Wednesday, November 14, 2007

Why does the American way fail in Japan and India?

S. GURUMURTHY
Now, some 210 million Americans use about 1.2 billion credit and retail cards, that is, some six cards for every individual. Effect: consumption debt, most of it on credit cards, has risen steeply. The Americans think of their own lifetimes whereas the Asians think of the next generation and, hence, save for the future, says S. GURUMURTHY

The text book rule tells us that interest rate cut leads to two consequences. First, it dampens the saver and excites the spender, so that bankers mourn and traders celebrate. The second consequence is subtler. Cut in interest, tells the text, impedes only interest-rated savings, but, it nourishes risk-bearing savings through stock markets. It needs no seer to say how it happens.

Disgusted with poor returns through low interest, savers take higher risks for better yield. In effect, low interest turns a saver into an entrepreneur! So when interest rates are cut, the stock broker joins the party with the trader. The text thus convinces us that fall in interest rate has the potential to promote savings and also spending simultaneously!

Low interest may trigger inflation if demand outstrips supply, warns a footnote. But that risk, experts counsel, may be mitigated by raising the interest rate. Otherwise, low interest regime, they say, structures a win-win situation for all — for savers and traders, for stock dealers and manufacturers, and above all, for governments, the notorious borrowers all over the world. How did low interest restructure the financial habits of one society, the US, and whether universalising its experience will work, is the story ahead.

The US became the first laboratory that tested the low interest model. The experiment started in mid-1981, when the low-end US Fed Fund Target Rate was 20 per cent. It was cut to 14.5 per cent in June 1981 and later, in September 1982, to 10 per cent. Thereafter, till today, that is for over 25 years, except for the second quarter of 1983, this limit of 10 per cent has never been breached.

Consistent trimming

In contrast, the US Fed cut the interest rates with such consistency that it was below 8 per cent between 1985 and 1990, except that in 1989 the figure hovered around 9 per cent. In January 1991, the Fed rate was cut to 6.75 per cent and further to 4 per cent in December 1991 and to less than 3.75 per cent in 1992 and 1993. It remained between 5.5 per cent or less, in 1994, and 6.5 per cent early in 2000.

Afterwards, the US Fed effected massive cuts. Starting from 6 per cent, the Fed cut the rate almost month after month to reach 1.75 per cent in end-2000; the Fed rate hovered between 1 per cent and 2.25 per cent in 2002 and 2003 and between 2.25 per cent and 5.25 per cent during 2004 to 2006. It is now 4.5 per cent effective from October 31, 2007.

The US Fed cut interest rate on 68 occasions and hiked it on 45 occasions, in the last 27 years. But the net effect was that the Fed rate came down from 20 per cent to as low as 1 per cent and now stands at 4.5 per cent. Thus, low interest has become an unalterable fundamental of US economy now.

Living on credit cards

Not how or why it happened, but what low interest did to the US, is instructive. One, the rate cut did excite Americans to spend. Even borrow to spend. Result: from the mid-1980s, US households became increasingly reliant on credit cards. Later, they even began living on them.

Now, some 210 million Americans use some 1.2 billion credit and retail cards, that is, some six cards for every individual. Effect: consumption debt, most of it on credit cards, rose steeply. From $338 billion in 1990 to $ 2.46 trillion, by the first quarter of 2007. A rise of over seven times in less than 17 years!

Each card now carries a debt of $8562 plus. With rate cuts inviting them to spend, credit cards made it easier for them to spend without experiencing the pain of handing currencies across the counter. Low interest also drew Americans away from banks and pushed them into Wall Street.

Consequently, the share of bank deposits in financial assets came down from 57 per cent in 1978 to 32 per cent in 1995 and in the same period the share of pension and mutual funds, which invested some 60 per cent of its funds in Wall Street, went up from 20 per cent to 42 per cent.

American household investment in Wall Street stocks, mainly through these funds, increased from 5.7 per cent in 1980 to 25 per cent in 1990 and peaked at 52 per cent in 2001. With unrealised appreciation of their Wall Street stocks giving them illusory wealth, they resorted to borrowing against it for their day-to-day spend. Later, this habit extended to borrowing against even more illusory wealth through appreciation of their homes. This has led to the much talked sub-prime crisis.

