Hey...... Can someone explain to me how an economy works.... I've tried but everytime someone gives me one logical explanation my mind seems to delve deeper into confusion....
Take for example the current hot topic - Rising Interest Rates in the Indian Economy.....
We say our economy is growing at a rate of 8% p.a. We all claim that it is great news and soon we will be the second largest economy in the world (Second perhaps only to China). Then why does this have our Central Bank worried? The Central Bank claims that there is too much liquidity in the market and goes on increasing interest rates to 'suck out' liquidity.... I'm confused as to how this helps...
Ok, lets try and address from where does liquidity come from.... Is it through Foreign Investors? We all know that the stock markets booming. Hey our Sensex crossed 10000 for the first time ever! Much of it is being blamed on FII inflows... That is good news too cause now we say that the Indian markets are coming of age...
It is perhaps also through direct investments being made in India (Not necessarily through stock markets).... Companies setting up facilities in India...
It could also come from the Central Bank by a lowering of interest rates....
But how do we define 'excess' liquidity... Hey that's a question I have absolutely no clue about......
Anyways... I'll just try and figure out what does liquidity do to an economy
More liquidity means more money in the hands of people.... In the hands of the industrialist to expand..... In the hands of the consumer to spend..... Thus more liquidity means more demand...
The Finance minister argues that more liquidity will cause inflation... His claim is that if there is more money in the hands of people then they are willing to spend more on available products... Seeing this spurt in demand manufacturers are more willing to raise prices and thus will lead to a rise in inflation... So the finance minister decides that liquidity is not good and he raises the interest rate making money more expensive..... Thus borrowers do not borrow and bankers start parking excess money with the Reserve Bank.....
But my views go thus...... I am a manufacturer. I have a business plan under which I am about to invest X Million in a plant. My project will go green in 3 years..... Most of the funds required for investing will come from my friendly banker.... But suddenly the finance minister goes ahead and hikes the interest rate by a huge 2%.... Now I go green in 3 1/2 years... So I am faced with three choices a) Abandon my Project totally b) Tweak my business plan a bit by raising revenues so I go green in 3 years as originally planned or c) Be a bit more patient and wait for 3 1/2 years! What am I more likely to do - Definitely not a). For the simple reason that I believe that the Indian market is to grow in this way in the near future.... I do not foresee any declining trend in the economy... So if I need to invest, I might as well do it now rather than wait till the Indian growth story is over. I however believe that high interest rates are here to stay..... So I might as well take advantage of this phenomenon and increase my selling price marginally so that I still go green as planned.. There is a rise in inflation caused by my increase in prices and I believe this is the strategy most of my fellow manufacturers will follow...
So where our Hon'ble Finance Minister is trying to contain inflation... what he ends up doing is a rather round - a - bout way of increasing inflation!
But I agree with one thing.... Inflation needs to be contained... Raising interest rates is not the solution (though it may work temporarily).... Going back to why inflation may be caused. Because people are willing to spend more on existing products? So I guess this is where the Goverment needs to do some thinking. Either, encourage a wider range of alternatives for individuals to spend. Or, ensure that the 'excess' money reaches more 'hands'. In a country where a vast majority is still below poverty line I think that is a better focus.... (I'm sorry, I dont really know how to achieve this for now... Maybe my next paper will give more ideas on how to ensure excess liquidity reaches right hands!)
Another alternative could possibly be the Government trying to ensure that 'excess' money comes in only those areas where such money is required... Say infrastructure...... In a developing economy like India where most of the states are reeling under deficit budgets... I am sure excess liquidity could do more help than harm!
Well... these are my views after all.... Unfortunately they are not supported by enough data.. (I am no statistician or research analyst).. So I can't prove that my theories are right... but from my limited viewpoint I can't understand how rising interest rates can help the economy!
Love
Take for example the current hot topic - Rising Interest Rates in the Indian Economy.....
We say our economy is growing at a rate of 8% p.a. We all claim that it is great news and soon we will be the second largest economy in the world (Second perhaps only to China). Then why does this have our Central Bank worried? The Central Bank claims that there is too much liquidity in the market and goes on increasing interest rates to 'suck out' liquidity.... I'm confused as to how this helps...
Ok, lets try and address from where does liquidity come from.... Is it through Foreign Investors? We all know that the stock markets booming. Hey our Sensex crossed 10000 for the first time ever! Much of it is being blamed on FII inflows... That is good news too cause now we say that the Indian markets are coming of age...
It is perhaps also through direct investments being made in India (Not necessarily through stock markets).... Companies setting up facilities in India...
It could also come from the Central Bank by a lowering of interest rates....
But how do we define 'excess' liquidity... Hey that's a question I have absolutely no clue about......
Anyways... I'll just try and figure out what does liquidity do to an economy
More liquidity means more money in the hands of people.... In the hands of the industrialist to expand..... In the hands of the consumer to spend..... Thus more liquidity means more demand...
The Finance minister argues that more liquidity will cause inflation... His claim is that if there is more money in the hands of people then they are willing to spend more on available products... Seeing this spurt in demand manufacturers are more willing to raise prices and thus will lead to a rise in inflation... So the finance minister decides that liquidity is not good and he raises the interest rate making money more expensive..... Thus borrowers do not borrow and bankers start parking excess money with the Reserve Bank.....
