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The Economic Times newspaper now and then publishes articles on current economic issues in a question and
answer format under the heading ET in the Classroom. They are simple to understand and remember.
Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely
available on the net. They are the property of the Economic Times. I have just consolidated all of them here for
the benefit of the readers.
Complete credit is for The Economic Times newspaper for these wonderful articles.
For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop
solution for getting acquainted with many economic jargon and concepts.
ET in the classroom: What is Islamic finance?
What is Islamic finance?
Islamic finance refers to a financial system that is consistent with the principles of Sharia, the sacred law of
Islam. It is different from regular banking in that it prohibits earning of interest (or riba) through the business of
lending. It also prohibits direct or indirect association with businesses involving alcohol, pork products,
firearms and tobacco. It also does not allow speculation, betting and gambling.
How does it work?
Islamic finance takes the form of Islamic banking and Islamic insurance, also known as Takaful.
Islamic banking is done in five ways:
1. Mudarabah, a profit-sharing agreement
2. Wadiah, a safe keeping arrangement
3. Musharakah, a joint venture for a specific business
4. Murabahah, cost plus arrangement where goods are sold with a pre-determined margin of profit
5. Ijirah, a leasing arrangement
Takaful is a form of mutual insurance based on partnership and collective sharing of risk by a group of
individuals.
How has Islamic banking progressed in recent years?
Islamic banking is most prevalent in Malaysia. It is spreading rapidly in West Asia, where the population is
predominantly Muslim. New global financial centers such as Singapore, Hong Kong, Geneva, Zurich and
London have made changes in regulations to accommodate the Islamic finance industry, which is nearly a
trillon dollar in size now.
Indian regulations do not allow Islamic banking but the government is considering allowing it.
What restricts the growth of Islamic finance?
Most banks conducting Islamic operations have a panel of Muslim scholars called Sharia committee or Sharia
board, which determines whether a product or practice complies with Islamic provisions. Also, the accounting is
done differently for which there is an official standard-setting body known as the accounting and auditing
organization for Islamic financial institutions. The strict code makes Islamic banking a very niche product.
ET in the classroom: Infrastructure debt fund
What is the Infrastructure debt fund or IDF?
Infrastructure debt fund is a debt instrument being set up by the finance ministry in order to channelise longterm funds into infrastructure projects which require long-term stable capital investment. According to the
structure laid out by the finance ministry, after consultations with stakeholders, infrastructure NBFCs, market
regulators and banks, an IDF could either be set up as a trust or as a company.
premium. Having sensed a dollar scarcity and fearing that things may turn worse, it will raise more than it
needs. When all companies start doing it, there is artificial scarcity. Not just banks, corporates in Greece would
also default
How will panic boil over to other Euro Nations?
Speculators will target Portugal, and then Italy. The logic is simple: if Germany & ECB do not help Greece,
they will also let Portugal and Italy sink. Soon these will be perceived as basket cases and their bonds, stocks
and currencies will face a brutal attack from short-sellers. That would be a problem as Italys debt is more than
the combined debt of Portugal, Spain and Ireland
So, times running out for Greece?
Close to $8 billion worth Greek bonds will mature in December. It needs the money before that, failing which a
default is inevitable. IMF is willing to lend a little over $8 billion, but only if Greece takes a string of austerity
measures. IMF is not spelling out exactly when it will sanction the loan. Some economists fear the IMF pressure
can make things difficult for Greece: how will lower consumption help a country which is already doldrums
Isnt Germany in a bit of a Catch-22 Situation?
It is. German politicians know that if there was no euro, its currency would have gained so much that their
exporters would have been wiped out. It needs the euro. But convincing Germans isnt easy. They dont want to
bail out all Europeans, particularly those who dont work hard. Some think Greece should be exiled from EU
for a few years to should put their house in order
ET in the Classroom: Interest rate futures
What is the interest rate futures on 91-day treasury bill?
Interest rate futures on 91-day Treasury bill are interest rate-driven derivative products that help banks, mutual
funds and primary dealers to hedge their interest rate exposure on treasury bills. Financial institutions can lock
in the interest rate or the yield on the 91-day treasury at a given date when counter parties enter into the interest
rate futures contract.
How are they settled?
The 91-day T-bill interest rate futures are cash settled. In case of the 91-day treasury bill, the final settlement
price of the futures contract is based on the weighted average price/ yield obtained in the weekly auction of the
91-day treasury bills on the date of expiry of the contract. But in case of interest rate futures on the 10-year
benchmark government security, the contract is physically settled.
How is the product structured?
The minimum size of the contract is Rs 2 lakh and the tenor of the contract cannot be more than 12 months,
according to market regulator SEBI, which has designed the product and will supervise its trading. The
maximum maturity of the contract can be for 12 months. The initial margin is subjected to a minimum of 0.1%
of the notional value of the contract on the first day of trading and 0.05 % of the notional value of the contract
thereafter.
What kind of volumes has the product generated so far?
