End of 2017. Happy new year to everyone

Posted on December 31, 2017 by Kalaimathi Shankar

It’s been long time I have n’t wrote any article and I am thinking of writing new posts going forward in 2018 (Happy new year to everyone). 2017 seems to be one of the fine/busy year in career wise and personally also (my little kid is growing).

I am thinking of sharing the books which I read in 2017 and it may help somebody who is looking to read books in the areas which I am interested.

As a new daddy I was thinking of few investment ideas and disciplined lifestyle. Hence I was looking for some book related and found Jim Rogers book called “A Gift to My Children: A Father’s Lessons for Life and Investing”. Actually this book will not provide any investment but it does provide more philosophical thoughts about investments. This is not only investment book, but a very good book for parents and it is packed with full of general life lessons from Jim Rogers with a passion for life.

Next book which I read in 2017 was “The little book that beats the market by Joel Greenblatt”. Actually I was looking for some book to explain about stock financial ratios like EPS, P/E etc. I found this book simply amazing to explain financial ratios in very simple terms. I recommend this book to every new beginner in investments and I strongly advise not to follow the trick which they mentioned in book.

Next book which I read in last year was Robert Kiyosaki book called “Rich dad and poor dad”. One of the best written book in well-organized way about financial education and lot of nice quotes in the books which actually gives very good feel while reading. Some of the best quotes in this book are below

Money is not taught in schools.  Schools focus on scholastic and professional skills, but not on financial skills.  This explains how smart bankers, doctor and accountants who earned excellent grades in school may still struggle financially all of their lives

Rich people acquire assets.  The poor and middle class acquire liabilities, but they think they are assets.

You and your children future will be determined by the choices you make today, not tomorrow.

Action always beats inaction.

 

One of the book which I amazed is “The Intelligent Investor by Benjamin Graham”. Reason behind my amazement is because this book is written very long ago but still those fundamental (like margin safety) remains same for all value based investment styles. Author is the guru for world ace investor Warren Buffet. I have nt completed this book fully (pretty big book) and I hopefully will complete in this year.

Other book which gave very deep insights to food and food industry is the book written by S.Ramakrishnan. This book talks so clearly about how our foods are adulterated and how our food habits affects health. I recommend this book to any visitors who likes to get conscious thoughts about food.

Happy new year (2018)  to all the bloggers and happy learning. See you soon with new post.

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Why rich is getting richer?

Posted on June 11, 2016 by Kalaimathi Shankar

Today there exist a common phenomenon called, “Rich is getting richer and poor is getting is poorer”. This post is regarding why such inequality is happening. If you look at all my post, I will try to explain everything in layman terms for beginners. This post will also help the beginners to understand the concepts clearly. If any queries, you can query me in comments section.

quote-the-rich-get-richer-and-the-poor-get-poorer-proverbs-308479

 People have different views on this like,

1. Rich people are talented people.

2. Rich people are hard workers and they are working around the clock to achieve the dreams.

 In other way around, if you look at the same issue in more granular way to understand, “Why rich is getting richer.” We need to visualize the monetary system and modern day economics. I can say this is one of the primary reasons behind this inequality (not only the primary reason).

 Policymakers need to focus on the poor and the middle class in resolving the inequality but modern monetary policy focusses mostly on improvising the life of rich. Let us get into detail and I am assuming at the end of this post you will understand be able to understand the below important economic tools.

1. Central bank’s policy – price stability vs. inflation targeting.

2. Quantitative easing.

3. Negative Interest Rates.

The goal of monetary policy varies across central banks of different countries. But most of the central banks in today’s world are targeting inflation. First let us see about price stability and inflation targeting

quote-it-is-well-enough-that-people-of-the-nation-do-not-understand-our-banking-and-monetary-system-for-henry-ford-63849

What is price stability targeting?

Price stability involves targeting a price index value like basket of goods instead of individual goods like rice, corn, butter etc.

For example consider,

Basket of goods in 2015 = 100$

Basket of goods in 2016 = 105$

From 2015 to 2016, value of goods inflated by 5% then central banks will use it monetary tools to reduce the price to 100$.

Again in 2017, if the value is 102$ the central bank will commit itself to bring back the price to 100$. This is quite opposite in inflation targeting and because of this reason, everywhere around the world prices are increased every year.

In price stability, central bank main agenda is to bring the value back to original value (100$) which may involve deflation.

What is inflation targeting?

Inflation means your money will buy less number of goods or purchasing power of the currency is reduced.

'Inflation is when everyone is so rich nobody can afford anything.'

Inflation targeting means central bank of the country targets officially certain level of inflation percentage officially. Most of the developed countries central bank targets 2-3% and developing countries central bank targets 5-6%.

 interest-rate-inflation

Is it surprising?

Yes, central bank of the country officially wants certain level increase in price of goods so that economy of the country will grow. Is it really insane? How a common man or old age people will bear the increase of price?

How the increase in price of goods makes economy to grow?

To understand this, let me tell a small story.

If you have $100,000 to buy a house, would you buy it today, knowing that tomorrow the price will drop to $95,000? Now if you know tomorrow the price will be $105,500, would you not buy it today?

Same principle, everything will be more expensive in the future, people are more inclined to spend their money. Inflation discourages stagnant money in the economy and it basically encourages the people to buy or invest something in the economy because in future it might be costly. Because of this reason only central bank encourages moderate inflation and they are say it will encourage investment which in turn boost the economy.

Now let’s just look into a story for inflation targeting vs. price stability targeting.

Let us assume for this story, a person who works hard and earns 100$ a year and have an expense of 90$ (net savings is 10$).

Year 1 (savings) = 10$

Inflation in year 2 is 10% but still the income is 100$. Since the person is having 10$ savings, he is able to manage the inflation.

In price stability mechanism, central bank will try to bring price back to 100$ hence no need to worry about the price increase in year 3. If there is drought or some unforeseen circumstance then only price increase will happen.

Now let’s see how inflation targeting works.

In inflation targeting, central bank of the country officially targets inflation. Let’s say the inflation is 5%.

Then person should earn in

Year 2 = 105$

Year 3 = 110$

Year 4 = 115$

To achieve the above earnings, person needs to work hard, increase the productivity, wage increase demand etc.  As per the modern economics, gradual increase in the price of goods creates demand in economy which in turn creates more business, employment etc.

Will this create problem for common man (lower and middle class people)?

Answer is pretty straight forward and it is “YES”.

How retired person (old aged people) will be able to withstand the price increase? Until or otherwise they have inflation protected investments.

How low wage workers will be able to withstand price increase? Is there any rules in any country, wage should be increased along with central bank targeted inflation rate?

All the savings of the people is getting eroded because of the price increase until or unless they have invested in some inflated protected investments. Do you think low/middle class people are doing this? Is there any enlighten happening to educate them?

Inflation targeting policy helps mostly rich people of the country and it really creating havoc problems for fixed wage workers because it really erodes the purchasing power. Persons who hold shares or stocks of companies gain during inflation. When prices increase, business activities expand which increases the profit of companies but they do not increase the wage of its employees. As profits increase, dividends on equities also increase at a faster rate than prices. But if you look at fixed wage workers or lower class people mostly keep the savings in savings account or fixed deposits which carry a fixed interest. It causes loss during inflation, because they receive a fixed sum while the purchasing power is falling. We need a proper education system to educate them.

Most of the people are not aware of the inflation and many are considering this as price hike.

 Hilarious-Quotes-47290-statusmind.com

 Why prices are not falling even when inflation is getting low?

Inflation is not related to price decrease. If inflation is getting low means prices are not rising in the economy and look at the factor called deflation which measures the decrease in price.

You can calculate the value of the money using the below formula

Reduced amount = amount/(1 + inflation rate)^number years

Let us assume you have 10,000$ and you like to calculate the value of $ after 20 years. By applying the above formula you can derive the value (assume inflation is 2%)

10,000/(1+0.02)^20 = 6711.41$

Required amount to compensate the inflation is calculated by the below formula

Required amount = amount * (1 + inflation rate)^number years

Required amount = 10,000 * (1+0.02)^20 = 14,859.47

You should have 14,859.47$ today to compensate the inflation after 20 years.

Central banks mostly controls inflation by Interest rates and the most modern day tool is

1. Quantitative easing

2. Negative interest rates

Quantitative easing is one of the tools used by central banks of US, Europe and Japan especially after the 2008 financial crisis. This policy was first used by Bank of Japan (BOJ- Japan central bank) in early 2000’s to control deflation and this policy is used by U.S Fed, UK BOE (Bank of England) and Euro zone ECB (European central bank).

What is quantitative easing (QE)?

QE is nothing but expanding the balance sheet of central bank of the country through asset purchasing program.

(Or)

Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.

quantitative_easing

 Is it confusing?

QE is nothing but printing out money in thin air by central bank of the country to purchase corporate bonds or stocks to create money supply for business expansion. 

Banks earn profits when they create new money through lending, but they lose money when they make bad loans. After 2008 crisis, banks are not willing to lend money. This results in minimizing the business expansion eventually layoff/job shrink will happen in economy. Since US is the world giant economy let us look at the Fed stimulus policy.

 QE.jpg

 Fed expanded its asset purchases program (QE) in the various intervals in the form of QE1 (December 2008), QE2 (November 2010) and QE3 (September 2012).  The Fed’s balance sheet expanded from about $850 billion to more than $4.4 trillion. Although the Fed has not announced an official end to the program, it began purchasing smaller amounts of bonds, referred to as tapering. 

Is really QE helps to simulate the economy?

