S.P.

Jain Institute of Management & Research, Mumbai

Making Sense of It.

Abridged Volume I
The Economic Forum - 2008

As a part of our endeavour to share with you the very best of the world of economics, we present an abridged volume of Making Sense of It. This volume covers all the topics covered under the Making Sense of It emails for the period 22nd August 2008 to 14th October 2008. We hope you will find this compilation a useful ready reckoner. We sincerely thank Prof. Preeta George for her highly valuable inputs.

Eco Forum Committee 2008

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GDP Gross Domestic Product

What it means?

1) A measure of total investment. Gross indicates that it is measured without subtracting any allowances for Capital Consumption1; domestic that it measures activities located inside the country regardless of their ownership. It thus includes activities carried on in the country by foreign owned companies and excludes activities of firms owned by residents but carried out abroad. Product means that it is a measure of the real output produced rather than output absorbed by residents. GDP is reported at both current prices and constant prices (Indexed prices). Source: Oxford Dictionary of Economics Faculty Speak: "GDP is a measure of the value of all goods and services produced in an economy in a year. This value is also equal to the incomes of those who have contributed to this value, which of course turns out to be the total income of all factor resources." Extra Capital Consumption: Loss of value of capital due to use ageing or obsolescence. (In simpler terms, Depreciation) Where to find: Most commonly found in Economy section of ET
1

Making Sense of it.

(22 Aug, 2008)

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Components of GDP - Consumption

What it means? i.e. GDP = C + I + G + (X-M). Here is explanation to the first component.

GDP is a measure of the value of all goods and services produced in an economy in a year. The expenditure method is the most common method to measure and understand GDP. GDP = Consumption + Gross Investment + Government Spending + (Exports - Imports)

Consumption Expenditure (C) is money spent by households and businesses on purchase of goods & services in the economy in the current year. It includes most personal expenditure of households such as food, rent, and medical expenses and so on. Where to find: Most commonly found in Economy section of ET Making Sense of it. (26 Aug, 2008)

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Components of GDP - Investment

What it means? i.e. GDP = C + I + G + (X-M). Here is the explanation to the second component.

GDP is a measure of the value of all goods and services produced in an economy in a year. The expenditure method is the most common method to measure and understand GDP. GDP = Consumption + Gross Investment + Government Spending + (Exports -Imports)

Gross Investment (I) represents spending on creating new capital goods, before making any allowance for 'capital consumption' or depreciation. "Investment" thus represents the money spent by households and businesses on the acquisition of "Investment Goods", i.e. goods which are designed to be used for further production as opposed to consumption. Gross Investment minus Capital Consumption is "Net Investment". Capital Consumption a.k.a Depreciation is an estimate of the loss of the value of capital goods through wear and tear, the passage of time, or technical obsolescence. Where to find: Most commonly found in Economy section of ET

Making Sense of it.

(August 29, 2008)

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Components of GDP Government Spending

What it means? i.e. GDP = C + I + G + (X-M). Here is the explanation to the third component.

GDP is a measure of the value of all goods and services produced in an economy in a year. The expenditure method is the most common method to measure and understand GDP. GDP = Consumption + Gross Investment + Government Spending + (Exports-Imports)

Government spending or government expenditure is classified by economists into three main types. 1. Government purchases of goods and services for current use are classed as government consumption. 2. Government purchases of goods and services intended to create future benefits, such as infrastructure investment or research spending, are classed as government investment. 3. Government expenditures that are not purchases of goods and services, and instead just represent transfers of money, such as social security payments, are called transfer payments. The first two types of government spending, namely government consumption and government investment, together constitute one of the major components of gross domestic product. Where to find 1. www.finmin.nic.in 2. The Budget Document 3. Document on the Economic Survey released every year
Making Sense of it. (September 1, 2008)

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Foreign Exchange Reserves

What it means?

