Thursday, October 16

Where is the money going?

Its Global Liquidity Crisis ! We all have been listening to this for a while now and are adversely affected by this. the global markets are down and money is flowing out of the emerging economies.
I am being asked a very valid question time and again. If money is flowing out of (say) India, it must be going somewhere. For every outflow of money, there must be a corresponding inflow somewhere. But that's not the case. the whole world is facing this liquidity crisis. A gentleman (he invested a lot in the equities and has lost millions due to fall in the market; "the FIs are selling") came up with an answer that the FIs are sitting on cash. OK! lets take this for a while. But are they hold currency notes. Nopes. This money shud then be deposited in the bank accounts. But again this liquidity crisis is most faced by banks. the banks dont have money to lend, the interest rates are shooting up. So is it that the banks are holding money with themselves are not willing to lend. Nopes; not possible.

First let me tell you the cause of liquidity crisis. Liquidity crisis occurs when the borrowers fail to repay. Remember the subprime crisis last year? The banks and other financial institutions lent to low-creditworthy borrowers huge sums of money and they defaulted. It all started from here.

Now let me explain how this non-payment of loan affects liquidity.
Lets go back to the basics of economics that we read in high school. the process of creating money by banks. We read that banks create money using the deposits it gets from the account holders. We know the concept Cash Reserve Ratio [CRR] (known by different but similar names in different countries). Central banks require banks to maintain a minimum percentage of deposit as reserve to meet withdrawal needs. This minimum percentage is called Cash Reserve Ratio. The banks lend the balance of the deposit to borrowers.
I'll explain in detail.
Assume that the CRR is 9% (as was in India about 15 days ago)
Mr. A deposits Rs 100000 into his bank account (Bank A). Based on the liquidity requirement, Bank A is required to hold 9% of 100000 = 9000 and lend the balance Rs 91000.
The bank lends this Rs 91000 to Mr B who deposits this money in say Bank B (even if he uses for any purpose, it ultimately goes to a bank account). Bank B again holds 9% i.e. 8190 and lends the balance (i.e. Rs 82810) to C Ltd and the money goes to Bank C and the process continues.
So we see that Rs 100000 deposited by Mr A in Bank A has already created (or circulated) money worth Rs 100000+91000+82810 = 273810. Mind you, the process continues and there is more money that is generated with this Rs 100000.
Mathematically, Maximum money that is generated with this Rs 100000 given 9% CRR is;
1 / CRR x Initial Money Deposited i.e.
1/0.09 x 100,000 = 1,111,111

Though there were various other related factors, the subprime itself let to writedowns of $501 billion in the US. Assuming a 10% reserve requirement, the banks lost $5010 billion of money creation.
Since there has been huge defaults, the banks are unable to generate money and are thus unable to lend too. Again, the increased demand for loans (and short supply) has led to increase in Interest rates as well.

This is indeed the main reason why the RBI has been trimming the CRR rates (6.5% from 9% in a matter of 10 days).

The policies are being put in place. Lets hope things shape up well !!!
As for the people who are wondering where has the money gone; I hope I have answered to an extent.

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