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The story of cheap money

Oct 1, 2009

Billions of dollars worth of individual and corporate savings have been lost in the current economic crisis that is being touted as the biggest since the Great Depression and has engulfed economies across the world. Some say greed. Some say innovation. But undoubtedly all fingers finally point to one culprit - cheap money. Alan Greenspan, ex-chief of the US Federal reserve, the one who has been accused of creating the bubble by keeping interest rates in the US at a 40-year low, also blames cheap money for the current crisis. While denying his ineptness in checking the bubble, he has acknowledged investors' tendency to gamble with cheap money. And this tendency seems to have been witnessed not just in the financial markets in US, but across the world.

For instance in India, the BSE-Sensex tryst with 17,000 has been propelled by availability of easy money, both in the past (September 2007) and now. The Reserve Bank of India (RBI) touted as one of the most conservative central bank in the world, has also been compelled to be generous in opening the liquidity tap. This was with the intention of 'stimulating' our sagging economy and bring it back to the '9% GDP growth' track.

The RBI's basic monetary tool to suck out liquidity from banks - the cash reserve ratio (CRR) has been sitting pretty at 5% for nearly twelve months now. The US Fed's and ECB's near-zero interest rates are also directing plenty of cheap hot money to the Indian markets.

From 17K to 17K
Source: RBI, Trend

While investors and speculators may be euphoric with the Sensex's 17,000 feat, there is every reason to practice caution. This is because with the Sensex already trading at nearly 20 times trailing 12-month earnings, earnings growth of even 20% + (on an average annual basis) will be insufficient to retain the current valuations.

Meanwhile the IMF has lowered its estimate for global write-downs for banks and other financial institutions to US$ 3.4 trillion (from US$ 5 trillion). But it has warned that loan losses are set to rise as unemployment grows. An IMF report says that while banks have enough capital to survive, their earnings are not expected to fully offset write-downs expected over the next 18 months. The institution believes that stronger action is needed to bolster banks' capital and earnings capacity to ensure they can support the economic recovery.

The IMF also believes that while the US institutions were about 60% through their needed write-downs, their European counterparts have recognised only 40% of their losses. Hence there is more bad news yet to come. The story of cheap money is far from over!

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