Liquid assets held by a countrys central bank for the purpose of intervening in the foreign exchange market, is called a foreign exchange reserve. These liquid assets can be in the form of gold, foreign currencies, or foreign government bonds. This also includes the reserves maintained by the country in a special account in IMF (international monetary fund). Foreign Exchange Reserves are funded by two major transactions; Transactions of trade, and transactions of capital. Transactions of trades are nothing but earnings from export of merchandise and services. Transaction of capital, involves receipts in the form of FDI, FII, and remittances from individuals abroad. Experts believe that the value of reserves should be able to fund the countrys import bills for up to 3 months, and thereby denote that value as the optimal value. However this may largely be relegated only to an ideal case, as most reserves are either way over or under that level. Foreign Reserves of notable states is as under: Source Wikipedia.com Rank Country/Monetary Authority Billion USD (end of month) Change in year 2007 1 People's Republic of China $ 1809 (June) +43.3% 2 Japan $ 1004 (April) +8.7% 3 Russia $ 597 (August 01) +56.8% Eurozone $ 563 (March) +16.6% 4 India $ 297 (August 22) +64.4% 5 Taiwan $ 291 (July) +2.7% 6 South Korea $ 260 (April) +9.7% 7 Brazil $ 204.194 (Aug 14) +105.9% 8 Singapore $ 176 (April) +19.1% 9 Hong Kong $ 160 (April) +14.6% 10 Germany $ 144 (April) +20.3% Large reserves of foreign currency allow a government to manipulate exchange rates usually to stabilize the foreign exchange rates to provide a more favourable economic
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environment. In theory the manipulation of foreign currency exchange rates can provide the stability, but in practice this has not been the case. There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. Even in the absence of a currency crisis, fluctuations can result in huge loses. For example, China holds huge U.S. dollar-denominated assets, but the U.S. dollar has been weakening on the exchange markets, resulting in a relative loss of wealth fro China. Extra: Foreign Exchange Reserves are used as a countrys defence against fluctuations in its currency value. If the Dollar is gaining against the INR and say reaches 45 INR to a dollar, then the RBI may intervene, by selling some dollars out of its reserves, and thereby provide support to the INR at that level and provide and indicator to the market. This is generally what is meant by RBI intervention or central bank intervention. Making Sense of it. (8 Sept, 2008)

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What it means?

The balance of trade or Trade Balance or net exports (symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade surplus and consists of exporting more than is imported; a negative balance of trade is known as a trade deficit or, informally, a trade gap. Balance of Trade is the largest component of the country's balance of payment. Factors that can affect the balance of trade figures include: Prices of goods manufactured at home (influenced by the responsiveness of supply) Exchange rates Trade agreements or barriers Other tax, tariff and trade measures Business cycle at home or abroad.

Balance of Trade

Many people believe that a trade deficit is detrimental for the economy. However, whether a trade deficit is detrimental or not is relative to the business cycle and economy. In a recession, countries like to export more, creating jobs and demand. In a strong expansion, countries like to import more, providing price competition, which limits inflation and, without increasing prices, provides goods beyond the economy's ability to meet supply. Thus, a trade deficit is detrimental during a recession but may help during an expansion. DEPARTMENT ECONOMIC DIVISION OF COMMERCE

EXPORTS & IMPORTS : (PROVISIONAL) JULY EXPORTS (including re-exports) 2007-2008 2008-2009 IMPORTS 2007-2008 74091 306946
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APRIL-JULY 194689 248498 27.6

50331 70018

%Growth 2008-2009/ 2007-2008 39.1

2008-2009 TRADE BALANCE 2007-2008 2008-2009

116276

421541 37.3 -112257 -173043

%Growth 2008-2009/ 2007-2008 56.9 -23760 -46258

*Figures (in Rs Crores) for 2007-08 are the latest revised whereas figures for 2008-09 are provisional.

Making Sense of it.

(12 Sept, 2008)

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Current Account Deficit

What it means? The difference between a nation's total exports of goods, services and transfers, and its total imports of them. Current account balance calculations exclude transactions in financial assets and liabilities. A Current Account Deficit occurs when a country's total imports of goods, services and transfers are greater than the country's total export of goods, services and transfers. This situation makes a country a net debtor to the rest of the world. Contrarily, a Current Account surplus is when a country's total imports of goods, services and transfers is lesser than the country's total export of goods, services and transfers. This situation makes a country a net creditor to the rest of the world. Hence current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. A substantial current account deficit is not necessarily a bad thing for certain countries. Developing counties may run a current account deficit in the short term to increase local productivity and exports in the future. This shall be taken up in more detail in further discussions of Word a Day. India has a current account deficit of 1.04 billion dollars for the fourth quarter of 2007-08 against a surplus of $4.25 billion a year ago. With this, according to data released by Reserve Bank of India, the current account deficit has risen by 77 per cent to touch $17.4 billion, constituting 1.5 per cent of GDP last fiscal, against $9.8 billion or 1.1 per cent of GDP in 2006-07.

[Unpublished]

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Countrys Capital Account

What it means?