Last week, the average daily trading volume for the 91-day T-Bill IRF was Rs 360 crore. So far, among the
exchanges, only NSE has introduced the product for trading. The interest rate futures (IRF) on 91-day TBills
clocked a volume of around Rs 730 crore on the National Stock Exchange (NSE) on the first day of trading last
Monday.
What are the advantages of the interest rate futures?
It is a good hedging tool for banks, primary dealers and mutual funds who have huge exposure to these money
market instruments such as 91-day treasury bills. There is no securities transaction tax (STT). The initial
margins are also lower, which could attract volumes for the product. Interest rate futures can be used by
investors to take a directional call on the interest rates or for hedging their existing position.
ET in the classroom: Central plan and role of plan panel and finance ministry
The governments budget exercise usually begins with fixing the contribution of the exchequer to the central
plan. Though distributed over many schemes, taken together this is the single biggest item of expenditure in the
annual budget. ET takes a look at the concept of Central Plan and the budget support to the plan.
What is central plan in the context of the budget?
Central or annual plans are essentially the five year plans broken down into five annual installments. Through
these annual plans, the government achieves the objectives of the Five-Year Plans. The details of the plan are
spelled out in the annual budget presented by the finance minister. But the actual responsibility of allocation
funds judiciously amongst ministries, departments and state governments rests with the Planning Commission.
What is gross budgetary support, or GBS?
The funding of the central plan is split almost evenly between government support (from the Budget) and
internal and extra budgetary resources of public enterprises. The governments support to the central plan is
called the Gross Budgetary Support, or the GBS. In the recent years the GBS has been slightly more than 50%
of the total central plan.
How is the GBS figure arrived at?
The administrative ministries responsible for various development schemes present their demands before the
planning commission. The planning commission aggregates and vets these demand. It then puts forward a
consolidated demand before the finance ministry for the budgetary support it needs from the cental excequer.
The amount approved by the finance ministry is usually less than that demanded by the planning commission
because of the multiple objectives the North Block has to keep in mind will making allocations. The planning
commission in turn adjusts the allocated amount among various demands.
How do GBS, central plan and plan expenditure differ?
Central plan includes the GBS and the spending of the public enterprises that do not figure in the budget. In that
sense the governments spending on the central plan is limited to GBS. But the centre also provides funds to
states and union territories for their respective plans. This contribution, together with the GBS, makes up the
total plan spending of the government for a year. This is about 30% of the total government expenditure.
ET in the Classroom: Self-help group
What is a self-help group (SHG)?
SHG primarily comprises members with homogenous social and economic backgrounds. It is a voluntarily
formed group consisting of women, rural labourers, small farmers and micro-enterprises. The concept is akin to
the concept of democracy. SHGs are formed by the members, for the members and of the members. The
number of members could be as less as five and could even go up to 20. They save and contribute to a common
fund which is used to lend to the members. Since they know each other, members do not seek collateral from
each other.
What are the goals of an SHG?
An SHG is seen as an instrument for achieving a variety of goals, including empowering women. Data from
NABARD, which pioneered the concept, shows that 90% of members in the SHG are women and most of them
do not have any assets. It also helps in developing leadership abilities among the poor, increasing school
enrolments, improving nutrition and in birth control. An SHG is generally started by non-profit organisations,
such as an NGO with broad anti-poverty agendas. It is also a popular channel of micro-lending by commercial
banks, particularly government-run banks.
of micro insurance, mutual fund products, pension products, receipt and delivery of small value
remittances/other payment instruments.
Who is eligible to be a banking correspondent?
RBI has allowed a host of entities to act as business correspondents (BCs) of banks. These include NGOs/MFIs
set up under Societies/Trust Acts; societies registered under Mutually-Aided Co-operative Societies Acts, or the
Co-operative Societies Acts of States; Section 25 companies, which are not-for-profit companies; companies in
which NBFCs, banks, telecom companies and other corporate entities or their holding companies do not have
equity holdings in excess of 10%; post offices and retired bank employees, ex-servicemen and retired
government employees.
How is a business facilitator different from a business correspondent?
Very often the term business correspondents is used interchangeably with the term business facilitators
(BFs). But RBI makes a clear distinction between the two. BFs are allowed to undertake only facilitation
services like identification of borrowers, collection and preliminary processing of loan applications, including
verification of primary information, creating awareness about savings and other products, processing and
submission of applications to banks and promoting and nurturing SHGs and follow-up of recovery and debt
counseling. However, facilitation of these services does not include conduct of banking business by BFs, which
is the exclusive function of business correspondents.
ET in the Classroom: Take-out financing
What is take-out financing?
Take-out financing is a method of providing finance for longer duration projects of about 15 years by banks
sanctioning medium-term loans for 5-7 years. It is given that the loan will be taken out of books of the financing
bank within pre-fixed period by another institution, thus preventing any possible asset-liability mismatch. After
taking out the loan from banks, the institution could offload them to another bank or keep it.