If you take a close look at QE, a major direct benefit of this program is institutions (got access to cheap credit) who play a major role in economy and not the daily wage worker. Expectation is that because the cheap credit business will expand, new jobs will be created. But inequality will increase rapidly, the low wage workers who don’t have access to cheap credit. They are also affected by inflation (new money printing always create inflation). To understand more on the impact, refer the below link which really depicts this issue clearly

http://www.cnbc.com/id/49031991

Negative interest rate

Negative interest rate is another unconventional monetary policy used by few central banks of the country to stimulate the growth in economy.

What is negative interest rate?

Once we keep our extra money in commercial bank deposits, then they are giving interest as an incentive to us. In the same way commercial banks keep their extra money in Central bank of their country then the Central bank will give interest as an incentive to the commercial bank. Banks also sees this method is risk free because they are parking the excess money in trusted place and they are earning interest as well. Even though Central bank interest rate is low, commercial bank sees this approach as risk free. But in the view of growth based economy, stalled money is not good. Basically money should be invested in some business then only economy will grow.

To encourage lending, central bank started to charge negative interest rates for commercial banks. Basically they cannot park the excess money with Central bank and if they do profits of the banks will get reduced due to negative rate hence they are forced to lend the excess money.

Who will get benefit from this policy?

Banks has to lend money and also they need to find risk free borrowers like highly paid professionals, big companies etc. Assumption from this policy is that borrower will buy new car or new house or renovating existing house which in turn stimulates the spending and results in growth. But this free money only increases inequality and the rich is getting richer easily and low wage workers are getting suffered because of the price increase. Just look at the housing bubble impact today, normal person is not affordable to buy a house in any cities of the world.

This article is not to pointing out the mistakes or blaming the policy and the current system which makes rich richer without considering the fact of fixed wage workers. Basically along with growth we need to reduce the inequality in this world, if only few sector of people in country are growing means, it’s not healthy growth and it is called bubble. People may argue that since we live in capitalist policy and everything is market driven but still majority of the world’s wealth is owned by few individuals. We need to educate the people about inflation and government should provide more stimulus in rural areas. Hopefully my views helps someone to get some enlightenment about monetary policy who is reading this.Thanks everyone!

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Is currency Undervalued or Overvalued?

Posted on March 27, 2016 by Kalaimathi Shankar

In today’s world, currency FX rate plays an important role in trade. Major export countries purposely keep their exchange rate low to boost exports and remain competitive among other. This post is to understand the impact of currency devaluation and how to classify currency as overvalued or undervalued.

What is currency devaluation?

Countries purposely keep their currency value low to remain competitive in international trade. Devaluation helps to encourage export and make imports costly.

For example just assume,

1 USD = 60 INR

US made pant cost = 30$

After import, pant cost in India = 1800 INR (60*30)

Now INR devalued to 70 (1 USD = 70 INR)

After import, pant cost in India will be more costly = 2100 INR (70*3)

This will encourage the domestic consumers in India to use local made pants because it will be cheaper than the imported.

Now look in the terms of export

1 USD = 60 INR

Indian made pant cost = 600 INR

Same pant will look more cheaper in International market = 10$ (quoted in $ because of international market)

Now INR devalued to 70 (1 USD = 70 INR)

Indian pant looks more cheaper in international market = 8$

Now consider another example in Thailand

Thailand made pant cost = 700 THB (Assume 1 USD = 35 THB)

Thailand pant cost in international market = 20$.

Now if Tunisian country wholesale company wants to import pant from other country because of the local demand. When they look in international market they feel Indian made pants are cheaper (8$) compared to Thailand (assuming quality of both countries are same). Now Thailand have two options either devalue the currency or find some other alternate product for export to remain competitive in international trade.

What is the impact of currency devaluation? Does it impact the world economy?

Answer is pretty simple, “YES”

Before getting into that, let we just recap the history of World War II which provides more insights about impact of currency devaluation.

“Money plays the largest part in determining the course of history”.

Currency_Wars

France economy was in bad shape especially after World War I (WW1) and not able to settle the debt which they accumulated in WW1. They devalued the currency purposely to remain competitive among other countries which resulted in trade surplus for France and trade deficit for other countries in Europe (UK and Germany) and rest of the countries as well. During that time, entire world currency system was based on gold based standards which resulted in more inflow of gold to France. Other countries in WW1 were also in debt and they also need to devalue the currency to remain more competitive in the world trade. Many countries moved out of gold standards based currency system as they were running out of gold which lead to great economic distress to other countries. Germany was in more terrible state as they were in hyperinflation. They moved out of gold standard and printed more currency notes. Most of the country’s currencies became worthless. Revolt began in many countries, because citizen were not getting basic needs like food, clothes etc. which resulted in WW2 (Germany invaded Poland). Supremacy among the country is not only the reason for WW2, currency devaluation (Currency war) is also one of the reason for WW2. Actually currency devaluation started to remain competitive in world trade but it went in other way around people lost faith in currency and trade became stagnant. Everyone knows the impact of WW2 and the economic state of the countries after the war. After the WW2, all countries agreed to keep stable exchange rates based on Bretton Woods agreement and IMF. From the above, bloggers can understand the impact of currency devaluation.

1 USD = 67 INR (approximately)

1 USD = 6.4 Yuan (approximately)

Is it really 1 USD buys 67 INR worth of goods in trade? Answer is “NO”. Then why that much difference in exchange rate. To understand this we need to look at three important terms

  1. Purchasing Power Parity (PPP)
  2. Real Effective Exchange Rate (REER)
  3. Nominal Effective Exchange Rate (NEER)

What is Purchasing Power Parity (PPP)?

Purchasing power parity is a measure of currency purchasing power i.e.) how much unit of currency buys set of goods compared to other currency. PPP defines how much adjustment needs to be made on the exchange rate between two countries.

For example to live a life for a day, citizen needs basket of products like water, vegetables, milk, egg, bread etc. and to buy these they need currency.

Country A currency requires 100 units to buy basket of goods

Country B currency requires 50 units to buy same baskets of goods means Country B currency is stronger to country A.

1 unit of Country B = 1.5 unit of country B.

Replace A with USD and replace B with SGD

1 USD = 1.5 SGD

PPP is crictized by many economist because you cannot find same basket of goods across two countries and also it never includes inflation, taxes, transportation cost etc. For example in India, people don’t like burgers, pizza and they eat this occasionally but in US it is not like that, burger is common for meal. PPP also does not include inflation, labor cost, operating cost and trade barriers. Labor cost and operating cost of India is cheaper in India compared to US.

Calculating the exchange rate based on the buying power of the currency is usually called as PPP Exchange Rate.  Based on this, economist predict whether currency is overvalued or undervalued.

currency-overvalued-big-mac-index

Using PPP, economist developed a model called Big Mac Index which is comparing the price of Big Mac burger across the various countries.

https://en.wikipedia.org/wiki/Big_Mac_Index

As per Big Mac Index, rupee is undervalued around 50-60 % and its value should be 1 USD should be in the range of 25- 35 rupees. But the current exchange rate is around 1 USD = 67 INR.

By the survey using PPP, INR is world third most undervalued currency.

Before getting into NEER and REER we will look into Nominal Exchange Rate and Real Exchange Rate.

In layman terms, nominal exchange rate is the rate which we see in FX market. It will say how many units of currency can be exchanged for another currency without considering the fact of purchase power of the local and foreign currency. In floating exchange rate mechanism it is simply based on demand-supply of the local currency against foreign currency.

1 USD = 67 INR

1 USD = 46 PESO

Real exchange rate is the rate which considers PPP along with inflation of two countries.  To understand in layman term let us look at an example below

Let us assume a basket of goods like rice, wheat, oil, bread, egg etc.

Country A requires 10000 unit of currency to buy basket of goods.

Country B requires 100 unit of currency to buy basket of goods

Based on PPP, we can say 1 unit of currency B is equal to 10 unit of currency A.

                1 unit of country B’s currency = 100 unit of country A’s currency

From the above you can see Country B currency is stronger than A because of the buying power.

Country A’s inflation is 11% (just assume)

Country B’ inflation is 1%

Net difference of inflation between two countries = 10 %

After inflation adjusted, real exchange rate is

1 unit of country B’s currency = 110 unit of country A’s currency

This is how real exchange rate is calculated i.e.) PPP is adjusted with inflation.

If nominal exchange rate is higher than real exchange rate then that country’s currency is called undervalued.

If nominal exchange rate is lesser than real exchange rate then that country’s currency is called overvalued.

Identifying basket of goods to calculate PPP is always difficult because necessity of the goods differs among people in different regions. Hence this methodology is always crictized and economist argue these model of calculating undervalue or overvalue of the currency prediction is wrong.

Next model which economist is using to predict undervalue or overvalue is that NEER and REER.

NEER means Nominal Effective Exchange Rate. NEER is an index that measures the local currency against weighted average of several foreign currencies, which usually will be the currency of trading partner countries. An increase in the NEER means appreciation of the local currency against foreign currencies.

REER means Real Effective Exchange Rate. REER is an index which is NEER, adjusted with inflation. An increase in REER means local currency is getting appreciated against foreign currency which in turn exports becomes expensive and imports becomes cheaper.

Reserve Bank of most of the countries will calculate the NEER & REER index and publish it. As of now we saw about currency devaluation, impact of currency devaluation, nominal exchange rate, real exchange rate, PPP, NEER and REER.

Now let’s go back to the basics and find whether Indian currency (INR) is overvalued or undervalued as per today’s nominal rate.