In economics, Capital Account statement for a state captures the following:

Capital Account = Foreign Direct Investment + Portfolio Investment + Other Investments Where Foreign Direct Investment is given as = Increase in foreign ownership of domestic assets - Increase of Domestic ownership of foreign assets, Portfolio Investment = Net Purchases of Investment Instruments by Foreigners across asset classes, And Other Investments Include = loans taken, given and re-payed etc. To attract Foreigners to invest in the country, the government works on setting up an attractive business environment, and takes policy measures that fosters business expansion. Generally lowering tax rates are one of the primary measures that attract foreign money into the country. Other Eco-Political factors like liquid secondary markets, easy norms follow the pattern. Extra: Many Countries control the outflows and inflows in this account by various measures. These measures could be in the form of restricting purchase of assets by foreigners or by placing a lower limit on the time unto which the investment cannot be liquidated. Such measures are in effect taken to prevent the flight of capital. The first signs of a flight of capital are in the form of depreciating currency. India which has seen its currency depreciate from 39 to 46 to a dollar is currently experiencing this phenomenon. This is due to changes in FII Flows, which have turned negative on FIIs selling their Indian Investments in the secondary market. Statistically Indias Balance of Payments: That is Current Account + Capital Account is given as under: (It clearly shows the way India is financing its import led growth, by having a Capital Account Surplus and a Current Account Deficit.)

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Indias Balance of Payments (US $ million) Item 200607 P AprilMarch Merchan dise Exports Merchan dise Imports Trade Balance Services Receipts Services Payment s Services, net Current Account Capital Account (net)* of which: Foreign Direct Investm ent Portfolio Investm ent External Commer cial Borrowin gs + Shortterm Trade Credit External Assistanc e NRI Deposits 1,27,090 1,91,995 -64,905 (-7.1) 1,19,163 63,867 55,296 -6 -9,609 (-1.1) 46,215 10,946 7,100 10,280 17,889 15,897 -4,567 -4,830 -2,775 2,563 -4,697 24,643 12,264 12,379 25,597 14,565 11,032 31,658 17,568 14,090 37,265 19,470 17,795 31,432 14,549 16,883 2006-07 AprilJune PR 29,674 46,620 -16,946 JulySept. PR 32,700 48,562 -15,862 Oct.Dec. PR 30,664 47,529 -16,865 JanMarch P 34,052 49,284 -15,232 200708 AprilJune P 34,960 56,540 -21,580

8,437

1,416

2,426

2,558

2,037

461

7,062 16,084

-505 3,959

2,152 1,458

3,569 3,994

1,846 6,673

7,458 7,048

3,275

417

1,554

-316

1,620

1,048

1,770 3,895

49 1,231

337 797

633 1,236

751 631

258 -447

Making Sense of it.

( 19 Sept, 2008)

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Currency Convertibility
What it means?

Simply put, Convertibility can be defined as the ease with which a country's currency can be converted into any other currency. Currently the rupee is fully convertible on the Current A/C. In other words, Indian residents are legally permitted to make and receive trade-related payments -- receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc. However, India is yet to embrace full Capital A/C convertibility. Capital account convertibility (CAC) means the freedom to convert local financial assets and liabilities into foreign financial assets and liabilities at market determined rates of exchange. This means that capital account convertibility allows anyone to freely move from local currency into foreign currency and back. It refers to the removal of restraints on international flows on a country's capital account, enabling full currency convertibility and opening of the financial system. This means that there are no restrictions on individuals and firms in terms of the quantum of financial and other assets which they can acquire overseas. However in the Indian context this is not the case. For instance, an Indian national doesn't enjoy unfettered access to equity markets abroad. The maximum investment is capped at US$ 250,000. Foreign Investment into the country is also not completely unrestricted. For example, an FII investing in a real estate project has to lock in his funds for a stipulated period, during which he can't repatriate it to his home country. Extra: So, what prevents India from fully embracing Capital A/c convertibility? The RBI is concerned that complete convertibility could lead to an unwarranted increase in the currency's volatility, and adversely impacts the real economy. Supporters of this view, point to the East-Asian financial crisis, as evidence of the same. The likes of Thailand and Malaysia witnessed a flight of capital in the late 90's. As foreign investors rushed to repatriate their funds, the domestic currencies collapsed under a deluge of selling pressure. This wreaked havoc on the local economies. Stock and property prices crashed, and business confidence plummeted, as investors headed for the exit.

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The opponents of this view believe that the RBI is some what paranoid. They argue that Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away. At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. The key lesson here is that in addition to reforms, the sequencing of macro-economic reforms is crucial. In hindsight, the East-Asian economies, jumped into Capital account convertibility prematurely. Their financial markets weren't developed enough to handle the massive flight of capital that ensued. Even the World Bank has said that embracing capital account convertibility without adequate preparation could be catastrophic. But India is now on firmer ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility. Making Sense of it. ( 21 Sept, 2008)

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Monetary Policy
What is monetary policy? Objectives of Monetary Policy

Monetary policy refers to the actions/policy decisions taken by the central banks of the countries (RBI in case of India) to influence the availability and cost of money and credit in the economy.

