Edutips

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Is gold a liquid asset? (29th March, 2018)

Gold cannot be considered as a liquid asset.
Most of the banks who sell gold coins and biscuits don’t buy back. Once sold, it is sold. No buying back.
What you can do is pledge them in a bank and get a loan and pay interest for that. That is paying interest on your own money.
However, paper gold is liquid, because you can sell it in the commodity exchange market and convert it into cash. Cash is the most liquid asset. Any asset that can be converted into cash within a short time are liquid. Real estate, machinery, jewellery are not considered liquid. Jewellery is generally considered as dead asset. It is quite difficult to convert them into cash, because nobody will be willing to buy them from others. Even if you are able to sell them it will be at a great discount. You will lose a lot of money in buying and selling jewellery.
Investment in stocks, mutual funds, bonds, bank deposits are considered liquid assets.

 

2008 Financial Crisis and Its Impact on Global Economy

Introduction

  • The financial crisis of 2007-08, also known as the global financial crisis, is considered by many economists to have been the worst financial crisis since Great Depression of the 1930s.
  • It threatened the collapse of large financial institutions, which was prevented by the bailout of banks by national governments, but stock markets still dropped worldwide.
  • In many areas, the housing market also suffered, resulting in evictions, foreclosures and prolonged unemployment.
  • The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of U.S. dollars, and a downturn in economic activity leading to the 2008-2012 global recession and contributing to the European sovereign-debt crisis.
  • The active phase of the crisis, which manifested as a liquidity crisis, can be dated from August 9, 2007, when BNP Paribas terminated withdrawals from three hedge funds citing ‘a complete evaporation of liquidity’.

Causes

  • The crisis was the result of ‘high risk’, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street – Levin-Cohen Report.
  • The financial crisis was avoidable and was caused by ‘widespread failures in financial regulation and supervision’, ‘dramatic failures of corporate governance and risk management at many systemically important financial institutions’, ‘a combination of excessive borrowing, risky investments, and lack of transparency’ by financial institutions, ill preparation and inconsistent action by government that ‘added to uncertainty and panic’, a ‘systemic breakdown in accountability and ethics’, ‘collapsing mortgage-lending standards and the mortgage securitization pipeline’, deregulation of over-the-counter derivatives, especially credit default swaps, and ‘the failures of credit rating agencies’ to correctly price risk – The Financial Crisis Inquiry Commission.
  • The 1999 repeal of the Glass-Steagall Act effectively removed the separation between investment banks and depository bank in the United States.
  • Research into the causes of the financial crisis has also focused on the role of interest rate spreads.
  • The immediate cause or trigger of the crisis was the bursting of the U.S. housing bubble, which peaked in 2004. Already-rising default rates on ‘subprime’ and adjustable-rate mortgages (ARM) began to increase quickly thereafter.

As banks began to give out more loans to potential home owners, housing prices began to rise. Easy availability of credit in the U.S., fueled by large funds after the Russian debt crisis and Asian financial crisis of the 1997-1998 period, led to a housing construction boom and facilitated debt-financed consumer spending. Lax lending standards and rising real estate prices also contributed to the real estate bubble. Loans of various types were easy to obtain and consumers assumed an unprecedented debt load. As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which derived their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continued to drain wealth from consumers and eroded the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.

From 2004 to 2007, the top five U.S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. Changes in capital requirements, intended to keep U.S. banks competitive with their European counterparts, allowed lower risk weightings for AAA securities. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers went bankrupt and was liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required for received government support.

Fannie Mae and Freddie Mac, two U.S. government-sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship by the U.S. government in September 2008.

These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations; yet they were not subject to the same regulation as depository banks.

 

Impact on Financial Markets

  1. The U.S. stock market peaked in October 2007, when the Dow Jones Industrial Average index exceeded 14,000 points. It then entered a pronounced decline, which accelerated markedly in October 2008. By March 2009, the Dow Jones average had reached a trough of around 6,600.
  2. The first notable event signaling a possible financial crisis occurred in the United Kingdom on August 9, 2007, when BNP Paribas, citing ‘a complete evaporation of liquidity’, blocked withdrawals from three hedge funds. The significance of this event was not immediately recognized but soon led to a panic as investors and savers attempted to liquidate assets deposited in highly leveraged financial institutions.