Though internationally this kind of lending has been in existence for many years, it came to India only in the
late 90s. These long-tenure loans were primarily introduced to incentivise banks to lend to the infrastructure
sector as banks back then had very little exposure to long-term loans, and also because they did not have
adequate resources of similar tenure to create such long-term assets.
What does the Reserve Bank rule say?
Banks/FIs are free to finance technically feasible, financially-viable and bankable projects undertaken by both
public sector and private sector undertakings, provided the amount sanctioned is within the overall ceiling of the
prudential exposure norms prescribed by RBI for infrastructure financing. They should also have the requisite
expertise for appraising technical feasibility, financial viability and bankability of projects.
Which institutions, besides banks, are engaged in this practice?
The government promoted Infrastructure Development Finance Corporation, by setting aside a corpus from the
union budget, with a primary mandate to promote infrastructure funding. Later, India Infrastructure Finance
Company also came up essentially to refinance infrastructure loans of commercial banks.
What are the problems with take-out financing?
Though take-out financing is a permissible practice in India, the concept has not taken off in a big way. Though
the concept in a way addresses the asset-liability issue, regulators still want banks to set aside higher capital for
their exposure. Besides, banks are also wary of taking risks such as construction risks, which may delay the
project as well as increase its cost.
LIQUID COAL
Did you know coal can be liquid fuel too?
Coal liquification is seen one of the options to cope up with high crude oil prices. While availability of coal in
plenty goes in favour of this process in the energy-scarce scenario, environmental concerns and high cost has so
far limited the use of coal-to-liquid (CTL) fuel to an insignificant position except in the case of South Africa.
Use of coal for power generation is considered a better option in India as there is no consensus among policymakers. Lets look at the basic issues related to conversion of coal into liquid fuel.
Can coal be converted into liquid fuel?
Yes. Coal can be converted into a synthetic liquid fuel and the process is known as coal-to-liquid (CTL)
worldwide. Broadly, there are two different methods to convert coal into liquid fuelsdirect and indirect
liquefaction. Under the direct method, hydrogen is added to crushed coal and liquid is created with the presence
of catalysts.
However, further refining of this liquid is needed to achieve liquid fuel with high-grade fuel characteristics. The
indirect liquefaction process first gasifies coal using oxygen, steamheating them to very high temperatures.
The resultant gas is purified and mixed with water.
The liquid fuel that is created can be refined to produce diesel, naphtha, jet fuel, cooking gas and lubricants.
Creating this fuel is a very intensive process that requires large amounts of coal, water and energy.
Is CTL commercially viable?
Skyrocketing price of oil and concern over depleting crude reserves are triggers generating interest in CTL.
Ambitious CTL projects are in operation in South Africarun by Sasol, the company that pioneered CTL.
Liquid fuel generated from coal caters to 30% of the needs of South Africa. Sasol has patented Fischer
Tropsch technology of indirect liquefaction, which converts synthetic gas, extracted from coal, into oil.
More than 30 CTL projects across the world are being studied for feasibility, depending on the quality of coal,
availability of water and other local conditions. The initial investment in CTL projects is quite high.
Is India game for CTL?
The government has studied CTL. The Tata Group, in collaboration with Sasol, made a presentation on a $8billion indirect liquefaction project using Sasols technology to convert high-ash Indian coal into liquid fuel
with a capacity of 80,000 barrels per day of liquid fuel.
An inter-ministerial group (IMG) examined the proposal. The Planning Commission rejected the idea, saying
that coal be better used for electricity generation rather than making liquid fuels. The IMD discussion also led to
a view that those wishing to set up CTL projects should bid for coal blocks, competing with other users.
Finally, the government offered three blocks of coal in Orissa with cumulative reserves of about six billion
tonnes for the project to private players. There were 22 applicants including Reliance Group and the Tatas. The
eligibility criterion says the applicant company should have a minimum net worth of $1 billion, besides having
a tie-up with the proven technology providers.
The IMG has to decide which companies would be allowed to implement CTL projects. What is CTLs impact
on the environment?
Green lobbies are fighting against CTL tooth and nail, alleging that Sasol has a questionable environmental and
social record in South Africa. They advocate higher investment in renewable resources like wind energy and
solar energy, rather than opting for CTL.
Liquefying large coal reserves will release huge amounts of carbon dioxide, a greenhouse gas. Proponents of
this technology say the gas can be captured and stored underground.
The cost of carbon capture and storage will impact the economics of CTL. Coal liquification requires vast
amounts of water too and this has led to concerns in water-deficient areas.
of return. You than start an STP where every month a pre-determined amount will be invested into an equity
fund. This helps in deploying funds at regular intervals in equities with minimum timing risk.
ET in the classroom: RBIs key policy rates
ET guides you through the key policy rates of the Reserve Bank of India
What are the key policy rates used by RBI to influence interest rates?
