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LEADING INDICATORS

OF THE
INDIAN ECONOMY

Lt Col D G Naik
Grenville Savio Noronha
Gnanasundaram C
Kaushik K

Course Project Report


of
HS 700 Applied Economics
Spring 2006

The economic dominance of the US is already over. What is emerging is a world economy. India
is becoming a powerhouse very fast. Peter Drucker, Management Guru, In Fortune

The dynamism shown by India in the last 15 years is phenomenal. Paul Wolfowitz, President,
World Bank

There is huge amount of optimism about India...the country is well positioned to accelerate from
its present 6.5% growth to around 8% in the near future. Montek Singh Ahluwalia, Deputy
Chairman, Planning Commission of India

India is growing fast and everyone seems to want a piece of the action.
Director of Market Services, London Stock Exchange

Martin Graham,

India has the potential to deliver the fastest growth over the next 50 years with an average rate of
more than 5 per cent a year for the entire period. Dominic Wilson, Senior Global Economist
and Vice President, Goldman Sachs

India is a rising economic influence of power in the international system. It's a great multiethnic
democracy. Condoleezza Rice, US Secretary of State

INTRODUCTION
An Overview of the Indian Economy:
Indian economic policy after independence, influenced by the colonial experience, which
was seen by Indian leaders as exploitative in nature, and by their exposure to Fabian
socialism, became protectionist in nature. The early policy makers formulated a policy of
import substitution, industrialization, state intervention in labour and financial markets, a
large public sector, overt regulation of business, and central planning. This led to a low
overall average growth rates upto 1980.
The economic reforms that surged economic growth in India after 1980 can be
attributed to two stages of reforms. The pro-business reform of 1980 initiated by Indira
Gandhi and carried on by Rajiv Gandhi, eased restrictions on capacity expansion for
incumbents, removed price controls and reduced corporate taxes. The economic
liberalization of 1991, initiated by then Indian prime minister P. V. Narasimha Rao and
his finance minister Manmohan Singh in response to a macroeconomic crisis did away
with the Licence Raj (investment, industrial and import licensing) and ended public
sector monopoly in many sectors, thereby allowing automatic approval of Foreign Direct
Investment (FDI) in many sectors .
The reform process has had some very beneficial effects on the Indian economy,
including higher growth rates, lower inflation, and significant increases in foreign
investment. The economy of India is now the fourth-largest in the world as measured by
purchasing power parity (PPP), with a GDP of US $3.36 trillion. When measured in USD
exchange-rate terms, it is the tenth largest in the world, with a GDP of US $691.87 billion
(2004). India was the second fastest growing major economy in the world, with a GDP
growth rate of 8.1% at the end of the first quarter of 20052006. The country's economy
is diverse and encompasses agriculture, handicrafts, industries and a multitude of
services. Services are the major source of economic growth in India today, though twothirds of the Indian workforce earn their livelihood directly or indirectly through
agriculture. In recent times, India has also capitalized on its large number of highly
educated people who are fluent in the English language to become an important location
for global companies outsourcing customer service and technical support call centers. It
is also a major exporter of skilled workers in software services, financial services, and
software engineering.
With the increasing importance of the economy of India, which is now well above
the one billion mark in population, monitoring Indian economic cycles is now of more
interest. Dua and Banerji established the dates of Indian business cycles and growth rate
cycles, with the help of a coincident index created for the purpose. However, the more
interesting question is that of whether there exists a set of leading index, a composite of
several leading indicators: designed to peak and trough earlier than the coincident
indicators, to collectively predict future economic activity. Such an index of leading

indicators will be an important and useful forecasting and planning tool for policymakers,
financial analysts, financial investors and businesses.

The Indicator Approach:


The indicator approach starts from the observation that the time series which describe the
individual economic processes do not all turn at once in periods of cyclical change. From
the large number of available time series, those are selected whose cyclical movement is
in a specific systematic relationship to the general business or economic cycle. The
indicator approach consists essentially of classifying economic indicators into leading,
coincident and lagging categories and then combining the relevant components into
corresponding composite indexes. This approach works because in a market-oriented
economy, in cycle after cycle, economic indicators reach turning points in a known
sequence. Basically, leading indicators turn before coincident indicators, which turn
before lagging indicators.
The coincident indicators measure current economic performance and are used to
represent the level of current economic activity. Examples of such indicators include
measures of output, income, employment, and sales. These help to date peaks and troughs
of business cycles. The leading indicators, on the other hand, combine series that tend to
lead at business cycle turns and provides a summary measure of what can be expected in
the near future. Leading indicators generally represent commitments made with respect to
future activity or are factors that influence such commitments. Examples are placement
of new orders, intentions to build, and changes in profitability. The lagging indicators
reach their turning points after the peaks and troughs of the coincident indicators, helps to
clarify and confirm the underlying pattern of economic activity identified with the help of
coincident and leading indexes. For instance, the levels of stocks, installment credit
outstanding, and interest rates depict previous changes in the economy. However, it has
to be added that the classification is subjective and a set of indicators may be seen
differently under different contexts.

The Ideal Indicator:


The object is to use economic cycle indicators to make an early diagnosis of cyclical
movements. The main question is to ascertain the cyclical turning points and to
distinguish between turning points which are to be rated as being cyclical and noncyclical fluctuations in the time series. The following formulations may be considered as
the prerequisites for the ideal business or economic cycle indicator:
1. It would cover half-a-century or longer, thus showing its relation to the business
cycles under a variety of conditions.
2. It would lead the month, around which cyclical revival centers, by an invariable
interval of say, three months or even better, six months. It would also lead the

central month of every cyclical recession by an invariable time interval, which


might differ from the lead at revival.
3. It would show no erratic movements, that is, it would sweep smoothly up from
each cyclical trough to cyclical peak and then sweep smoothly down to the next
trough, so that every change in its direction would herald the coming or recession
in the general economy or business.
4. The cyclical movements would be pronounced enough to be readily recognized,
and give some indication of the coming change.
5. It would be so related to the general economic activity as to establish as much
confidence as the nature of such things allows that its future behavior in regard to
economic cycles will be like its past behavior.