As per Big Mac Index, INR should be traded in the range around 25-35

1 USD = 25-35 INR

But economist argue that this model of prediction is incorrect because Indian people taste is different. Hence to remain competitive, burger remains cheap in Indian Market. Might be correct!

But I went in other way around to find PPP for INR against USD. Let us compare New York and Bangalore because both the cities are most costly city in the respective countries.

Have a look at the below site which compares the prices of New York and Bangalore. http://www.numbeo.com/cost-of-living/compare_cities.jsp?country1=India&city1=Bangalore&country2=United+States&city2=New+York%2C+NY&displayCurrency=USD

You would need around 7,222.74$ in New York, NY to lead the same standard of life that you can have with 85,000.00Rs (1,271.87$) in Bangalore (assuming you rent in both cities).

By looking at this cost of living data, you can easily say Rupee is undervalued compared to USD. Even if you add inflation of both countries (India and US) still rupee value is undervalued and more or less it is getting closer to Big Mac Index.

As per PPP analysis we can clearly say INR is undervalued against USD.

Now let’s look at REER and NEER index which RBI is publishing periodically to identify whether INR is undervalued or overvalued.

NEER_REER

 

If you look at the above data it is just index value and it not exact exchange rate against any specific currency. To get value against specific currency we need to do few calculation which is shown below.

Six Currency trade based index value for REER = 120.82

Nominal rate of USD against INR = 67 INR

Exchange Rate based on REER = Nominal * (REER/100)

Exchange Rate based on REER = 67 *(120.82/100) è 80.4

As per the above calculation you can see INR is overvalued. INR should be in the range of 80 against USD to remain competitive in international market. Not too sure how India is calculating inflation because there is huge difference among cities and villages in India.

Conclusion is that rupee is undervalued by PPP (should be around 25-35 against USD) and overvalued by REER (should be around 80 against USD).

PPP is available for most of the currencies in the world even third party vendors like Bloomberg is calculating its own value and publishing it. REER and NEER is getting published by most of the country central bank and IMF. By looking at PPP and NEER/REER we can calculate whether currency in overvalued or undervalued.

Most of the countries, keep their exchange rate undervalued to remain competitive in international market. Too much of depreciation always cause panic in international market because of that reason only when China depreciates the currency entire world market was crashed. Hopefully history won’t repeat again and there is a quote from Karl Marx which is very apt for this post. And this marks end of this post as well!

KarlMarx

 

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One Country – two currency (CNY and CNH)

Posted on March 6, 2016 by Kalaimathi Shankar

After my last post, I thought of writing about China currency system and this article is about it. If you look at China they started economic reforms since 1978 and they achieved world second largest economy status. Economist are saying even China will overtake US and becomes world largest economy in the -coming years, this is not possible without proper currency system. China achieved reserve currency status in the late 2015. There are few critical comments about the China currency and I am going to ignore that in this post, it is regarding the positive sides of Chinese currency system. I always admire this country because they reformed in short span and made it huge remarkable growth. Just compare the size and population of the country and regulating/reforming the country is not an easy task.

China

By the end of this post bloggers can understand the below.

  1. Difference between CNY, CNH and RMB (Renminbi).
  2. What is offshore and onshore currency?
  3. What is international currency?
  4. What is fully convertible currency? Is RMB fully convertible?
  5. How China is liberating the currency without opening up capital account fully?
  6. What is internationalization of China currency (Renminbi)? Why Chinese government is pushing these reform and the various difficulty in this?

Renminbi (RMB) is the official currency of China and CNY (Chinese yuan) is account of unit in RMB like we have cents in a dollar and paisa in a rupee. CNH is the offshore currency of China.

To understand the offshore currency model, we need to understand international trade.

Let’s us classify the trade into three categories. This is not a thumb rule but most of the countries follow this

  1. Trade between two developed countries
  2. Trade between developed and developing countries
  3. Trade between two developing countries or undeveloped countries

In the case of 1, trade invoicing will happen in exporter’s currency. For example, US is exporting goods to UK then US exporter will receive payment in USD.

In the case of 2, trade invoicing will happen in developed country currency. For example trade between China and US (developed and developing country).

In the case of 3, trade invoicing will happen in developed country currency.For example trade between India and Brazil will happen in USD.

If you see most of the trade is happening in developed country currency (International currency like USD, JPY, EURO, Sterling and RMB).

If you look at the above three cases majority of the international trades are happening in USD. Now international countries need USD to settle their trade and the currency market which resides outside US is called EURO DOLLAR. EURO DOLLAR is nothing but US dollar denominated deposits in foreign banks and in other words it is to be called as offshore currency market for USD. If a country’s currency needs to be international currency then it should have both onshore market (inside US) and offshore market (outside US). Without offshore market, international participants cannot settle the trade and a currency cannot become international currency.

For better understanding in layman terms let us look at an example.

Country A produces more wheat and rice and uses X as currency. Country B is in severe drought and uses Y as currency. Now country B needs wheat and rice from country A and -there are only two options as listed below

  1. Country B needs to buy goods from country A using their own currency (Y). This is applicable only if country A accepts country B’s currency.
  2. Country B needs to exchange their currency to country A’s currency (X). For this they needs to go FX market and convert currency Y to X.

Let us assume country A told I will sell wheat and rice to you in X currency only(A’s currency). Now country B need bank account for currency X and they need lending market as well. Country A currency (X) in country B will be called as offshore currency. Lending rate of currency X will differ in Country A and B. Without setting up offshore currency infrastructure it is quite difficult for country B to buy goods from country A.

Why lending market is important for offshore currency?

If another country currency needs to be used in international transaction means they need loans in that currency and also offshore interest rate always differs from onshore market rate (marginally). For USD, LIBOR (London Interbank Offer Rate) is the lending market. Not only USD all the international currencies like JPY, EURO, Sterling lending rates are decided in this market by leading banks of this world.

Now get back to CNY and CNH, CNY is the official currency unit of RMB and CNH is the offshore currency.

Is RMB different from other international currencies?

Answer is yes, RMB (CNY) is the only international currency without having open capital account and flexible exchange rate (FX rate). Let us see these in detail.

What is international currency?

An international currency is a currency, which is capable of carrying value in international trade (invoicing currency) and there should be no restriction for residents and non-residents to hold that currency. Most importantly value of the currency should not get eradicated in time value relationship and also country should have well liquid financial system in capital market and debt market.

What is open capital account?

Open capital account means country should not have any restriction limit for the residents as well non-residents to convert the currency to another currency. In other words it will be called as convertibility of the currency. Most of the countries in today world have strict rules on capital account to avoid capital flight especially after ASIAN Financial crisis in 1997.

What is capital flight?

When the country currency value is getting devalued in international market it will create fear among the people in that country, their money becomes worthless in near future. Hence they will try to sell their own currency and buy other international currency like USD, GBP etc.

To understand this we need to revisit ASIAN financial crisis in 1997. Before 1997, Thailand was one of the best emerging economy in Asia and all the international investors were flown to Thailand for investment. Because of the fixed exchange rate regime, international investors exchange risk is limited and domestic investor also borrowed huge amount of money from other countries. There was no capital controls and it means foreigner can invest millions and millions of money in Thailand and domestic investor as well can invest in foreign currency denominated assets without any capital control. Speculative attack was done on Thailand economy and this leads to Thai Bhat currency depreciation because investors are selling Thai Bhat in international market and fleeing back. Central bank of Thailand made the currency to floating rate from fixed rate and this increased burden on domestic investors because they have to pay foreign currency denominated loans. It means they need to pay more (currency is devalued). Local people started to sell their own currency in international market to escape from devaluation.

Thai

If you look at the above you can visualize the devaluation. All the foreign denominated loans are more costly and ratio of default got increased in the country. Entire banking system collapsed, unemployment got increased and stock market index lost huge amount of money.

After this incident, Thai central bank has imposed strict rules on Capital account transactions to avoid capital flight.

What is meant by strict rules on capital account?

Imposing tight control on country citizen in holding up foreign assets like bonds, equity, loans etc.

Imposing tight controls on citizens converting the country currency to another currency. For example, if individuals wants to expand business in abroad, there is cap amount and above that they need to get regulatory approval.

FDI and FII have threshold amount limit for investment in the country. If not, it will lead to another speculative attack by FII and FDI by pulling out massive amount of money from the economy.

What is meant by Convertibility of the currency?

Convertibility of the currency defines how easily country currency can be converted to another currency without any restriction.

For example, let us take Indian rupee which is fully convertible on current account and partly convertible on capital account. Fully convertible on current account means any Indian citizen wants to do business with other countries means they can sell INR and buy USD as FX spot transaction. For invoicing trade purpose they can sell & buy INR and there is threshold limit if it exceeds government prescribed limit. In capital account there are lot of restrictions for FII /FDI and citizens, they are not allowed to freely move the financial assets from India to another country.

I think from the above explanation bloggers can easily grab ideas about International currency, Open capital account, Capital flight and Convertibility of the currency.           

Background of RMB internationalization:

Now get back to RMB, China decides to internationalize RMB because they are the world second largest economy with more depends on export oriented income. China act as a factory for rest of the world. Before RMB internationalization, Chinese exporter exports goods to other country, they will do trade invoicing in USD and they will convert to RMB in FX spot transaction. This involves FX risk for the Chinese exporters because if their profit falls down CNY becomes weaker against USD. To avoid FX risk, China decides to internationalize the RMB without opening up capital account. Hong Kong act as a perfect place for Chinese to taste the flavor of internationalization of RMB. CNH is the capital account liberalized form of CNY which is planned by Chinese regulators.