One of the first victims was Northern Rock, a medium-sized British bank. The highly leveraged nature of its business led the bank to request security from the Bank of England. However, the British government relented, and the bank was taken into public hands. Northern Rock’s problems proved to be an early indication of the troubles that would soon befall other bank and financial institutions.

  1. The first visible institution to run into trouble in the United States was the Southern California-based IndyMac, a spin-off of Countrywide Financial. The primary causes of its failure were largely associated with its business strategy of originating and securitizing Alt-A loans on a large scale. The strategy resulted in rapid growth and a high concentration of risky assets. IndyMac often made loans without verification of the borrower’s income or assets, and to borrowers with poor credit histories. When home prices declined in the latter half of 2007 and the secondary mortgage market collapsed, IndyMac was forced to hold $10.7 billion of loans it could not sell in the secondary market. Its reduced liquidity was further exacerbated in late June 2008 when account holders withdrew $1.55 billion or about 7.5% of IndyMac’s deposits.
  2. In September 2008, the crisis hit its most critical stage. There was the equivalent of a bank run on the money market funds, which frequently invest in commercial paper issued by corporations to fund their operations and payrolls. Withdrawal from money markets was $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover their short-tern debt.
  3. There is a direct relationship between declines in wealth and declines in consumption and business investment, which along with government spending, represent the economic engine. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500 was down 45% from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008.

Further, U.S. homeowners had extracted significant equity in their homes in the years leading up to the crisis, which they could no longer do once housing prices collapsed. Free cash used by consumers from equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period.

The problem with the economy is the loss of close to $6 trillion in housing wealth and an even larger amount of stock wealth.

  1. The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities. Both MBS and CDO were purchased by corporate and institutional investors globally. Derivatives such as credit default swaps also increased the linkage between large financial institutions. Moreover, the de-leveraging of financial institutions, as assets were sold to pay back obligations that could not be refinanced in frozen credit markets, further accelerated the solvency crisis and caused a decrease in international trade.

 

Effects on the Global Economy

The Brooking Institution reported in June 2009 that U.S. consumption accounted for more than a third of the growth in global consumption between 2000 and 2007. “The US economy has been spending too much and borrowing too much for years and the rest of the world depended on the U.S. consumer as a source of global demand”. With the recession in the U.S. and increased savings rate of U.S. consumers, declines in growth elsewhere have been dramatic. For the first quarter of 2009, the annualized rate of decline in GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the U.K., 18% in Latvia, 9.8% in the Euro area and 21.5% for Mexico.

Some developing countries that had seen strong economic growth saw significant slowdowns. For example, growth forecasts in Cambodia show a fall from more than 10% in 2007 to close to zero in 2009, and Kenya may achieve only 3-4% growth in 2009, down from 7% in 2007.

The World Bank reported in February 2009 that the Arab World was far less severely affected by the credit crunch. With generally good balance of payments positions coming into the crisis or with alternative sources of financing for their large current account deficits, such as remittances, Foreign Direct Investment (FDI) or foreign aid, Arab countries were able to avoid going to the market in the latter part of 2008. This group was in the best position to absorb the economic shocks.

European Debt Crisis

The European debt crisis is a multi-year debt crisis that has been taking place in the European Union since the end of 2009. Several euro zone member states (Greece, Portugal, Ireland, Spain and Cyprus) were unable to repay or refinance their government debt or to bail out over-indebted banks under their national supervision without the assistance of third parties like other European countries, the European Central Bank (ECB), or the International Monetary Fund (IMF). The euro zone crisis resulted from a combination of complex factors, including the globalization of finance; easy credit conditions during the 2002-2008 period that encouraged high-risk lending and borrowing practices; the financial crisis of 2008-2012; fiscal policy choices related to government revenues and expenses; and approaches used by states to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

Japan and the Global Financial Crisis

The economic turmoil of 2007 and 2008 had mixed effects on the Japanese economy. Going into the crisis, Japanese banks – and consumers more generally – held much less debt than their counterparts in Europe and the United States. As a result, no major Japanese bank collapsed during the crisis, and some Japanese financial institutions were well-placed to swoop in and purchase assets at greatly reduced prices as the crisis progressed. Japan’s iconic automaker Toyota, however, experienced the first yearly losses in its history in 2008. The Japanese yen soared in value during the latter half of 2008 as international governments dropped interest rates, undermining the profitability of the “carry trade” through which many investors had bet on interest rate disparities. By April 2009, however, sagging global demand had taken a toll on Japan’s economy, nearly halving the country’s exports and leading Tokyo into its first trade deficit in thirty years.

