It is good to start something very serious in a
funny note, especially when you are about to sail into dark waters of
economics. Many times I have been asked to explain this Quantative easing (QE) thing and there is
nothing easy about it. But now there are fears that after USA has ended QE and
looking to raise interest rates which may result in fall of Indian stock market
as FII’s will be leaving India for higher interest rates. Actually the reality
is even i do not understand the real reason behind QE because what we hear in
the public stands does not make any sense related to results achieved so far
and common business sense. So let’s try this together…
Suppose there is 100 rupees in the market with
Mr X, who exchanges it for Wheat from Y, Y exchanges the same for Clothes from
Z and Z exchanges the same for Shoes from S. So total goods traded are 100
wheat+ 100 Clothes+ 100 shoes=300. But we were only having 100, so this 100 has
done the work of 300, thrice of original money supplied. This 3 is the velocity
of money I.e 300/100=3. So base money is never equal to total money gets
supplied in an economy, but total money is equal to Base money M multiplied by
Velocity V, S=MxV. Now we know money supply is never fixed, it depends on
velocity or we can better say propensity to consume by the people. People are
more confident so they will do more transactions which means more demand and so
more GDP i.e Growth.
Many thinks that this Base money is created by
central Banks (RBI or
FED) in
the form of currency notes or coins or bank credits either by purchasing Govt
bonds or giving loans to commercial banks But this is not true at all. This
money is just a small part of total money in the economy. In reality, most of
the money is created by our Commercial Banks like HDFC, SBI etc. They create
the money out of thin air. Commercial banks (we will take HDFC) provide loans to the corporate and
general public. But we think that HDFC loans out money equal to its Deposits.
If HDFC is having 100000 as deposit then it can loan only upto 100000. But the
reality is far from this. Banks are required to keep only a part of their
deposits in cash as statutory or necessary reserves (say 10%) they can loan out the
balance. Because people are not coming to draw their total funds…they will only
need a part of it. That is 10% and with this banks can meet the time cash
demand of depositors.
So HDFC can now loan out 90000 out of 100000,
keeping 10000 as reserves with RBI. So you think it is all over and no new
money is created? No…it is just the start. Suppose Mr X gets the loan of 90000
and he pays the same to Y for buying a machine. So now what will Y do
with 90000/- ? Well, it will surely come into bank in the account of Y, so now
bank is having another 90000 as deposit, and so it can loan out another 81000
of it. So Banks can play this game for 8-9 times and total loan amount will be
around 7 lac to 8 lac. So with one lac banks can create 8 lac of money…so this
is money out of thin air.
And if this money is invested in increasing
production, then it is good but if it is invested in buying assets then it may
lead to inflation. Like someone can take loan to produce more pulses (India is short of this) or he can buy a house.
Pulses will surely lead to growth and it can actually lower inflation due to
stoppage of costly imports but buying a house or a car can lead to high
inflation if the loan is not supported by rising income or if the cost of loan
is higher than rise in income level. And cheap loans can really make people to
invest in assets rather than taking risks of production.
That was precisely what happened in USA in
2000. Loans were cheap so people just went on investing in real estate. This
only inflated the prices as supply can not be increased as fast as compared to
demand. This lead to speculators entering in the game with cheap money…and
prices kept on rising. People were just taking loans for buying houses thinking
they could sell these for high prices or could rent these for income. But
around 2005, interest rates rose as a response to market forces and inflation
risk.
This led to a fall in property prices and
buying fell. This made speculators to sell houses cheaply to pay out the loans
which further reduced the prices. More selling started and prices fell down…some
people who could not sell their homes for profit defaulted on their loans. When
banks tried to sell those houses, they were getting only a part of their
loans…it led to panic selling by banks to cover the losses and hell broke .
This chaos spread to normal spending in the
economy as people reduced their spending due to unemployment and insolvency.
Banks stopped giving further loans to clean their balance sheet and USA fell into
recession. People were focusing on repaying their loans first, so they curbed
their excessive consumption. Many of young Americans went back to stay with
their parents.
In normal circumstances, a central Bank (FED) can lower interest
rates to make people spend more by taking loans cheaply. It is called Monetary
policy. Our RBI is trying the opposite by keeping interest rates high as it
wants to fight inflation. Fed also tried this by taking interest rates near
Zero so that people could take cheap loans for consuming or investing which
would give a flip to the economic activity and so as to employment levels. But
this looks good only in theory, it never happens in reality. Or we can better
say it can happen in an economy where people are saving in excess due to high
interest rates (as in China) which is making many productive resources lay idle.