Monetary policy is essentially a stabilisation policy. It is not intended to influence the longterm growth potential of the economy, but aims at ironing out the fluctuations in the economy also referred to as business cycles. This is done to minimise fluctuations and ensure a sustainable mix of growth and inflation in the economy. Instruments of Monetary Policy Alteration of REPO/Reverse REPO Rates

(Repo is short for repurchase agreement. Repo rate is the rate that RBI charges the banks when they borrow from it. Reverse repo rate is the rate that RBI offers the banks for parking their funds with it.) Changing Reserve requirements (Cash Reserve Ratio, Statutory Liquidity Ratio) Open Market Operations

Time Period Historically, the Monetary Policy is announced twice a year - a slack season policy (AprilSeptember) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. However, the Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy. Type of Monetary Policy 1. Expansionary Policy increases the total supply of money in the economy. It is used as tools against unemployment and recession by lowering interest rates 2. Contractionary Policy decreases the total supply of money in the economy; it is used as a tool against Inflation by raising interest rates.
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How does it work? As an illustration, consider that an economy is growing too fast. This is also referred to as overheating of the economy: a situation that typically happens in the boom phase when GDP (gross domestic product) growth exceeds the long-term growth potential of the economy. The producers of goods are not able to make enough goods to meet the rising demand. The resultant demand-supply mismatch creates inflationary pressures in the economy. This situation is regarded as unsustainable, as the high growth translates into higher inflation. In this situation, the RBI raises interest rates to depress spending and reduce the pressure on inflation. Making Sense of it ( 01 Oct, 2008)

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Fiscal Policy
What is Fiscal Policy? Objectives of Fiscal Policy

Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances).

1. To achieve a desirable price level Fiscal policy should be used to remove fluctuations in price level so that ideal level is maintained. 2. 3. 4. 5. To achieve desirable consumption level To achieve desirable employment level To achieve desirable income distribution To increase the capital formation

6. To divert existing resources from unproductive to productive and socially more desirable uses. 7. To protect the economy from the ills of inflation and unhealthy competition from foreign countries. Instruments of Fiscal Policy 1. 2. 3. 4. Public expenditure Taxes Public debts Seignorage, the benefit from printing money

Types of Fiscal Policy A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

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An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit. Contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus. How Fiscal Policy Works? Fiscal policy is based on the theories of British economist John Maynard Keynes. If an economy has slowed down, unemployment levels are up, consumer spending is down and businesses are not making any money, a government thus decides to fuel the economy's engine by decreasing taxation, giving consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. In the meantime, overall unemployment levels will fall. With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This in turn rekindles businesses and turns the cycle around from stagnant to active. If inflation is too strong, the economy may need a slow down. In such a situation, a government can use fiscal policy to increase taxes in order to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine tune spending and taxation levels, with the goal of evening out the business cycles. Difference between Monetary Policy & Fiscal Policy Monetary policy is typically implemented by a central bank, while fiscal policy decisions are set by the national government. The former brings about a change in the economy by changing money supply and interest rate, whereas fiscal policy is a broader tool with the government. Making Sense of it. ( 10 Oct, 2008)

