Saturday, March 22, 2014

Why is credit so relevant to India's economy?

This article was first published in the business section of on March 12, 2014; Co-author: Khemchand H. Sakaldeepi

In the first article in the series of understanding how the economic machinery works, we introduced transactions, credit, interest rates and inflation (the article can be read here). This part will deal with the importance of credit and introduces deleveraging. The third part will talk about the impact of deleveraging and introduces fiscal deficit. The concluding part, weaves all the different parts of the economic machinery together to help the readers take a view on the current economic scenario in India.

But why is credit important?
Credit allows the borrower to increase his spending today. Remember that the borrower is required to improve his productivity so that he can pay for his past expenses in the future. Credit is good because spending drives the economy. One persons spending is income for another.  It is the fuel to the engine.

When someone’s income rises he can borrow more and spend more as his creditworthiness increases. Creditworthiness is made up of two things – his ability to repay and his real assets that he bought from his rising income. This process continues until the spending at the origin stops. This whole process is cyclical. Hence the short term credit cycles are formed.

Credit is relevant in the short run but what actually matters is productivity in the long run. That is the amount of goods and services our country produces. This is measured by GDP. The credit created just acts as the motivational force to improve our productivity.  It helps businessmen to compete in the market and produce more efficiently.

In fact, credit is an outcome of human behavior. We want to spend more that our neighbors. Sometimes greed and envy take over the thinking process, making people irrational.

In a country like ours, the culture can actually help us be better economists. Our wisdom of ages teaches us not to be overly greedy and not overly materialistic, as is evident from the high savings rate of our households. If we all were to work rationally then our country will automatically become more productive in the long run.
The only problem with credit is that it forces us to consume or spend more when we acquire it and it forces us to spend less than we produce when we have to pay it back. Hence if we take credit, it is of utmost importance that we also produce more so that we can maintain our spending status when we have to repay.
This does not always happen. An example is the US housing bubble when people borrowed more than they could produce. This bought the lenders to their knees.

This does not mean that credit is bad. It is bad only if you borrow to consume but do not increase your productivity. Credit does create inflation due to more money coming into the market and creating more demand for goods and services.

Now let us talk about credit cycles that are long term in nature and the most dangerous. The short term typically lasts for 5-8 years but the long term cycle lasts for 75-100 years.  This happens because people are more willing to borrow and spend than to pay back and assume that productivity will naturally increase. They think that things will forever be great and that credit will always be available.

Now imagine a weighing machine. On one hand we have income (productivity) and on the other hand we have debt. When debt is increasing and incomes rise with the same rate then we have little to worry. In such an environment assets value soar and inflation is observed (Inflation is a proxy of growth here). But this environment does not last forever.

When the debt repayment increases more than the income we must believe that recession is at hand.
But there can be a worse scenario.  In the developed world in the years 1929 and 2008, the rate of increase in debt had outpaced the rate of growth of income. This led to the peak of debt cycle and recession. The consequences are as expected. Incomes fall, people cut spending, asset prices drop, credit disappears, stock market falls, social tensions rise, people feel poor. This scenario is called – Deleveraging

A vicious cycle begins –This is different from recession because interest rates cannot be further reduced.

If the interest rates are already very low (even close to 0%), lenders stop lending, borrowers stop borrowing. The economy comes to a halt. This is something that has not happened in India since 1991, just before the financial reforms. We as a country have this opportunity to learn from others’ mistakes as well as our past and can actually be careful in creating CREDIT BUBBLES.

In 1991, the government of India was close to default. The central bank had refused to new credit with which the country runs and foreign exchange reserves had dried up. Remember this was a world where the government used to run all the businesses and there was little private participation. We had to airlift our gold reserves as a pledge with IMF.

Wednesday, March 12, 2014

Debunking the Indian economy machine

This article was first published in the business section of on March 12, 2014; co-author: Khemchand H. Sakaldeepi, Swiss Re

The subject of economics has always been very fascinating and yet confusing. Many curious and critical minds find it difficult to actually understand the state of our economy. We all understand the meaning of GDP, IIP, inflation, interest rates and intervention of central bank, that is, the RBI, to control money flow, the volatility of Indian rupee etc. But it is very difficult to join all the dots.

The media and academia are ripe with reports, articles and peer reviewed papers. All of these are many times contradictory and have their own school of thought, and for a common man it is difficult to comprehend.

In this article we will attempt to put the conceptual pieces together. This article is divided into four parts. The first part introduces transactions, credit, interest rates and inflation. The second part will deal with the importance of credit and introduces de-leveraging. The third part will talk about the impact of deleveraging and introduces fiscal deficit. The concluding part, weaves all the different parts of the economic machinery together to help the readers take a view on the current economic scenario in India.

How the Economic Machine Works
Let us begin by summarising the framework created by Ray Dalio of Bridewater Associates. He presents a very robust framework to understand 'How the economic machine works'. If one understands this well, the rest will be just nuts and bolts to play with.

Let us begin by imagining that the economy works like a simple machine. This is something that many people do not understand, or if some do understand it, then they are at disagreement over how it actually works. This is the exact reason why policy-makers and economists just cannot come to a conclusion when taking critical decisions. Therefore Dalio presents a simple template that can help us in more ways than we can imagine.

The economy is made up of simple parts called ‘transactions’ that come together and is repeated over and over again. These transactions, above all, are driven by human nature. Some assume that they are rational and others say they are irrational. These transactions create three main forces that drive the economy:
·                     Productivity growth
·                     The short term debt cycle
·                     The long term debt cycle

The transaction here refers to quid pro quo where the Numéraire (unit) is usually the currency (due to historical reasons) issued by a statutory body of the government of various countries (There are other interesting forms of money but we shall not deal with them in this article).

In any transaction we have a buyer paying for goods and services using money (store of wealth) and/or credit (store of expected future wealth) to the seller.  This summation drives the economy. If we can understand transactions then we can also understand the economy.

The biggest participant in these transactions is the government. It consists of the central and state governments and the central bank, the RBI in our case. The government collects money in the form of taxes (direct and indirect) and the RBI controls the flow of money in the country.

The RBI has two basic tools to influence the flow of money and credit in the economy -- interest rates and printing new money. We must now pay attention to credit.

This is the most important and least understood concept. It is important because it is a really big and volatile part of the economy. Credit can be created out of thin air. All we need is a buyer (borrower) and a seller (lender).

The buyer in principle borrows to pay for his present needs and the lender just acts as a facilitator for the prospect of increasing the value of their excess money. Here come the interest rates.

When the interest rates are low then people are more likely to borrow than when the interest rates are high. The RBI controls the interest rates that it charges the banks for giving them money (repo rate).

The historical interest rates and inflation rate in India are shown in the chart below. One can note that the rate has gradually been increasing since 2010 to curb inflation in India.

When credit is created it becomes debt. This is an asset for the lender but a liability for the borrower. When the debt is settled then the asset and liability both disappear.

The Debt to GDP or the level of credit with respect to the assets and goods that produced is given below. Fortunately we are well off here as compared to other countries like Japan (214.3%), Singapore (114%) and USA (72.5%).

Yet, they are supposedly (based on some mathematical default models) more likely to pay off their debt in the long run than India. India at 67.57% lags behind China (31.7%), Brazil (54.9%) and Russia (12.2%).