Fenil's Library

I write for a living. And there are nights when my subconscious is at work and I just can't sleep. Yesterday was one of those nights. After having tossed around on my bed for an hour, I got up, and walked a couple of floors down to her place. 

"Here's your coffee," she said, as soon as I entered her flat.

"How did you know I was coming?"

"I am your alter ego. Sad you haven't realised that. Now tell me what the investing scene looks like, with Barack Obama as the President of the US," she asked. 

"Oh, not much has changed. Last year was the worst for stock markets in the US since the 1930s. Hardly surprising the investors have pushed nearly $3.85 trillion into money market funds," I replied. 

"Money market funds?" 

"Yeah, money market funds, which are essentially mutual funds that collect money from investors and invest in financial securities issued by the government and maturing in less than a year's time." 

"But why does the government need to issue these securities?" 

"For the simple reason that it spends more than it earns and in order to make up for the difference it needs to borrow." 

"But why have the investors put so much money into money market funds?" her questioning continued. 

"That's because investors don't want to take any risk. Also, with so much money parked in money market funds in the US, the big institutional investors are investing very little money in stock markets around the world. And that largely explains why the stock markets have been so dull over the last few weeks," I answered. 

"Hmmm… But what kind of returns have the investors been earning on these investments?" 

"After adjusting for expenses, the average return on these funds has been around 0.40%, which is peanuts. For investors, therefore, the all-important consideration now is the safety of their investments."

"You know I was reading somewhere that Barack Obama is planning a fiscal stimulus to revive the economy. Martin Feldstein, an economist, who was the chairman of the Council of Economic Advisors to Ronald Reagan, had told the US Congress that to be effective, the package will need to be around $800 billion. There are also talks about a second bailout package — TARP II (troubled asset relief programme part II) as it has been labelled. Where will all this money come from?" she asked.

"Oh that's simple; the government will have to borrow. Where else will it come from?" 

"I presume this borrowing will be of a longer maturity. Does that mean the people who have invested in money market mutual funds that invest in government issued financial securities maturing in less than one year will also invest in financial securities of longer maturity?" 

"Wish I had a straight answer to that. The return on a financial security with a maturity of 10 years issued by the US government is currently at 2%. Even with the humongous borrowing that the US government is indulging in, the return continues to be at a very low rate because there is a huge demand for government issued financial securities among investors. Everybody is looking for safety of investment and financial securities issued by the US government seem to be the best place to park money in." 

"Do you see a problem in that?" 

"Well, let me throw some numbers at you. In the last 15 months, Arab kingdoms and China have been the two biggest buyers of financial securities issued by the US government. The Arabs bought securities worth $245 billion and China bought $233 billion. But will they continue to buy these securities? I have my doubts. Oil price has crashed from highs of $140 a barrel to a low of around $35 a barrel in December. Given this, experts believe the revenue earned from oil exports by members of the Organisation of Petroleum Exporting Countries (comprising mainly the Arab nations) will be down to $440 billion in 2009 from $962 billion in 2008. Not a good sign. On its part, China is an export-driven economy. But with the world economy slowing down, its export revenues are largely expected to fall." 

"Are you saying the major investors in US government securities will not have enough dollars going around for them to continue investing at the same rate as before?" 

"You got it." 

"Well, to make it attractive for investors to continue investing in US government securities, the return will have to go up, which in a way means the interest rate offered on these securities will have to go up. Then, the interest rate at which banks in the US lend to consumers will go up, too, making borrowing more expensive. And when that happens, the US consumer, who is addicted to borrowing to buy stuff, will buy even lesser stuff than he is buying now. A lot of this stuff is produced by companies in countries such as China and Japan. This will have an impact on companies whose major market is the US, slowing down their earnings even further. This will largely include US based companies and companies from China and Japan who export majorly to the US. A further slowdown in earnings will have an impact on the stock prices of these companies, which are listed in markets throughout the world." 

"So, stock markets are not going to revive anytime soon?"

"Yes, especially the US stock market, whose revival can revive the stock markets around the world," I said. "Your coffee has revived me though. Thank you." 

(The example is hypothetical)