Illustration of a Leading Indicator:


Figures 1 and 2 illustrate the concept of leading indicators. The time series chosen as a
leading indicator in Fig. 1 is the business climate for predicting the industrial production.
In Fig. 2, business climate is taken as the indicator for the Gross National Product (GNP)
of the erstwhile Federal Republic of Germany.

Figure 1: Illustration of leading indicator for industry for


(a) the erstwhile Federal Republic of Germany and (b) European Union

Figure 2: Illustration of leading indicator for the economy


of the erstwhile Federal Republic of Germany

List of Leading Indicators for Indian Economy:


The following is an exhaustive list of likely candidates for series which can be considered
as leading indicators of the Indian economy:
Trends in Gross Domestic Product (GDP): Contribution of Agriculture,
Industry and Services
Purchasing Power Parity (PPP) Index
Fiscal Deficit
Trends in Inflation Rate
Interest Rates
Credit Off-take
Balance of Payment
Foreign Exchange Reserves
Crude Oil Rates
Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII)
Trends
Rain fall Index
Sensex
Exchange Rate
Savings/GDP Ratio
Human Development Index
Electric Power Generation
The scope of this report has been restricted to a few indicators which can qualify as
leading indicators of the Indian economy.
Table 1 lists the trends in a select list of key indicators of Indian economy for the three
year period 2002-05.

Table 1: Key indicators of the Indian economy

GROSS DOMESTIC PRODUCT


Kaushik K

Basics of GDP:
Gross domestic product, or GDP, is one of several measures of the size of its economy.
Until the 1980s the term GNP or gross national product was used. The two terms GDP
and GNP are almost identical. The most common approach to measuring and
understanding GDP is the expenditure method:
GDP = consumption + investment + government spending + (exports imports)
"Gross" means depreciation of capital stock included. Without depreciation, with net
investment instead of gross investment, it is the Net domestic product. Consumption and
investment in this equation are the expenditure on final goods and services. The exports
minus imports part of the equation (often called net exports) then adjusts this by
subtracting the part of this expenditure not produced domestically (the imports), and
adding back in domestic production not consumed at home (the exports).
Economists have preferred to split the general consumption term into two parts; private
consumption, and public sector spending. Two advantages of dividing total consumption
this way in theoretical macroeconomics are:
Private consumption is a central concern of welfare economics. The private
investment and trade portions of the economy are ultimately directed (in
mainstream economic models) to increases in long-term private consumption
If separated from endogenous private consumption, Government consumption
can be treated as exogenous, so that different government spending levels can
be considered within a meaningful macroeconomic framework.
Therefore, GDP can be expressed as:
GDP = private consumption + government + investment + net exports
or simply,
GDP = C + G + I + NX

The Present State of GDP:


The robust performance of the Indian economy continued during the second quarter
(July-September) of 2005-06. According to the Central Statistical Organisation (CSO),
the economy recorded a real GDP growth of 8.0 per cent in the second quarter of 2005-06
maintaining the momentum of growth in the first quarter, and notably higher than that of
6.7 per cent a year ago. Real GDP originating from the agricultural and allied activities
benefited from the positive impact of the near normal South-West monsoon. Overall, the
economy thus recorded a real GDP growth of 8.1 per cent in the first half of 2005-06, one
percentage point higher than a year ago.

Figure 3: GDP trend for 50 years from 1950 to 2000 at 1993-94 prices

Figure 4: GDP Growth at current market price for the last five years

The GDP growth trend for the last three years appears to indicate the beginning of
a new phase of cyclical upswing in the economy from 2003-04. The initial momentum to
this new phase of expansion, in 2003-04, was provided by agriculture. After a somewhat
subdued impetus from the farm sector in 2004-05, there is a moderate recovery in
agricultural growth in 2005-06.This is partly because of a change in the rainfall pattern
from erratic to a near-normal distribution. In contrast to the sharp fluctuations in
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agriculture, industry and services have continued to expand steadily. Industry and
services have acted as the twin engines propelling overall growth of the economy. Over a
somewhat longer horizon, in the six years between 2000-01 and 2005-06 (AE), on
average, services with a share of 52.0 per cent of GDP, contributed 65.0 per cent of GDP
growth, and increased its share in GDP from 49.8 per cent to 54.1 per cent. During the
same reference period, on average, with a share of 25.8 per cent of GDP, industry, by
contributing 28.0 per cent of GDP growth, increased its share in GDP from 25.9 per cent
to 26.2 per cent.

The Significance of GDP:


The growth in GDP indicates the overall improvement of the economy. The rate
of growth of GDP vis--vis population growth and inflation rate is indicative of the
additional resources being made available in the country. It also facilitates capital
formation as higher FII and FDI is attracted, when the GDP growth is superior to the
other constituents of the sub-continent. This, in turn, is likely to propel further growth
and add impetus to the buoyancy of the economy.

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HUMAN DEVELOPMENT INDEX


Grenville Savio Noronha

Introduction:
The UN Human Development Index (HDI) is a comparative measure of poverty, literacy,
education, life expectancy, childbirth, and other factors for countries worldwide. It is a
standard means of measuring well-being, especially child welfare. The index was
developed in 1990 by the Pakistani economist Mahbub ul Haq, and has been used since
1993 by the United Nations Development Programme in its annual report.
The HDI measures the average achievements in a country in three basic dimensions of
human development:

A long and healthy life, as measured by life expectancy at birth.


Knowledge, as measured by the adult literacy rate (with two-thirds weight) and
the combined primary, secondary, and tertiary gross enrolment ratio (with onethird weight).
A decent standard of living, as measured by gross domestic product (GDP) per
capita at purchasing power parity (PPP) in US Dollar.

The first two indicators are social indicators. Life expectancy, a much desired objective
of human beings, reflects the progress made in such fields as health, infant and child
mortality and nutrition.