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Purchasing Power Parity

This purchasing power exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States. PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces. This concept has been used over the last few years in the form of cost arbitrage. For example, many American and European Pharmaceutical companies such as Novartis, Sandoz, and Pfizer have set up their factories in India to manufacture medicines at almost 1/5th the cost as compared to manufacturing the same in USA or Europe. Theoretically it would mean that one dollar would be equivalent to Rs. 9 on PPP Basis. (Considering that USD 1 = Rs. 45). Theoretically, this would mean that there would be massive inflow of dollars in India, thereby leading to excess of supply of dollars in India, thereby leading to appreciation of the Rupee against the dollar. This should continue till the rupee appreciates to the extent of Rs. 9 for each US dollar. However this does not practically happen since there can be marked differences between PPP and market exchange rates due to market disruptions like government policy, speculation, regulations etc. For example, in 2005 the one United States dollar was equivalent to about 7.6 Chinese yuan theoretically this means to buy a particular basket of products in USA will cost USD 1. The same basket in China shall cost 7.6 Chinese yuan. However the same is not necessarily true since practically the exchange rate on PPP basis should have been USD 1 = 1.8 yuan (as per World Bank reports). This could give rise to possibilities of arbitrage. That is one can buy a particular basket of products in China for Yuan 1.8, export and sell it in the USA for USD 1 and come back and convert it into Chinese yuan again and get Yuan 7.6 in the bargain. However on a macro level, these possibilities of arbitrage are effectively taken care of by measures such as import duties, anti-dumping laws etc. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. (This means while the GDP per person in China is USD 1800, by the same USD 1800, he can buy goods worth USD 7204 had he been in the USA. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory.) At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615. This means that even though a particular basket of products in Japan costs USD 37,600, the same can be bought in the USA for USD 30,615. Hence for
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proper comparison it is necessary to equate the PPP of all countries in the same denomination, in this case USD. India: Even though our GDP has just recently crossed USD 1 Trillion per annum, the GDP on a PPP basis is USD 3.2 trillion. This makes India the fourth largest economy in the world by PPP basis just after USA, China and Japan. Using data of nominal GDP, India ranks 12th largest. (Nominal GDP means the one which is reported and does not contain any adjustments by way of PPP or other parameters) This would mean that the GDP per capita (on PPP basis) is around USD 2,740 considering a population of approximately 1.1 billion. However India ranks at approximately 126th place in that regard on nominal basis (per capita income is USD 965) with China being at 99th place. The primary reason for the same is the large populations of the respective countries.

Making Sense of it.

( 14 Oct, 2008)

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Making Sense of it. ( 16 Nov, 2008)

Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as annual percentages increase though the Consumer Price Index. As inflation rises, every rupee you own buys a smaller percentage of a good or service. Inflation can also be described as a decline in the real value of moneya loss of purchasing power. There are two main causes/types of Inflation: 1. Demand-Pull Inflation: This is too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies. 2. Cost-Push Inflation: When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports. The table given below shows the top 5 countries with high levels of Inflation: It's a miracle as to how Zimbabwe economy is still surviving. A sausage sandwich sells for Zimbabwean $50 million. A 15-kg bag of potatoes cost Zimbabwean $260 million. But then, Zimbabwean $50 million is roughly equal to US$ 1! While considering the actual rate of growth in terms of GDP we need to see the general inflation rate in the economy. Example:

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If GDP of a country has increased from USD 100 million to USD 120 million with the general rate of inflation being 5% then the actual rate of growth in GDP terms is not 20% (20/100) but 13% (15/105). Problems with Indian Inflation Rate In India, inflation is calculated on a weekly basis every Friday based on Wholesale Price Index (WPI).WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, price data for 435 commodities is tracked through WPI which is an indicator of movement in prices of commodities in all trades and transactions.

India is the only major country that uses a wholesale index to measure inflation. Most countries use the Consumer Price Index (CPI) as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for. The main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view as India constituted the last WPI series of commodities in 1993-94. Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation. The other issue is that the WPI doesn't have any services in it. That clearly makes it a faulty index because we do spend a good amount of money on services, such as rent, etc. However , the problem with using CPI is two fold: o There are 4 types of CPI : CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour. So the big question is Which CPI to use? o There is too much of a time laf in reporting CPI numbers and hgence it is not available in real time while making decisions related to monetary policy.

Variations to inflation:

Deflation is when the general level of prices is falling. This is the opposite of inflation. Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system.

Stagflation is the combination of high unemployment and economic stagnation with inflation.
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Making Sense of it. ( 25 Nov, 2008)

Liquidity Adjustment Facility

What is liquidity adjustment facility (LAF)?

