Advent on easy credit-a boon or a curse
Living beyond means is not something that is uncommon. It starts at the smallest level and manifests itself in the company structure, state and even the whole country. In the long term it is disastrous for the concerned person/company / country. But as one tastes the forbidden fruit of easy credit it is difficult to have the mental strength to delay instant gratification.
Individual: One cannot help but notice that in today’s generation people tend to save less. The proliferation of information has also enhanced the need of the people. The advent of easy money allows people to get money to satisfy their needs and not be constrained by monthly pay cheques. But in truth there is nothing called a free lunch. The easy money has to be repaid at some point of time. One lives in an optimistic world where the future earnings will increase to take care of the debt. But in most cases people get caught in the debt cycle. Youth seems to be the time when one gets the maximum in debt. Some of the cost that comes at this age includes
1. Cost of collage education
2. Cost of marriage
3. Cost of living on own expense
4. House loan
Most people spend years repaying such loans. Earlier one needed to exert considerable effort in being able to secure a loan. But today you would be inundated with calls in order to take loans in the form of credit card, personal loan, home loan, loan against property etc. One may wonder why one would try to target people who may not have the best credit history or payment. The reason for this is that one is able to charge an interest premium. This type of aggressive lending has been responsible for the subprime crisis that rocked the financial world from its roots. Also as one is starting on his career the money is not that high. But youth has a long span of working career left. Thus they are the people who are targeted to give loans to.
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Vicious cycle of lending
Companies:
One may wonder how a company can live beyond its means. After all most companies show a healthy bottom line i.e. profits. Thus it seems strange that such an entity may be accused of living beyond its means. The answer to this lies in the fact that companies of today are seen having a increased about of debt in order to fund their fast expansion plans. An example will help clarify the point.
Let us take an example of a company operating in the FMCG space. It has a gross margin of 20%. Let the organization be selling $ 100 million worth of products. Here the rate of interest is taken as 10%. For the sake of simplicity, the effect of depreciation in not taken into the picture though it is a very important for companies in order to get tax benefit. Let the tax rate be around 30%. Thus the net profit after taxes is 20* .7 = $14 million. As the company is operating in a growing market it estimates that it will need to double the production in order to meet the increasing customer demand . But for that one needs a capital of $ 100 million. To get this money the company has to wait around 100/14 = 7.14 years. But concurring to the example of living beyond its means it takes the entire sum as loan.
Now production increases to $ 200 million
Margin @ 20 % comes to around 40 million
Gross profit is 40 million
Loan interest is 10 million
Profit after deducting interest is 40-10 = $ 30 Million
After tax the amount is = 30 * .7 = $ 21 million
With this increased cash flow the company can raise $ 100 million to pay for the loan in $100/21 = 4.78 years. Thus for the organization it makes more economic sense in taking a loan instead of waiting to collect the money.
In the real world many companies in the bid to grow indulges in the acquisition of a rival company through leveraged buyouts. This is especially true for companies trying to enter new markets quickly .But along with such amove increasing top line and bottom line it also put a lot of risk on the company . Profit margins are not things that are written in stone. It can change with change with business environment. Whereas one presently has a margin of 20 % intense competition may reduce it to a 10%. Such move drastically changes the equation. In the first case the profit of the firm is reduced to 10 which after tax deduction is reduced to $ 7 million. But in the second case the profit falls from $ 4o million to $ 20 million. As the fall in margin does not change the interest rate the interest that need to be paid remains at $ 10 million. Thus the profit after interest is $10 million which after tax deduction reduces it to $ 7 million. In other words the loan did not cause change in profitability of the company. One here assumes that the interest will not change. But in the real world the rating of the company takes a beating with the reduction in profit margins. With that borrowing cost of the organization goes up. Worse still the demand of the product may spiral down to the original $ 100 million. Then with 10% margin the organization makes $ 7 million after tax deduction. While in the second case the revenue becoming $ 100 million instead of $ 200 million the gross profit becomes $ 10 million which after paying the $ 10 million interest reduces to zero. Thus on good times easy financing helps a organization in propelling growth. But in the bad times as shown the blessing becomes a curse. This type of aggressive leverage caused the demise of many organizations in the down turn that shook the world in 2008.