Significance:
The index is useful and meaningful, especially for the less-developed countries. While it
gives importance to income, it does not do so unduly. The decline in its weightage after a
certain point, automatically raises the importance of social indicators. Equally important,
the inclusion of social indicators, the HDI stresses the importance of the quality of life.
The index helps bring into the limelight the wide disparities that exist in the levels of
human development between them and the developed countries.
In the following passages, there will be several comparisons made to China. We
felt that since China is our biggest competitor today, it would be apt to make to include it
in the future discussions to show how India stands.
In the last Century, Indias population has increased from 250 to 1000 million, an
increase of about 400%! In India, in the last 100 years the actual number of poor people,
has steadily increased. In China, all young children go through 9 years of schooling, this
ensures 100% literacy. In India it is hardly 50%. Chinas per capita is US$845 vs US$425
for an Indian. Their GDP is 2.5 times of India. Because of Chinas successful Population
Policy, China has added 300 million LESS people, in the last 30 years. China has been
able to reduce the people below poverty line to 3%, i.e. only 40 million people. India has
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40% or 400 million below the poverty line. We fail to understood the fact why some
thinkers and leaders, in India, mention that our population is our strength. How can they
make such statements, with so much poverty, illiteracy & a low standard of living? Its a
nightmare for the POOR in India! The average age in China, for women to get married,
the first time, was 23.57 years, in 1998.
India has 17% of the worlds population, 2.2% of the land area, 1.4% of the
worlds GDP and only 0.6% of the world trade. This means that 98.6% of the Worlds
GDP [Buying Power] & 99.4% of the Worlds Trade is not with India! India must plan
larger exports, for increasing the standard of living of its people.

Employment:
Population, food security, education and remunerative employment opportunities are
closely interconnected. Rising levels of education and rising living standards are
powerful levers for reducing birth and mortality rates. As population growth slows to
replacement levels over the next two decades, Indias greatest challenge will be to expand
the opportunities for the growing labour force, to enrich their knowledge and skills
through education, raise their living standards through gainful employment and make
provisions for ensuring a good life for the aged. India has met the challenge of producing
sufficient food to feed everyone, but it has yet to meet the challenge of generating
sufficient employment opportunities to ensure that all its people have the purchasing
power to obtain the food they require. Gainful employment is one of the most essential
conditions for food security and economic security. Conversely, food security
is an essential requirement for raising the productivity of Indias workforce to
international levels .
Indias labour force has reached 375 million approximately in 2002, and it will
continue to expand over the next two decades. The actual rate of that expansion will
depend on several factors including population growth, growth of the working age
population, labour force participation rates, educational enrolment at higher levels and
school drop-out rates. Projections based on these parameters indicate that Indias labour
force will expand by 7 to 8.5 million per year during the first decade of this century, and
will increase by a total of about 160-170 million by 2020, i.e., 2.0 percent
per annum.
Total unemployment in India has been estimated to be about 35 million persons in
2002. This figure takes into account the significant level of underemployment and
seasonal variations in the availability of work. It also reflects wide variations in the rate
of unemployment among different age groups and regions of the country. Approximately
three-fourth of the unemployed are in rural areas and three-fifth among them are
educated. The recent trends towards shedding excess labour to improve competitiveness
and increasing capital intensity have further aggravated the situation. A clear consensus is
now emerging that major changes in economic policy and strategy will be needed to meet
the countrys employment needs.

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Employment in the organized sector:

Education:
Literacy, the basis of all education, is as essential to survival and development in modern
society as food is to survival and development of the human body. Literacy rates in India
have arisen dramatically from 18 per cent in 1951 to 65 per cent in 2001, but these rates
are still far from the UMI reference level of 95 per cent. Literacy must be considered the
minimum right and requirement of every Indian citizen. Vast differences also remain
among different sections of the population. Literacy among males is nearly 50 per cent
higher than females, and it is about 50 per cent higher in urban areas as compared to the
rural areas. Literacy rates range from as high as 96 per cent in some districts of Kerala to
below 30 per cent in some parts of Madhya Pradesh. Rates are also significantly lower
among scheduled castes and tribes than among other communities. Literacy is an
indispensable minimum condition for development, but it is not sufficient. In this
increasingly complex and technologically sophisticated world, ten years of school
education must also be considered as an essential prerequisite for citizens to adapt and
succeed economically, avail of the social opportunities and develop their individual
potentials. Education is the primary and most effective means so far evolved for
transmitting practically useful knowledge from one generation to another.

In terms of total investment in R&D, Indias expenditure is 1/60th of that of


Korea, 1/250th of that of the USA, and 1/340th of that of Japan. More significantly,
atomic energy, space and defense research account for 71 per cent of all central spending
on science and technology, which means that relatively little is left for investment in
agriculture, energy, telecommunications and other crucial sectors within the sphere of
science and technology. R&D expenditure even in Indias fast-growing IT sector has
been averaging around 3 per cent of sales turnover (STO), which is much lower as
compared to the 14-19 per cent expended by internationally reputed software firms.
These low figures reflect on our R&D performance. Indias share of global
scientific output in 1998 was only 1.58 per cent of the worlds total. Out of 500,000 new
patent applications filed globally each year, China accounts for 96,000 and Korea
accounts for 72,000, while India accounts for only 8,000. Of greater concern has been the
countrys inability to capitalize on our huge pool of manpower and extensive network of
scientific research organizations for transferring proven technologies from the lab to the
land and to the factory. Despite possessing the worlds largest cadre of agricultural
scientists, we have not been able to extend the momentum of Green Revolution to other

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regions and crops and to update the scientific practices of our farmers to levels
comparable with most other nations. Crop productivity remains far below and production
costs far above world averages. A similar gap exists in the application of science and
technology for food processing and many other industries. High technology exports
account for only 6 per cent of total manufacturing exports for India, compared to over 20
per cent for the UMI reference level.