CNY and CNH are same i.e.) there is no physical currency exists as CNH and it is open capital account form of CNY. To understand more in layman terms, earlier we saw if any country wants to use their currency as international currency, they have to allow international investors to hold their currency. As a part of RMB internationalization, Chinese regulators formed bilateral swap agreements with other nations to internationalize the RMB.

https://en.wikipedia.org/wiki/Internationalization_of_the_renminbi#List_of_RMB_Bilateral_Swap_Agreements

How China is trying to internationalize without opening up capital account? How they are using CNH?

CNH is the offshore version of CNY and any international investors using CNH they can do trade with Chinese exporters and settle the trade. Chinese exporters can move the money back from Hong Kong to China without any capital restrictions but there is capital restriction if Chinese exporters move the money from China to Hong Kong. Basically using CNH, Chinese exporters can invoice the trade in RMB and receive the money but still restriction applies if they try to convert to other currency for moving the money out of China (controlling capital flight).

Why China is so eager to internationalize the currency? Is it only because to reduce FX risk associated with trade?

Answer is pretty simple and it is “NO”. Once you become international currency you can accumulate more debt in the form of bonds. As I mentioned earlier in this post, if any business needs to expand they need more money. For money they cannot only depend on banks and they need strong capital market (Equity and debt market). Once you become international currency other countries will try to grab your sovereign government bonds and corporate bonds. Because other countries needs that bond for future investment purpose and country can accumulate more debt like US today. US is the world most debt country with 18 trillion dollars and running with deficits for the past few years. Even they are in deficit budget still countries and individual’s looks US bonds as a safest investment because international trades are happening in USD and they need US dollars for their future. Even China allowed CNH denominated bonds (DIM SUM bonds) in Hong Kong after RMB internationalization and international investors are flying to buy those bonds. Dim Sum market increased like anything from 2009 and you can look at the stats by googling over web.

Below are my questions in my mind for the past few months. Let us see how China will become international currency.

Will China overtake US and replace RMB as international currency?

Tough times for China right now. Will they overcome?

Will PETRO DOLLAR era will be replaced by PETRO YUAN?

Will China become fully convertible currency on both capital and current account?

This marks the end of my post. For any queries, you can query me in comments section. Thanks!

 

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How currency exchange (FX) rate works?

Posted on January 3, 2016 by Kalaimathi Shankar

After my post on money, I was trying to understand how exchange rate works and how it is controlled or managed by central bank of the country. This post will make you understand the basics of currency exchange rate. Actually I was about to post on the topics of falling crude oil prices and start up boom but because of other commitments I am not able to make it and soon I will post on those topics also. By the way, Happy New Year to everyone and this is the first post in this year.

Post_Header

Below were the questions in my mind and I am repeating those questions here so that it will be easy for the viewers to get a clear idea about the agenda of this post.

  1. Does higher exchange rate means stronger economy?

I USD = 66.50 INR

1 USD = 6.4 CNY

1 USD = 122 Yen

1 USD = 36 THB

1 USD = 71 RUB

Conversion rate of USD to THB is less compared to USD-INR rate. Then is it true that the Thailand economy is stronger than India? In the same way, is it rite to say Indian economy is stronger than Russian economy by looking at the exchange rate? By looking at the exchange rate we cannot say which country economy is strong. We will look in more detail about this later.

  1. What are the factors affecting exchange rate?
  2. Who manages exchange rate?
  3. What is the relationship between exchange rate and interest rate? Once US FED increased interest rate, USD is getting stronger against the major currencies of the world.
  4. Is there any relationship between inflation and exchange rate?
  5. How central bank manages exchange rate of the country?
  6. In 2015, we were keep on hearing China’s devaluation of its own currency? How they able to achieve that easily? Why China keep on buying US debt? Why they are pegging against US dollar?
  7. Why Indian rupee (INR) keep on depreciating and Indians are worrying about this? But in China they are devaluating the currency overnight easily. Why India is not doing like this?

First let us get into the basics so that it will be easy to understand the concepts

What is exchange rate?

Exchange rate of the currency represents the value of its money in international trade. In other words, exchange rate is a price of a currency stated in units of another currency,

1 USD = 67 INR

1 USD = 6.4 CNY

Why exchange rate exists?

Exchange rates exist because countries have to exchange their national currencies with foreign currencies to engage in trade (buy and sell of commodities) and financial transactions with other countries.

Most of the international trades and transaction will happen in USD, EURO, POUNDS, YEN and FRANC. These currencies are called as IMF Reserve currencies and even Chinese Yuan will be part of reserve currency basket. Every central bank of country maintains these currencies as foreign reserves.

What is domestic and foreign currency?

Let’s us say a person lives in India then

Domestic currency – INR

Foreign currency – Other currencies USD, YEN etc.

Why international trades is happening in reserve currencies not using the country domestic currency?

In today’s world there are almost 180 fiat currencies exists. If every country settle the cross border trade using their domestic currencies then international trade becomes more complicated. To explain this let me give an example

Country A produces surplus wheat – INR

Country B produces surplus oil – USD

Country C produces surplus rice – THB

Country D produces surplus cotton – YEN

Country A needs oil and Country B needs wheat hence both countries happily exchange their domestic currencies for their cross border trade. Country C requires oil but country B does not require rice because they able to produce in their country hence country C finds difficult to get oil. Because of this reason only people invented money and now again same problem in international trade. Basically if both countries needs some commodities to exchange then there is no problem in exchanging domestic currencies but if they don’t then there is problem.

Hence they need universal currency to address this issue. Majority of the international trade in today’s world is happening through USD and the rest is by other reserve currencies like Pounds, Yen etc. I am not here to explain why USD is reserve currency (to know more about this refer my post on “Bretton woods system – How money is created”).

What is FX market?

FX market is a place where all the currencies are bought and sold. FX market is not exchange traded i.e.) it is traded over the counter by commercial banks, central banks, FX brokers, institutional clients etc. Major participant in this market are the larger international banks. Size of the market is very big and transaction size is about $5 trillion per day.

What are the factors affecting exchange rate?

Currency also follows basic economics model i.e.) demand-supply policy.

If there is more demand on domestic currency in FX market then domestic currency gets stronger against foreign currency.

1 USD = 67.50 INR

If there is more demand on INR against USD, then INR becomes stronger. Then exchange rate may become

1 USD = 67.20 INR

Domestic currency demand may get increase in the following cases

  1. Exports

For example, Indian manufacturer exports his items to a buyer in US, Indian exporter receives the payment for his export in US$. Therefore, if the Indian exporter is to use his US$ income in India, he has to sell his US$ (foreign currency) proceeds to a bank for INR (domestic currency). This will make the Indian currency stronger. Similarly if Indian importers have to buy USD for payments to suppliers then INR may get weaker. Thus Indian currency becomes weaker if there is more sell of domestic currency when compared to buy of domestic currency.

  1. Remittance from abroad

Citizen who is working outside the country may send foreign country money back to his home country for personal needs like family expenses and investments. This involves buying of domestic currency using foreign currency (selling of foreign currency and buying domestic currency). Demand increases on domestic currency because of remittance. To more about remittance, refer my post on Remittance.

  1. Foreign investments inflow

Foreign investment involves buying of domestic currency hence it creates demand for the domestic currency.

  1. Foreign borrowings

Individuals or banks borrow money from foreign banks or individuals and this create demand on domestic currency when they try to convert foreign currency to domestic currency.

If there is more demand on foreign currency then domestic currency gets weaker against foreign currency. Following are the cases where foreign currencies demand will be higher than domestic currencies.

  1. Imports are high compared to exports.
  2. Foreign travel – It will increase the demand of foreign currency.
  3. Foreign investments outflow – Foreigners taking their money back to the home country.
  4. Foreign loan payments.

Interaction between demand for and supply of a particular foreign currency against the domestic currency will determine the exchange rate of the foreign currency in the country. The demand will have an upward pressure on the value of the foreign currency and supply will have a downward pressure. The increase in the value of a currency against another currency is termed as appreciation of the currency whereas a decline in the value is the depreciation of the currency.

In addition to the above factors there are few other micro economic factors like

  1. Inflation
  2. Interest rate of the country

Before explaining inflation and interest rate let me explain important thing here so that it is easy to understand inflation.

If money is everything, why can’t central bank print more money and make everyone rich?

To explain this, let me give an example so that it will be easy to understand.

Let us assume there are three sons in a family, mother told I will give 1 slice of bread if you earn 1$. They lived happily by working hard and giving the earning to mom.

Now cost of bread is 1$

After a month each son got wage increase in their work and their salary becomes 2$. Even now also mom is able to make three slices of bread only and son is giving 2$ for bread slice. If not other brother will give 2$ and eat two breads. Mom does not want any son to sleep in hunger, so  mom decides to increase the price to 2$ so that everyone will get equal share. Just assume mom cannot make more bread slice in this example.

Now cost of bread is 2$

This is called inflation. Inflation means your money will buy less quantity of goods in economy. In the above example, same bread costs 2$. Hence printing money alone will not make you rich and it just inflates the money in economy. Actually production needs to be increased in the economy along with money supply else it will simply create inflation.

By the above example you can understand that increase in money supply alone will not solve the needs in economy. Actual production needs to get increased along with money supply then only money becomes valuable in economy.

Just replace mother with country and sons as citizens then you can visualise the economy.

