Why are we still struggling despite our Government's claim of improving Income

Ever wondered why we are still struggling even though our incomes have increased for the last few years? Our government’s propaganda machinery also had us believed that our lives had improved due to the increase in disposable income and hence everything is in good hands. By doing so, it will ensure that they will be re-elected in the next election. But why are we still hard pressed to meet ends need despite improving economic fundamentals such as higher economic growth rates, lower inflation, increasing GDP per capita, booming housing sector, improving external sector and so on. 

The following is Malaysia's GDP/capita chart from 2007-2011. It showed the GDP had been rising from $6905 in 2007 to $9656 in 2011 despite a slowdown to $6902 in 2009 due to the Global Financial Crisis.



Source : World bank

Everything seems to be falling into places and our standard of living should next be elevated to a new sustainable level. Why is this not happening?

What are the causes?

In his daily life, an individual is faced with problems in compromising his choices between his ‘needs and wants’. There are certain basic needs that you have to satisfy in order to survive such as food, lodging, transport and etc.
Due to your limited resources (income), you had to carefully allocate it so as to maximize your final objective within your budget. Unfortunately, however well you plan and budget your income, you soon realized that an increase in income actually causes more difficulty for you in meeting your budgets. In other words you may look better off outwardly but in actuality you are struggling to meet your monthly bills. Why is this so? The main reason is due to inflation.

Who is responsible for Inflation?

Who is responsible for all the inflation in the economy? The answer is the Government and how can it manage to do that? There are three ways the Government can inflate the economy.

1. By printing more money or Quantitative Easing as it is known without any backing of real money like gold. It is merely turning on the Printing Press and print or in other words COUNTERFEITING.  To illustrate how would an increased in the money supply causes inflation, we shall use the following example hypothetical economy.

Total Money supply is $100

There are only 2 products in the economy - a chicken and a duck.

Each of them are priced at $50 each

What will happen when the Money Supply is doubled to $200? Although the Money Supply is doubled but the supply of goods remains the same – one chicken and one duck. Since there are more money to spend the people will eventually bid up the prices for the chicken and duck in order to obtain what they want. In the end the price will have to go up until an equilibrium is reached between rise in price and the Money Supply.

2. The second method is through the Banks. Since the banking sector operates on the basis of Fractional Reserve Banking and by increasing the amount of funds the bank can lend out, it greatly help increase the Money Supply in the economy. Banks are required to reserve a certain percentage (normally 3-10%) of their deposits in order to remain solvent, maintain investor confidence and also act as an insurance against a ‘bank run’. This reserve is known as the Statutory Reserve Ratio (SRR) and Central Banks can either increase or reduce this percentage so as to manage the Money Supply in the economy. An increase in the ratio means Central Banks are moping up excess liquidity and is aiming for a ‘tight money’ regime  in the economy and vice versa.

Say for example the bank receive a $100 deposit, it can lend out $90 after deducting $10 for the SRR. Then when the borrower of the $90 writes a cheque to somebody who will later deposit it back into the bank. When the bank receives the $90, it can then lend out 90% of it which is $81 and this process will go on until finally it will reach $1000 or ($100+$90+$81+….. = $1000). By the time it reaches $1000, the bank had already made more than 40 different loans from the original $100. So the leverage in this case is 1 to 10 ($100 to $1000) and can be best shown in the table below.

Number	Amount	Less 10%
1	100	90
2	90	81
3	81	72.9
4	72.9	65.61
5	65.61	59.04
6	59.04	53.14
7	53.14	47.83
8	47.83	43.04
9	43.04	38.74
10	38.74	34.87

What will happen if the SRR is reduced to 5%? Again the bank when receive $100 will lend out $95 and the $95 will again make its way back to the bank and the process will go on until it reach $2000. The process can be shown in the table below.