Table showing boys and girls in school through the years:

Health for All:


The health of a nation is difficult to define in terms of a single set of measures. At best,
we can assess the health of the population by taking into account indicators like infant
mortality and maternal mortality rates, life expectancy and nutrition, along with the
incidence of communicable and non-communicable diseases.
According to these measures, the health of the Indian population has improved
dramatically over the past fifty years. Life expectancy has risen from 33 years to 64
years. The infant mortality rate (IMR) has fallen from 148 to 71 per 1000. The crude birth
rate (CBR) has declined from 41 to 25 and the crude death rate (CDR) has fallen from 25
to under 9. The couple protection rate (CPR) and total fertility rate (TFR) have also
improved substantially. Despite these achievements, wide disparities persist between
different income groups, between rural and urban communities, and between different
states and even districts within states. The infant mortality rate among the poorest quintet
of the population is 2.5 times higher than that among the richest. Maternal mortality
remains very high. More than one lakh women die each year due to pregnancy-related
complications.
Like population growth and economic growth, the health of a nation is a product
of many factors and forces that combine and interact with each other. Economic growth,
per capita income, employment, levels of literacy and educationespecially among
femalesage of marriage, birth rates, availability of information regarding health care
and nutrition, access to safe drinking water, public and private health care infrastructure,
access to preventive health care and medical care, health insurance, public hygiene, road
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safety, and environmental pollution are among the factors that contribute directly to the
health of the nation.

Life expectancy at birth:


70.00
60.00
50.00
Male

40.00

Female
30.00

Persons

20.00
10.00
0.00
1941- 1951- 1961- 1971- 1981- 1986- 1991- 1996- 200051
61
71
81
86 E 91 E 96 E 2000 2005

Population Birth Rate and Death Rate:


350.00
300.00
250.00
200.00

Birth Rate*
Death Rate*

150.00
100.00
50.00
0.00
1941- 1951- 1961- 1971- 1981- 1985- 1990- 1991- 199251
61
71
81
85
90
91
92
93

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MONSOON AND ITS IMPACT ON AGRICULTURE


C Gnanasundaram

Introduction
More than 58% of country's population depends on agriculture, a sector producing only
22% of GDP. The agriculture and allied sector witnessed a growth of 9.1% in 2003-04,
which fell steeply to 1.1% in the current fiscal year. Favorable monsoon facilitated an
impressive growth rate of 9.6% in 2003-04 on the back of negative growth in the
preceding year. However, deficient rainfall from the southwest monsoon is estimated to
have caused a significant decline in kharif crops production in the current year.

Monsoon and its Forecasting in India


Indian economy which is still considered as an agricultural economy is Dependant on
the amount of monsoon rains as large parts of the agricultural produce comes from the
monsoon fed crops. Good monsoon always means a good harvest and brings in cheers all
around the country. A weak or bad monsoon is always considered as a big set back to
Indias economy and always results in a big loss in the country GDP levels.
Understanding the mechanisms driving global weather patterns leads us to
question "what went wrong" when inconsistent weather conditions arise. Whenever
periods of drought or flooding exceed than what is normally expected, driving forces in
the weather have likely been either suppressed or enhanced in some manner.
As with any meteorological phenomenon, especially one demonstrating a periodic
(cyclic, or recurring) tendency, attempts to forecast the monsoon have been underway for
ages. Efforts to predict the performance of the monsoon based on correlations of
observed weather features have been pursued since the late 1800s, when it was assumed
that Himalayan snow-cover directly effected regional weather patterns. However, before
forecasting can be attempted, knowledge of the phenomenon itself must be understood.
In the case of the Indian monsoon, what to look for in the period leading up to the
monsoon onset as well as during the active monsoon itself are vital components of
understanding the physical nature of the phenomenon

IMD Methodology
In the months prior to the expected start of the rainy season, the Indian Meteorological
Department (IMD) predicts the onset date and rainfall potential of the monsoon using a
statistical model that evaluates 16 "precursor" conditions, which indicate the potential
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strength of the monsoon circulation. Of the 16 parameters used, 6 regard temperature


conditions, 3 wind or pressure field values, 5 pressure anomalies, and 2 snow-cover. The
most important of these appear to be: 1) the position of the 500mb ridge centered over 75
E longitude averaged over the month of April; 2) monthly average temperatures over the
Indian sub-continent (March and May monthly averages at different locations); and 3) El
Nio/Southern Oscillation conditions. Independent studies have shown these parameters
to have a high correlation separate from other fields, and are frequently used separately
for unofficial pre-season forecasts.
Once the season has begun, forecasts of daily rainfall are attempted by observing
and predicting the lengths of "active" and "break" periods. These are naturally occurring
phases in the monsoon, lasting from 5 to 7 days, identified by fluctuations in the typical
pattern. Several features associated with the active phase, brings rain to the northern
Indian Plains and its west coast. They include tropical depressions in the Bay of Bengal, a
low-level jet stream along the east African coast, and the variations in the monsoon
trough, the area of low pressure that develops over India during the summer monsoon
season.
The current monsoon forecast methods are generally either statistical or
numerical. Statistical forecasts look at correlation or relationships between known
phenomena and the event being analyzed, such as the earlier example of monsoon
performance bases on the Tibetan Plateau snow pack. However, their strength lies in
steering one towards a logical result rather in absolutes. For instance, in the case of the
Asian drought of 1987, the monsoon was weak, resulting in one of the worst droughts of
the century. But the El Nio which caused the disruption in world weather patterns was
not as strong as the 1982-83. In contrast, a numerical model is a mathematical simulation
of the atmosphere, represented by known physical relationships such as the equations of
motion and thermo-dynamics etc. For example, the various models used by
meteorologists to provide temperature and precipitation forecasts out to 5 days are
numerical models, run on supercomputers due to the large amounts of data being
processed.
This is a very serious issue for developing countries like India because such
countries rely so heavily on agriculture for economic and cultural survival. 27% of India
s gross domestic product comes from its agricultural production. 13-18% of India s total
annual exports are agricultural products. Because India is an underdeveloped country, its
agricultural system does not benefit from advanced technology. Without such advanced
irrigation systems and other technological benefits, changes in India s rainfall and
climate would have incredible effects.

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The Importance of rainfall


Output growth severely affected by rainfall, especially in earlier years when share of
agriculture was 40 50 %; data crucial for proper estimates of production function, tfpg
etc.