In the above example just assume, sons got more wage increase to 10$ and their workload also doubled in the workplace. They need more food to make sure they are more fit and healthy. Hence all three sons decided to  import bread from nearby country but the selling country demanded more money for bread (1 slice for 3$). Now because of money supply, inflation happened and in turn induces import. As we already discussed if there is more import compared to export then exchange rate falls for the country.

Now again going back to story

Country A –> INR –> 1 bread = 1 INR

Country B –> USD –> 1 bread = 1.5 INR

Now exchange rate of both currencies said to be 1 USD = 1.5 INR (just assume in this story)

Inflation in country always demands imports and in turn exchange rate of the currency falls against the country which they are importing.

Even few analyst predict exchange rate of the country by using inflation data. For example, if the exchange rate for US$ is Rs.67 and inflation is 4% in US and 7% in India, the exchange rate should increase (or US$ should appreciate) by 3% assuming other things remain constant.

If inflation increases then import will get increase and in turn makes currency weaker in FX markets. Now you can understand why exchange rate increases if inflation exists.

Some people have a habit of comparing the exchange rate of a particular hard currency such as US$ across the countries and make comments on the comparative value of the domestic currency. However, there is no justifiable economic reasoning for direct comparisons of the levels of the values or exchange rates of the currencies. For example, if the exchange rate of US$ is 67 Indian Rupees, 120 Yens, 1.50 Euros and 6.4 Chinese Yuan, there is no economic theory to say that Japanese is the lowest valued currency or Euro is the most valued currency or Japanese Yen is weaker than Chinese Yuan or Indian Rupee is more valued than Yen for international transactions. These exchange rates are in different values due to differences in underlying factors that determine demand and supply conditions and there are no economic techniques to quantify how these differences determine different exchange rates.

Most of the central banks of the country manipulates it exchange rate to remain competitive in the world market. For example, China devaluates its own currency in the FX market to remain competitive in the export market. We can discuss about this later.

Now we can move into next micro economic factor called Interest rate of the country.

To understand interest rate, let me give an example

Bank A gives – 2%

Bank B gives – 2.5%

From the above you can easily say if we deposit money in Bank B we can get good returns. Same is applicable for country as well. If country interest rate is high then international investors will deposit their money in that country banks or buy bonds (I am not talking about bond market in detail here). If international investors investing in that country means they have to sell their currency and buy the currency of investing country.

For example, India interest rate is 6.75% and US interest rate is 0.5%. Now US investor is looking to invest in Indian market because of better returns and investor has to sell USD in Forex market and buy INR for his investment.

Because of this, INR demand will get increased and it will get appreciated against USD. Interest rate is also one of the factor for creating demand  of that currency in international market.

As of now we saw the basic factors affecting the exchange rate of the country.

Who manages exchange rate of the country?

Even though market demand and supply decides the exchange rate of the country but the exchange rate is controlled by central bank of the country. In today’s world most of the central bank controlling the exchange rate either by selling the own currencies or buying their own currencies in FX market to control the exchange rate of the country. Central bank will interrupt in FX market based on the demand-supply micro economics.

To understand more, first we have to understand how exchange rate system works.

Up to 1973 only we had international monetary system, i.e.) collapse of Bretton woods system.

What is Bretton Woods system?

All the currencies of the world should be tied to gold and central bank of the country will be authorized party of printing currency (objective is to have fixed exchange rate system to avoid another world war). But at the end of World War II there was no enough gold in many countries, hence it was difficult to print currency against gold then US came out with different idea because they had huge amount of gold after the World War II (read the history of World War II to know how they got huge gold). US mentioned I will link US dollar to gold at the rate of $35 per ounce of gold and other countries can print their currency using USD as reserve money instead of gold (US valued their currency equals to gold). Most of the countries agreed and few opposed but somehow this system was implemented.

Brentwoods

After 1971, world’s exchange rate system shortly is classified into below

  1. Fixed exchange rate system
  2. Floating exchange rate system
  3. Managed floating exchange rate system.

Fixed exchange rate system:

In fixed exchange rate system, central bank of the country fixes the exchange rate of the country against foreign currency. There are many currencies in the world that follows exchange rate regime and even developed countries like Hong Kong also follows it. But to maintain fixed exchange rate, central bank of the country needs to maintain huge foreign reserves else fixed exchange rate is not possible.

Main benefit of fixed exchange rate system is to encourage export and to encourage international investors (avoiding exchange rate risk). But maintaining fixed exchange rate there is huge risk involved for the country because it may leads to overvalued currency, inflation and black market for FX transaction.

To understand this, let me give an example.

Country A maintain fixed exchange rate of 1.2 times of USD. Let us assume Country A is Bahamas (just for our example alone actually rate is 1 USD = 1 BSD).

What it means?

1 USD = 1.2 BSD

USD is stronger than BSD hence exports to US will provide more income to Bahamas country citizen. Because of high income there will be more export to US from Bahamas. Because of more export there will be increase in foreign reserve in Central bank of Bahamas.

Let us assume interest rate of Bahamas is 2% and in US is 0.5%. Then Bahamas will look like as better investment destination for US investors because interest rate is high and also investors are protected from exchange rate risk.

Because of high exports and international investors in Bahamas there will be huge foreign reserve currency in Bahamas Central bank.

How central bank manages exchange rate in FX market?

Central bank of the country will sell his own currency against foreign currency or buy his own currency against foreign currency depends on the market condition.

To understand how central bank intervenes in FX market I would like to go back to bread example.

Let us assume person A contains 100,000 breads, person B and person C contains 100 breads. Now all three wants to sell bread in open market and everyone in business wants to sell their goods for more profit and wants to buy at cheaper rate. Hence person B quoted sell as 1.2 $, person C quoted sell as 1.3$ and person A quoted sell as 1.1$. Now everyone who likes to buy will buy at 1.1$ because that is best buy rate (cheapest one). Rest of them (B and C) either reduce the price in open market or there breads will not make a business in open market.

Now replace the person A as Central bank of the country and the rest as market participants then you can easily visualize the economy of country. By this logic only most of the central banks devaluates its own currency in FX market especially China. This is called devaluation of currency.

If there is more export or tourism on the country then there will be huge foreign currencies on central bank of the country because international payment will occur mostly in USD then citizen of the country will exchange its foreign currency to local currency in central bank of the country. Then it will be easier for central bank to maintain low exchange rates to remain competitive in the international trade.

For export nations like China, exchange rate defines how competitive in international trade and because of this reason they devaluates its own currency in FX market to remain cheapest export country.

Disadvantages of Fixed Exchange rate:

We saw that huge foreign reserves are important for maintaining fixed exchange rate but in addition there are huge risks as well like inflation, foreign investors pulling out from the country. Before 1997, most of the Asian countries follows fixed exchange regime and this crisis made lot of changes in ASIAN economy. For example, Thailand currency crisis is one of the best example of Fixed exchange rate and they adopted floating exchange rate because of this crisis.

Fixed exchange rate increases inflation and increases money supply in economy. To understand this let me give an example and we need to go back to bread example again.

Let us assume there are 100 breads, 100 BSD in economy (equal money supply 1:1) and bread cost is 1 BSD. Because of the high production there are 200 breads produced in economy instead of deflation in country they decided to export breads to other country (assume Bahamas exports breads to US). Now Bahamas decided to export extra 100 breads to US at 1USD (100 USD = 120 BSD) and now central bank of the country needs to print additional 120 BSD and economy grows up to 220 BSD. Now inflation in country will happen because of the additional money available in economy and we already saw if there is inflation people will import more goods from foreign country. If there is more import then there is more demand on foreign currency and it makes foreign currency stronger and local currency weaker which is not the desired one for fixed exchange system.

More export –> Increase in money supply –> More imports –> Inflation –> weaker domestic currency in FX market –> Central banks steps in and buy its own currency and sells it foreign currency to maintain exchange rate.

Above is possible only if central bank has adequate foreign currencies and if not it will lead to deficit in central bank account.

To control inflation, central bank of the country needs to increase interest rate in the country. Most of the countries in today’s world uses interest rate to control inflation. But we already saw if there is more interest rate then there will be demand for local currency in FX market which leads to currency stronger. In fixed exchange rate regime, central bank loses its control in managing inflation. Inflation is one of the serious issue in fixed exchange rate system.

More export –> Increase in money supply –> More imports –> Inflation –> Increase in increase rate to control inflation –> demand increases for local currency –> Central bank steps in to sell own currency for foreign currency.

Floating and managed floating rate system:

Most of the countries in today’s world follows this system either managed floating or floating. Instead of central bank fixes the exchange rate, market demand/supply determines the exchange rate. In both the cases, central bank of the country intervenes the FX market if the exchange rate moves beyond the desired rate. India is one of the best example for floating/managing exchange rate system.

By following floating/managed floating rate system, central bank is having full control to manage inflation using interest rate. Even China Central bank says they are also following managed floating rate system but more or less they follows fixed exchange rate system.

If you look at China they are the world biggest exporting nation and if they are biggest exporting nation then there should be more demand on Yuan rite. Why Yuan is less compared to US dollar even they are biggest exporting nation? China keep on selling US dollars in FX market against Yuan so that they can maintain Yuan as lower value in FX market so that China can remain competitive in export market. Now you can understand why China keep on buying US debts!!

China foreign reserves alone equals to 3 trillion USD.

How china able to get huge foreign reserves?

Only with few countries alone China accepting Yuan as settlement and the rest of international payments for them is happening using USD. These USD are getting accumulated in China Central bank (PBOC) as foreign reserve and they need to increase the values of these reserves by buying US bonds and equities. Because of the huge foreign reserves China is able to devaluate its own currency easily.

