Personal Finance

The Complexity of Money


indian rupees

Vivek Kaul

Over the last two weeks I have come to realise that people share a very complex relationship with money. A friend of mine who makes more than Rs 50 lakh a year, owns two homes, a couple of cars, and holidays abroad in exotic locations ever year, has constantly been cribbing about the 10% increment he got after the yearly performance appraisal.
“So were you expecting more?” I asked him. “Not really. The company hasn’t been in a great shape, so even 10% is very good. The average increments this year have only been around 6-7%,” he replied.
“So then what is the issue?” I asked.
“Well you know,” he said, such and such person, “who I tend to compete with got an increment of 11%.” This difference of 1%(actually I should be saying 100 basis points, but that sounds too technical) had been bothering him no end.
I tried telling him that his salary was nearly 50% more than the other person he was talking about. “So in absolute terms your increment is greater than his,” I explained.
“Yeah. But it would have been better if I made more in percentage terms as well,” my friend replied.
What this little story tells us is that people share a complex relationship with money. How else do you explain what my friend earning more than Rs 50 lakh per year was going through? There is no doubt that money motivates. An experiment carried out in 1953, showed just that. As Margaret Heffernan writes in Wilful Blindness – Why We Ignore the Obvious At Our Peril “Patients were asked to hang on horizontal bars for as long as they could; most could take it for about 45 seconds. When subjected to power of suggestion and even, in some cases, hypnosis, they could stretch to about 75 seconds. But when offered a five dollar bill the patients managed to hang from the bar for 110 seconds.”
So money does motivate people to work longer. And in many organisations that is equivalent to working harder. But as Heffernan puts it “money has a more complex influence on people than just making them work longer.”
Experiments carried out by behavioural psychologist Dan Ariely suggest that the less appreciated we feel our work is, the more money we want to do it. Ariely gave research participants a piece of paper that was filled with random letters. The participant were divided into three groups, and had to find pairs of identical letters on the sheets of paper given to them and mark them out.
While returning their papers, the the participants in the first group wrote their names on the sheets of paper and handed it back to the experimenter. He took the sheet, looked it over, said “Uh huh” and put it in a pile.
The participants in the second group did not write their names on the sheets of paper. The experimenter took their sheets without looking at them and without saying anything. He placed them in a pile. The sheets handed over by the participants of the third group were immediately shredded, as soon as they handed them over.
In order to be a part of another round of the experiment, those in the third group whose sheets were shredded wanted twice the amount of money in comparison to those in the first group, whose sheets were simply put in a pile. Those in the second group whose work was saved but ignored wanted as much as participants of the third group whose sheets were shredded.
As Ariely put in a blog on www.ted.com “Ignoring the performance of people is almost as bad as shredding their effort before their eyes.” And when that happens people want to be paid more.
The next question that crops up is that does paying people more money make them work smarter?This question is of utmost importance given the fact that some of the highest paid people in the world brought it to the verge of economic collapse a few years back in late 2008.
Ariely and a group of researchers tested this out in an experiment they carried out in India (to control the costs involved in running the experiment). In this experiment, research participants were asked to play memory games and assemble puzzles while they were throwing tennis balls at a target. One third of the participants were promised one day’s pay, if they performed well. Another one third were promised two weeks pay. And the final third were promised five months pay (the real reason behind conducting the experiment in India), if they did well.
The results were surprising. Those who were promised a day’s pay and two weeks pay as a financial reward, performed equally well. But those who were offered five months pay, performed the worst.
Ariely explained this surprising finding in an article he wrote for The New York Times. Very high financial rewards act as a double edged sword, Ariely wrote. “They provide motivation to work well, but they also cause stress and preoccupation with the reward that can actually hurt performance.”
Of course this in no way means that people don’t want to paid more, even though the prospect of earning more money starts hurting their performance beyond a point. Also, more money doesn’t always make people happier.
Research carried out by economist Angus Deaton and psychologist Daniel Kahneman (who won the Noble Prize in economics) in 2010 found that more money makes people happier upto an income of $75,000 per year. As Kahneman writes in Thinking, Fast and Slow “The satiation level beyond which experienced well being no longer increases was a household income of $75,000 in high cost areas (it could be less in areas where the cost of living is lower). The average increase of experienced well-being associated with incomes beyond that level was precisely zero…Higher income brings with it higher satisfaction, well beyond the point at which it ceases to have any positive effect on experience.”
So earning more money is not always directly proportional to greater happiness. But then why does money continue to bother people (as we saw in my friend’s case) so much? Nassim Nicholas Taleb perhaps has an explanation for it in Anti Fragile “The worst side of wealth is the social association it forces on its victims, as people with big houses tend to end up socialising with other people with big houses.”
Beyond a point the need for more money is an essential part of being seen at the top of the rat race. More money is also equated with higher intelligence and leads to greater respect from the society at large. As John Kenneth Galbraith, one economist who thoroughly deserved a Nobel prize, but never never got it, put it in A Short History of Financial Euphoria: “Individuals and institutions are captured by the wondrous satisfaction from accruing wealth. The associated illusion of insight is protected, in turn, by the oft-noted public impression that intelligence, one’s own and that of others, marches in close step with the possession of money.” Hence, money after a point becomes a measure of intelligence and success and that creates problems of its own.
The article originally appeared in the Wealth Insight magazine dated August 1, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