Construction of Rainfall Index


For each year, only rainfall for four months, June through September, are considered.
1. Area of each state =As
2. (Mean)Rainfall for each rainfall station, 1871-2003: s
3. Standard deviation for each rainfall station, 1871-2003: ss
4. (4 months mean) Rainfall for each station and year: Rs
5. Define: Js = (Rs - s)/ss; for each rainfall station and year
6. Yearly Rainfall Index = S (As* Js)/SAs

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19

FOREIGN DIRECT INVESTMENT(FDI) IN INDIA


C Gnanasundaram

Introduction:
Foreign direct investment is investment made by a foreign individual or company in
productive capacity of another country. It is the movement of capital across national
frontiers in a manner that grants the investor control over the acquired asset.
The idea of India is changing. This is best proved by the increasing number of
countries showing interest to invest in India. Another encouraging factor is that India is
considered a stable country for investing in by corporates overseas. This is evident from
the fact that not a single corporate has approached the World Bank Group's Multilateral
Investment Guarantee Agency (Miga) for non-commercial risk cover for making
investments into the country. India has displaced US as the second-most favoured
destination for foreign direct investment (FDI) in the world after China according to an
AT Kearney's FDI
Foreign direct investment (FDI) has become a key component of national
development strategies for all most all the countries over the Globe. FDI is considered to
be an essential tool for jump-starting economic growth through its bolstering of domestic
capital, productivity and employment. The reliance on FDI is rising heavily due to its all
round contributions to the economy. The important effect of FDI is its contributions to
the growth of the economy. FDI has an impact on country's trade balance, Increasing
labour standards and skills, Transfer of new technology and innovative ideas, Improving
infrastructure, skills and the general business climate. Foreign direct investment (FDI) is
considered to be the lifeblood for economic development as far as the developing nations
are concerned. FDI to developing countries in the 1990s was the leading source of

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external financing. The rise in FDI volume was accompanied by a marked change in its
composition. That is investment taking the form of acquisition of existing assets (mergers
and acquisitions) grew much more rapidly than investment in new assets particularly in
countries
undertaking
extensive
privatization
of
public
enterprises.

FDI IN INDIA AND US:


India and the US have multi faceted relations in the field of politics, economics and
commerce. India-US economic relations in the form of bilateral investments and trade
constitute important elements in India-US bilateral relations particularly because India is
now the second fastest growing economy in the world and USA is the world's largest
economy.
Economic Reforms introduced since 1991 have radically changed the course of the
Indian economy and has led to its gradual integration with the global economy. The
effect of this reform process on trade and investment relation with US is profound. USA
is the largest investing country in India in terms of FDI approvals, actual inflows, and
portfolio investment. US investments cover almost every sector in India, which is open
for private participants. India's investments in USA are picking up. USA is also India's
largest trading partner. By 2003, India became the 24th largest export destination for the
US. In terms of exports to the US, India now ranks eighteenth largest country.

US INVESTMENT IN INDIA:
With regards to FDI U.S. is one of the largest foreign direct investors in India. The stock
of actual FDI Inflow increased from U.S. $11.3 million in 1991 to US $4132.8 million as
on August 2004 recording an increase at a compound rate of 57.5 percent per annum. The
FDI inflows from the US constitute about 11 percent of the total actual FDI inflows into
India.
Top sectors attracting FDI from USA are: Fuels (Power & Oil Ref.) (35.93%),
Telecommunications (radio paging, cellular mobile & basic telephone services (10.56%)
Electrical Equipment (including Computer Software & Electronics) (9.50%), Food
Processing Industries (Food products & marine products) (9.43%), and Service Sector
(Fin. & Non-Fin. Services) (8.28%).

FDI IN CHINA
China has principal attractions like low-cost labor and an enormous domestic market of
more than 1.2 billion consumers. The investment climate has been opened up gradually.
In the 1980s, foreigners were restricted to export-oriented joint ventures with Chinese

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firms. In the early 1990s, they were allowed to manufacture goods for sale in the
domestic Chinese market; and by the mid-1990s; the establishment of wholly foreignowned enterprises was permitted. China's accession to the WTO forces the government to
open up the services sector. In 2004,China being one of the fastest-growing economies in
the world attracted actual FDI of more than US$60.6 billion, up 13 per cent from the
previous year. Foreign direct investment (FDI) in China dropped slightly in the first five
months of the year 2005-06 but within a reasonable fluctuation. China attracted US$22.4
billion of FDI over the period, a 0.79 per cent decrease from the previous year, according
to statistics published by the Ministry of Commerce. Contracted direct investment to
China, which indicates the future trend of FDI flow rose nearly 15 per cent over last year
to US$65 billion. The ministry said China approved 16,437 new foreign-invested
ventures between January and May, down 4.75 per cent year-on-year. Based on official
information, the country realized FDI of US$4.89 billion in May, a comparatively large
decrease of some 22 per cent over last year. Although all the figures for the period show
a declining or slowing growth rate, experts said the average investment in each project
was increasing. India is the sixth most attractive FDI destination.
Although far behind China, India figures among the ten most attractive
destinations for foreign investment, according to a new survey. India jumps to sixth place
from 15th last year, said a survey by leading global consulting firm A T Kearney Inc.
Other surprises in this year's survey, besides India, has Poland, Russia and Brazil
replacing France, Italy, Canada and Australia in the top ten. India's English-speaking
population too is highly valued by American, Canadian and British investors. Overall,
European and Asian executives view India more favorably this year. India is a prime
offshore location for low and high-tech activities, its low-cost, English-speaking and ITsavvy labor force, coupled with a large market potential, underpin global executives'
improved outlook and investment confidence this year. Services sector investors ranked
India as the fourth most attractive this year, up from the 14th place in 2002, it said adding
as a leading offshore location India received investments from GE Capital, American
Express, Citibank, Conseco, British Airways, Dell Computers and Reuters. This FDI
resulted in the development of call centres, back office support and facilities to handle
knowledge-intensive activities. However, FDI remains significantly lower than China and
Brazil, it noted. Investors still face a highly bureaucratic business climate as well as
ceilings on foreign ownership in India. From software giant Microsoft to telecom biggies
Nokia and Samsung to auto majors Honda and Toyota, global players now eye India as
the most attractive destination for investment. December 2005 alone saw a number of
global business leaders in India lauding India's great economic prowess and making huge
investment promises.
E GLOBE

