Wednesday, March 4, 2009

Liquidity, Interest Rate, Lending & Investment

Central banks around the world choose to take the risk of pressing the interest rate pedal to the floor in the hope of sending more liquidity into the system so that the economy can move faster, hopefully forward.

Question: Will even zero interest rate increase liquidity or lending?

I am not too sure about the purpose of zero interest rate. At zero interest rate, you still have to repay the loan that you have borrowed. If your business or your income stream is not steady, you may even have problems repaying the banks.

The advantage of a zero interest rate is that (a) you do not have to pay the interest component which lightens your repayment burden, if you have an income stream in the first place. If not, then (b) you refinance your loan. I suspect this is what is happening, with banks now marketing as hard as your vitamins salesmen. With refinancing, banks can pull customers away from other banks and build up their loan book - but if the loan book consists mostly of bad loans (i.e., if the economy does not recover fast), then these banks are likely to face the problem of bad loans before long. I suspect inexperienced banks will now be the most aggressive.

If the zero interest rate is encouraging banks to refinance bad customers (because of too much liquidity in the system), then where is the lending to good borrowers.

What are good borrowers?

Good borrowers are businesses who have a track record in dealing with banks and have shown, in their transaction history, a good habit of repayment on time - which means that they have given priority to loan repayment over their other commitments. It is these customers with an intimate relationship with banks that are considered to be good, and hence are "likely" to get the support of the banks during hard times like this - "likely" only if the banks have a good memory. If the banks are run by young people who behave like market analysts, then they would not understand "relationship banking" and kill even their best customers by their pursuit of numbers.

So far in our story, we have not seen banks lending for investment yet. Banks generally do not know business. They know customers - they know the characteristics of types of customers in different activities - and they manage their risks according to those characteristics.

The people who invest are people who know business. They are on the ground looking at the developments in every nook and corner. They know what is cheap and expensive. They know what is a bargain. They know future value. In other words, they see opportunities.

Those who are the first to seize opportunities are those with cash. With zero interest rate, they are being forced to invest their cash in projects to get some decent returns. This is why prices must be allowed to fall so that valuations can come down to more "realistic" levels - realistic in the sense that investors in opaque situations are enticed to take risks in investments because of the price. If not, then bad investors are being rescued to continue to plague the efficiency of the economy.

2 comments:

ben said...

Hi Prof,

I met up with my lawyer friend and he confirmed your take and it's happening right now in the banking industry. Sigh!

p/s always enjoy your clear and concise analysis. keep up the good work

etheorist said...

Ben,

I am confirmed but not reassured.