Number	Amount	less 5%
1	100	95
2	80	90.25
3	64	85.73
4	51.2	81.45
5	40.96	77.37
6	32.76	73.5
7	26.21	69.82
8	20.97	66.33
9	16.77	63
10	13.42	59.86

By the time it reaches $2000, the bank had already made more than 100 different loans from the original $100. So the leverage in this case is 1 to 20 ($100 to $2000). So in conclusion, by reducing the SRR from 10% to 5%, central banks will be able to increase the Money Supply in the economy by 100%.

3. The third method is through the government’s Open Market Operations of securities such as bonds. When the government made a purchase of bonds or also known as ‘open market purchase’ it will increase the money supply in the economy. How it works?  When the Government purchases a $100 bond from a bank then it will need to issue a cheque for the purchase. The bank in return will either have to deposit it into its account with the Central Bank or cash in for currency which will be stored in its vault.  The end result is the Central Bank will end up with $100 more in bonds and less $100 in reserve while the bank will end up with an extra $100 in reserves and less $100 in bonds. Hence there will be an increase of $100 in the Money Supply.

An ‘open market sale’ of bonds will have a reverse effect and it will cause a contraction of $100 in the Money Supply. Such operation of buying and selling of securities by the Central Bank is similar to the job of a floodgate controller in a dam. By releasing or closing the gates, it can then manage the level of water in the dam.   

Coming back to our main point on why we are worse off despite our increased disposable income throughout the years. We present to you another hypothetical case study. Our case study is based on the following assumptions.

1. An individual with an income of $1000
2. No other source of income
3. He has a basic set of needs and wants

The following table describes his basic needs and wants.

Table 1 - His Monthly Budget on Basic Needs

No.	Description	($)
1	Food	150
2	Housing	200
3	Clothing	80
4	Education	100
5	Transportation	130
6	Medical	70
7	Entertainment	90
8	Insurance	100
9	Savings	80
	TOTAL $	1000

Table 2 - His other wants (Gratification)

No.	Description	($)
1	Super Bike	150
2	Swimming Pool	100
3	A new MPV	120
4	A bigger House	180
5	A dream holiday	100

As can be seen from the above table, there are certain basic needs that must be satisfied in order to continue living. He family need food to survive, clothing, education for children, transport to work, a house to live in and etc. After deducting these basic needs he is left with $80 for savings for the future.

You notice that apart from the needs he also has a list of wants which include a super bike, swimming pool, a new MPV and etc. Due to the budget constraint of being left with only $80 after all the expenses he cannot afford to have any of the other things that he wants. One way is to sacrifice some of the basic necessities in order to get one of the things that he love to have but he is unwilling.

What happen if he had a pay rise?

Then it will be a different story. Due to the Government’s pump priming and its inflationary effect on the economy, it causes an ‘appearance of a boom in the economy’. Bosses thinks that the economy is reaching a new plateau and orders are coming in, he decided to hire more workers and also giving a pay rise to existing workers. Say he got a pay rise of $100 from his boss. Assuming that this individual neglects the effects on inflation and he is overjoyed by the pay rise and soon went to purchase a Pool with a monthly commitment of $100. In other words he is back to square one and only able to save $80 a month.

What he failed to foresee is the effects of inflation through an increased in the paper money supply brought about by the government that is about to begin. He will realize that after a few months it will cost him more than the increase of $100 per month to maintain his present lifestyle. In other words his pay rise had been completely absorbed by inflation. He had to pay more for his basic needs than what he is paying now.

As a result of inflation, his cost of living had indeed gone up. The table below shows his new cost of living as a result of inflation.

Table 3 – Inflation adjusted Cost totaled $1100

No.	Description	($)
1	Food	165
2	Housing	220
3	Clothing	90
4	Education	120
5	Transportation	150
6	Medical	100
7	Entertainment	100
8	Insurance	120
9	Savings	35

Reduced standard of living

The above table shows that he may just made it through his monthly budget with a savings of $35 a month. However there is a little problem because he had earlier bought a Pool with a monthly installment of $100. How is he going to pay for this? There are two ways for him to get around this problem.