It is a mechanism by which the Reserve Bank of India (RBI) draws out funds from the money market at a time of surplus and infuses liquidity whenever there is a temporary shortage. The RBI achieves this by getting banks and primary dealers to bid for funds if there is a shortage and by borrowing from them if there is a surplus. RBI introduced this scheme on 5th June 2000 and revised it again in 2001-02. Reasons for introduction of LAF Amongst its many functions, Reserve Bank of India also acts as the banker of last resort. In this role, the central bank has to ensure that it can inject funds into the system to help participants tide over temporary mismatches of funds. Refinance, as it used to happen earlier was at a fixed rate which was largely divorced from the cost of equivalent short-term funds in the market. This gave rise to a non-egalitarian distribution of interest rates in the short end of the curve. Further, the amounts that could be borrowed were determined by a preset limit. To do away with the deficiencies, RBI moved to an auction system of repos and reverse repos to suck-out and inject liquidity to the market. The three broad objectives of LAF are as follows: To give RBI greater flexibility in determining both the quantum of adjustment as also the rates by responding to the system on a daily basis. To help RBI ensure that the injected funds are being used to fund day-to-day liquidity mismatches and not to finance more permanent assets. To help RBI set a corridor for short-term rates, which should ideally be governed by the reverse-repo (top band), and repo (lower band) rates. This would impart greater stability in the markets. How does it do this? The Financial Markets Committee, consisting of the operational Departmental Heads, which meets every day in the morning to assess market conditions, is responsible for decisions relating to the LAF. The Committee meets again at 12 noon to assess the bids received under LAF. The exact quantum of liquidity to be absorbed or injected and the accompanying repo and reverse repo rates are determined by the Committee after taking into
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consideration, the liquidity conditions in the market, the interest rate situation and the stance of monetary policy. The decisions are based on a myriad factors including net inflows and outflows on account of forex operations, current account balances of the banks against the CRR requirements, open market operations, redemption of loans and coupon payments, announcement of new issues by the government, un-drawn liquidity support on account of export refinance, collateralised lending facility to banks and level I refinance to PDs and the overall situation of the call money market. The rate of interest however is determined on the basis of the bids received from the market. LAF Scheme Features Eligibility All Scheduled Commercial Banks (excluding Regional Rural Banks) and Primary Dealers (PDs) having Current Account and SGL Account with RBI, Mumbai will be eligible to participate in the Repo and Reverse Repo auctions. Minimum bid size To enable participation of small level operators in LAF and also to add further operational flexibility to the scheme, the minimum bid size for LAF is Rs.5 crore and in multiples of Rs.5 crore thereafter.

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Making Sense of it. ( 26 Nov, 2008)

Demand Liabilities and Time Liabilities

Demand Liabilities of Banks include all liabilities which are payable on demand. They may come at any time. Demand Liabilities include: o o o o o o o o o Current deposits Demand liabilities portion of savings bank deposits Margins held against letters of credit/guarantees Balances in overdue fixed deposits Cash certificates and cumulative/recurring deposits Demand Drafts (DDs) Unclaimed deposits Credit balances in the Cash Credit account and Deposits held as security for advances which are payable on demand.

Time Liabilities are those which are payable otherwise than on demand. Time Liabilities include: o o o o o o Fixed deposits Cash certificates Cumulative and recurring deposits Time liabilities portion of savings bank deposits Staff security deposits Deposits held as securities for advances which are not payable on demand and Gold Deposits.

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( 28 Nov, 2008)

Cash Reserve Ratio

What is Cash Reserve ratio (CRR)?

Making Sense of it.

The Cash Reserve Ratio (CRR) refers to the liquid cash that banks have to maintain with the Reserve Bank of India (RBI) as a certain percentage of their demand and time liabilities. For example if the CRR is 10% then a bank with net demand and time deposits of Rs 1,00,000 will have to deposit Rs 10,000 with the RBI as liquid cash. At present the CRR is 5.5% To which banks is CRR applicable? The CRR is applicable to all scheduled banks including the scheduled cooperative banks and the Regional Rural Banks (RRBs). There is no minimum or maximum level of CRR that needs to be fixed by the RBI.

Does RBI impose on penalty on banks for defaulting on CRR deposits? RBI doesn't pay any interest on the funds held with it as CRR. The RBI has the authority to impose penal interest rates on the banks in respect of their shortfalls in the prescribed CRR. According to Master Circular on maintenance of statutory reserves updated up to June 2008, in case of default in maintenance of CRR requirement on daily basis, which is presently 70 per cent of the total CRR requirement, penal interest will be recovered at the rate of three 3% per annum above the bank rate on the amount by which the amount actually maintained falls short of the prescribed minimum on that day. If shortfall continues on the next succeeding days, penal interest will be recovered at a rate of 5% per annum above the bank rate. In fact if the default continues on a regular then RBI can even cancel the bank's licence or force it to merge with a larger bank.
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How is CRR used as a tool of credit control? CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of bank deposits, however over the years it has become an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RBI feels that the money supply is increasing and causing an upward pressure on inflation, the RBI has the option of increasing the CRR thereby reducing the deposits available with banks to make loans and hence reducing the money supply and inflation. What impact does CRR have on interest rates? Let's understand this with an example. Suppose at present, the total amount of deposits with banks is Rs 10, 00,000 and the CRR is 5%. i.e. Rs 50000 is held by banks with RBI as reserves. Now every one percentage point cut in CRR means the banking system will have nearly Rs 10,000 more available for lending. As more money chases the same number of borrowers, interest rates come down. Thus a fall in CRR reduces interest rates and a rise in CRR increased interest rates. Limitations CRR is a crude monetary policy tool. It is used in India since there is limited capital account convertibility and domestic banking system isn't sufficiently evolved. More advanced economies don't change the CRR often. Their capital accounts are open, and their banking systems more evolved. For example: China's currency is not fully floating, rather its value fluctuates in a narrow band. Also, it has restricted capital account convertibility. It was faced with a deluge of foreign inflows, enticed by China's growth prospects. These inflows are converted into yuan, adding to domestic liquidity. This domestic liquidity cant find a sufficient outlet since China's Capital account is not fully convertible. This surfeit of domestic liquidity in turn fuels commodity and asset price inflation. This is a headache for the Central bank trying to control inflation. The banking system is not very well developed, despite the Central Bank raising its policy rate; Chinese banks were on a lending spree.