Why India is not able to do it like China?

If you see INR in FX market it is getting weaker and weaker every year because India’s central bank (RBI) don’t have huge foreign reserve like China. India’s foreign reserve is almost around 350 billion USD which ten times lesser than China. However still RBI intervenes in FX market to control exchange rate.

When India’s INR will gets stronger against USD?

One thing we have to keep in mind, exchange rate defines how countries goods are competitive in international market. Once India becomes export nation like China then INR will becomes stronger USD like China. India reserves are ten times lesser than China and this is the right time for India to become export nation because of the low crude oil prices and programs like “Make In India”.

To say in one word we can say, look at the currency as like as other commodities. If there is more demand on currency in FX market then it will get stronger and if there is less demand then it will become weaker.

This marks end of my post, hope all the bloggers able to understand my views on FX market. IF any queries you can post in comments section. Happy new year to everyone !!

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Thanks to everyone!

Posted on November 21, 2015 by Kalaimathi Shankar

Hi, this post is for saying thanks to everyone who is viewing my blogs and encouraging me to write about my interest. Actually I started this blog to share my thoughts in my leisure time but by looking at the visitors who visited from different countries across the world, I am really excited and happy. It looks like I traveled across those different those places, yes my knowledge and thoughts are reached.

Gaining knowledge is the first step to wisdom.

Sharing it, is the first step to humanity.

I will continue to share my thoughts in my free time. Again thanks to the everyone who visited my blog and future thanks to the bloggers who is going to visit.

Stats

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Is stock market really adds value to country economy?

Posted on November 21, 2015 by Kalaimathi Shankar

Last few days I am thinking about this and found few answers as well. If understanding is different from your view, bloggers can comment and correct.

Why countries economy is linked to Stock Market Index?

If stock index goes high then people are saying country is in growing mode and if it falls everyone is saying economy is going down. How the index points determines the health of economy? Even sometimes in recession index points will increase that does n’t mean country is growing (because of investor sentiment based on future anticipation it is growing high). Sometimes even in panic investors sell their shares and even that time share price will fall. My point is that if sentiment plays a role in index points then how economy status is decided based on this. Is really stock market add financial value to the economy?

Before that I will explain about Stock Market basics so that it will be helpful for the readers who wants to know basics.

Stock Market is a place where firms raises funds for their business. To be clearer stock market is always is divided into two categories

Primary market

Secondary market

Primary Market:

This is the place where companies raises funds for their business using IPO (Initial Public Offering). Actually it is the place where stock market add value to the economy of the country because based on the money collected by the company in IPO is used for business expansion. If business is getting expanded then more jobs, more export and obviously country GDP is growing. If more investments in stock market then more growth and jobs and this is the reason where developed countries have good capital market infrastructure.

What means buying share in IPO?

Investment in shares represents ownership of the company and no promised returns (means they are entitled to dividends of the company but dividend ratio is decided by the company even sometimes it can be zero).

What is dividend?

A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders.

Is people are buying shares only for dividends?

Answer is no. Apart from dividends, more important reasons to holding stock is to get capital gains. You can see shares in the market with low dividends but high market price.

What is capital gains?

Profit from the sale of share in secondary market.

Up to this I will complete the primary market. Let’s get into secondary market where the actual game starts.

Secondary market:

Secondary market is the place where shares traded on the Stock Exchange and market participants are looking for capital gains.

Capital gains in the secondary market transaction will not add any financial value to the company.

Why still the company management worries about the price fall?

In my view there are two reasons.

  1. Considerable amount of share is still in firm owner’s management so that high share prices is good for them because that is the price they can sell the shares in market.
  2. Current share price of the company is the future IPO price of the company. If company needs more money in future expansion they can still issue new shares hence they always wants the current share price with high market price.

By the above you can understand secondary market trading does not add any direct benefit to the company but adds value for future growth. Then why the economy is related to the stock market index?

What drives the price of shares?

Company’s profits and future plans determines the price of the share. As of now just ignore the other contribution factors for share price i.e.) If share price goes high means company’s profit is increased. Profit increase means more business in the country and more money in the economy. This is the reason why STOCK MARKET INDEX IS RELATED TO ECONOMY of the country.

Price discovery is the biggest task in share trading. Investors has to clearly analyse the company’s profit details and pay the price for shares in secondary market. If not that leads to stock market crash like DOT COM BUBBLE (I will explain this bubble in separate post).

Apart from this taxes plays an important role. It is adding significant value to the country’s economy and it is directly added to countries income.

Let’s see how stock market adds income to the government.

Even though trading happens between two individuals in stock exchange but it adds more value to the economy in the form of tax. Let’s take one market (India) and explain this. Shares trading in India is not free from tax and there are two tax components namely

STT – Securities transaction tax

Capital gains tax

Securities Transaction Tax (‘STT’) was introduced in the Union Budget of 2004-05 by the then Finance Minister, Mr. P Chidambaram.  As the term implies, STT is a levy on the value of taxable securities purchased or sold on a recognized stock exchange in India and is collected by the broker at the time of the transaction itself. STT on different products is tabulated below

Sr No Taxable securities transaction STT rate Payable by
1 Purchase of equity shares – Delivery Transaction  0.1 per cent Purchaser
2 Sale of equity shares – Delivery Transaction  0.1 per cent Seller
3 Purchase of a unit of equity oriented fund – Delivery Transaction Nil –
4 Sale of a unit of equity oriented fund – Delivery Transaction  0.001 per cent Seller
5 Sale of an equity shares or a unit of an equity oriented fund – Non Delivery Transaction  0.025 percent Seller
6 Purchase of Futures Nil
7 Sale of Futures  0.01 per cent Seller
8 Purchase of Options  0,125 per cent Purchaser
9 Sale of Options  0.017 per cent Seller

 

Capital gains is exempted from tax if investors holds shares for more than 12 months. If not investors has to pay 15% on the capital gains.

Around 55-60% of trading activity is done in intraday (i.e., holding a stock for less than 24 hours). Think how much of the capital gain tax will be flowing back to the government. Either BUY or SELL still government enjoys steady flow of money to their account in the form of tax.

In 2014 alone government collected 6000 crore in STT (920 Million USD) and also it is collected by broker at the time of transaction itself. Now you can understand why stock market is more important to the economy!

Every countries tax on share transaction is different from another and also we have to be careful in international share trading i.e.) have to look at tax structure of the country and then invest. I like to explain this in separate post and I will do surely.

Is stock market adds value to the economy?

Yes, stock market adds value to the economy.

This marks end of my post. Comments are more welcome!

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Volcker Rule

Posted on October 17, 2015 by Kalaimathi Shankar

                                                               Volcker rule

Most o people in banking world would have heard this term and the below pictures also gives  some hint about this topic. After 2008 crash there are lots of reforms in US financial world to avoid recession similar to earlier ones.

Volcker1

Volcker rule is part of Dodd frank regulatory policy and it is to bring commercial banks into good olden days (In plain vanilla term I can say only deposit and loans). In one word I can say stopping commercial banks in speculative investments but still they can hedge (no speculation). And also this rule helps to draw clear boundary between commercial banks and investment banks. I have used a lot of financial terms here and I will explain those in this post so that it will help the person who are not familiar with those terms. Let us see everything in detail in this post hopefully I will convey my thoughts in easy understandable manner so that it will help to enlighten the people who read this!

OH!! Then what went wrong in commercial banking world during 2008. Is there any learning’s from earlier recession?

Answer is pretty simple: YES YES!!

Before digging more, let’s look at few terms.

Investment banking:

Investment banks specialize in large and complex financial transactions such as underwriting acting as an intermediary between a securities issuer and the investing public, facilitating mergers and other corporate reorganizations, and acting as a broker and/or financial adviser for institutional clients. Major investment banks are Goldman Sachs, JP Morgan, Citigroup etc.

Commercial banks:

A financial institution that provides services, such as accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment products like savings accounts and certificates of deposit.

Hedging:

In derivative world hedging plays an important role. Hedging means minimizing the risk associated with the investment or trade (reducing the loss). Hedging means insuring yourself against a negative event to reduce the loss. Remember, the goal of hedging isn’t to make money but to protect from losses.

In layman terms let us look an example to understand more.

We are buying insurance for our bikes or cars, to insure yourself against accidents, theft etc.

Speculative:

These are the people in trading world who wants make money only by betting. These people whose ultimate motto is to make money not like hedgers they are in trading to reduce the risk in investment.

Proprietary trading:

When a firm uses its own money for trading to make profits. Trading means selling/buying stocks or bonds, derivate instruments etc.

Lessons we learned from 2008 crisis is that most of the financial firms did proprietary trading using customer’s money not their own money. Especially commercial banks forget their core business i.e.) they did trading using customers deposited money under the assumption that they will make only profit but the game ends in different scenario.

Let us move into Volcker rule now.

What is Volcker rule?

Federal Reserve chairman Paul Volcker formed this rule under Dodd Frank regulation and the core aim of this rule is that commercial banks should not do proprietary trading however they can do hedge trading in government securities (T-bills and bonds).

I did few googling and found that the Volcker Rule is based on the Glass-Steagall Act of 1933.

Glass-Steagall had two major prongs:

  1. The creation of the FDIC, which guarantees consumer deposits up to a certain amount.
  2. The separation of commercial and investment banking institutions.

As per rule 1, all the deposits in US bank are insured up to 250,000 US$. To learn more about this, refer the below link

https://www.fdic.gov/about/learn/symbol/

In India, all the bank deposits are insured by Deposit Insurance and Credit Guarantee Corporation (DICGC). But insured amount is very less and it is 1 lakh INR.

