So the dollar flows out of the US to developing countries, where they get handsome returns for their money,” Prof Williams looks at the others and asks, “Is that clear?”
The three students nod their heads in unison and reply: “Yes, we even read reports that the dollar inflow into India has been causing a lot of headaches for those people, rendering their exports less competitive as the dollar has depreciated against the rupee.”
“So, now you know why everybody is watching the Fed’s moves very closely?” Prof Williams concludes with a smile.
Monday, January 28, 2008
US recession
Will US economy fall into recession?
First let us see what is recession?
"A recession is a decline in economic activity of a country, lasting more than a few months or even years.”
What does the Fed (US’ central bank) rate cut mean or why does the Fed cuts the rate so often?
Recently, Federal Reserve Board announced an emergency cut of 0.75 per cent in short-term rates. When the Fed cuts the interest rates, it expects the business community to borrow more money from the banks to invest in their business. On the other hand it expects their people to borrow more money and spend it, which will once again result in more sales for the companies that will make profits and re-invest their profits to expand their business. This is expected to trigger a chain-reaction that will prop up the economy.
The low interest rate will also mean discouraging the people to keep money in the banks. Your deposits in the banks will earn less interest, while you may think that it would be profitable to spend the money rather than save.
What connection it has with India?
When the Fed cuts the rate, people in US may move their money to countries where their deposits will earn more interest. If the bank interest rates in India are more than the US, people in US will feel it would be better if they invest their money in India and earn more interest on their deposits. That is the main reason why the interest rate cut in US propels the stocks markets in India. When the Fed cuts the interest rates, more people take their money out of US and invest in a place like India, where the returns from the stock markets are the best in the world.
Will the interest rate cut boot the economy immediately?
The benefits of a rate cut take at least six months to percolate through the economy.
Million dollar question
After the rate cut, the interest rate now stands at 3.5 per cent. What would the US do if the interest rate touches zero?
Post your answers
First let us see what is recession?
"A recession is a decline in economic activity of a country, lasting more than a few months or even years.”
What does the Fed (US’ central bank) rate cut mean or why does the Fed cuts the rate so often?
Recently, Federal Reserve Board announced an emergency cut of 0.75 per cent in short-term rates. When the Fed cuts the interest rates, it expects the business community to borrow more money from the banks to invest in their business. On the other hand it expects their people to borrow more money and spend it, which will once again result in more sales for the companies that will make profits and re-invest their profits to expand their business. This is expected to trigger a chain-reaction that will prop up the economy.
The low interest rate will also mean discouraging the people to keep money in the banks. Your deposits in the banks will earn less interest, while you may think that it would be profitable to spend the money rather than save.
What connection it has with India?
When the Fed cuts the rate, people in US may move their money to countries where their deposits will earn more interest. If the bank interest rates in India are more than the US, people in US will feel it would be better if they invest their money in India and earn more interest on their deposits. That is the main reason why the interest rate cut in US propels the stocks markets in India. When the Fed cuts the interest rates, more people take their money out of US and invest in a place like India, where the returns from the stock markets are the best in the world.
Will the interest rate cut boot the economy immediately?
The benefits of a rate cut take at least six months to percolate through the economy.
Million dollar question
After the rate cut, the interest rate now stands at 3.5 per cent. What would the US do if the interest rate touches zero?
Post your answers
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