Country:
For a country to grow it needs to continuously invest in improving infrastructure so as to move towards a higher plane. It is in this that the country faces a problem. To maintain growth momentum a high amount of investment is needed. It is for this reason that many countries growing at a very fast pace has opened their economy in order to get investments from outside. This Foreign Direct Investment (FDI) helps to propel the economy to a higher growth trajectory by supplying the much needed capital that is needed to grow. But this with every other thing has its own downsides. The steroid driven growth is dependant on high external investments .As long as the money flows there is cheer in the country. The country shows strong growth, the stock market hits new high and everything looks very rosy. But the moment the investors start to pull money out due to some internal or external reason all hell breaks loose. The growth prospect gets downsized and that creates a vicious cycle in which more and more investors pull out money .This phenomenon is called contagion in the financial circles. This sort of behaviour is seen in the Asian Crisis, the crisis in Russia, Mexico, Argentina, Brazil and other south American countries. As the investors pull money out the economy collapses .The only country which has escaped this till now is USA which even after being in debt and facing the subprime crisis did not have a total collapse like the other countries . Though only time will tell whether USA will face a slow haemorrhage like that happened in Japan or survive victorious as it has done in all previous cases.
Easy credit – The better side
One can go on saying the vice that living on borrowed money can bring upon .But the advent of easy money is not totally bad per se. The influx of easy money helps in all levels.
Individual: The advent of easy money has helped people move up the social ladder .Before easy credit even if a person was bright he would have difficulty climbing the social ladder. Knowledge was the property of the rich. But with the advance of easy credit even if a student does not have money to pursue higher education he can avail credit to fulfil his dream .This in the end brings social equality. Also with skill advancement the economy of the country also takes off. Also the advent of easy money helps start-ups make their ideas a reality by providing private equity. Also credit helps people realise the happiness of material benefit at a much earlier age. Before the advent of easy credit men had to wait till their late 30s before accumulating enough to buy a house. But with easy credit in the form of housing loan people are able to afford house at a much earlier rate. Also this leads to a higher consumption which leads to increase in demand for the products organizations are making .
Company: The ability to raise easy credit helps it grow at a pace much faster than it would have otherwise. The risk notwithstanding this helps organization with better planning over resources to grow at a fast pace. One cannot imagine Tata’s taking over companies like land rover, Jaguar, Corus with out the availability of easy credit . Of course many mergers like this fail. But that constitutes business risk that is part and parcel of doing business .
Country: When the country fundamentals are strong this foreign investment helps the country go to a higher growth trajectory. This also ensures that money flows to where it generates maximum value. This is beneficial both for the country investing as well as the country where the investment is taking place. By the growth of one country the other country earns a better return of its capital as well as creation of a bigger market.
Conclusion: The blips put aside the growth of easy money has facilitated better standard of living the world over. The rate of innovation has shot up and economic growth has spiralled with the advent of easy money. Of course it has also caused increased carbon footprint and greater utilization of natural resources causing a greater amount of pollution and global warming. But as is the universal case there is nothing like a free lunch. There are environmental consequences to economic growth. But if we take a long term view the advent of easy money has made the standard of living around the world surge to a much higher plane particularly after 1900.
So instead of deriding the lure of easy credit one should focus on financial education to the masses which will enable them to get the maximum from the process. One needs to appreciate that the real interest rate has gone down with the advent of easy money. Thus the access of easy money is not a curse. Rather it is boon .But like all good things care has to be taken that it is optimized to help the world prosper rather than creating a bubble and crashing .
Easy Credit facilitating better standard of living