Lower interest rates can force people to consume more. China is exactly doing
the same by lowering its interest rates.
But USA was different, people were already
having high debt…debt to income ratio was very high. So low interest rates
could not seduce people to take even more loan when there was already an
environment of fear and low growth. Corporates were having spare capacity and
high cash. So it did not worked at all. Public just never went for cheap loans.
Instead they were paying back their loans. Banks were also reluctant to create
more loans as they wanted to clean the earlier mess. As no new loans were
getting created and old one was paid back…it was destroying money. Low interest rates could
have made people with excess savings to spend more but instead many of them
invested in foreign assets like stock markets for better returns. You cannot
take people as dumb, who would throw their money just because it is not
earning. They can look to Gold for parking.
So Fed tried something extraordinary. It went
for Quantative easing which was meant for pumping more cheap money into the
economy. People are thinking that by QE, Fed just put more money into the
economy but how Fed did this…not many are aware of this. Actually Fed thought
that if people are not taking loans…so let’s give them money.
Government treasury Bonds and other financial
assets like bonds etc are bought by Pension funds, insurance companies and
commercial Banks. These Bonds have coupon rate of interest which is
payable yearly. Like 10% for a 1000 Rs. Face value Bond for 3 or 10 years. It
means by paying 1000 I’ll be getting 100 rs every year as interest. But these
bonds are traded in secondary market also, so if interest rate falls to 5% in
the economy (mostly
bank rate on deposits),
then the price of this Bond will rise to 2000 which will make interest of 100
exactly as 5%. So on this basis prices of bonds keep fluctuating.
So Under QE, what Fed did was buying these
bonds from the market at very high rates so as to bring the effective yield on
these to near zero which made institutions holding them to sell these to Fed.
And what was the result, Banks got huge amount of deposits after Pension funds
and Insurance companies sold their bonds and got huge amount of money from Fed.
so banks were in the position to lend this money to the public cheaply and
economy would perform. But in general pension funds are not going to keep their
money idle at banks with zero interest rates so they would invest this in other
avenues like stock market or real estate which would raise the wealth of the
public holding these , so in result confidence would rise and so as
spending.
But the money , which are invested by fund houses into stock market etc will
not leave banks at all as the same will anyway come back to banks in the form
of deposit but from other source.
Also
the money paid by Fed to commercial banks for their Bonds also increased the reserves
of these banks with Fed and so banks used this for making more loans.
How banks Make Loans
But if Fed was really thinking like this then
there is one very fundamental flaw in this model. I am not an economist but i dont
think banking acts like this in real life.When someone approaches to bank for Loan, bank
never checks if they are having adequate reserves or not. They just simply
approve the loan and in the evening if they find they are short of reserves at
RBI, then they can take short term loans (one day) from other Banks or even
from RBI. So banks are never short of Reserves. Banking is always demand side
economics where supply can be raised as per demand. Banks are never short of
reserves but of capital. This is the way banks operate and they can create any
amount of money if it is demanded by public by way of debt. So this debt is the
primary source of our money supply and it may look very scary for a common man.
So just by having deposits and reserves at Fed
can not result in more lending. If people do not want to take any loan and
banks are reluctant to take risk then nothing will work. So it is only wishful
thinking that more reserves and deposit will spur credit demand.
But nothing like this happened, Fed bought
around $ 4 trillion under QE-1, 2 ,3 but 80% of this is still in Fed’s reserve
held by Commercial banks. This amount was never lent to the public so it was
never used for the purpose for which it had been created. Stock markets did
rise in US but not Gold, not Oil and not any other commodity like copper, Zinc
etc. if rise of stock markets is linked with QE than why the same is not true
for commodity market.
Surprisingly Fed started paying Interest to
Banks on their reserves with Fed which further prompted banks to not to lend
this money to risky loans as they were happy earning .25% interest from Fed
with no interest payments on deposits. Banks have earned a windfall from this
interest in this period and banks’ balance sheets have never been in this good
shape. This step is confusing us about the motive of Fed, whether it wants to
lend or keep this money into reserves. If it was concerning with possible high
inflation but inflation was already very low in USA!!