The key policy or signalling rates include the bank rate, the repo rate, the reverse repo rate, the cash reserve
ratio (CRR) and the statutory liquidity ratio (SLR). RBI increases its key policy rates when there is greater
volume of money in the economy. In other words, when too much money is chasing the same or lesser quantity
of goods and services. Conversely, when there is a liquidity crunch or recession, RBI would lower its key policy
rates to inject more money into the economic system.
What is repo rate?
Repo rate, or repurchase rate, is the rate at which RBI lends to banks for short periods. This is done by RBI
buying government bonds from banks with an agreement to sell them back at a fixed rate. If the RBI wants to
make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it
cheaper for banks to borrow money, it reduces the repo rate. The current repo rate is 5.50%.
What is reverse repo rate?
Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. Like
the repo, this is done by RBI selling government bonds to banks with the commitment to buy them back at a
future date. The banks use the reverse repo facility to deposit their short-term excess funds with the RBI and
earn interest on it. RBI can reduce liquidity in the banking system by increasing the rate at which it borrows
from banks. Hiking the repo and reverse repo rate ends up reducing the liquidity and pushes up interest rates.
What is Cash Reserve ratio?
Cash reserve Ratio (CRR) is the amount of funds that banks have to park with RBI. If RBI decides to increase
the cash reserve ratio, the available amount with banks would reduce. The bank increases CRR to impound
surplus liquidity. CRR serves two purposes: One, it ensures that a portion of bank deposits are always available
to meet withdrawal demand, and secondly, it enables that RBI control liquidity in the system, and thereby,
inflation by tying their hands in lending money. The current CRR is 6%.
What is SLR? (Statutory Liquidity Ratio)
Apart from keeping a portion of deposits with RBI as cash, banks are also required to maintain a minimum
percentage of deposits with them at the end of every business day, in the form of gold, cash, government bonds
or other approved securities. This minimum percentage is called Statutory Liquidity Ratio. The current SLR is
25%. In times of high growth, an increase in SLR requirement reduces lendable resources of banks and pushes
up interest rates.
What is the bank rate?
Unlike other policy rates, the bank rate is purely a signalling rate and most interest rates are delinked from the
bank rate. Also, the bank rate is the indicative rate at which RBI lends money to other banks (or financial
institutions) The bank rate signals the central banks long-term outlook on interest rates. If the bank rate moves
up, long-term interest rates also tend to move up, and vice-versa.
ET in a Classroom: Currency Peg
As China and the US tussle over the value of the Yuan, ET helps you deconstruct the issue.
What is a currency peg?
There are various ways in which the price of one currency against another is arrived at. In a pegged exchange
rate, the value of the currency is fixed with respect to another currency, usually the US dollar. In other words, it
is the rate the country or the central bank of the country maintains as the official exchange rate. Chinese
currency, for example, is pegged at 6.83 yuan to the dollar.
How is the currency peg maintained?
Currency pegs work only when the central bank has the muscle to intervene in the market to check the currency
from going beyond a permissible band. It should be able to supply the market with enough dollars in the event
of a huge demand at the pegged rate and in the event of too much supply be ready to buy dollars from the
market. It implies that the central bank must have large foreign exchange reserves. China has foreign currency
reserves of nearly $2.5 trillion.
How does a currency peg help?
Countries go for a pegged exchange rate to have stability in the foreign exchange market. China had also
effectively gone to a dollar peg in July 2008 keeping its currency steady at 6.83 yuan to a dollar as it fought the
global economic crisis.
The stable currency creates a conductive environment for investments as investors do not fear losses on account
of currency fluctuations. Exports benefit as appreciation is kept in check. However, there are numerous
instances of currency pegs causing financial crises. Pegged values are difficult to maintain if the central bank is
not in position to intervene and defend the peg.
Why is the US so bothered about the currency peg?
The US believes that China accumulates its huge current account surplus (to the tune of 8% of GDP) and the
US, its current account deficit (to the tune of 2.9% of GDP) because its currency is undervalued, making its
exports to the US cheap and its imports from the US expensive. The US blames the pegged yuan for the
resultant global imbalance, and wants the yuan to appreciate.
A bit of history
From 1997 to mid-July 2005, Chinese currency was pegged to the US dollar. On 21 July 2005, China ended the
peg to the US dollar and switched to a crawling peg linked to a basket of currencies. The renminbi gradually
appreciated over 20% over the next three years. In July 2008, China went back to the dollar peg, bringing the
Yuan appreciation to an end. Yuan is now valued a 6.83 to a dollar with a plus/minus 0.5% fluctuation.
ET in the classroom: Quantitative easing
The US seems ready for another round of quantitative easing to boost growth, employment generation and
consumer spending. There is consensus among economists and policymakers in the worlds largest economy
that the Federal Reserve should target a higher level of inflation to spur growth. ET takes a look at the concept
of quantitative easing.
What is quantitative easing?
