Archive | May, 2010

How the Global Economy functions…

28 May

A simple and lucid framework to help you understand the present functioning of the global economy-

Balance of payments of a country can be broken down into two parts- trade balance and capital account balance. Summing up the two parts should give us zero as they are an accounting identity. So,

Trade balance (surplus/deficit) = Exports – Imports

Capital account balance (surplus/deficit) = Capital inflows – Capital outflows

Balance of payments = trade balance + capital account balance

If trade balance is in surplus, the capital account balance will be in deficit of an equal magnitude and if trade balance is in deficit, capital account balance will be in surplus of an equal magnitude (to finance the deficit).

The developed nations (read US, EU) import like crazy from developing nations (read China, India). Thus,

Trade balance (developed nations) = deficit (imports > exports)

Trade balance (developing nations) = surplus (exports>imports)

As we know, the US$ is the world currency. So, if Chindia (China + India) exports, it receives US$. And if it imports, it pays in US$. Since exports > imports for Chindia, these guys are getting more dollars than using them. So, they are accumulating dollars.

What does Chindia do with these dollars? They need a safe avenue to invest them, and what can be more safe than the US govt bonds. So Chindia buys US govt bonds (which the US govt issues to finance its deficit).

So,

Capital account balance (developed nations) = surplus (inflow of dollars from Chindia that buy US govt bonds)

Capital account balance (developing nations) = deficit (outflow of dollars for buying dollar denominated US govt bonds)

These capital account surplus/deficit offset the surplus/deficit trade balance.

In summary,

Chindia produces,  sends the good for US consumption and accumulates dollar. The US consumes. And in huge quantities. It starts running a deficit and has to print bonds to finance the deficit. These same bonds are then bought by Chindia, so the dollars come back to the US. The US can now again buy from Chindia and Chindia can now again start exporting to the US.

And the cycle continues…..

Institute for New Economic Thinking

18 May

I came across an excellent article by Sanjaya Baru in the 17th May 2010 edition of Business Standard, titled ‘Renewing Economics’, in which he talks about the Institute for New Economic Thinking, established by the legendary investor George Soros to rethink economics. You can visit the homepage of the institute at http://www.ineteconomics.org for more details on this. Going forward, it would be really interesting to see what perspectives the institute comes up with. I was very happy to know that YV Reddy, the previous Governor to the Reserve Bank of India, is part of the institute’s advisory board.

There was an excellent quote by Soros in the same article, which I would like to reproduce here…

“Economic theory has modelled itself on theoretical physics…… It has sought to establish timelessly valid laws that govern economic behaviour and can be used reversibly both to explain and predict events. But instead of seeking laws capable of being falsified through testing, economics has increasingly turned itself into an axiomatic discipline consisting of assumptions and mathematical deductions – similar to Euclidean geometry.” (emphasis mine)

Couldn’t agree more I think.

The world of finance…

16 May

I believe the world of finance is unnecessarily made out to be too complex. The greatest hurdle in promoting the finance literacy and increasing financial inclusion is the image of finance as an arcane world that is comprehended only by ‘experts’. And matters become worse when these ‘experts’ let you down, as was the case during the sub prime crisis. There is obviously a vested interest in keeping things the way they are. I really sometimes wonder that the art of investing if broken down to the bare basics, isn’t all that complex at all. The habit of saving and evaluating financial instruments like bonds, equities, commodities, etc for making an investment decision can be achieved without complete reliance on the people of finance.

The case which I find most disturbing is the way ULIPs are sold in India. Every instance that I have come across of ULIPs being peddled is fraught with so much of misinformation that it seems downright illegal. Having talked to numerous people who have bought this instrument for tax savings purposes, not even one has come out as having properly understood the pros and cons of buying a ULIP. Let me clarify one thing at the outset, ULIPs are not an inferior investment product. However, without understanding the basic structure of a ULIP and without comparing it with an ELSS scheme, an investor will not be in a position to understand that an ELSS may actually make more sense for him than a ULIP.

More on this later.