What we can learn from Chidambaram's turkey problem

turkeyVivek Kaul

“The rupee depreciation of June, July was quite unexpected,” said finance minister P Chidambaram on August 1, 2013.
What does Chidambaram mean here? He probably means that the government was caught unaware on the depreciation of the rupee against the dollar over the last two months. They were not prepared for it.
And if the government had realised that the rupee would lose value against the dollar as fast as it has, then it would have done a few things to control it, like it is trying to do now.
When one looks at the economic reasons behind the rupee’s fall against the dollar they were as valid then, as they are now. The current account deficit for the period of 12 months ending March 31, 2013, had stood at 4.8% of the GDP or $87.8 billion. The current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances.
During the period of twelve months ending December 31, 2012, the current account deficit of India had stood at $93 billion. In absolute terms this was only second to the United States.
As Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management point out in a report titled Don’t Take Your Eye of the Ball “At $93billion, India’s current account deficit in 2012 was second only to the US in absolute terms, and higher than the UK, Canada and France.”
A high current account deficit meant that India’s demand for dollars to pay for imports should have been higher than the supply. The dollars that India earned through exports and the dollars that were being remitted into India were not enough to pay for the imports.
Hence, this meant that the rupee should have lost value against the dollar. But that did not happen because foreign investors kept bringing dollars into to invest in stocks and bonds in India. At the same time Indian corporates were borrowing in dollars abroad and kept bringing that money back to India. The Non Resident Indians were also bringing dollars into India and converting them into rupees to invest in bank deposits in India because interest rates on offer in India were higher.
All this effectively ensured that there was a good supply of dollars. This in turn meant that the rupee did not lose value against the dollar, even though the current account deficit had gone through the roof.
But a high current account deficit should have been warning enough for the government that rupee could snap against the dollar, at any point of time. The dollars coming in through foreign investors in bonds and stocks and NRIs deposits, could go back at any point of time. Also, money being borrowed by the Indian companies in dollars, would have to be repaid. And this would add to the demand for dollars.
Hence, steps should have been taken to control the high current account deficit by controlling imports. And at the same time steps should have been taken to ensure that dollars kept flowing into India. The government got active on this front only after the rupee started to lose value against the dollar since the end of May, 2013.
But why did the government and the finance minister not figure out what sounds a tad obvious with the benefit of hindsight? As I have explained here, here, here,here and here, most of the factors that have led to the rupee depreciating against the dollar, did not appear overnight. They have been work-in-process for a while now.
So why did Chidambaram find the rapid depreciation of the rupee against the dollar “unexpected”? The basic reason for this is the fact that between January and May rupee moved against the dollar in the range of 54-55. It was only towards the end of May that the rupee started rapidly losing value against the dollar.
Chidambaram and others who had thought that the rupee will continue to hold strong against the dollar had become of what Nassim Nicholas Taleb calls the turkey problem. As Taleb writes in his latest book Anti Fragile “A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal … the key here is such a surprise will be a Black Swan event; but just for the turkey, not for the butcher.”
Chidambaram expected the trend ‘of a stable rupee’ to continue. What was true for the first five months of the year was expected to be true for the remaining part of the year as well. But sadly things did not turn out like that, and the rupee like Taleb’s turkey got butchered.
By May end, foreign investors were falling over one another to withdraw money from the Indian bond market. When they sold out on bonds, they were paid in rupees. Once they started converting these rupees into dollars, the demand for dollars went up. As a result the rupee rapidly lost value against the dollar, and only then did the government wake up.
As Taleb writes “We can also see from the turkey story the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence, a mistake that tends to prevail in intellectual circles.”
Just because something is not happening at the present time, people tend to assume that it will never happen. Or as Taleb puts it, an absence of evidence becomes an evidence of absence. Chidambaram was a victim of this as well.
There is a bigger lesson to learn here. People expect any trend to continue ad infinitum. For example, before the financial crisis broke out in late 2008, Americans expected that housing prices will keep increasing for the years to come. In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. This faith came from the fact that housing prices had not fallen in the recent past and everyone expected that trend to continue.
The same phenomenon was visible during the dotcom bubble of the 1990s. Every one expected the prices of dotcom companies which barely made any profits, to keep increasing forever. The great investor Warren Buffett stayed away from dotcom stocks and was written off for a while when the prices of dotcom stocks rose at a much faster pace than the value of investments that he had made. But we all know who had the last laugh in the end.
The Japanese stock market and real estate bubble of the 1980s was also expected to continue forever. A similar thing has happened with gold investors this year. Just because gold prices had rallied for more than 10 years at a stretch, investors assumed that the rally will continue even in 2013. But it did not.
Hence, it is important to remember that just because a negative event hasn’t happened in the recent past, that doesn’t mean it will never happen in the time to come. In India, currently there is a great belief that real estate prices will continue to go up forever. Is that the next ‘big’ turkey waiting to be slaughtered?