Why QE
This makes me think that Fed is actually
helping Banks in coming out of the mess created in last decade with reckless
lending. Fed may have bought many of the not so good or Junk bonds mainly
related with real estate (I do not have any data for this, but need to check this one
out). This
step of Fed provided banks with much needed cash and capital (profit earned is
part of capital). Stock prices of banks skyrocketed after this. This have also
stopped the possible panic that could have crept in general public after the
demise of Lehman Brothers, and people might have lost interest in banks and
that would have created havoc in the USA Banking and economy. So this QE may
not be looking like achieving what was planned but it may have prevented a
disaster.
And by making all this noise, Fed is actually
creating feel good factor. I am always of the view that most important factor
that can bring growth in an economy is not Capital and technology but
CONFIDENCE of general public in the system and government’s capability. And by
paying interest on reserves Fed is purposefully keeping the money with itself
as money belonging to those bonds is already in the economy. Fed may be looking
to sell these bonds when USA looks like coming back on track to these banks.
Because if that money is again absorbed in the economy then it will become very
difficult for Fed to sell these bonds into the market as this will drop the
prices of these bonds significantly and interest rates will skyrocket.
After this QE, USA has not experienced any
material rise in GDP and employment rates. The small rise witnessed may not be
due to QE alone. But there are views that it has prevented a complete failure.
So this QE can either be failure of Fed or there is something more to the
story. I am just guessing because I need to gather a whole set of data to
testify this which currently I am not having.
There is another way except for QE to spur growth. That is instead of giving
money to fund houses and banks, Fed can simply give money to USA government by
subscribing to their zero rate bonds. So USA Govt will now have the money and
it can spend where it feel is necessary. It can also waive the taxes from
citizens leaving more money with them and so more demand and goodwill factor.
Government can invest this money in sectors which are deprived of investments
like it can provide free loans to Shale Gas producers to reduce their cost of
production. But only problem with this is that it will increase the already
high Government debt to GDP ratio. It will also be very difficult to get the
approval for it politically. But I feel this is a much better chance as
government knows better than citizens where there is over supply and where is
under investment.
Now coming to Indian stock market
There is widespread fear that as USA has ended
its QE program and will be raising interest rates which will prompt USA
investors leaving emerging markets and this will create panic in the stock
markets of those countries. Now as we know not much of the QE money has left
USA. After excluding Fed reserves, the most of the balance is invested in USA
stock market and real estate. I feel that not much of QE (Cheap money) has come
into Indian stock market. The money which in fact has come into Indian market
may be savings of the general USA public which are hard hit by this zero
interest rate policy. Savings of the life of so many of USA citizens have
become worthless and are not earning anything in USA. This money was looking
for profitable avenues and Indian stock market was one of them.
Even so this money was invested into Indian
market when rupee was much stronger. So there will be a loss if they sell it
due to rupee fall if this money is invested for short term. FII’s are generally
in india for long term and they are here because they have faith in Indian
story. Most of all, FII’s are just around 20% of total Indian stock market and
this is not big. Indian domestic investors are much stronger and bigger now and
they can absorb any such plight of FII’s. No McDonalds and KFC will leave india
as they have faith in Indian story and they have invested for long term. Much
of the FII money is invested in Indian Bonds which still provide more interest
rate but may be with lower ratings.
Demand by USA may be fuelling growth in china
now and in Japan in the past, but Indian story is built upon domestic demand
and creation of adequate infrastructure. India just need cheap commodity prices
which are here. Recent recorded Growth in USA failed to lift commodity prices.
There are also fears that further lowering of oil prices may hit USA shale gas
producers hard as they are incurring losses even at $ 50 for oil and this may
result in low investments and employment.
RBI is having large reserves of dollars of
around 400 billion which are more than sufficient to support the Indian rupee
in case of selling by FII as they will demand dollars in exchange of
rupee. Also most of these fears have already been discounted for in the Indian
market since last year. Also I do not think that rate increase in USA will be
massive as this will severely hit any recovery made so far. This small increase
will be more than offsetted by rupee fall which has already taken place and
more of that will occur in case if FII’s are selling. Moreover there are high
chances that USA will further delay its rate increase as economic data needs to
be tested over long term to confirm whether it is sustainable or not.
So I feel India will be able to withstand any
rise of interest rates in USA much better as we are in much better place.