1. Take out any of the items listed from 1 – 8 in the above table.
2. Reduce the expenditure on the items above

Needless to say he will opt for choice number two where he will reduce the expenses in some of the items. After some consideration he decided to change his lifestyle to the following.

Table 4 – Adjusted lifestyle with pool

No.	Description	Old  ($)	New ($)
1	Food	165	150
2	Housing	220	220
3	Clothing	90	80
4	Education	120	120
5	Transportation	150	150
6	Medical	100	90
7	Entertainment	100	80
8	Insurance	120	100
9	Swimming Pool		100
10	Savings	35	10
	TOTAL $	1100	1100

When he is faced with limited resources he had to make a choice on which of his basic needs that had to be trimmed down in order to absorb the expenses of the pool. For as long as he had to pay for the monthly installment of the pool he had to scale down his spending on some of the things he had taken for granted. From the above table after his revised budget, his monthly expenses on food, clothing, medical expenses, entertainment and also his monthly savings have been reduced.

Deceived into thinking of better off

What can be conclude from the above is that although the amount of things he is entitled is more than before (10 items inclusion of the pool) but the monetary distribution of his spending had been altered due to the effects of inflation. Had he know the effects on inflation before hand then he would not have bought the swimming pool. He had a choice of getting rid of the pool so as to maintain his former lifestyle but he didn’t. Now his life is less enjoyable because of the reduce budget on the few things that he earlier enjoyed. He thinks that he is better off because he was deceived into thinking he now have more things in life. In actuality has his life improved due to inflation?  

 

  

Misconception on Foreign Funds inflow causes Volume increase

Volume had long been an important indicator in the study of market sentiment. A bull market accompanied by heavy volume indicates commitment among investors and is usually regarded as healthy and will help prolong the run. Whereas a bull run with light volume indicate less commitment from investors and eventually the trend will run its course much sooner than expected.  However over the past there had been much misconception among investors regarding the volume of shares in a particular stock market. 

It is perceived not only among investors but also analyst that an increase inflow of foreign funds will eventually lead to an increase in volume in the stock market. Hence it will be bullish in the short and medium term. In fact we always hear about analyst blaming lackluster performance of the local stock market is due to the lack of participation of foreign funds. This brings us to the next question on whether they know what they are talking about?

We shall present below a study on whether the inflow of foreign funds does increase the volume in the stock markets. Below is a chart on the different components that help made up the total volume in the market. The Stock market is actually made up of three different markets and they are the Primary, Secondary and Tertiary Markets and by adding their volumes will give us the total market volume.  


 

From the above it can be deduce that the total volume in the market consists of Primary, Secondary and Tertiary volumes. Tertiary volume is the volume of new shares from new IPOs. Primary volume is the existing volume of all the stocks traded in the market. Secondary volume is derived from a stock split or bonus issue (stock dividend).

To build our case on whether foreign funds will actually increase the volume in the stock market as many investors perceived, we think of a hypothetical stock market based on the following assumptions.

1. Only 5 companies
2. 100 shares are allocated to each of them

So our model stock market will look like the following.

Table 1
Stocks held by Domestic and Foreign Investors

Company	Stock Qty	Domestic	Foreign	Total
A1	100	100	0	100
B1	100	100	0	100
C1	100	100	0	100
D1	100	100	0	100
E1	100	100	0	100
	500	500	0	500

From the table, initially all stocks are held by domestic or local investors. The total shares are 500 and equally divided into 5 companies. What will happen when foreign investors start buying up some shares in the local companies? In Table 2 below we will present to you the scenario on what will happen.

Will Foreign Buying Increase Primary Volume?