The article originally appeared on www.firstpost.com with a different headline on August 2, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

 

Why RBI killed the debt fund

RBI-Logo_8Vivek Kaul 
The Reserve Bank of India(RBI) is doing everything that it can do to stop the rupee from falling against the dollar. Yesterday it announced further measures on that front.
Each bank will now be allowed to borrow only upto 0.5% of its deposits from the RBI at the repo rate. Repo rate is the interest rate at which RBI lends to banks in the short term and it currently stands at 7.25%.
Sometime back the RBI had put an overall limit of Rs 75,000 crore, on the amount of money that banks could borrow from it, at the repo rate. This facility of banks borrowing from the RBI at the repo rate is referred to as the liquidity adjustment facility.
The limit of Rs 75,000 crore worked out to around 1% of total deposits of all banks. Now the borrowing limit has been set at an individual bank level. And each bank cannot borrow more than 0.5% of its deposits from the RBI at the repo rate. This move by the RBI is expected bring down the total quantum of funds available to all banks to Rs 37,000 crore, reports The Economic Times.
In another move the RBI tweaked the amount of money that banks need to maintain as a cash reserve ratio(CRR) on a daily basis. Banks currently need to maintain a CRR of 4% i.e. for every Rs 100 of deposits that the banks have, Rs 4 needs to set aside with the RBI.
Currently the banks need to maintain an average CRR of 4% over a reporting fortnight. On a daily basis this number may vary and can even dip under 4% on some days. So the banks need not maintain a CRR of Rs 4 with the RBI for every Rs 100 of deposits they have, on every day.
They are allowed to maintain a CRR of as low as Rs 2.80 (i.e. 70% of 4%) for every Rs 100 of deposits they have. Of course, this means that on other days, the banks will have to maintain a higher CRR, so as to average 4% over the reporting fortnight.
This gives the banks some amount of flexibility. Money put aside to maintain the CRR does not earn any interest. Hence, if on any given day if the bank is short of funds, it can always run down its CRR instead of borrowing money.
But the RBI has now taken away that flexibility. Effective from July 27, 2013, banks will be required to maintain a minimum daily CRR balance of 99 per cent of the requirement. This means that on any given day the banks need to maintain a CRR of Rs 3.96 (99% of 4%) for every Rs 100 of deposits they have. This number could have earlier fallen to Rs 2.80 for every Rs 100 of deposits. The Economic Times reports that this move is expected to suck out Rs 90,000 crore from the financial system.
With so much money being sucked out of the financial system the idea is to make rupee scarce and hence help increase its value against the dollar. As I write this the rupee is worth 59.24 to a dollar. It had closed at 59.76 to a dollar yesterday. So RBI’s moves have had some impact in the short term, or the chances are that the rupee might have crossed 60 to a dollar again today.
But there are side effects to this as well. Banks can now borrow only a limited amount of money from the RBI under the liquidity adjustment facility at the repo rate of 7.25%. If they have to borrow money beyond that they need to borrow it at the marginal standing facility rate which is at 10.25%. This is three hundred basis points(one basis point is equal to one hundredth of a percentage) higher than the repo rate at 10.25%. Given that, the banks can borrow only a limited amount of money from the RBI at the repo rate. Hence, the marginal standing facility rate has effectively become the repo rate.
As Pratip Chaudhuri, chairman of State Bank of India told Business Standard “Effectively, the repo rate becomes the marginal standing facility rate, and we have to adjust to this new rate regime. The steps show the central bank wants to stabilise the rupee.”