 

Emerging and Developing Economies Drive Global Economic Growth

Advanced economies led global economic growth prior to the financial crisis with ‘emerging’ and ‘developing’ economies lagging behind. The crisis completely overturned this relationship. The International Monetary Fund found that ‘advanced’ economies accounted for only 31% of the global GDP while emerging and developing economies including China ($6,851 billion incremental GDP from 2007 to 2014), Brazil ($877 billion), India ($809 Billion), Russia ($758 billion), Indonesia ($424 billion), accounted for 69% of global GDP form 2007 to 2014.

 

Summary

World Economy from 2007-2011

  • On 9 August 2007 BNP Paribas announced that it was ceasing activity in three hedge funds that specialized in US mortgage debt. Nobody knew how big the losses were or how great the exposure of individual banks actually was, so trust evaporated overnight and banks stopped doing business with each other.
  • On 15 September 2008, the US government allowed the investment bank Lehman Brothers to go bankrupt. When Lehman Brothers went down, the notion that all banks were “too big to fail’ no longer held true, with the result that every bank was deemed to be risky. Within a month, the threat of a domino effect through the global financial system forced western governments to inject vast sums of capital into their banks to prevent them collapsing.
  • The winter of 2008-09 saw coordinated action by the newly formed G20 group of developed and developing nations in an attempt to prevent recession turning into a slump. Interest rates were cut to the bone, fiscal stimulus packages of varying sizes announced, and electronic money created through quantitative easing. At the London G20 summit on 2 April 2009, world leaders committed themselves to a $5 trillion fiscal expansion, and extra $1.1 trillion of resources to help the International Monetary Fund and other global institutions boost jobs and growth, and to reform of the banks. From this point, when the global economy was on the turn, international co-operation started to disintegrate as individual countries pursued their own agendas.
  • 9 May 2010 marked the point at which the focus of concern switched from the private sector to the public sector. By the time the IMF and the European Union announced they would provide financial help to Greece, the issue was no longer the solvency of banks but the solvency of governments. Budget deficits had ballooned during the recession, mainly as a result of lower tax receipts and higher non-discretionary welfare spending, but also because of the fiscal packages announced in the winter of 2008-09. Austerity became the new watchword, affecting policy decisions in the UK, the euro zone and, most recently in the US, the country that stuck with expansionary fiscal policy the longest.
  • The dressing down given to Washington by Beijing following S&P announcement was, however, telling. Growth rates of close to 10% mean that the moment China overtakes the US is getting closer all the time, and the communists in the east now feel bold enough to tell the capitalists in the West how to run their economies.

 