Central banks usually stimulate a slowing economy by cutting interest rates, which encourage people to spend
by borrowing more or discouraging them to save. But with interest rates in the developed world already close to
zero, that option is no longer available. In such situations , the central banks resort to pumping money directly
into the economy, a process known as quantitative easing. It is done by buying bonds usually government
paper but can also be private bonds from banks and financial institutions. The developed countries used
quantitative easing to spur growth in the aftermath of the financial meltdown of 2008.
What is the idea behind quantitative easing?
At any given point of time there is a fixed amount currency /money chasing products and services available in
the economy. The idea essentially is to get more money into the system chasing the same amount of produce to
drive up their prices. In the case of quantitative easing, the bondsellers will receive money that has not been in
circulation, which will increase the money supply in the system. As the money in the economy increases the
demand for different products rises.
Pure quantitative analysts look only at numbers with almost no regard for the underlying business. Although
even fundamental analysis look at numbers from a balance sheet, their primary focus is always the underlying
business, the environment in which the company is operating and so on. Quantitative analysts create
mathematical algorithms, which help them arrive at buy and sell decisions.
Which is the best?
The different analytical tools have different uses. For instance, fundamental analysis could be used to identify
companies with a possibility of strong earnings growth in the future.
Technical analysis could be used to decide when to buy this stock. When you combine technical and
fundamental analysis it is called techno-fundamental research. Depending upon your style and time frame of
investment you could choose among them.
ET in the classroom: Care for a Dim Sum?
Chinas growing affluence and influence over the world economy has created huge demand for assets
denominated in yuan, the basic unit of the renminbi. China is also keen to globalise its currency to offset any
losses to its record foreign exchange reserves due to weakness of the dollar. This has led to the creation of
the Dim Sum bond market in Hong Kong. ET explains the concept.
What Is A Dim Sum Bond?
A bond denominated in yuan and issued in Hong Kong. Derived from a traditional Chinese cuisine that offers a
variety of small eats, Dim Sum bonds are issued by Chinese government and companies as well as foreign
entities.
What Makes Dim Sum Bonds Attractive For Investors?
Investors across the world are looking for opportunities to make money out of Chinas phenomenal growth, but
the countrys stiff capital controls prohibit them from investing in Chinese debt. Dim Sum bonds offer an
avenue to such investors. Investors are rushing to the Dim Sum market on expectations that Beijing will
continue to let the yuan appreciate. Exposure to yuan-denominated assets also provides an alternative to bonds
issued by western governments and companies and fits well with the Principle of Diversification, that a
portfolio containing different assets and kinds of assets carries lower risk.
Lower interest cost is also encouraging companies to raise money through the Dim Sum market. Last
month, IDBI Bank became the first issuer of Dim Sum bonds from India. It sold 650 million yuan ($102
million) of three-year bonds priced at a fixed coupon of 4.5% per annum. The bank said it cut a percentage
point off its dollar funding costs by going to the Dim Sum market. Reports say infrastructure lender IL&FS is
also planning to raise $100 million through yuan denominated bonds.
Is There A Limit On Such Issuances By Indian Entities?
Recently, the yuan was added to the list of currencies in which Indian companies can raise funds overseas, in
addition to dollar, euro, pound and yen. Indian firms can raise an equivalent of $1 billion in yuan.
How Big Is the Dim Sum Bond Market?
The Dim Sum market has risen from 10 billion yuan in 2007 to more than 100 billion yuan. Analysts forecast
the market to grow beyond 300 billion yuan in 2012.
Where can Indian Issuers deploy The Proceeds?
Indian issuers can deploy the money for capital expenditure within China and use the proceeds for settling trade
accounts. They can also enter into swap contracts to get other currencies. However, if the money is to be
brought back to India, companies will have to comply with the External Commercial Borrowing guidelines set
by the Reserve Bank of India.
branch of the parent bank situated within India, and it undertakes international banking business involving
foreign currency denominated assets and liabilities.
The concept comes from the practice prevalent in several global financial centres. Here an OBU can accept
foreign currency for business but not domestic deposits from local residents. This was conceived to prevent
competition between local and offshore banking sectors.
What was the need for OBUs?
In addition to providing power, tax and other incentives to SEZs, policymakers felt a need to provide SEZ
developers access to global money markets at international rates. So in 2002, RBI instituted OBUs, which
would be virtually foreign branches of Indian banks. These would be exempt from CRR, SLR and few other
regulatory requirements.
RBI regulations make it mandatory for OBUs to deal in foreign exchange, source their foreign currency funds
externally, follow all prudential norms applicable to overseas branches and are entitled for IT exemptions. Thus
in many respects, they are free from the monetary controls of the country.
What price, freedom from regulations?
In the eight years that they have been operational, concerns have been raised that, funding by OBUs to SEZs
would lead to increase in external debt of India. Also, some have suggested that OBUs as vehicles for extending
dollar loans have no use as long as they are restricted to doing business only in the zones in which are they
located.