All this suggests an environment of “tight liquidity” in the Indian financial system. What this also means is that instead of borrowing from the RBI at a significantly higher 10.25%, the banks may sell out on the government bonds they have invested in, whenever they need hard cash.
When many banks and financial institutions sell bonds at the same time, bond prices fall. When bond prices fall, the return or yield, for those who bought the bonds at lower prices, goes up. This is because the amount of interest that is paid on these bonds by the government continues to be the same.
And that is precisely what happened today. The return on the 10 year Indian government bond has risen by a whopping 33 basis points to 8.5%. Returns on other bonds have also jumped.
Debt mutual funds which invest in various kinds of bonds have been severely impacted by the recent moves of the RBI. Since bond prices have fallen, debt mutual funds which invest in these bonds have faced significant losses.
In fact, the data for the kind of losses that debt mutual funds will face today, will only become available by late evening. But their performance has been disastrous over the last one month. And things should be no different today.
Many debt funds have lost as much as 5% over the last one month. And these are funds which give investors a return of 8-10% over a period of one year. So RBI has effectively killed the debt fund investors in India.
But then there was nothing else that it could really do. The RBI has been trying to manage one side of the rupee dollar equation. It has been trying to make rupee scarce by sucking it out of the financial system.
The other thing that it could possibly do is to sell dollars and buy rupees. This will lead to there being enough dollars in the market and thus the rupee will not lose value against the dollar. The trouble is that the RBI has only so many dollars and it cannot create them out of thin air (which it can do with rupees). As the following graph tells us very clearly, India does not have enough foreign exchange reserves in comparison to its imports.
import
The ratio of foreign exchange reserves divided by imports is a little over six. What this means is that India’s total foreign exchange reserves as of now are good enough to pay for imports of around a little over six months. This is a precarious situation to be in and was only last seen in the 1990s, as is clear from the graph.
The government may be clamping down on gold imports but there are other imports it really doesn’t have much control on. “The commodity intensity of imports is high,” write analysts of Nomura Financial Advisory and Securities in a report titled India: Turbulent Times Ahead. This is because India imports a lot of coal, oil, gas, fertilizer and edible oil. And there is no way that the government can clamp down on the import of these commodities, which are an everyday necessity. Given this, India will continue to need a lot of dollars to import these commodities.
Hence, RBI is not in a situation to sell dollars to control the value of the rupee. So, it has had to resort to taking steps that make the rupee scarce in the financial system.
The trouble is that this has severe negative repercussions on other fronts. Debt fund investors are now reeling under heavy losses. Also, the return on the 10 year bonds has gone up. This means that other borrowers will have to pay higher interest on their loans. Lending to the government is deemed to be the safest form of lending. Given this, returns on other loans need to be higher than the return on lending to the government, to compensate for the greater amount of risk. And this means higher interest rates.
The finance minister P Chidambaram has been calling for lower interest rates to revive economic growth. But he is not going to get them any time soon. The mess is getting messier.
The article originally appeared on www.firstpost.com on July 24, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