Refer the below one for more understanding

http://www.dicgc.org.in/english/FD_A-GuideToDepositInsurance.html

In Glass-Steagall act point 2 is not followed by financial institutions that leads various impact in 2008.

Are we happy now ?

Because Volcker rule is implemented hence we can avoid certain crisis again? I can say yes, but still there are few holes in that rule. Banks can’t make speculative trades, but they can hedge existing bets using techniques virtually indistinguishable from speculative trades. There is big debate always finding out whether trade is hedge trade or speculative. By using this loophole still banks are able to play their part.

If the Volcker Rule worked the way it was intended, a bank’s profit would only be derived from the difference between interest earned on loans and interest paid on deposits. Do you think it is possible? Then banks cannot pay huge salaries and bonuses!!

Let us see how dice rolls in the future. Now even Hillary also coming out with different form of Volcker. Rules are getting tightened day by day and investment banks are getting screwed every day. For Hillary proposal refer the below link.

http://www.vox.com/2015/10/7/9473769/hillary-clinton-volcker-rule

Posted in Equity and Derivatives | Tagged , | Leave a comment

How money is created?

Posted on September 19, 2015 by Kalaimathi Shankar

Last few days I spend few hours of my leisure time (train travel during my work and night time in weekends) to understand how monetary system works in the world. I am not micro economist but last few months I am studying various countries economics and their trade import/exports. Actually this helps me to understand how the global monetary system works and it was interesting for me to learn and explore more on that. I am not sure whether I will be able to convey my learning’s or finding’s in single post and if not able to convey I will continue the same in my next post.

I will list down my questions before getting into the post so that it will be easy for everyone who read this. If it helps someone learning I will be very happy (life is a meaningful journey we have to learn every day and share our knowledge to others).

  • What is money?
  • What is the difference between Currency and Money? Why two terms? Isn’t it confusing?
  • Why dollar(usd) becomes international settlement currency?
  • How Central bank of every country prints currency and release it?

 

What is money?

Money is nothing but a paper printed by the Central bank of the country and it depends on the targeted inflation rate and GDP. Printed money is backed by nothing (please make note here I will explain this later).

  1. What is inflation?
  2. What is GDP?
  3. Why central banks encourage inflation for growth?

I don’t want to discuss more in the terms of economist model here because it will not be easy to understand by normal person with less knowledge in economics. Using this model of modern explanation, economists are confusing the common people and making it difficult to understand the monetary system. Hence I will try to explain in easy understandable form.

When I started to study the monetary system I went through various books and videos. Everywhere one point is clear without understanding banking system it is quite difficult to visualize the system. Because banks are the one who helps to stabilize economy and this is the statement economist says everywhere. Hence I started to dig how banking works and how they make profit. Actually banks were formed when people wanted to store their valuable asset.

In the very beginning of our human race where human started to trade across various parts of the world or colonies, the main problem they faced is that they need something unanimously for settlement of the trades. They followed different methods as below.

 Commodity as money (Barter system):

When people needs something they will seek the opposite seller and swap the commodity for their trade. This is called Barter system.

Barter1

Barter2

However this system fails because it is too hard to carry the commodity along with them and it is very hard to buy in smaller quantity.

It looks funny now. Let’s say if we are in barter system now then our bank balance might looks like below pic

Barter3

Hence people moved to different system as follows.

 

Precious Metal as money:

Because of the failure of Barter system, people wanted to invent a different form of trading. They want a system which should be easily transferrable, accountable, reliable, portable etc. Because of this reason people started to use precious metals like Gold, Silver, Copper, precious stones etc.

After many forms of evolution gold based coin becomes predominantly accepted money (please note I used term money here not currency) for trading across the globe.

Once the gold became money then banking system became necessary in the world. To understand this I read a story about Goldsmith and most economists believes this is the place where banking system was born. Actually this story helps me to understand more about banking system like reserve ratio, reserve currency etc. Let me write the story here so that we can understand how the banking system works.

Goldsmith story:

Moneysmith1

Once gold was accepted universally as a medium of exchange in trade everyone was happy in the world. They worked hard to produce goods and they exchanged gold made coins for their trade. But they felt more unsecured to keep their high valued coins in home because robbery increased at that time because of the greediness. Hence they want a place to keep the coins safely. In the olden days there was goldsmith who already had safety measures like secured wallet storage and security guards for safekeeping the gold, hence people started to seek help from Goldsmith.

Moneysmith2

People: Will you please keep my gold coins safely?

Goldsmith: Dude, sure. Then, what is my profit?

People: I will give you rent for that.

Goldsmith: Pretty good deal. I am in dude!

Goldsmith happily makes money without doing anything. People are happy because risk of robbery becomes zero. But still people feel hard to take their coins during their travel.

Just assume X need to give 10,000 coins for the trade did with Y. X needs to carry 10,000 coins in the hand and needs to travel along with that and it is still unsafe, so they want something different and it should be easily transferrable. After discussion with goldsmith and people they invented new system called bearer note or I.O.U (I owe you) or paper money (note the term paper is money and not currency).

What it means?

Goldsmith started to issue paper money against the amount of gold which investors are holding in the wallet. Each paper money is backed by gold in the goldsmith wallet and people can easily carry their paper money in their own pocket and carry their trade. If anyone wants gold back they can simply go to Goldsmith and submit their bearer note or I.O.U or paper money and demand gold back. Goldsmith started to lend his own money and profits (rent which people are paying) at higher interest rate to people. Up to this stage everyone was happy including people and goldsmith (he is lending his own money and making profit even though people is giving rent promptly).

Does it sound like banking system?

Yes, you are right!

Moneysmith3

Things started to becomes messy once Goldsmith becomes greedier because the borrowers pay more interest than rent. Goldsmith realized not many people returned to his office for asking gold by swapping the I.O.U or bearer notes or paper money. Hence he started to print more currency (note currency here not money) without backed by gold (just printing in paper) and started to lend and he became super rich.

Depositors became so suspicious of goldsmith how he became so rich in short time frame. They wanted to visit the banks wallet and confirm whether the gold was there or not. All gold was there. They told sorry to Goldsmith and happily left the place. This gave more confidence to Goldsmith and he started to print more currency and start lending. Goldsmith became extra ordinary rich and again suspicion increased among the people and this time they not only visited bank and all the people together asked their gold back. Now goldsmith was in deep trouble and he is not able to return the gold back, Entire system becomes collapsed (doomed).

Now just relax and come out of the story!

Replace the greedy Goldsmith with banks and thinks of the whole system then you can understand the current banking system and all the flaws in Goldsmith story are corrected in this modern banking system. Not all commercial banks can print currency only the central bank of the country can print currency and it acts as bank to bankers. Central bank defines reserve ratio for lending i.e.) the amount of depositors money can be loaned. Every deposit we are making in the bank has been lending it to someone and banks are making profit from that. Local reserve currency is nothing but every commercial bank needs to deposits their reserve in central bank of the country.

Now the greedy goldsmith is replaced by modern banks (still greedy exists which we can see later) and money printing is taken care by central banks based on targeted GDP & inflation not backed by gold like Goldsmith. Banks are happily lending the hardly earned depositors money like the greedy goldsmith without much effort and making the money from debt (interest paid by borrowers).

What is the difference between Currency and Money? Why two terms? Isn’t it confusing?

In my post, I marked in bold to differentiate money and currency. Let me reiterate here as below

Banks and governments create currency from nothing (just printing in paper and in digitized world they are just typing the number in computer). Currency is a medium of exchange.

Money is a medium of exchange and a store of value backed by something like gold or some precious metals as in olden days.

Both are medium of exchange but differs lot. Earlier every paper money printed in this world is backed by gold but suddenly this system vanishes from practices. To understand this we need to slightly understand monetary history which was never revealed in our text books during school or college days.

After World War II all the countries in the world decided to increase the global trade and should promote transparent trading model which needs globally accepted banking system. Hence as part of this IMF (International Monetary Fund) was formed which has been later called as World Bank. World Bank invites members of all the countries to discuss on the fully negotiated monetary system in Bretton Wood (New Hampshire, USA). Their most important goal was to prevent each country from pursuing selfish policies, such as competitive devaluation, protectionism and forming trade blocks, which damaged the world economy in the 1930s.

The chief features of the Bretton Woods system was an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to gold and the ability of the IMF to bridge temporary imbalances of payments. Basically the agenda is tying all the currencies in the world are tied to gold and all the countries can do trade peacefully without any war by swapping currencies for the trade. Actually the way of tying gold will provide fixed exchange rates as well (not like today free floating exchange rate based on demand and supply). But the agreement was made differently and this history is not recorded in many places.

What is Bretton Woods system?

All the currencies of the world should be tied to gold and central bank of the country will be authorized party of printing currency (objective is to have fixed exchange rate system to avoid another world war). But at the end of World War II there is no enough gold in many countries, hence it was difficult to print currency against gold then US came out with different idea because they had huge amount of gold after the World War II (read the history of World War II to know how they got huge gold). US mentioned I will link US dollar to gold at the rate of $35 per ounce of gold and other countries can print their currency using USD as reserve money instead of gold (US valued their currency equals to gold). Most of the countries agreed and few opposed but somehow this system was implemented.

Brentwoods

This is the place where USD becomes so precious currency in the world but other countries needs US Dollars to print currency rite hence US started to give loans for them. USD becomes governing currency of the world because it is backed by gold (trustable) and all went well until it is backed by gold.

How many of us know this story?

