Embed Doc
Copy Link
Readcast
Collections

CommentGo Back

Download

I get lot of questions on these topics nowadays..When will recession end, whether I shouldinvest in stocks , whether rupee will move up/down etc etc….Being IIM students, quite a fewexpects us to be well versed & knowledgeable in all these areas..Infact these are milliondollar questions which even very well renowned economists are trying to find answers for…In this post I’m trying to answer some of these with my limited economics & financeknowledge… Ofcourse, these explanations are highly debatable..But anyway, if you areinterested in the subject, read on…

What is Recession ? Whats happening in the economy ?

Mathematically/Economically , if a nation has gone through two continuous quartersof negative GDP growth, it is said to be in Economic Recession… Leaving out all such stats& complicated explanations, what has happened in the economy is that people are extremelyreluctant to spend.. Banks are reluctant to lend, consumers are tightening their wallet fearingtougher days ahead, limited investment comes to stock market, businesses are cutting downon various projects -- All in all, the circulation of money in economy has come down to alarge extent..

Why is this happening ?

The root cause as many know comes from the financial crisis in US..Now I’m notgoing into the subprime literature & explanations, but will present mainly a postscript picture..Businesses operate on credit. i.e, they rely very highly on external finances. Its like, if a company has 10L in assets, it’ll typically do businesses in excess of 10L by raising moneythrough various means – private equity, stock market , corporate bond market ( this is largelyabsent in India ) and lot of other sources.. In short, most companies in US & many companiesin India rely heavily on external finances. Due to the banking crisis, lot of these externalfinance sources have dried up… partly due to bank failures in US, partly due to reducedconfidence among investors , the credit lines ( cash supply) for most companies have driedup..This effect is more prevalent in US & to a lesser extent in India.

How can we get out of this ?

The way to get out of this crisis is to bring back an optimistic outlook in theeconomy..i.e, its not that banks / people don’t have the money… It’s just that everyone hasturned out to be extremely cautious in spending money, which has got economy to ascreeching halt .. Hence to kickstart it again, you have to make people spend.

How are Governments addressing this ?

There are two ways in which Governments can address troubles in economy.. One ismonetary policy ( layman’s explanation – by altering the money supply using central bank )and fiscal policy ( spending by Government itself which typically leads to short fall in Govt’sfinances ) ..Monetary policy tools have been extensively used in the recent past by all central banks – Interest rate cuts, SLR / CRR adjustment etc.. What they are trying to do by these measures isthat they are just trying to increase the availability of money in the system so that people startspending.. But whats happening is that, every one (in US) is still extremely cautious .. Andspending hasn’t kick-started inspite of easy availability of money .. And in US, they are fastapproaching a situation known as ‘liquidity trap’ – lot of money in the system, but nonespends,and monetary policy is ineffective … US has actually reached the bottom limits of monetary policy – their interest rates are almost zero , Meaning there is very limited scope of further using monetary policy tools to get out of this… In a developed economy like US,rates & money supply is ideally governed by something called as BCD nexus ( Bond – Currency – Derivatives Nexus ) … It’s a bit advanced topic..So, don’t want to discuss thathere.. The fact is that the Fed measures in US have almost broken the so called BCD nexus ,which is again dangerous to an open economy.On the other hand, Fiscal policy tools have been often criticized by economists duringthe post – Keynes era a lot.. The catch in using fiscal policy to get out of recession is that the private businesses will suffer a lot…The explanation goes like this …Govt Increases spending -> deficit in govt finances -> fiscal policy says monetize thedebt or print money to cover the deficit ( which has lot of other implications ) / raise moneythrough govt guaranteed bonds - > Raising more money through Govt guaranteed bondsmeans you have to raise the interest rates of govt bonds - > private businesses would find ittough to raise money since people would always invest in govt bonds as they are more safeand give high interest -> this would again dry up the already tight credit lines for private businesses. .Economically, this situation is called ‘crowding out of private business’And in a place like US where the lobbying strength of private enterprise is very high inall levels of government, significant fiscal policy measures are unlikely to come.

Whats the situation in India with respect to these measures ?

India is still in a very better shape compared to US. The interest rates are still high (i.e, there is still scope for monetary policy measures to come ) , no banking failures … But

the problem with India is that large part of corporate credit lines used to come from privateequity from abroad / Indian stock market.. And these sources have dried up. . Plus , anaverage man in India still prefers to invest in assets like Gold / land / even stash his savings ina locker .. This is actually very detrimental to the economy as the money thus locked in are inunproductive assets..i.e, there is no circulation of this money in the economy…And equitymarket is still viewed with significant aversion among Indian middle class.

So what is the alternative? Fiscal policy ?

Fiscal policy is still an alternative in India. Reason being, unlike in US, a large part of India isstill very much underdeveloped… Significant infrastructure projects are still required inIndia.But more than that, I would say a vibrant corporate bond market is the solution in India..Reason – as I said, an average Indian investor is still risk averse. He would any day put hismoney in a bond (which is basically an investment with assured returns) than in equity(which has a risk of losing money). A competitive corporate bond market would typicallydrive the stock market to higher levels of efficiency . Small & Medium enterprises in Indiaare still at the mercy of a large number of money lenders who charge exorbitant rates of interest. That situation has to change if we have to get out of this slowdown.

Why the corporate bond market is not developed in India ?

Many reasons – Any of you who would have been fleetingly reading the news would beaware of the changes that SEBI( which governs the equity market) has gone through over thelast two decades to counter lot of scamsters. I would say, the implementing a corporate bondmarket is even tougher than that. Because, a bond is something in which you are assured thatyou get a certain amount of payment regularly..Now how would a regulatory agency assurethat for whomever who want to float a corporate bond ? Its not an easy task and it requiresmuch thought & good implementation mechanisms.. Credit rating agencies , trading houses,regulatory checking…All these are not easy to implement.. But at the same time, this is notan impossible task too.

Should I invest in stock market now ?

Long term investment – Yes…Infact a definite yes..But pick the companies carefully.Short term – Pretty difficult to get good returns unless you know the nuances of day-trading.

I’m running a company / I’m in a significant decision making post in a company.. How should I counter this slowdown ?