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( 2 Dec, 2008)

Statutory Liquidity Ratio

What is SLR?

Making Sense of it.

SLR is Statutory Liquidity Ratio. It's the percentage of Demand and Time Maturities that banks need to have in any or combination of the following forms: i) Cash ii) Gold valued at a price not exceeding the current market price, iii) Unencumbered approved securities (G Secs or Gilts come under this) valued at a price as specified by the RBI from time to time. The maximum limit of SLR is 40% and minimum limit of SLR is 25%. Following the amendment of the Banking regulation Act(1949) in January 2007, the floor rate of 25% for SLR was removed. Presently the SLR is 24% with effect from 8 November, 2008. Objectives of SLR 1. To restrict the expansion of bank credit. 2. To augment the investment of the banks in Government securities. 3. To ensure solvency of banks. A reduction of SLR rates looks eminent to support the credit growth in India. What is the difference between SLR and CRR?

What SLR does is it restricts the bank's leverage in pumping more money into the economy. On the other hand, CRR, or cash reserve ratio, is the portion of deposits that the banks have to maintain with the RBI. Higher the ratio, the lower is the amount that banks will be able to use for lending and investment. The other difference is that to meet SLR, banks can use cash, gold or approved securities where as with CRR it has to be only cash. CRR is maintained in cash form with RBI, where as SLR is maintained in liquid form with banks themselves.
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What does a reduction in SLR mean?

A cut in SLR means that the home, car and commercial loan rates will go down. It also means that banks will now have the option of selling government securities that until now formed part of their statutory investments.

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Repo Rate and Reverse Repo Rate

(6th December, 2008) Repo Rate Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. A point to be noted in this case is that RBI Repo rate is a rate at which RBI will provide liquidity to the banks, for a collateral (viz G-Secs.). This also means that this becomes a ceiling rate for this type of funding, and the banks can approach others banks for the same, who will perform this activity at a lower rate. Please do not confuse it with the call money rate, as that rate is for non-collateralised funding. RBI Repo Rate Behaviour in the year 2008

RBI Cut the Repo Rate to 6.5 % today, (6th Dec,2008) not reflected in the graph Source Bloomberg.com Reverse Repo Rate Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money is in safe hands. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI. It can cause the money to be drawn out of the banking system. Here again, this rate becomes the floor rate for banks to absorb liquidity from other banks, as at this rate the banks having additional liquidity can directly deposit their funds with RBI. Reverse Repo Rate Behaviour in the year 2008
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RBI Cut the Rev Repo Rate to 5% today, (6th Dec, 2008) not reflected in the chart.

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Pegged Float, Managed Flat, Free float

Free Float / Managed Float / pegged The story of valuation of exchange rate is intricately connected with two major philosophies all over the world. They are: 1. 2. Pegged Rates Floating Rates

I.

Pegging of the currency:

The Bretton Woods System was adopted in 1944 immediately upon the conclusion of World War II. The ideology adopted was that of "Pegged currency exchange rates" Pegged Currency exchange rates means the value of a currency is fixed with reference to a reference currency. For example, For most of its early history, the Chinese Renminbi was pegged to the U.S. dollar at 2.46 yuan per USD (note: during the 1970s, it was appreciated until it reached 1.50 yuan per USD in 1980). When China's economy gradually opened during the 1980s, the RMB was devalued in order to reflect its true market price and to improve the competitiveness of Chinese export. Thus, the official RMB/USD exchange rate declined from 1.50 yuan in 1980 to 8.62 yuan by 1994 (lowest ever on the record). Improving current account balance during the latter half of the 1990s enabled the Chinese government to maintain a peg of 8.27 yuan per USD from 1997 to 2005. On 21 July 2005, the peg was finally lifted, which saw an immediate one-off RMB revaluation to 8.11 per USD. This explains the concept of Managed Float / Dirty Float.

