The credit boom in India is hard to miss. Everybody is borrowing. Banks are borrowing, because the customers are borrowing. And there is not end to this trend in sight. Interestingly, against the basic teachings of economics, the interest rates are also rising. Conundrum is how they call it. So, I thought of sitting back and asking few basic questions.
Borrowers borrow money because (and when) they need it most. Or when they think they have a good advantage by borrowing money. Like tax advantages for instance. Another important reason to borrow is when you can use the funds more effectively and produce a return much more than cost of borrowing.
So, to see the last statement more closely
1. Let us assume the case of Mr. A. He thinks he can borrow the money from his agents (sometimes banks, markets, investors etc) for X% and produce a return of X+Y%. That means of the returns of X+Y% that he is able to produce, he is willing to part with X% of reward to his creditors; this modus-operandi works well when there is a return (X+%) associated with the deployment of the borrowed money.
But in case in the returns are not in equal to or above X%, and then Mr. A pays his creditors out of his pocket. And depending on his deep pockets can pay them fully or default.
2. Borrowers always prefer lower interest rates as the margin of safety between the debts being effectively serviced and pinching their pockets (defaulting) is high. As the interest rates go up, this margin of safety reduces. This is because no business can consistently make good profits. Even if the businesses do achieve the profits, the borrowing for other purposes (un-productive like tax-benefits) become less lucrative as the rates rise. You do not want to pay more interest just because you want to save tax. Saving tax by paying some interest looses its utility when taken to extremes.
3. When the asset purchased or the money utilized does not give you with any returns other than instant gratification and a promise of (possible) returns long time into the future, the borrower is into much deeper risk. Away from this margin of safety the only utility for the person is more utility of the gratification than forgoing/ postponing the gratification.
So why are people borrowing to enjoy the benefits. Undaunted by the rising interest rates and undaunted by what future’s mystery holds.
Some economic terms that can be used to explain the nature is “risk appetite” “velocity of money” “inflation” ‘consumer confidence/ sentiment/ expectations”. And I am sure there are many more (not to mention the derivatives).
Borrowers borrow money because (and when) they need it most. Or when they think they have a good advantage by borrowing money. Like tax advantages for instance. Another important reason to borrow is when you can use the funds more effectively and produce a return much more than cost of borrowing.
So, to see the last statement more closely
1. Let us assume the case of Mr. A. He thinks he can borrow the money from his agents (sometimes banks, markets, investors etc) for X% and produce a return of X+Y%. That means of the returns of X+Y% that he is able to produce, he is willing to part with X% of reward to his creditors; this modus-operandi works well when there is a return (X+%) associated with the deployment of the borrowed money.
But in case in the returns are not in equal to or above X%, and then Mr. A pays his creditors out of his pocket. And depending on his deep pockets can pay them fully or default.
2. Borrowers always prefer lower interest rates as the margin of safety between the debts being effectively serviced and pinching their pockets (defaulting) is high. As the interest rates go up, this margin of safety reduces. This is because no business can consistently make good profits. Even if the businesses do achieve the profits, the borrowing for other purposes (un-productive like tax-benefits) become less lucrative as the rates rise. You do not want to pay more interest just because you want to save tax. Saving tax by paying some interest looses its utility when taken to extremes.
3. When the asset purchased or the money utilized does not give you with any returns other than instant gratification and a promise of (possible) returns long time into the future, the borrower is into much deeper risk. Away from this margin of safety the only utility for the person is more utility of the gratification than forgoing/ postponing the gratification.
So why are people borrowing to enjoy the benefits. Undaunted by the rising interest rates and undaunted by what future’s mystery holds.
Some economic terms that can be used to explain the nature is “risk appetite” “velocity of money” “inflation” ‘consumer confidence/ sentiment/ expectations”. And I am sure there are many more (not to mention the derivatives).
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