The psychology of discounts

discount-10Vivek Kaul
The power discounts have over consumer spending became apparent to me on a recent visit to Delhi. An aunt of mine decided to travel nearly twenty five kilometres in a DTC (Delhi Transport Corporation) bus to have lunch in a restaurant in Connaught Place, which was offering a 20% discount. And this was a time when the heat in Delhi was killing, with the temperature being greater than 40 degrees Celsius.
After coming back to Mumbai I heard about a high end lifestyle brand putting its goods on sale. And women queued up for it from 6.30am in the morning, despite the heavy rains.
That’s the power the words discount and sale have on the human mind. They can really get people out there to shop, despite the rains and the heat.
In fact Eric Anderson and Duncan Simester carried out an experiment to test whether just labelling something to be “on sale” lead to higher sales. Jonah Berger discusses this experiment in his book Contagious – Why Things Catch on. As he writes “Anderson and Simester, created two different versions of the catalogue and mailed each to more than fifty thousand people. In one version some of the products(let’s call them dresses) were marked with signs that said “Pre-Season SALE.” In other version the dresses were not marked as on sale.”
The results were very interesting. The items on which a sale sign had been marked, saw the demand go up by more than 50%. “The prices of the dresses (i.e. the items marked to be on sale) were the same in both versions of the catalogue. So using the word ‘sale’ beside a price increased sales even though the price itself stayed the same.”
While just mention of the world ‘sale’ is likely to increase sales, the trick is not to overuse it. As Anderson and Simester point out in a research paper titled The Role of Sale Signs “if customers’ price expectations are sensitive to the number of products that have sale signs, this strategy is not without cost. Using additional sale signs may reduce demand for other products that already have sale signs.” Also, if a product is always on sale then there is a problem because people can’t compare it with anything.
Despite these negatives, the fact is that everyone wants a good deal. In fact such is people’s fascination for getting a good deal that in some cases they are even willing to pay more. Berger carried out a small experiment in which a barbecue grill is on sale. Originally priced at $350, now its being sold at $250, a saving of $100. He ran this ‘deal’ through 100 people and 75% of the people said that they would buy the grill.
There was another scenario in which the same grill was on sale but at a different store. Originally it had been priced at $255 and was now selling at $240. Berger ran this ‘deal’ through 100 people and only 22% of the people said they would buy the grill.
And this is what made things really interesting. “Both stores were selling the same grill. So if anything, people should have been more likely to say they would buy it at the store where the price was lower….More people said they would purchase the grill in scenario A (the first scenario where a $350 grill was being sold for $250), even though they would have to pay a higher price ($250 rather than $240) to get it,” writes Berger.
Discount and sales offers play tricks on the human mind leading it to make irrational decisions, which are exploited by marketers. Akshay Rao of the University of Minnesota carried out a research on discounts and offering something extra for the same price, which he published in a paper titled When More Is Less: The Impact of Base Value Neglect on Consumer Preferences for Bonus Packs over Price Discounts.
In this paper Rao came to the conclusion that “shoppers prefer getting something extra free to getting something cheaper.”He explains this through an example of coffee beans. On a normal day, 100 coffee beans are being sold for Rs 100. One day, a discount of 33% is on offer. This means 100 coffee beans are sold for Rs 67.
Another day, a 50% extra offer is on. This means 150 coffee beans can now be bought for Rs 100. But what this also means is that 100 coffee beans can be bought for Rs 67. So a 33% discount offer and a 50% extra offer are economically equivalent. There is no difference between them, at least theoretically.
But real life turned out to be different from theory as usual. Rao and his team carried out an experiment and found that they managed to increase sales of a consumer packed good by over 70% in a retail store, when they used the extra/free bonus pack format in comparison to offering a discount on the product. Rao attributes this to the fact that the human mind is not good at performing arithmetic with complex forms such as logarithms, fractions, probability and percentages.
So if you have ever wondered why everyone from biscuit companies to mobile phone operators wants to give out something extra, rather than offer a discount, you now know why.
The inability to handle basic maths leads to marketers exploiting it in other ways as well. One such way is to express discount in a way where it seems larger than it actually is. As Berger writes “Twenty percent off on that $25 shirt seems like a better deal than $5 off. For high-priced big-ticket-items, framing price reductions in dollar terms (rather than percentage terms) makes them seem like a better offer. The laptop seems like a better deal when it is $200 off rather than 10 percent off.”
Whether marketers express discount in absolute terms or in percentage terms depends on the rule of 100. If the price of a product is less than $100 (or Rs 100 or any other currency) the percentage discount will seem bigger. Vice versa is true, if the price of a product is higher than $100. “For a $30 shirt…even a $3 discount is still a relatively small number. But percentage wise (10 percent), that same discount looks much bigger…Take a $750 vacation package or the $2,000 laptop. While a 10 percent discount may seem like a relatively small number, it immediately seems much bigger when translated into dollars ($75 or $200),” writes Berger.
The interesting thing is that the rule of 100 doesn’t seem to have caught on in India as yet. This could be a killer application for discount websites, which still focus on expressing discounts in percentage terms. As I write this the Bangla version of Amish’s The Immortals of Melhua is selling for Rs 130, a 33% discount on a price of Rs 195, on one of the discount websites. Now wouldn’t Rs 65 off have sounded so much more better?
While marketers are quick to latch on to these tricks, in this case they seem to have missed out on something rather obvious. Rest assured this anomaly will be corrected in the days to come.
The article originally appeared in the Wealth Insight magazine dated July 1, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)