This would create an unnecessary regulatory arbitrage like booking business because there is some arbitrage
advantage on offer. Anyways, ground realities could not be more different. Hardly a handful of banks have set
up their OBUs, so the argument looks very farfetched.
SEZ, itself as a concept has been struggling, given the issues that SEZ developers have faced over acquiring
land from farmers.
What is the future of OBUs?
Most international financial centres still house OBUs, so saying they are not required may be incorrect.
However, some analysts have said OBUs are losing relevance at a time of increasing globalisation.
They say OBUs will be of no use after the economy opens up fully and the rupee is fully convertible. These
experts argue for one or two OBUs, instead of having several of them spread across the country.
ET In the Classroom: Public Debt Office
What is a public debt office?
A public debt office or a debt management office is an autonomous government agency which acts as the
investment banker to the government and raises capital from the markets for the government.
It formulates the borrowing calendar for the government and decides upon the maturities of the securities to be
issued on behalf of the government. A public debt office works separately from the central bank and has
nothing to do with the formulation of the monetary policy or setting interest rates.
What are the conflicts of interests if the body that formulates the monetary policy also acts as the
Centres investment banker?
There are certain inherent conflicts of interest when the agency, which raises funds for the government, also
manages its monetary policy and regulates interest rates. The basic conflict of interest is between setting the
short-term interest rates and selling government securities. The Reserve Bank of India, like a good merchant
banker to the government, sells bonds at high prices. At lower interest rates or yields, it runs the risk of adding
to inflationary concerns. Another area of concern is that RBI is also the regulator of all banks, which means the
central bank, could arm-twist the banks to buy bonds at higher prices or for longer tenors.
For a very long time now, economists have been arguing in favour of an independent debt management office,
which in the Indian discourse is called National treasury management agency or debt management agency, so
that RBI can be relieved of the burden of being the Centres investment banker.
What is the practice in advanced economies?
Developed economies such as the UK, the US and New Zealand, already have independent public debt offices
in place. Former RBI governors have time and again complained about the difficulties in managing government
debt while trying to keep interest rates high to rein in inflation.
Does India have a debt management office?
The finance ministry had proposed setting up of the debt management agency in its 2007-08 Budget. A series of
expert committees have recommended the establishment of the debt management agency. These include groups
headed by the former finance secretary Vijay Kelkar, former World Banker Percy Mistry and ex-IMF chief
economist Raghuram Rajan.
A draft legislation had also been created by the Jahangir Aziz Working Group. While presenting the Budget for
2011-12, finance minister Pranab Mukherjee had announced the governments intention to introduce the bill for
an autonomous debt management office in the next financial year.
How is it expected to be structured?
The agency is likely to be an autonomous body under the administrative control of the finance ministry. The
central bank will be on the management committee of the agency. A middle office or MoF is already working in
the finance ministry that prepares the borrowing calendar of the Centre.
A mid-office would constitute a single comprehensive database about all liabilities and guarantees of the
government of India. For now, the 21 public debt offices of RBI continue to function. The structure and
functions of the debt management office have been discussed and reworked on for three years now but little
sense of urgency has been seen.
ET in the Classroom: Non-competitive bidder
What is non-competitive bidding in dated government securities?
The Government of India conducts periodic auctions of government securities and of the total amount notified
for auctions, a certain portion is kept aside for the non-competitive bidder, or the small and medium investors.
Non-competitive bidding means a person would be able to participate in the auctions of dated government
securities without having to quote the yield or price in the bid. That saves him the worry, about whether the bid
will be on or off-the-mark.
How is the process useful?
It helps deepen the government bonds market by encouraging wider participation and retail holding of
government securities. It enables the participation of individuals, firms and other mid-segment investors who
neither have the expertise nor the financials to participate in auctions. RBI gives such investors a fair chance of
assured allotments of government securities.
Who can be referred to as the non-competitive bidder?
RBI allows individuals or firms, provident funds, corporate bodies or trusts who do not have current account
(CA) or subsidiary general ledger (SGL) account with the Reserve Bank of India. Regional Rural Banks (RRBs)
and Urban Co-operative Banks (UCBs) can also apply under the non-competitive bidding scheme.
Eligible investors have to place their bid through a bank or Primary Dealer (PD) for auction. Each bank or PD,
on the basis of firm orders, submits a single bid for the total sum of non-competitive bids on the day of the
auction.
The bank or PD will furnish details of individual customers, viz., name, amount, etc., along with the
application. The non-competitive bidding facility is available only in dated central government securities and
not in treasury bills.
What happens if the total amount offered for bidding via non-competitive bidding basis exceeds the
amount allotted?
In case the amount bid by PDs on behalf of the investors is more than the reserved amount through noncompetitive bidding, allotment would be made on a pro-rata basis. For example, the amount reserved for
allotment in an auction in noncompetitive basis is Rs 15 crore.
The total amount of bids for noncompetitive segment is Rs 20 crore. The partial allotment percentage is
=15/20=75%. That is, each bank or PD, who has submitted non-competitive bids received from eligible
investors, will get 75% of the total amount submitted.