22

23

SENSEX THE BAROMETER OF INDIAN ECONOMY


Lt Col D G Naik

Introduction
Though the BSE was established in 1875, till the decade of eighties there was no scale to
measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in
1986 came out with a stock index that subsequently became the barometer of the Indian stock
market. Due to is wide acceptance amongst the Indian investors, SENSEX (Sensitivity Index) is
regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides
the time series data over a fairly long period of time (From 1979 onwards).
Right from early nineties the stock market witnessed heightened activity in terms of
various bull and bear runs. The market value of listed companies of India Inc hit Rs 29.11 trillion
(Rs 29,11,000 crore) on March 24, 2006 - an increase of Rs 12 trillion (Rs 12,00,000 crore) in the
past 12 months when compared with Rs 17.08 trillion (Rs 17,08,000 crore) the same time last
year.
The SENSEX captured all these events in the most judicial manner. One can identify the
booms and busts of the Indian stock market through SENSEX.

Significance of SENSEX as a Leading Indicator


Rising SENSEX is indicative of improving business climate and greater growth expectations.
Since rising trend in SENSEX attracts investments from retail, institutions, and Foreign
Institutional Investors, it facilitates capital formation at relatively reasonable rate and with greater
ease. This in turn gives fillip to the capex and the growth cycle acquires continuum as a result.

Calculation Methodology
SENSEX is scientifically designed as per
globally accepted construction and review
methodology. SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid
and representative companies. The base year of SENSEX is 1978-79 and the base value is 100.
The calculation of SENSEX involves dividing the Free-float market capitalization of 30
companies in the Index by a number called the Index Divisor. The Divisor is the only link to the
original base period value of the SENSEX. It keeps the Index comparable over time and is the
adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips
etc. During market hours, prices of the index scrips, at which latest trades are executed, are used
by the trading system to calculate SENSEX every 15 seconds and disseminated in real time.

Index Closure Algorithm


The closing SENSEX on any trading day is computed taking the weighted average of all the
trades on SENSEX constituents in the last 30 minutes of trading session. If a SENSEX
constituent has not traded in the last 30 minutes, the last traded price is taken for computation of
the Index closure. If a SENSEX constituent has not traded at all in a day, then its last day's
closing price is taken for computation of Index closure. The use of Index Closure Algorithm
prevents any intentional manipulation of the closing index value.

24

The Index was initially calculated based on the "Full Market Capitalization" methodology
but was shifted to the free-float methodology with effect from September 1, 2003 which is
regarded as an industry best practice globally.
Free-float market capitalization is defined as that proportion of total shares issued by the
company, which are readily available for trading in the market. It generally excludes promoters'
holding, government holding, strategic holding and other locked-in shares, which will not come to
the market for trading in the normal course. Thus, the market capitalization of each company in a
Free-float index is reduced to the extent of its Free-float available in the market. As per this
methodology, the level of index at any point of time reflects the Free-float market value of 30
component stocks relative to a base period. The market capitalization of a company is
determined by multiplying the price of its stock by the number of shares issued by the company.
This market capitalization is further multiplied by the free-float factor to determine the free-float
market capitalization.

Major advantages of Free-float Methodology


*
A Free-float index reflects the market trends more rationally as it takes into consideration
only those shares that are available for trading in the market.
*
Free-float Methodology makes the index more broad-based by reducing the
concentration of top few companies in Index. For example, the concentration of top five
companies in SENSEX has fallen under the free-float scenario thereby making the SENSEX
more diversified and broad-based.
*
A Free-float index aids both active and passive investing styles. It aids active managers
by enabling them to benchmark their fund returns vis-a - vis an investable index. This enables an
apple-to-apple comparison thereby facilitating better evaluation of performance of active
managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best
suited for the passive managers as it enables them to track the index with the least tracking error.
*
Free-float Methodology improves index flexibility in terms of including any stock from the
universe of listed stocks. This improves market coverage and sector coverage of the index. For
example, under a Full-market capitalization methodology, companies with large market
capitalization and low free-float cannot generally be included in the Index because they tend to
distort the index by having an undue influence on the index movement. However, under the Freefloat Methodology, since only the free-float market capitalization of each company is considered
for index calculation, it becomes possible to include such closely held companies in the index
while at the same time preventing their undue influence on the index movement.

Maintenance of SENSEX
One of the important aspects of maintaining continuity with the past is to update the base year
average. The base year value adjustment ensures that replacement of stocks in Index, additional
issue of capital and other corporate announcements like 'rights issue' etc. do not destroy the
historical value of the index. The beauty of maintenance lies in the fact that adjustments for
corporate actions in the Index should not per se affect the index values.
The Index Cell of the exchange does the day-to-day maintenance of the index within the
broad index policy framework set by the Index Committee. The Index Cell ensures that SENSEX
and all the other BSE indices maintain their benchmark properties by striking a delicate balance
between frequent replacements in index and maintaining its historical continuity. The Index
Committee of the Exchange comprises of experts on capital markets from all major market
segments. They include Academicians, Fund-managers from leading Mutual Funds, Finance-