Table 2
Stocks held by Domestic and Foreign Investors

Company	Stock Qty	Domestic	Foreign	Total
A1	100	90	10	100
B1	100	100	0	100
C1	100	80	20	100
D1	100	75	25	100
E1	100	90	10	100
	500	435	65	500

The above table shows the effect as a result of shares purchase by some foreign funds in companies A1, C1, D1 and E1 which amounts to 65 shares. The total volume of shares still remains at 500 but the only difference is that the locals now held fewer shares with only 435 and the balance of 65 shares were held by the foreign investors. So in other words there is no increase in the Primary Volume as a result of foreign investors buying into the market and the only change is the transfer of ownership from the local to foreigners.

How about Tertiary Volume?

As we have explained earlier the Tertiary Market consists of new IPOs. IPOs are classified into Tertiary because they are newly listed companies and foreign investors can participate through the allocation to institutional investors.

Table 3
Stocks held by Domestic and Foreign Investors after an IPO

Company	Stock Qty	Domestic	Foreign	Total
A1	100	90	10	100
B1	100	100	0	100
C1	100	80	20	100
D1	100	75	25	100
E1	100	90	10	100
F1	100	90	10	100
	600	525	75	600

As can be seen from the above, as a result of the IPO from F1 the volume of shares went up from 500 to 600 and so does the volume of shares held by foreign investors. In this case foreign investors did increase their holdings by 10 shares through its allocation to foreign investors. However this is only a ‘One Off’ situation, where after the shares are listed, it will be transferred to the Primary Volume. Its influence can be considered negligible. 

Same for Secondary Volume?

The same situation will exist in the Secondary Market where the volume increases after a share split or bonus issue and to a lesser extent through rights issue. The following table shows the effect after a 1 : 1 share split.
performed by C1.

Table 4
Stocks held by Domestic and Foreign Investors after share split

Company	Stock Qty	Domestic	Foreign	Total
A1	100	90	10	100
B1	100	100	0	100
C1	200	160	40	200
D1	100	75	25	100
E1	100	90	10	100
F1	100	90	10	100
	700	605	95	700

Although after this exercise, it does increase the foreign holdings but its effect can be negligible. This is because such corporate exercise will not happen every year.

Not all capital inflows go to Portfolio investments

In summary, we can conclude that despite all the excitement over the increase inflow of foreign funds, its effect on the volume on the stock market is negligible. The only benefit will be the increase in liquidity in the markets. How much of the capital inflows that go into the portfolio is another question as we know some of it will also go into fixed income investments. In fact quite a fair bit of the inflows are make up of what we call ‘carry trades’ and does not go into portfolio investments .

A good example will be the Japanese carry trade. A carry trade is basically an arbitrage of interest rates in different countries. To show you how a carry trade works we present you the following example.An investor will first borrows 1 million Japanese yen from a Japanese bank with an interest rate of 0.5%. Then he converts it into Rupiah to buy Indonesian Sovereign bonds that yield 6.8%. What happen next is that the investor automatically earns 6.3% (6.8% - 0.5%) from this venture without doing anything as long it is kept till maturity. But such a trade involves foreign exchange exposures because what if the Rupiah depreciates? If the depreciation is large enough it will not only wipe out the 6.3% gain but also incur heavy losses to the investor. To avoid such losses, the investor can hedge his investment through foreign exchange forward contracts and options.


In other words, why should foreign investors risk their capital gambling in the stock markets when they can earn money without doing anything. In recent years since the 'carry trade crisis' a few years back, investors are much wiser by hedging their investments. So it is not surprise to see a big chunk of the capital inflows are carry trades in nature. 

In actual fact foreign funds does more damage to the stock market than the benefits it provide. Any signs of an economic downturn, they are the first to withdraw their funds. By pulling out from the stock market it not only create a hole in the market but also will help to contribute to the devaluation of the currency in the host country through the depletion of its foreign reserves. In short if it (foreign fund) is 'hot money' in nature then it will give more trouble than it's worth.