Is The World Fueled By Credit?

At The Motley Fool, we highly value the idea of being Motley, which is to say we are open to fellow Fools disagreeing or even having different investing ideas.

But, one common thread that connects all of us at the Fool is the belief that leverage is a double-edged sword in investing. We never promote the use of leverage when investing and we also tend to avoid companies that are highly leveraged. Yet in this article, I would like to explore the very thing that we constantly remind our readers to avoid: Credit.

Imagine a world with a purely cash-based economy. Every time an individual buys something, he or she has to use cash to pay for it fully. Groceries, school fees, cars, houses – everything has to be paid off fully with cash. Companies have to do the same thing too. A company has to pay all its suppliers in cash when goods arrive. There are no loans, credit cards, trade financing, or bank guarantees to speak of.

Would our economy work in this way? Clearly not. Most companies can only operate with the help of credit. Suppliers give credit terms to their customers; banks provide trading financing and bank guarantees for their clients; the bond markets provide companies a platform to issue debt to finance their operations or make long-term investments.

In fact, during instances when credit freezes, panic ensues.

For instance, the Chinese A-Shares market crash that happened in 2015 occurred mainly because regulators were forcing brokerages to reduce the credit provided to investors.

In another instance, the global financial crisis of 2007-09 started to unfold when investors realized that the subprime bonds they were purchasing were filled with low quality mortgages and the market refused to fund additional subprime mortgage bonds. This dried up the market almost completely, thereby cutting the credit facilities required by property speculators and home buyers.

Regardless of how much we avoid leverage in our personal investments, we have to know that credit still plays a huge role in the global economy. Therefore, it might be wise for investors to get to know more about it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.