But my views go thus...... I am a manufacturer. I have a business plan under which I am about to invest X Million in a plant. My project will go green in 3 years..... Most of the funds required for investing will come from my friendly banker.... But suddenly the finance minister goes ahead and hikes the interest rate by a huge 2%.... Now I go green in 3 1/2 years... So I am faced with three choices a) Abandon my Project totally b) Tweak my business plan a bit by raising revenues so I go green in 3 years as originally planned or c) Be a bit more patient and wait for 3 1/2 years! What am I more likely to do - Definitely not a). For the simple reason that I believe that the Indian market is to grow in this way in the near future.... I do not foresee any declining trend in the economy... So if I need to invest, I might as well do it now rather than wait till the Indian growth story is over. I however believe that high interest rates are here to stay..... So I might as well take advantage of this phenomenon and increase my selling price marginally so that I still go green as planned.. There is a rise in inflation caused by my increase in prices and I believe this is the strategy most of my fellow manufacturers will follow...
So where our Hon'ble Finance Minister is trying to contain inflation... what he ends up doing is a rather round - a - bout way of increasing inflation!
But I agree with one thing.... Inflation needs to be contained... Raising interest rates is not the solution (though it may work temporarily).... Going back to why inflation may be caused. Because people are willing to spend more on existing products? So I guess this is where the Goverment needs to do some thinking. Either, encourage a wider range of alternatives for individuals to spend. Or, ensure that the 'excess' money reaches more 'hands'. In a country where a vast majority is still below poverty line I think that is a better focus.... (I'm sorry, I dont really know how to achieve this for now... Maybe my next paper will give more ideas on how to ensure excess liquidity reaches right hands!)
Another alternative could possibly be the Government trying to ensure that 'excess' money comes in only those areas where such money is required... Say infrastructure...... In a developing economy like India where most of the states are reeling under deficit budgets... I am sure excess liquidity could do more help than harm!
Well... these are my views after all.... Unfortunately they are not supported by enough data.. (I am no statistician or research analyst).. So I can't prove that my theories are right... but from my limited viewpoint I can't understand how rising interest rates can help the economy!
Love
G.
4 comments:
The traditional view, which I supppose the RBI is following, is that inflation if left unchecked /unmoderated can affect economic growth. Some people who are bullish will borrow anyway, but others will curtail when it hurts. If this hike is not enough, more hikes will follow. In fact if my memory serves me right, the Reagan / Thatcher theory was - control inflation at all costs even if it affects job growth.
The excess money may also be because of heavy government borrowings - higher rates may force the Govt. to curtail ?
One thought - why are call rates rising if there is so much liquidity - some other factors at play?
A possible answer to your question as to why call rates are rising... When RBI increases its Repo - Reverse repo rates.. banks rush in to park funds with the central bank.. Thus RBI manages to temporarily suck out liquidity... However the demand for money in the economy - given the prevailing bullish view - does not seem to die down. In this circumstance banks compete with each other for lucrative funding projects and thus borrow from each other rather than from the Central Bank. This leads to a more competitive environment in the funds market where demand exceeds supply (Again this is a purely temporary and cyclical phenomenon). Hence a rise in call rates!
Let me try to explain how this works:
The total income of the economy is used for:
Consumption
Savings
Savings in turn is used for investment
Thus the total expenditure is on
Consumption expenditure
Investment expenditure
Consumption and Savings depend on the interest rates.
Whether one is willing to consume all that one earns now or whether one wants to spend part of it now and part of it later. One would save for a later day if one believes that the income earned from the savings plus the savings will fetch greater consumption satisfaction at a later date. If one does not believe in this, then one would tend to consume now rather than later. Of course, some minimum savings will be kept for a rainy day.
So assuming one to be rationally thinking in this manner, one can influence consumption and savings by changing interest rates.
Now lets assume that interest rates go up. So savings should go up too. But demand goes down. So therefore investment becomes less attractive. Therefore Savings > Investment. Therefore overall growth of expenditure in the economy falls. Therefore the growth rate of the economy falls too.
Now lets assume that interest rates are lower. This will increase consumption expenditure. Therefore savings will reduce. Therefore the future investments will be reduced. But because borrowings are cheap, the current investments would go up to meet increased demand for current consupmtion. This will in turn fuel further consumption. Thus the savings will continue to be reduced thus affecting the money available for investment in the future. If investment reduces, the future growth rate will be affected. Thus we will not be able to sustain a high growth rate.
Now which situation is better - because both lead to similar results.
The situation of increased interest rates are better - because it allows the savings to be mopped up. When savings are mopped up by the government, there is excess liquidity (so to say) with the government. It can then decide to invest this in employment generating projects - without a demand being there. This will create more jobs. And therefore more income. This income will spurt consumption and savings. This consumption will lead to more investments. Therefore the economy can go on a increased growth path. Hence the interest rates are increased.
When to increase interest rates and when not to will depend on the propensity of the government to spend on such infrastructure projects whenever necessary. In the second instance, the government does not have the ability to spend if the savings go down. Therefore even if it wants to rectify the situation, it is not in a position to do so.
If the government does not have such a policy then it does not matter whether the rates go up or go down.
Hope I have clarified the point.
A recent interview with Finance Minister P Chidambaram clears my doubt...
When asked to comment on interest rates, PC replies "Interest rates have two functions. The first is controlling inflation and dampening inflation expectation. The other is stimulating growth. The central bank is concerned about the former and the government with growth. Hence, a balance has to be struck by finding an interest rate that dampens inflation and also stimulates growth. We are always searching for that magical number. Rates have hardened during the last twelve months, but I hope they will become benign."
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