Until 1971 if you provide USD in US central bank they will give you gold in return. Just look at the old USD and latest one.

OLD USD

Just look at the above image (bottom). “Ten Dollars in gold coins payable to bearer on Demand”.

Look at the new USD notes there is no word like that and even in any of the currencies in today’s world there is no word like that.

New USD

Look at the replaced world “This note is legal tender for all DEBTS, PUBLIC and PRIVATE”

All went fine up to the time it is backed by gold until 1971 (Nixon’s shock). All countries worked very hard tried to decrease trade deficit especially Japanese, Germans and French but US was engaged in war with Vietnam hence their trade deficit widened and they also needed more money for wars. Gold backed by money started to recede (after US president Nixon ordered to abandon the system) and they started to print money backed by nothing. Whole Bretton wood system collapsed and every country currency adapted to floating rate exchange system (today monetary policy) instead of fixed rate exchange system like the Bretton Wood system,

More info about end of Bretton wood system in World Bank site is below

https://www.imf.org/external/about/histend.htm

By now you can clearly understand “Currency is a medium of exchange backed by nothing and money is a medium of exchange backed by valuable asset”

Why dollar(usd) becomes international settlement currency?

I think now we are clear how USD became predominant currency in the world and why every currency quoted against USD in forex market and everywhere. Before 1971 itself all the countries mostly becomes debt to US and then every country started to do their export using USD hence most of the international trades are settled using USD because they need to settle their debt. Debt becomes part of our life and you can see most of the countries in the world are in huge debt.

How Central bank of every country prints currency and release?

This is the place where I started to study about this whole monetary system and tempted me to learn this. In my childhood days I asked my parents by showing the currency paper notes and asked the following notes.

Who is printing this?

Answer is all we know, central bank of the country.

Can we print this paper currency (because it is backed by nothing)?

Answer is no because as per the law of any country it is illegal.

If Central banks print currency how they release it to public?

This one I have not got answer for many days from many people including my parents, teachers and the peopleI met. I got this answer after I went through the below publication.

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf

This article clearly explains how the modern banking system works and how the money creation is happening in the economy. Very big thanks to them because it clearly explains the debt economy which we are living today and the way they explains states clearly the following

  1. 1. Money is nothing but debt.
  2. If every citizen of the country is having too much savings in the bank. Do you think country is in prosperous and wealthy mode? Answer is no and they are in recession (modern economics will call this as inflation or hyperinflation). Too much of money in the economy is called inflation because money alone won’t buy anything there should be production in the country not only the money. If money (buying power) alone means every country can print more currency and make their citizens as more happy.
  3. If there is debt in the economy then there is money. Please note too much of debt also bad for the economy. Modern economy transferred to this shocking debt state from Goldsmith story and the money takes different form as debt.
  4. If there is more savings then also recession and if there is more debt then also recession. Then how the economy is driven in the country? Because of this reason every Central bank of the country targets GDP and inflation which we can see in detailed manner of this post.
  5. Only few portion of physical money is created by Central bank of the country and the rest is created by the commercial banks using the process of lending. Physical money (cash or fiat currency) is very less in the economy and debt money in the economy is huge.
  6. Commercial banks are creating money like anything by each and every penny/cents/paisa of the citizen’s hard work in a fraction of second through a process called lending and a policy called fractional reserve ratio and money supply is controlled by interest rates of the central bank.

Before getting into details of how commercial banks are creating money. First we see how Central bank of the country creates/prints money. Now we clearly know there is no gold backing system hence Central bank can prints as much as money they want. But if they print more means that leads to inflation hence they target minimal inflation and maximum GDP. Based on the required GDP and inflation they print paper currency. Now the question comes, currencies are printed by Central bank and now how they release to public. This is where more trick arrives and we need to understand this clearly to get full picture how the economy of the country drives.

Let us take US because they are considered as giant of the world. How they print and release the currency in the country?

To understand this we need to understand two important organisations.

FED (Federal Reserve System) – Central bank of US

US Treasury

What is FED?

As you know, central bank of the country is having rights to issue (but FED won’t print) currency and decide interest rates, lend money to commercial banks, increase/decrease money supply etc. Basically they will manage monetary policy of the country.

For more info on FED, please refer the education document from FED site

http://www.bostonfed.org/education/pubs/banking2.pdf

What is treasury?

Treasury is financial agent for US government and its main responsibility is to fund the government. Basically they will manage fiscal policy of the country.

How treasury get funds?

By collecting tax from people and getting funds from government projects like Railways, coal mining etc.

What is deficit spending?

If government spends too much money compared to the revenue (tax money and other government incomes) then it is called deficit spending. Then in that case, government is having two options either increase tax of the people or issuing debt securities which is nothing called bonds. If government increases taxes then money supply will be reduced in the economy and also people will lose trust in the government (basically in next election they won’t be back to power) hence government try to issue bonds for managing government debts.

To manage deficit spending (which is every citizen debt) government easy option is releasing bonds by ordering US Treasury. Please note here money creation actually starts by debt (not yet created but money creation reason is debt).

US treasury will conduct auction and in this place all the big banks in a race buys those debt bonds.

Bond

Is it confusing? Why banks buys debt bonds?

In olden days banks wallets are filled with gold and in this modern world it is filled with debt bonds (this will act as precious collateral for banks). US treasury has got required money from banks through auction. As of now no new money is created in the economy only treasury got required for their government deficit.

Banks along with collateral (bond they bought) will visit FED then swap bonds with currency. YES, NEW MONEY IS CREATED in the economy. New money is created when the Federal Reserve buys a treasury bond from a bank. But where did the money that the Federal Reserve used to buy the bond with really come from? The simple answer is: “Out of thin air”.

New money is created only if there is debt which is more contrary from the olden days of banking system. Now you can understand why debt everywhere!

Do you think new physical currency is printed whenever FED swaps bond with banks?

Answer is pretty simple: NO

In this digital world, FED will simply update the accounts of the bank with numbers. Only few amount of physical currency exists in this world and the rest is simple digital number. In US there is only 1.2 trillion dollar that exists physically and the rest is only digital currency. Refer the FED website

http://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html

As of now we saw how new currency is created and only few exists in physical form. Rest of the money in the economy is created by the commercial banks through the process of lending. Once banks got money in their account then only real game starts in this world.

Money’s origin is debt and this debt will spread across every country through the process of lending by commercial banks. Every loan we are making with the bank is creating new money in the country. If you look closely in this modern economy only few portion of the money is created by central bank and rest of the money is created by commercial banks through the process of lending. Because of this reason only interest rates becomes so important to the economy.

Now just look at an example how commercial banks creates money in the economy through the process of lending.

Let us assume in the country there are only two banks. Let us assume central bank states 10% as reserve ratio

What is reserve ratio?

Reserve ratio means amount of money that commercial bank can hold of it depositors money without lending the whole deposited amount. Lets us look below example for better understanding.

Just assume there are only two banks in the country (Bank A and B) with reserve ratio as 10% and having deposit as 10,000.

Step 1: Both banks have below amount

Deposit      Loans they can give

A Bank     10,000       9000

B Bank     10,000       9000

Total money in the country: 20,000

Step 2: Customer X deposits 1000 in Bank A

Deposit      Loans they can give

A Bank     11,000       9900

B Bank     10,000       9000

Total money in the country: 21,000

Step 3: Customer Y gets a loan of 900 from A bank and made some transaction and transacted amount got deposited into B bank

Deposit      Loans they can give

A Bank     11,000       9000 (Note: only loan amount reduced not the deposit amount)

B Bank     10,900       9810

Total money in the country: 21,900

Only 1000 got deposited in the bank A but in turn total money in the country got increased by 1900. 1900 virtual money got created in the economy. By this way vast amount of virtual money is getting created in the country by the commercial banks without getting printing physically by the Central Bank. Now just think 1 million deposit it will make huge impact in the economy.

By the above example you can easily understand how the money is created in the country depends on the deposit and lending. If lending stops then there is no money creation/circulation in the country and this is biggest impact to human race itself. Most of the money in this modern world are created through the process of lending and this lending process will have serious impact to all the countries economy. Current Greece crisis itself is one of the best examples for this system. Too much lending in Greece caused a big havoc and the entire country is in big debt.

Now you can understand the below without much explanation.

  1. Why banks are issuing credit cards so cheaper? (because in every transaction we are creating new money in the economy)
  2. Why banks insists digital transaction for huge amounts? (because they don’t have physical money)

What it means if banks are showing more profit?

I think now any one can say and the answer is more people in the country are in debt. If there is no debt then banks cannot make profit. By measuring the banks growth you can measure the countries growth easily.

From this you can easily conclude that current monetary system is operated based on debt of the each and every person in this world. This is the primary reason why more people in this modern world are in debt compared to our ancestors. Even they earned less they lived happily but now we earn more money but it is not enough, hence today’s world has to be called as debt world.

Debt spreads across every countries not only Greece but still the world is driven by debt based money. How? If money is invested in productive manner then it will makes the economy of the country into a good shape.

Just assume if 10 persons gets loans from bank (each 1 million) and invested in real estate. Consider 10 more persons (each 1 million) gets loan from bank and started a business like electronic gadgets, medicines R&D. First 10 (real estate) will only speculate the market and their value won’t appreciate much and the rest invested in start-up having high chances of becoming billionaire if they worked wisely. That’s why you can see China, Korea and all who is becoming fast growing nation through their productive economy. Hence production should drive the economy not the speculation based.

I think I covered only few aspects of money creation and I will continue write about this in my future post. Thanks very much~!

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