25

Journalists, Market Participants, Independent Governing Board members, and Exchange


administration.
Adjustment for Bonus, Rights and Newly issued Capital. The arithmetic calculation involved
in calculating SENSEX is simple, but problem arises when one of the component stocks pays a
bonus or issues rights shares. If no adjustments were made, a discontinuity would arise between
the current value of the index and its previous value despite the non-occurrence of any economic
activity of substance. At the Index Cell of the Exchange, the base value is adjusted, which is used
to alter market capitalization of the component stocks to arrive at the SENSEX value.
The Index Cell of the Exchange keeps a close watch on the events that might affect the index on
a regular basis and carries out daily maintenance of all the 14 Indices.
* Adjustments for Rights Issues: When a company, included in the compilation of the
index, issues right shares, the free-float market capitalisation of that company is
increased by the number of additional shares issued based on the theoretical (ex-right)
price. An offsetting or proportionate adjustment is then made to the Base Market
Capitalisation (see 'Base Market Capitalisation Adjustment' below).
* Adjustments for Bonus Issue: When a company, included in the compilation of the
index, issues bonus shares, the market capitalisation of that company does not undergo
any change. Therefore, there is no change in the Base Market Capitalisation, only the
'number of shares' in the formula is updated.
* Other Issues: Base Market Capitalisation Adjustment is required when new shares are
issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is
reduced by way of buy-back of shares, corporate restructuring etc.
* Base Market Capitalisation Adjustment: The formula for adjusting the Base Market
Capitalisation (Cap) is as follows:
New Base Market Cap = (New Market Cap / Old Market Cap) x Old Base Market Cap
To illustrate, suppose a company issues right shares which increases the market
capitalisation of the shares of that company by say, Rs.100 crores. The existing Base
Market Capitalisation (Old Base Market Capitalisation), say, is Rs.2450 crores and the
aggregate market capitalisation of all the shares included in the index before the right
issue is made is, say Rs.4781 crores. The "New Base Market Capitalisation " will then be:
2450 x (4781+100)/ 4781 = Rs.2501.24 crores
This figure of 2501.24 will be used as the Base Market Capitalisation for calculating the
index number from then onwards till the next base change becomes necessary.

Criteria for Selection and Review of SENSEX Constituents


The scrip selection and review policy for BSE Indices is based on the objective of:
* Improvement
* Transparency
* Simplicity
Quantitative Criteria.
* Final Rank: The scrip should figure in the top 100 companies listed by Final Rank. The final
rank is arrived at by assigning 75% weightage to the rank on the basis of six-month average

26

full market capitalisation and 25% weightage to the liquidity rank based on six-month average
daily turnover & six-month average impact cost.
* Trading Frequency: The scrip should have been traded on each and every trading day for
the last six months. Exceptions can be made for extreme reasons like scrip suspension etc.
* Market Capitalization Weightage: The weight of each scrip in SENSEX based on six-month
average Free-Float market capitalisation should be at least 0.5% of the Index.
* Industry Representation: Scrip selection would take into account a balanced representation
of the listed companies in the universe of BSE. The index companies should be leaders in
their industry group.
* Listed History: The scrip should have a listing history of at least 3 months on BSE.
However, the Committee may relax the criteria under exceptional circumstances.
Qualitative Criteria.
*Track Record: In the opinion of the Committee, the company should have an acceptable
track record.

Index Review Frequency


The Index Committee meets every quarter to review all BSE indices. However, every review
meeting need not necessarily result in a change in the index constituents. In case of a revision in
the Index constituents, the announcement of the incoming and outgoing scrips is made six weeks
in advance of the actual implementation of the revision of the Index.

27

Constituents of Sensex as on 21-Mar-06


BSE Code
Name
500410
Associated Cement Companys
Ltd.
500490
Bajaj Auto Ltd.
Bharat Heavy Electricals Ltd.
500103
532454
Bharti Tele Ventures Ltd.
500087
Cipla Ltd.
Dr Reddy's Laboratories Ltd.
500124
500300
Grasim Industries Ltd.
500425
Gujarat Ambuja Cements Ltd.
HDFC
500010
HDFC Bank Ltd.
500180
500182
Hero Honda Motors Ltd.
500440
Hindalco Industries Ltd.
500696
Hindustan Lever Ltd.
532174
ICICI Bank Ltd.
500209
Infosys Technologies Ltd.
ITC Ltd.
500875
500510
Larsen & Toubro Limited
532500
Maruti Udyog Ltd.
532555
National Thermal Power Corpn.
Ltd.
500312
ONGC Ltd.
500359
Ranbaxy Laboratories Ltd.
500390
Reliance Energy Ltd.
Reliance Industries Ltd.
500325
500376
Satyam Computer Services Ltd.
500112
State Bank of India
532540
Tata Consultancy Services Limited
500570
Tata Motors Ltd.
500400
Tata Power Co. Ltd.
500470
Tata Steel Ltd.
507685
Wipro Ltd.

28

Sector
Housing Related

Adj. Factor
0.7

Transport Equipments
Capital Goods
Telecom
Healthcare
Healthcare
Diversified
Housing Related
Finance
Finance
Transport Equipments
Metal,Metal Products & Mining
FMCG
Finance
Information Technology
FMCG
Capital Goods
Transport Equipments
Power

0.7
0.35
0.35
0.6
0.75
0.8
0.8
0.9
0.8
0.5
0.75
0.5
1
0.8
0.7
0.9
0.3
0.15

Oil & Gas


Healthcare
Power
Oil & Gas
Information Technology
Finance
Information Technology
Transport Equipments
Power
Metal,Metal Products & Mining
Information Technology

0.15
0.65
0.5
0.55
0.9
0.45
0.2
0.6
0.7
0.75
0.2

29

INFLATION
Lt Col D G Naik

Introduction
Inflation is an increase in the general level of prices, or, alternatively, it is a decrease in the value
of money. To say that prices have gone up means that the value of money (purchasing power)
has gone down.
Inflation is one of those economic phenomena that affects every citizen, almost everyday.
During periods of falling inflation, prices may still go up because actually, when inflation is down,
it is only the rate of increase in prices that is down. While nominal incomes go up, the real worth
of incomes is eroded with price-increase.
The rate of inflation is important because it affects the planning at all levels. For example,
if prices are declining, holding inventories is expensive, and sellers will try to minimize
inventories. The price at which people borrow and lend funds will also depend heavily on what
they expect to happen to prices. The real rate of return will decline for higher inflation rate.