More. With low interest impeding savings and unrealised appreciation in stock prices encouraging spending, US savings declined from around 8 per cent of GDP in late 1970s to insignificance. Finally, in the year 2004, US savings turned negative for the first time since the Great Depression in the 1930s. But low interest is but one side of the story.

The US government taxed and, in exchange, provided social security to Americans, thus substituting tax for voluntary savings and investment. This greatly relieved the Americans of the need to save and manage their savings. With the people in deficit in their personal finances and the government in deficit in public finances and the nation itself in deficit in trade balance, the US, which had a net international investment position of 7 per cent in 1982, has now become the most borrowed nation in the world. Its net investment turned into net foreign liabilities exceeding $2.5 trillion or 25 per cent of GDP.

But the real story starts only now. Japan copied the US and cut interest rates to promote consumption. India cut the rates to promote investment and risk capital. Did the rate cut work in Japan and India in the way it worked in US? Read on. The Economist magazine reports that Japan sits on household financial assets of $12.5 trillion now, trebling from $4 trillion plus in 1990. Most of this is in safe, not risky, investments. To force its people, who are obsessed with savings, to spend, Japan regularly cut interest rates from some 6 per cent in 1990 and finally made it zero (yes, zero) in 2001, where it remained for five years.

In 2006, Japan set the interest at 0.25 per cent and doubled it to 0.5 per cent in February 2007. How did Japanese respond to this nil or negligible interest? They increased the savings by more than three fold even as interest rates crashed.

Unlike their American counterparts, they did not queue up in the malls nor rush to the Nikkei. Over 56 per cent of their savings is held in safe modes, that is, in deposits and currency despite nil or negligible interest. Only, yes only, 5.9 per cent of their savings is in stocks.

Savings is their mantra

Indians too did something similar. Interest rate on Indian government bonds was as high as 13 per cent till as late as 1996-97. It more than halved to as low as 6 per cent a couple of years back. Yet the household saving of 18.5 per cent in 1990s incrementally rose to 22.3 per cent in 2005-06. Like the Japanese, Indians too have clearly defied the economics of low interest. Again, like the Japanese, they have kept away from the stock market, despite the crash in interest rates.

The share of stocks in their savings portfolio hovered around 2 per cent in 2001-02, to 2.6 per cent in 2004-05. Even the figures projected for future cannot make Dalal Street smile, as up to the year 2012, Indians will invest no more than 4 per cent of their savings in stocks! Five years from now, in 2012, their most trusted savings instrument will still be small savings! This brings India and Japan nearer, but, takes both away from the US.

Converging point

Why does the American way fail in Indian and Japan? The answer lies in the family and culture of the two countries. Their families tend to be self-reliant, not dependent on the state. Nor are they tense expectants of the stock-market-fortune-based social security. Savings and investment are the points at which micro economics and macro economics converge.

While, in family-based societies, microeconomic behaviour is influenced by culture and family, the macroeconomic policies of the state are influenced by US-led global institutions, thus creating a mismatch between the two. Mr Bosworth, an economist at the Brookings Institution in the US, traced “cultural differences” as the reasons for the contrast between Asia and the US on savings.

Mr Bosworth noted that Asians have a ‘dynastic’ view of savings, that is, accumulate wealth beyond their lifetimes for their families, and for multiple generations in the future, while Americans think only of their retirement, that is, their own life and nothing beyond. This explains almost everything. When, then, will the Indian economic discourse factor India in, in the place of US, for formulating its interest, savings and investment policies?

A tail-piece: Even in US, the low interest stock market dualism seems to be fatiguing as, with the market turning bearish from 2001, the US household investments in stocks have declined from 52 per cent in 2001 to 47.5 per cent in 2005!

Also, the theory that the stock market allocates capital more fairly than banks, on the basis of which stock markets are favoured in today’s discourse, has been questioned in studies, which showed that, in the US and the UK, the capital allocated by stock markets to non-financial sectors has been negative — yes, negative — during the period 1970 to 1989. Still the US may not rethink. But we need to think.

(The author is a corporate advisor. His e-mail is guru@gurumurthy.net)

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