Local Inflation versus Global Inflation

If you are equity investor, you would have heard these terms - inflation, interest rates, liquidity, Yen-carry - umpteen times and must be thinking - why it matters so much. Well, to be honest, it matters and matters a lot. Let us first understand what does these terms mean.

• Liquidity is an economist's word for more cash and credit.

• Inflation is the word used to describe what happens to a currency when too much liquidity is made available. It is a term used to describe general rise in prices. It can be because of supply shortages or excessive/speculative demand. Supply shortages can be cleared with fiscal measures/incentives/policy reforms whereas excessive demand is curbed by monetary measures.

Monetary measures (like hiking interest rates) are taken by Central banks. Central Banks control the quantity of the money they emit, and by extension, its quality. What they cannot do is increase the quantity and the quality at the same time. Hence, when central banks release more liquidity in the system to boost demand, quality factor deteriorates. It invites excessive speculation in non-priority sectors of the economy. Sooner or later, it starts hurting the economy. Government's and RBI's stance - "Quality of growth is more important than pace of growth. Unfortunately, quality only comes with pace in monetary world''

Right now, we are at peculiar situation where inflation locally is a supply side problem, and globally, it's a demand side problem.

Local Inflation - Supply Shortages

India's inflation is a supply side problem. There is genuine demand but due to large number of constraints ranging from resource, infrastructure to policy - supply has not caught up with demand. As a result, prices are running away leading to general rise of prices of everything. It has reached to a level where it is making everyone uncomfortable. Government of the day understands this, but unfortunately due to political compulsions does not want to initiate reforms to address it.

There is a saying - If you cannot increase supply, kill the demand. So, RBI is taking monetary steps to cool down growth anticipating demand will come down, and inflation will come down to manageable limits. Yesterday, I saw a comment from one economist - "After this rate hike, based on his models, Indian economy will grow at 7.5% - 8%". I can only say this - Economists are brilliant people; they are better at maths and statistics and economic models - but what about their understanding of human behavior. Please remember, Financial markets are never about maths. If that would have been the case, there would have been no financial markets.

The message - Financial markets are never about maths. Here, the impact is psychological, and how it impacts demand. Generally, it is seen that as long as people see their future bright - they will continue to borrow no matter what the interest rate is. That's why inflation becomes so difficult to control - and there comes a point where everything just falls through the roof. I don't know whether we have reached that point, but we are very close to that point. Jim Jubak, market savvy commentator on MSN said this about India few weeks back -

Jim Jubak’s short-term prognosis on India: India may face a big domestic credit crunch -- caused when lenders stop lending and borrowers can't get the cash they need to run their businesses -- causes India to fall far short of current forecasts of 9% to 10% annual growth. Foreign investors begin to withdraw money from the Mumbai stock exchange, producing another 30% "correction." The current Congress Party government loses power. After stumbling with politically motivated attempts to reduce food and fuel prices in rural areas, a new government bites the bullet, raises interest rates and cuts bank lending enough to slow inflation and the economy. Overseas cash begins to return. It won't play out exactly like that, of course. I don't know how deep any credit crunch might be or how much the Reserve Bank of India might have to slow the economy to reduce inflation to its 5% to 5.5% comfort zone. I don't know how long the Congress Party government might be able to cling to power. I don't know how other global markets would react to a big drop in Indian stocks.

India has a huge supply side problem, and we required full blown economic reforms in past 2-3 years to release excess supply in the system to keep moving. But Government of the Day spoiled the opportunity and it seems we don’t have the breadth to run now. A recent study by the Reserve Bank of India says that it will take 18 months to two years to add significant supply. I think it's reasonable to expect that India story is over in short term. It's time to get worried. Because it would be brave to assume that we will continue to grow despite current interest rate environment.

Global Inflation = Excessive/Speculative Demand - There is a single factor responsible for it - Japan's weak Yen policy. We also call this factor as Yen carry trade.

Japan’s weak yen policy has created abundant liquidity in the system – through rock bottom borrowing costs. At one point of time, interest rates in Japan was 0%. Japanese interest rates are now at 0.5%, which means, you can borrow in Japan at 0.5% and invest just about anywhere else in the world, and make cool returns. This has caused phenomenal asset bubble in the world. There is rarely any asset class that has not benefited from this phenomenon. It has made the term - "corelation coefficient" redundant (Gold often goes up when stocks fall, but now it moves in tandem with stocks). Since, this asset bubble has been built on borrowed money, one day the party will end, and the sad part is it will be very ugly end. We got a taste of what a rate and liquidity shock could be like in just last May-June carnage. That's why, investors/traders keep such a close eye on interest rate and currency movement. In today's time, fundamentals have taken a backseat, and most of the investors bandwidth gets consumed in tracking Central Bank movement across the world. Make no mistake, India's phenomenal bull run is an output of cheap and excess liquidity in the world.

There is nothing to worry at the current juncture. The world is awash with cash, and it seems liquidity party may continue for a while. Indian equity markets are more prone to correction on global liquidity factors than local liquidity factors. So, while local inflation and higher interest rate may create problem for Indian public at large, as an equity investor - you should be more worried about liquidity in global arena.

Money is not cheap anymore

Why rise in interest rates can dampen housing boom?

I know this is an interesting question. There is an argument that - If astronomical rise in house prices never dampened the demand for houses, then how couple of percentage points of rate rise can dampen demand. Well, to your surprise, it will.

You need money to buy a house. Houses are high value items, and buying decision needs to be supported by availability of credit. I guess after the recent rate hike - the factor that will get hit the most - who will fund it? RBI is not only hiking rate but is also sucking out liquidity from the system. There is now liquidity crunch developing in banking system. It is a situation when lenders refuse to grant credit to large sections of borrowers on risk perception on certain asset class. Also, when money becomes expensive, banks become very judicious on lending side. The evaluation becomes very stringent. Suddenly, it takes more time to get loan sanctioned.

People borrow when they see their future bright in terms of career and salary growth. Interest rates don't matter that much as long as one sees a bright future for oneself. But remember, RBI is also trying to slow down the growth, and we don't know how economy will respond to such measures - will it be a significant slow down or will it be a minor slow down? Generally, these things end up with significant slow down, and it may mean a not so rosy future in short term for large working section of the country. It may just reduce the urgency factor on part of individuals to buy a house.

Also, this is the same time, when we may see significant supply hitting the market. One of the reasons that why property prices were running away was that there was feeling of left behind, and supply was not enough to cater to everyone's demand. But when people will see that property prices are not rising anymore, the urgency factor will go away.

All these factors cumulatively may dampen demand.

The existing loan borrowers are now facing the real heat of rate hike. The EMIs are hitting through the roof.

The leaner borrowers may be able to absorb and ride through this rough patch but it will be difficult for heavy borrowers.