ET in the classroom: Potential growth rate
The countrys policymakers seem to be fighting a losing battle with Inflation. Some economists link the
persistently high prices to the pace of economic growth. They say Indian economy is expanding at a rate beyond
its potential growth rate. ET examines the concept and its relationship with prices:
What is the potential rate of growth of an economy?
Potential output is broadly the maximum output growth that an economy can sustain over the medium to long
term without stoking inflation. In a recent report on India, the International Monetary Fund (IMF) estimates
Indias potential growth rate at 7-8%.
What factors decide the potential growth rate?
There are two major determinants of the potential rate at which an economy can grow in the long run. One is the
rate of increase in key inputs such as labour and capital, while the other is the rise in productivity. Within the
two key inputs, labour has a bigger say in determining the potential growth rate.
The increase in labour supply through an increase in number of workers or the numbers of hours put by a
given number of workers and an increase in labour productivity will result in an increase in the long-term
potential growth rate.
Anything that aids productivity increases can help boost potential growth rate. Infrastructure investments and
skilling of labour can raise Indias potential growth rate because the country has ample labour supply.
How does growing faster than the potential rate cause inflation?
The overall demand in the economy picks up due to fast growth and more resources are used to meet higher
demand. After a point, the economy may not find enough inputs to meet the demand, leading to an increase in
prices.
If there is surplus capacity in the economy then it can grow above the potential rate for a while. But for an
economy already working at full capacity, excessive demand results in increase in the price level.
The IMF says India was growing at a rate faster than its potential rate in 2007-08, but because of the financial
crisis in early 2009 substantial slack emerged in economy. It says the quick rebound from the crisis has
exhausted that slack and now there is a risk of high inflation if the Indian economy grows too fast.
ET in a classroom: How are poverty numbers calculated
Widespread poverty is the biggest challenge for Indias policymakers. The government has drawn criticism for
its inability to tackle the menace despite high economic growth. Some estimates place the number of poor at
40% of the population. ET looks at how poverty numbers are generated:
How is the poverty line defined?
The concept of poverty is associated with socially perceived deprivation with respect to basic human needs.
Historically, India has followed a poverty line, which is based on a minimum number of calories that an
individual should consume and a rupee amount was calculated on this basis. The existing rural and urban
official poverty lines were originally defined in terms of per capita total consumer expenditure (PCTE) at 197374 market prices and is adjusted over time and across states for changes in prices.
The method still retains the original 1973-74 all-India reference poverty line baskets (PLB) of goods and
services. These PLBs were derived separately for rural and urban areas, anchored in per capita calorie norms of
2400 (rural) and 2100 (urban) per day. People whose PCTE is below the required minimum are considered to be
below the poverty line.
What is the international poverty line?
The common international poverty line is based on an income of around $1 a day. In 2008, the World Bank
revised the figure to $1.25 at the 2005 purchasing power parity.
What is the new way to define the poor?
As the earlier estimates of poverty have been largely perceived as inadequate, a committee led by Suresh
Tendulkar came up with a new way to define the poor. Tendulkar moved away from calorie anchor while
testing the adequacy of actual food expenditure. The method uses same consumption basket for rural and urban
poor, but applies different price levels of rural and urban areas to arrive at the poverty estimate. The major
departure from the original method is the provision for including expenditure on health and education.
Does India need to redefine poor?
With India hitting a high growth trajectory, the living standards and consumption patterns in both urban and
rural areas have changed, while existing data continues to use consumption baskets that reflect trends prevalent
in 1973-74. Earlier poverty mechanisms also assumed that basic social services like health and education would
be supplied by the state; therefore even as both were covered in base year 1973-74, no account was taken for the
change in the proportion of expenditure in these services since then.
ET in the Classroom: Competition
Why is competition important? What is its economic rationale?
Competition, according to economic theory, forces firms to develop new products, services and technologies
which would give consumers greater choice and better products. If more and more firms deal in a similar
product, consumer choice widens. This causes product prices to drop below the level that would be if there were
no competition; that is, if there was just one firm (monopoly) or a few firms (oligopoly).
How is competition measured?
Competition is generally measured by calculating concentration ratios . Concentration ratios indicate whether an
industry consists of a few large firms or many small firms. Two of the most commonly used metrics are the
Herfindahl Hirschman Index (HHI) and the N-firm concentration ratio.
Herfindahl Hirschman Index:
Under the HHI, the market share of each firm in a relevant sector is squared and added to arrive at a statistical
measure of concentration. The value of the index varies from close to 0, indicating nearly perfect competition,
to 10,000, indicating the presence of just one firm, a monopoly. HHI = s1 2 + s2 2 +3 2 + + sn 2 (Where sn
is the market share of the nth firm, and s varies from close to zero to 100).