II. Floating Rate Regime:

This concept consists of basically two options,
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a. b.

Free float currency Managed Float currency A. Managed Float / Dirty Float:

With the end of the Bretton Woods regime in 1973, most countries moved to partial floating of their currency. This basically meant Holding the currency value of a country within some range of a reference currency. A dirty float occurs when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency.

The RMB is now moved to a managed floating exchange rate based on market supply and demand with reference to a basket of foreign currencies. The daily trading price of the U.S. dollar against the RMB in the inter-bank foreign exchange market would be allowed to float within a narrow band of 0.3% around the central parity published by the People's Bank of China (PBC); in a later announcement published on 18 May 2007, the band was extended to 0.5%. Hence, if the value of the renminbi to the dollar was RMB 8 for USD 1, it would effectively mean a range of RMB 7.98 to RMB 8.02 for USD 1. (0.5% band). Implication: The RMB would not be allowed to depreciate below 8.02 nor will it be allowed to appreciate more than RMB 7.98 per USD. B. Free Float / Clean Float:

Free float currency regime effectively means, central banks of any country would not under any circumstances interfere in the foreign exchange markets. The determination of the exchange rate of one country with reference to another shall be done purely on the basis of market forces. About 19% of the economies have adopted Free Float regime, about 22% of the economies, especially the smaller ones have adopted the Fixed Peg Arrangement and 27% including India and China have adopted the managed float system of foreign exchange currency valuation. For an economy to be said to have adopted a free float strategy, they should have desisted from interfering in the forex markets since a few years. Countries like Canada have stopped interfering in their exchange markets since 1997. The same is true for USA and other developed economies who have adopted the free float
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policy religiously. However it is understood that the Bank of England does at regular intervals enter the forex markets for stabilisation of the pound against other currencies.

C. Fixed:

Following are the advantages OF THE DIFFERENT CURRENCY FLOAT REGIMES

Monetary discipline. Limits speculation. Reduces uncertainty. No link between trade imbalances and exchange rates. Floating: Monetary policy autonomy. Smooth trade balance adjustments.

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Debt Monetisation
13th December, 2008

What is debt monetization and how does it work?

1. Suppose the government runs a deficit. As an example, let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.

2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.

3. Suppose it decides to borrow issue new debt. Then the Treasury (US Treasury Department, which is a government department) sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).

4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.

5. Now lets do the monetization step. This can happen automatically, as explained below, but for now lets have the Fed (the United States Federal Reserve, the central bank) conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.

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6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed.

How can constant interest rate rules potentially cause debt monetization to occur automatically?

Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate. That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?

1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.

2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money.

3. In the end, what happens? Its just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed.

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Market Stabilization Scheme

(15th December, 2008) What is Market Stabilization Schemes (MSS)? The Government issues treasury bills and/ or dated securities under the MSS in addition to its normal borrowing requirements, for absorbing liquidity from the system that arises due to imbalance of capital flows. These will have all the attributes of existing treasury bills and dated securities. This scheme was introduced in FY 2004-05.

Specifically, these are issued and serviced like any other marketable government securities. The treasury bills and dated securities are issued by way of auctions to be conducted by the RBI. Up to five per cent of the notified amount of the sale of the stock will be allotted to eligible individuals and institutions as per the Scheme for Non-Competitive Bidding Facility in the Auction of Government Securities.

The Government, in consultation with the RBI fixes an annual aggregate ceiling for these instruments. For 2004-05, the ceiling was be Rs. 60,000 crores. The MSS issuances budgeted for 2008-09 are Rs 2,55,806 crore (Rs 2.55 trillion), significantly higher than the estimate of Rs 1,41,135 crore (Rs 1.41 trillion) in the 2007-08 Budget, and marginally lower than the actual issuance of Rs 2,71,903 crore (Rs 2.71 trillion) in the financial year on account of equity investments by foreign institutional investors (FIIs) and overseas borrowings by companies.

The amounts raised under the MSS is held in a separate identifiable cash account titled the Market Stabilisation Scheme Account (MSS Account) which is maintained and operated by the RBI. The amounts credited into the MSS Account is appropriated only for the purpose of redemption and/ or buy back of the treasury bills and / or dated securities issued under the MSS. The payments for interest and discount are not made from the MSS account. The receipts due to premium and / or accrued interest are not credited to the MSS account.
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The treasury bills and dated securities issued for the purpose of the MSS is matched by an equivalent cash balance held by the Government with the RBI. Thus, there will only be a marginal impact on revenue and fiscal balances of the Government to the extent of interest payment on treasury bills and/ or dated securities outstanding under the MSS.

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