Current excess can lead to future stress.
Here, let me break it down for you
In Sri Lanka interest rates have been low for a long time. When interest rates are low people spend rather than save. But when they stay low for a long time people will begin to expect them to go up again and well, how many loans does an average person need anyway?
But the Central Bank doesn’t look likely to increase rates soon. Low interest rates have fueled the economy and is one reason that we have hit 8.3% growth in the second quarter of 2011. Credit is freely available, and so people spend, and so the economy prospers. This is a good strategy for growth, but only in the short to medium term.
Some people, like LBO’s fuss budget, are saying that there is a ‘credit bubble’ about to burst because banks are lending more than people are depositing. So far people have been spending. Like there are a lot of cars being brought in. But lately inflation has been slowing, and even though this is attributable to falling global commodity prices, it can also mean that the pull of demand in prices is slowly letting up.
This indicates that people are now kind of tired of spending their money on consumables. They are expecting interest rates to go up because they have been to low for too long. And no good thing lasts forever. So they are boarding up the windows and calling the dog in.
So now they are stuck with loans they are apprehensive about, since payments might increase when rates increase. And if paying the loans become unsustainable then they will simply default, i.e. the credit bubble will pop.
This is exactly what happened in the US when the sub prime mortgage bubble burst. But the similarities end there. Consequences were so large in the US because the loans were so massive and regulation turned a blind eye. Moreover, complex financial derivatives played a large role in bringing about the collapse and, because a lot of big banks had their hand in the chicken curry pot, they all got burnt.
In Sri Lanka, at most, a few leasing companies might collapse. The size and distribution of our loan base is not information that is freely available. Adding smoke to the situation is the undeniable fact that the government has also been borrowing money from the banking system. This is a practice that is generally frowned upon in ‘Macroeconomics for Dummies’ because it can distort the monetary landscape and make people see an oasis where there is only choking dust and sand.
But more worryingly people now have nowhere to put their money, be it savings or excess cash.
Domestic investment is low. The stock market is so-so. Foreign investors got spooked a long time ago and now its mostly the speculators passing the wench around in a circle.
People would like to invest in businesses, to take advantage of all the other people’s spending. But for an average Siripala, starting a business in Sri Lanka is like trying to go into a nightclub with rubber slippers. You must be joking. You have to know the right people, grease the right palms and you know, have the law on your facebook friends list so that they will not balk at enforcing your basic rights.
Even big firms aren’t investing that much. Getting things done hear is near impossible. And there is a lack of confidence in economic fundamentals. Foreign investors come but then turn away rather than hack their way through a jungle of red tape.
It’s not all bad though. The situation is improving i think. The government must slowly begin to realize that improving the business environment is top priority for growth to happen, and they are doing outreach. But will concrete change come fast enough to prolong the wave we are riding before it fizzes out and we crash board first into salt and sand? No one can tell at this point.
Speaking of points, we seem to have digressed slightly, back to the average Siripala. So government change in the business environment cannot help him, at least not now.
A few years ago people would have given their money over to shadow financial corporations like Sakvithi and Ponzi schemes like Golden Key because they didn’t know any better and because they are greedy. Chances are most people have now learned their lesson and burnt their fingers and so won’t think of giving their money over to get rich quick schemes, but one can’t underestimate the power of a heady mix of greed combined with stupidity and voluntary blindness.
‘But the Central Bank is keeping a watch, right? Any really seedy companies will probably be rooted out by their vigilant eyes’ we say.
Again, don’t be too sure of this. The CB’s actions in connection with the Ponzi schemers has at most been reactive. And there has been little or no broad based public education on shrewd investment. Besides, the CB has a lot on its hands right now, and are focusing all their energies in maintaining a propped up rupee and dodging a threatening balance of Payments crisis. My guess is they have no time for any bit players emerging out of the wet works to prey on a suspecting, but vulnerable public. Again our man is on his own.
Land has always been that old faithful, that friend on standby. You buy a patch of land and hold on to it. You might, nay, you will end up with a massive return on your investment in twenty years. The land market has slumped from its peak a few years ago but prices have been out of the reach of demand. Chances are this will change as more people see no option but to invest in land based assets, despite it being a long term investment. What is happening is that money that should have been saved will go out of the reach of investors when it gets sunk in land.
..Or bad things will happen
This is bad for the economy since a high savings rate is key for gross domestic capital formation and economic growth at a fundamental level. The central bank needs to control the credit bubble and reign in money before something horrible happens.
The exchange rate peg is already under pressure, the CB is trying to prop it up while at the same time carrying out monetary policy that is trying to push it down. Your standard economic textbook will call this process sterilized intervention. This only works in the short term when there is a likelihood of sudden and detrimental currency fluctuations. Sterilized interventions have rarely shown to be robust growth oriented monetary policy tools.
When the central banks prop the exchange rate by selling foreign currency to the domestic market and at the same time inject that domestic currency back into the market using other means, it gets caught up in a vicious cycle that becomes over-relaint on continued inflows of foreign currency, i.e in our case, loans and sovereign bond inflows. Its like a drug, you use it cause it feels good and gives you a high, but when it runs out the withdrawal symptoms can kill.
If the forex stops coming in, the CB will have no choice but to let the rupee drastically depreciate. This is an extreme case, but if it happen then its more than likely that investors will launch a ‘speculative attack’ on the rupee and scoot. Much like what happened to the Asian Tigers in ’97. Better for the CB to ease out of it now, while the going is still good.