Current Economic Problems

  • The US Federal Reserve has finally raised interest rates for the first time in almost a decade. Income and wealth inequality in the United States has grown steadily since the global financial crisis erupted in 2008, but monetary-policy normalization could mark the beginning of the end of this trend. Americans earned 4% less income in 2014 than they did in 2000, and for the first time in more than 40 years, middle-class Americans no longer constitute a majority of the population. America’s 20 wealthiest people now own more wealth than the bottom half of the entire population. Ironically, this trend was exacerbated by the policy response to the financial crisis. While the recession of 2007-2008 caused higher-income groups to suffer more than lower-income groups, the opposite has been true since 2009. Since then, about 95% of all income gains have gone to the top 1%. As the Fed slowly raises interest rates, those middle-class families holding their hard-earned savings at the bank will finally start realizing some return on their deposits.
  • The Chinese economy now confronts – real and financial – the twin challenges. On the real side, China needs to achieve a transition away from unsustainable investment-led growth. China’s investment rate of 41% of GDP was extraordinarily high. But by 2010-2011, it had soared to 47%, as the authorities unleashed a real estate- and infrastructure-construction boom aimed at offsetting the threat to exports and employment arising from advanced-country deleveraging. As China shifts to a more sustainable consumption-led growth model, it needs better investment – and less of it. In the meantime, China’s financial challenge is intensifying. While the growth in services is generally desirable, the expansion of China’s financial services – currently the economy’s fastest-growing service industry – is generating serious risks. Chinese policymakers now face a dilemma. Constraining new credit would fuel a surge in defaults on bank loans and wealth-management products, and would cause investment to contract much more rapidly than consumption can feasibly grow. But allowing the credit boom to continue will create even bigger problems in the future. For now, China’s leaders seem to be going with the “more credit” option. Bank lending has accelerated over recent months. Total debt is still growing at a faster pace than nominal GDP. And if current trends hold, the debt burden could amount to well over 300% of GDP by 2020. (Recently, the IMF has agreed to add the Chinese yuan to its reserve currency basket. In a statement, IMF Managing Director Christine Lagarde noted the yuan’s inclusion is a “clear representation of the reforms” taking place in China. “The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and global economy,” Lagarde said. Lagarde and the United States had supported its inclusion in the basket, known as Special Drawing Rights (SDR). It will join the euro, yen, pound and dollar in the reserves basket. The yuan will have about an 11 percent weighting in the SDR.)

 

Why Economic Crisis of 2007 Was not an Economic One (17th March, 2018)

The economic crisis of 2007 was not an economic one. Why?

The inflation adjusted US housing price index in 1900 was close to 102 (Base year 1890, 100). In 2000, it was 120, and in 2007 it was close to 195. From 1890 to 1990 (100 years), the percentage increase was 25%. From 2000 to 2007 (7 years), it was a whopping 62.5% (Source: Observations, Saturday, July 23, 2011).

For 100 years, the framework in people’s mind was an average annual price growth of 0.25% for housing. All of a sudden, people’s framework of housing price growth changed phenomenally. What was the cause? It was nothing but financial innovation and a conducive environment.

Is financial innovation bad? Consider this. More than 60% of Americans own a house. The remaining 40% of Americans need a house. This is a huge opportunity in the housing industry. We need to build a lot of houses and we need fund for this. Who will finance a huge amount to this housing sector? The neo liberal capitalism does not allow the government to take an active role of this social benefit. The free market forces will find a way to solve this housing problem. In deed! The free market forces found a way.

The total asset value of houses (Single family owning a house) in US was about $20 trillion in 2000. These assets are not productive except that it meets the cost of staying in a house. If you own a house you don’t need to pay rent. If not it costs you a rent. These assets are investments made in the past. What if these house owners are encouraged to build houses for the rest of 40% Americans who do not own a house? Great idea. The house owners can be financed taking the collateral security of their houses. In turn, the house owners can build a second home that can be rented out. As there is huge demand for houses, the asset price will continue to increase. In addition to house rent, the second home will also produce capital gains for the owner. A safe bet for the financial institutions.

Besides, there are other positive aspects for the US economy. Demand for raw materials, capital goods, and labor will place the economy in robust growth. Wage increase will improve income level and purchasing power. In turn, consumption will increase resulting in higher GDP. This really sounds good. Then what went wrong?

It is the greed of financial institutions and some people. The financial innovation was not executed prudently. Loans were sanctioned on bad assets and these bad assets were clubbed with good assets (Securitization, another financial innovation) in order to get more funds from other higher financial institutions in the hierarchy. The higher financial institutions did not scrutinize the securities. Hedge funds were brought into the game to avoid risks (yet another financial innovation). All these unscrupulous financing happened just to make more profits while the Sun is shining. The Sun was shining but a volcano erupted and spewed dirt that screened the Sun. The edifice built by the financial innovations collapsed. The weak pillars could not withstand the huge load.

Once you start feeding you should not break it before the task is completed. In case of housing loans, the repayment period is very long. People need income continually in order to repay the loans. Otherwise, the loans will require liquidation. The bubble bursts and asset prices come down drastically that deteriorates liquidation process. This is what happened once you stopped feeding. Greed screens prudence.