Significance of Inflation as Leading Indicator


Currently, a great deal of popular attention is being paid to issues relating to inflation and its
measurement in India, than ever before, reflecting some new realities. First, with the dismantling
of most administered interest-rates, the link between inflation and interest rate is, relative to the
past, more closely tracked by savers, investors and financial intermediaries. Second, with the
progressive opening up of the economy, the integral link between inter-country interest rate
differentials, inflation rate differentials and the forward exchange premia are closely observed
when viewing exchange rate movements. Third, in a liberalised trading regime and market
determined exchange rate regime, and also if the country has to allow the economy to be
"globalised" or more open, inflation-tracking is critical in terms of maintaining competitiveness of
domestic industry. Fourth, the market participants carefully track inflation data to anticipate and
assess monetary policy changes, in view of the recent trends in the manner of articulation of such
policy changes.
The two frequently used measures of inflation in India are based on Wholesale Price
Index (WPI) and Consumer Price Index (CPI). Then the discussion would turn to the concept of
core inflation and its relevance to India. Some exploratory analysis is attempted on the apparent
puzzle of the current low inflation being accompanied by relatively high growth in money supply.
Wholesale Price Index (WPI)
The WPI is the main measure of the rate of inflation often used in India. The WPI is available for
all commodities, and for major groups, sub-groups and individual commodities. The basic
advantage of this measure of inflation is its availability at high frequency, i.e. on weekly basis with
a gap of about two weeks, thereby enabling continuous monitoring of the price situation for policy
purposes. This index does not cover non-commodity producing sectors viz. services and nontradable commodities.
Consumer Price Index (CPI)
The important measure at the point of consumption is the Consumer Price Index for Industrial
Workers (CPI-IW) which is meant to reflect the cost of living conditions and is computed on the
basis of the changes in the level of retail prices of selected goods and services on which a
homogeneous group of consumers spend the major part of their income. Its coverage is broader

30

than the other indices of CPI like the CPI for Agricultural Labourers (AL) and the CPI for Urban
Non-Manual Employees (UNME). Besides, CPI-AL and CPI-UNME are not considered as robust
national inflation measures because they are designed for specific groups of population with the
main purpose of measuring the impact of price rise on rural and urban poverty.
Comparision of WPI and CPI
While each of the measures has its advantages as well as weaknesses, the selected measure of
inflation should broadly capture the interplay of effective demand and supply forces in the
economy at frequent intervals. This will be facilitated if the price indices have a high periodicity of
release, and it is in this sense that WPI is superior to CPI. WPI's coverage of commodities is also
high. While services do not come under the ambit of WPI, the coverage of non-agricultural
products is better in WPI than CPI, making WPI less volatile to relative price changes as against
the CPI. The coverage of tradable items, essentially manufactured products (weight = 57.06 per
cent) is higher in the case of WPI whereas the coverage of non-tradables like services pertaining
to education, medical care and recreation are more in the case of CPI-IW. The weekly periodicity
of WPI with a lag of a fortnight often coincides with the release of banking and money supply data
on 14 day basis.
Core Inflation.
A measure of inflation that excludes certain items which face volatile price movements. Core inflation
eliminates products that can have temporary price shocks because these shocks can diverge from the
overall trend of inflation and give a false measure of inflation. Core Inflation is thought to be an indicator of
underlying long-term inflation.

Core inflation is most often calculated by taking the Consumer Price Index and excluding
certain items from the index, usually energy and food products. Other methods of calculations
include the outliers method, which removes the products that have had the largest price changes.
A measure of core inflation has two distinct uses for monetary policy purposes. While one
role is in setting or formulating policy, the second role is in providing policy accountability.
Because of these two uses, many central banks are interested in estimating core inflation. But, it
should be equally recognised that different methods used to estimate core inflation give various
estimates and hence it is very difficult to have a precise and unique definition, which is universally
acceptable. Hence, the need for further research on defining core-inflation, appropriate for India.

Problems arise when there is unanticipated inflation

Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For
those who borrow, this is similar to getting an interest-free loan.
Uncertainty about what will happen next makes corporations and consumers less likely to
spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their purchasing power
and, consequently, their standard of living.
The entire economy must absorb repricing costs ("menu costs") as price lists, labels,
menus and more have to be updated.
If the inflation rate is greater than that of other countries, domestic products become less
competitive.

Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even
deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the
economy is weakening. As you can see, it's not so easy to label inflation as either good or bad -it depends on the overall economy as well as your personal situation.

31

19
70
19 -71
71
19 -72
72
19 -73
73
19 -74
74
19 -75
75
19 -76
76
19 -77
77
19 -78
78
19 -79
79
19 -80
80
19 -81
81
19 -82
82
19 -83
83
19 -84
84
19 -85
85
19 -86
86
19 -87
87
19 -88
88
19 -89
89
19 -90
90
19 -91
91
19 -92
92
19 -93
93
19 -94
94
19 -95
95
19 -96
96
19 -97
97
19 -98
9
19 899 99
-2
00
0

30

25

20

15

10
InflWPI
InflCPI

-5

-10

32

CONCLUSION
Leading Indicators are useful tools for forecasting and planning both for the Policy
makers and Business houses. The accuracy of forecast based on leading indicator will
depend up on the quality of data which has been relied upon and the process followed to
construct this indicators.
Some of the indicators elaborated above though not meticulously constructed
provides a useful clue to the way ahead for the growth of economy as a whole for India.

33

References:
1. Pami Dua and Anirvan Banerji, A leading index for the Indian economy,
Working paper no. 90, Centre for Development Economics, March, 2001.
2. J D Lindlbauer, Business Cycle Indicators From Qualitative Data, In Searh of
Economic Indicators Essays on Business Surveys (Lecture Notes in Economics
and Mathematical Systems, Werner H. Stringel, Ed. Berlin: Springer-Verlag,
1977.
3. Raj Kapila and Uma Kapila, Understanding Indias Economy Reforms: The Past,
The Present and The Future, New Delhi: Academic Foundation, 1996.
4. Uma Kapila, Indian Economy since Independence, New Delhi: Academic
Foundation, 1998
5. [Online], Available: http://en.wikipedia.org/wiki/Economy_of_India
6. [Online], Available: http://en.wikipedia.org/wiki/Gross_Domestic_Product
7. [Online], Available: http://ibef.org/home.aspx
8. [Online], Available: http://www.investopedia.com
9. [Online], Available: http://www.rbi.org.in
10. [Online], Available: http://www.ibef.org
11. [Online], Available: http://rbi.org.in/
12. [Online], Available: http://www.economywatch.com/

34