( Disclaimer - Quite long post )
I get lot of questions on these topics nowadays..When will recession end, whether I should invest in stocks , whether rupee will move up/down etc etc….Being IIM students, quite a few expects us to be well versed & knowledgeable in all these areas..Infact these are million dollar 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 & finance knowledge… Ofcourse, these explanations are highly debatable..But anyway, if you are interested in the subject, read on…
What is Recession ? Whats happening in the economy ?
Mathematically/Economically , if a nation has gone through two continuous quarters of 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 extremely reluctant to spend.. Banks are reluctant to lend, consumers are tightening their wallet fearing tougher days ahead, limited investment comes to stock market, businesses are cutting down on various projects -- All in all, the circulation of money in economy has come down to a large extent..
Why is this happening ?
The root cause as many know comes from the financial crisis in US..Now I’m not going 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 money through various means – private equity, stock market , corporate bond market ( this is largely absent in India ) and lot of other sources.. In short, most companies in US & many companies in India rely heavily on external finances. Due to the banking crisis, lot of these external finance sources have dried up… partly due to bank failures in US, partly due to reduced confidence among investors , the credit lines ( cash supply) for most companies have dried up..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 the economy..i.e, its not that banks / people don’t have the money… It’s just that everyone has turned out to be extremely cautious in spending money, which has got economy to a screeching 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 is monetary 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’s finances ) ..
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 is that they are just trying to increase the availability of money in the system so that people start spending.. But whats happening is that, every one (in US) is still extremely cautious .. And spending hasn’t kick-started inspite of easy availability of money .. And in US, they are fast approaching a situation known as ‘liquidity trap’ – lot of money in the system, but none spends,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 that here.. 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 during the 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 the debt or print money to cover the deficit ( which has lot of other implications ) / raise money through govt guaranteed bonds - > Raising more money through Govt guaranteed bonds means you have to raise the interest rates of govt bonds - > private businesses would find it tough to raise money since people would always invest in govt bonds as they are more safe and 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 in all 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 private equity from abroad / Indian stock market.. And these sources have dried up. . Plus , an average man in India still prefers to invest in assets like Gold / land / even stash his savings in a locker .. This is actually very detrimental to the economy as the money thus locked in are in unproductive assets..i.e, there is no circulation of this money in the economy…And equity market 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 is still very much underdeveloped… Significant infrastructure projects are still required in India.
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 his money 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 typically drive the stock market to higher levels of efficiency . Small & Medium enterprises in India are 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 be aware of the changes that SEBI( which governs the equity market) has gone through over the last two decades to counter lot of scamsters. I would say, the implementing a corporate bond market is even tougher than that. Because, a bond is something in which you are assured that you get a certain amount of payment regularly..Now how would a regulatory agency assure that for whomever who want to float a corporate bond ? Its not an easy task and it requires much 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 not an 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 ?
- Know your business sector really well & try to see what all changes are coming up.
- Invest in people. A set of established processes / practices wont drive you out of recession. Infact if you follow such dogmatic practices, its highly likely that you would go bust. Rather, invest in people who can innovate. New products/ ideas / new ways of doing business etc would be the critical factor which would make you a winner. Pick & retain people who can do that.
- Cost rationalization ( Not layoffs :- ) )
When will the economy recover ?
The million dollar question J .. US economy – I would say, its pretty tough to predict.. I would bet that the recovery in US economy would depend on some very good innovation related product / company.. As in, say if I-phone was released this year, Apple might have kickstarted the US recovery.. So, depends .. Recovery there would be largely driven by some of the innovation based companies like Google / Apple /3M or some of the oil & energy companies ( this would inturn depend on when the economy of China & india comes good J ) .. It is unlikely to be kick-started by some heavy machinery / automobile (unless say GM comes with an innovation like ‘flying car’ J ) / construction / infrastructure related companies.
Indian economy – I would bet on 2009 end to 2010 April/May or so …
Reasons
- A long inventory replenishment based explanation ( actually derived from an Interview of Chanda Kochaar, which I’m unable to find a link ) , which I’m too bored to type in here J
- A lot of regulatory mechanisms are supposed to come in US & Europe over banking, insurance and lot of other sectors – this would ( hopefully ) drive lot of outsourced work here & inturn would drive up the spending in India
- Lot more readings & some gut-feel J