The economy, markets and policies
Intro to Economics part - 2
In 2008, Ratan Tata’s dream of making the worlds most affordable car was within reach.
The Tata Nano factory in Singur, West Bengal was built and ready to start production.
But just as it was all coming together, everything collapsed.
The communist led state government forced Tata motors to shut down the factory, even before a single car had rolled out.
After months of back and forth, and political deadlock, Tata motors gave up and pulled out of West Bengal.
Just when they thought it was all falling apart, Ratan Tata gets a call, on the other side of the phone was Gujarat’s chief minister Narendra Modi, he offered a deal and says “Come here. We’ll make it work.”
And within 48 hours, a new site was identified in Sanand. Approvals were fast tracked and land was cleared. In less then a year, the first Nano car rolled out of the factory in Gujarat.
Soon the word spread that Gujarat was one of the easiest place in India to do business.
And one by one, companies followed, Ford, Suzuki, bombardier, even Chinese electronic firms were all setting up massive plants in the state.
Soon ports were built, roads got connected from factories to markets and the towns were transformed into industrial hubs.
In just few years, Gujarat transformed into one of India’s fastest growing state economies.
All this growth happened because, Gujarat’s government had built a system.
They built a business friendly policy and the cleared bottlenecks, that pushed the growth forward.
What I wanted to tell you with this story, was that economies don’t just grow by themselves.
They respond to forces that influence their growth direction.
In every modern economy there are two major and very important entities that influence them.
And in today’s edition that’s exactly what we’re talking about.
We’ll look at how;
central bank policies and government policies shape the economy and markets
And how you, as a trader/investor can use that information to understand the direction of the economy and markets.
This is the 2nd letter of the “Intro to economics series”, where we’re talking about basics of economics that every trader an investor should know.
So if you haven’t already, subscribe to our newsletter to receive future newsletters directly to your mail.
Now let’s get going.
Gujarat didn’t become a industrial hub by chance.
The state’s government engineered policy systems that made doing business easier, faster and cheaper.
Just like Gujarat, every country wants its economy to grow as a whole, predictably and efficiently.
That’s where central bank and central government comes in, they control the direction and pace at which the economy is growing. (Not like in a socialist or communist countries)
One controls the flow of money into the economy through spending, taxation, and incentives.
The other controls the cost and availability of money through interest rates and liquidity.
Together they decide the speed of growth and direction of the economy.
(Well in most cases they want to economy to go in upward direction meaning growth, it’s only goes down if the policies they implement fails.)
And if you’re trying to understand the markets direction, then you have to watch these two government bodies and their action very closely.
Let’s break it down and understand how they operate, what tools they use and why traders obsess over every move they make.
The Central bank : The monetary Policy
The central bank is not like any other regular bank. It’s not here to make money.
It’s job is to ensure currency stability, manage inflation and maintain a healthy financial system. This is called monetary policy.
In our country that’s done by RBI - Reserve Bank of India.
To do these things, it uses two powerful levers: Interest rates and liquidity.
Interest rates: The cost of money
Interest rates decide how cheap or expensive it is to borrow money.
(We’ll talk about this in detail in our next edition)
For now just know that, when central bank cuts rate, borrowing becomes cheaper.
And suddenly loans don’t look so expensive.
People take loans to buy homes, companies will raise debt to fund projects. And because of that demand for things raises. And the markets will have bull runs.
But when the central bank raises rates, everything slows down.
The cost of loan raises, EMIs will go up and businesses will pull back on expansion.
This will cause the demand to slowdown and the markets will also cool off.
It’s not about morality or politics rather a simple math.
Lower rate = more borrowing = more spending = economic growth.
Higher rates = less borrowing = spending = economy cools down. (Not crash)
Liquidity: The flow of money
The second lever is liquidity.
This isn’t about the cost of money, it’s about how much money is actually available in the system.
The central bank controls how much money is flowing in the system by injecting cash into the system through something called Quantitative easing.
When you hear quantitative easing just know that RBI is printing and sending out cash to the financial system. (We’ll talk about this in details in upcoming letters)
So when there’s more cash in the system, banks can create more loans.
More loans means more investments and spending.
And when that happens markets usually go up.
But when liquidity is pulled out, meaning RBI stops printing money and goes on to take deposits from banks, (banks will deposit their cash with RBI to earn interest)
Credit in the system will dry out. So less loans to issue, less investments and spending which causes the markets to slowdown.
Liquidity is like oxygen for the financial system to run on.
This is where markets react before the economic shifts happen.
Every rate decision, repo adjustments and liquidity operations acts as a signal for markets.
That’s why all market participants are focused on monthly monetary policy updates.
This is how central banks accelerate or slow down the growth of the economy.
While the central bank controls the cost and flow of money, the government decides where that money should go, what to build and where to spend.
Central Government: The fiscal policy
The government influences the economy though spending, taxation and incentives.
This is called Fiscal Policy.
1. Spending: Injecting demand into the system.
Governments are the biggest spenders in an economy.
When the government spends, it creates direct economic activity.
When government decides to build a road, it creates jobs for construction workers, gives contracts for cement companies and demand for steel will rise and so on.
When they subsidize agriculture, farmers will have more money left for their pocket for spending, that money will circulate in rural economies.
When they launch housing schemes , that will pump the demand into real estate, cement, steel, labor and home loans.
So every rupee spent by the government, flows into someone’s hands and it keeps moving.
During difficult times (like the Covid lockdown) this spending becomes a lifeline for the economy.
And during good times, it’s will become the growth accelerator for the economy.
Taxation: Taking money out of the system.
Taxes are the flip side of spending.
When the government increases taxes, the disposable income of people and businesses goes down, so does spending and investments.
The less they tax, the more money left in the system to circulate.
So taxes aren’t just about funding government budget, they are also a tool to manage demand.
Cutting taxes will stimulate consumption and raising taxes can cool inflation or reduce budget deficits.
They both send a signal to markets about the future growth and policy directions.
Incentives & Subsidies: Nudging behavior.
Beyond spending and taxes, governments also shape the behavior of the economy.
If the government wants an industry to grow they will offer them tax holidays or subsidies.
If they want to grow green energy, they offer solar companies cheap loans or tax breaks.
If they want manufacturing to scale up, they will launch schemes like PLIs (production linked incentives).
These decisions change the structure of the economy.
Every budget, every subsidy and every infrastructure project is a deliberate choice to shape the economy’s future.
The long term impact of the government policy is massive.
Because when governments decides to spend or cut down on spending, entire industries can rise or fall.
Markets don’t react to fiscal policy as reactively as they to monetary policy.
But fiscal policy is as important as monetary policy because it shapes the growth of the economic development.
Markets are a forward looking machine. they mostly move based on future expectations.
But the economy is slow moving, the policies take time to take effect on the economy.
That explains the mismatch in economy and market movements.
When the government announces a spending plan, or the central bank cuts rates, the market doesn’t wait for GDP data to improve.
They will react instantly to the signal.
We’ll talk more about this in our next edition so stay tuned.
So this is how monetary policy and fiscal policy affects the economy.
Now you know why they do it and how they do it.
When you understand these policies you’ll get a better sense of the direction in which the economy is headed.
So next time you trade/invest in a stock you know what to look for.
Read monthly monetary policy reports, checkout government schemes or incentives that are impacting a certain industry or sectors. This will give you a better edge in markets then most traders/investors.
In our next edition we’ll look at business cycles and economic indicators. They help us understand where we are and which direction the economy is headed in upcoming months to years.
So subscribe to our newsletter, follow us on Instagram to stay updated and see you next week.
Have a great trading week.
Bye!
Manoj