Tuesday, January 17, 2012

Too much borrowing is damaging

We receive sales calls trying to sell us a credit card. There is a lot of meaning to the economy of credit card buying habits. When a person wanted to buy something that was in excess of his available funds, he can use someone else’s savings and buy it. Now, on repayment he reduces his monthly savings and increases more spending. However, if collectively, a society went on a shopping mood, it would result in serious events: 
  • As a result of higher sales and profitability, the companies would be happy. The companies will expand capacities in anticipation of demand. Immediate positive result of this is, Jobs will be created, more factories built, more revenue to Government and a fill good factor will also felt.
  • Banks would be happy as they would expand Loan book, higher profit and large balance sheet. Then recruitment of more people, pay hefty salaries, giving them sales target to be achieved and believing that this growth is for real.
  • As Government has more tax revenue, will spend more. The Governments subsidy spending on social sectors is not productive and do not create an asset.
  • Increase in asset prices. More people buy assets, they leverage, and buy more assets. This leads to an asset inflation, which increases core inflation as input prices increase. Agricultural land gets converted into construction and investment land, increasing pressure for food prices.
  • Society as large feels good that they spend more, earn more, and save more. Everyone feels good till the party ends because events starts turning reverse. Such as price spike of a commodity or maintaining the living at higher costs. Governments in turn try to “simulate” the economy by reducing interest rates, but this hardly works.
Government has choice of taxing and using it to spend on infrastructure or paying pension, subsidies and loss incurring companies to save them defaulting.
The bad part is the debt trap of borrowing to keep the fire burning which starts in the government and the society.
  • Governments have the power to print any amount of currency and hence can pay down any debt. This creates a false impression that governments are AAA.
  • This false belief has been perpetrated to such an extent that government believed in false power. Hence currencies depreciate and cause inflation, and erosion of buying power.
  • Government then try to reduce own responsibility by saying that the private sector will do the work more efficiently and with less corruption. So we “invite” private and foreign companies.
  • The central bank is an authority allowing restructuring loans to avert a banking crisis, and banks generously utilize the window to restructure.
Looking to India, we consume more, import more, export less and have a trade deficit. Downward pressure on the currency and its impact on inflation, The country funds its trade deficits using long term FDI, repatriation of earnings by NRIs and welcomes FII inflows. However, the inflow is of the nature of short run. Strong decisions are yet to be taken by the Government. In absence of firm actions, this situation will continue until a strong leadership takes control.
After discounting the negative factors and hopefully encouraging steps from government, economy will make U turn. Optimism will improve in market and the first runners will earn high returns and laymen will follow them. It is rightly said that “Only unexpected is expected from the market”.