Disbelief is one important factor that put the break on feeding. A mere 25% growth of asset price over a period of 100 years from 1890 to 1990 had changed to around 62.5% from 2000 to 2007 over a period of just 7 years. Suddenly, people realized that this growth is unbelievable. How long will it go?

Secondly, the wage growth of the 40% American who do not own house was not matching with the asset price growth of 62.5% from 2000 to 2007. Let us see some data: From 1948 to 1973, the productivity was up at 96.7% while the hourly compensation was up at 91.3% for the same period. However, from 1973 to 2013, the productivity was up at 74.4% while the hourly compensation was up at a mere 9.2% for the same period (Automation could be the reason behind that, added by author). Source: EPI analysis of Bureau of Labor Statistics and Bureau of Economic Analysis of data.

That means the wage growth was absolutely not changing and it was stagnating for quite a long period (40 years!). To whom the new houses are built? The newly built houses are just show-pieces, owned by the rich.

Thirdly, the shelter costs have been increasing faster than the costs of other items. Shelter is considered a minimal human need, along with food and other consumer items. Median monthly housing costs, which include utility costs, have increased by 128%, from $348 in 1985 to $793 in 2005 (Source: U.S. Department of Housing and Urban Development Office of Policy Development and Research). While wage is almost stagnating, the shelter costs increased by 128%. That means people reduced their expenditure on food and other consumer items in order to pay the increased shelter costs. When 40% of Americans reduce an expenditure of $445 monthly on food and other consumer items, what is expected to happen? Recession.

Conclusion:

The economic crisis was just one of the dimensions of social order. While the American Social Structure (groups, strata and class, as well as the system of relations between them) provided an opportunity to build numerous houses to the 40% of Americans who do not own a house, the interactions between the sub-structures were not in order. While the American people have not yet completely shifted their mindset (framework) from the past, unbelievable asset price increase instilled doubt in their mind and in the institutions. The crisis within the institutions was another dimension that was not in order. Demography was another dimension which is undergoing severe crisis currently.

 

Why should you sell your gold?

In 1975, the gold price was $160.86 per ounce. During the same year, in India, the price was Rs.540 per 10 grams. Currently, the gold price is averaging below $1100 per ounce; in India, it is averaging below Rs.26, 000 per 10 grams.

In dollar terms, the price has increased 6.8 times from 1975 to 2015. In rupee terms, the price has increased a whopping 48 times. Is this the reason why Indians are frenetic about buying gold? Hold! There is another reason why gold price in India is unreasonably increasing comparing to international price trend. In 1975, rupee was trading at Rs.7.94 (US 1 dollar). Currently, rupee is trading around Rs.65 (US 1 dollar). The rupee-US dollar exchange rate has increased by 8 times during this period. Therefore, gold price in India is directly proportional to the product of international gold price increase and rupee-US dollar exchange rate increase.

A recent research suggests that gold price might touch $850 per ounce and $350 per ounce according to high real price and low real price trend of gold respectively.

Scene I: International gold price at $850 per ounce

In India, if people want the gold price at Rs. 26,000 per 10 gram the rupee-US dollar exchange rate shall be Rs. 80 (US 1 dollar) at the current product (54.4) of international gold price increase (5.3 times) and exchange rate increase (10 times).

Scene II: International gold price at $350 per ounce

At Rs. 26,000 per 10 grams, the rupee-US dollar exchange rate shall be Rs. 192 (US 1 dollar) at the current product of (54.4) of international gold price increase (2.2 times) and exchange rate increase (24.7).

Exporters will be happy with the rupee-US dollar exchange rate of Rs. 80 or Rs. 192. However, India is not a net exporter of goods and services. India might experience hyperinflation if it wants to keep the gold price at Rs.26, 000 per 10 grams. The central bank would interfere to keep the gold price lower at a manageable level. Policy makers and administrators will have a good time managing inflation, current account deficit, and smuggling of gold.

Revisiting on 19th July, 2017

International gold price is above $1200 per ounce. Nothing happened as predicted by the research. Happy going so far.

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