N-firm concentration ratio:
This method measures the dominance of the biggest firms in a particular sector. N in this case is the number of
firms being considered. A four-firm concentration ratio, for instance, would just sum up the market shares of the
four biggest firms in the market. Fewer firms having a large market share would indicate less competition.
to additional consumers without any huge additional cost), possibility of price exclusion and bestowing
externalities on society. However, these characteristics were not considered absolute.
For taxation purposes, the income-tax department considers companies dealing with electricity, water supply,
sewerage, telecom, roads & bridges, ports, airports, railways, irrigation, storage (at ports) and industrial parks or
SEZs as infrastructure. However, special tax benefits are also given to sectors like fertilizers, hospitals and
educational institutions, adding to the confusion.
The Reserve Bank of India and the Insurance Regulatory and Development Authority has also tried to define
infrastructure and identify sectors.
Why is a precise definition of infrastructure needed?
A clear understanding of what is covered under the rubric of infrastructure is necessary for policy formulation,
setting of targets, and monitoring projects to ensure consistency and comparability in the data collected and
reported by various agencies. Moreover, the emphasis on infrastructure has led to the government extending
many incentives and tax benefits to infrastructure companies. Without a proper definition these benefits can be
misused.
What is the international norm?
Globally, too, defining infrastructure has been an arduous task. The US and most European countries have
defined infrastructure sectors for tax purposes. There is no consistency across the developed world on what
constitutes infrastructure. Many countries have also identified sub-sectors like core infrastructure, social
infrastructure, retail infrastructure, and urban and rural infrastructure.
How is India approaching the issue?
The finance ministry will identify the sectors primarily based on the characteristics set out by the Rangarajan
committee with some additional requirements. Based on the criteria, the finance ministry is likely to notify 25
sectors as infrastructure. These sectors will be eligible for tax incentives, viability gap funding and will be
covered by regulatory framework for infrastructure which will include levy of user charges.
ET in the Classroom: corporate repo bonds
What is corporate repo bond?
Banks, corporate and primary dealers pledge corporate bonds with each other to raise short-term money. It is
similar to banks pledging government securities (gsec) with RBI to raise short-term money. Unlike pledging of
g-secs, here the borrower who pledges corporate bonds does not receive the entire value of the bond.
When did RBI allow repo in corporate bonds?
RBI guidelines on repo in corporate debt securities came into effect on March 1, 2010.These guidelines were
amended in December 2010 as the market participants demanded a reduction in hair-cut margins. It was
reduced from a flat rate of 25% to a band of 10-15%, depending on the rating of the corporate bond. According
to the amended guidelines, the settlements had to be made within two days of the deal.
How does the repo in corporate bonds work?
Investor A, who needs finance for an interim period, can issue these bonds while entering into an agreement
with investor B that at a given point of time he would buy back the bond from investor B, though the bond
issuer would have to suffer a hair-cut margin of 10-15%, which will vary according to the credit rating of the
bond.
How active is the repo in corporate bonds in India?
Only five deals have been reported so far. Companies that have issued corporate bonds in India are REC,
PFC, HDFC and NHB.
Interest rate paid on Casa is much lower compared to other deposits like term deposits or recurring deposits.
While banks do not pay any interest on current account, interest paid on savings account deposit is 4%. Banks
therefore make maximum effort to increase the share of Casa on their books to reduce their overall cost of
deposits. HDFC Bank has the highest share of Casa to total deposits at 52%, followed by the State Bank of
India at 48% and ICICI Bank at 45%.
What does Casa mean for customers?
Recently, RBI increased interest paid on savings account deposits from 3.5% to 4%. Further a year ago, RBI
told banks to pay interest on savings deposits on a daily basis rather than paying on the minimum balance
maintained by them in six months. As a result, savings account customers earn better returns compared to what
they earned a year ago. Further, interest earned on savings account deposits does not attract TDS (tax deduction
at source). Interest income above 10,000 a year attracts TDS of 10% in case of term deposits. However, there is
no major benefit for current account deposits, which is mainly maintained by corporates and traders.
What are the disadvantages of high Casa?
These deposits can move out of banks books anytime, leading to asset-liability mismatches. While in case of
term deposits, banks are almost certain that the depositor may not withdraw money before the maturity of the
deposit and may also renew the deposit on maturity. Further, to finance long-term projects, banks need to have
long-term liabilities on their books to avoid mismatches. Banks cannot rely on Casa deposits to fund long-term
loans.
ET in the Classroom: Sovereign debt crisis
What is sovereign debt crisis?
Sovereign debt crisis means the sovereign governments borrowing from domestic and external markets is in
excess of its capacity to repay, resulting in loan defaults requiring rescheduling of loans or bailout packages
from other countries or multilateral institutions such as IMF.
How did the Greek crisis originate?
The crisis in Greece surfaced in 2007-08, when it came to be known that Greece was not in a situation to meet
its repayment obligations to its external creditors. The budget deficit of Greece was in the range of 13.6% of its
gross domestic product. The stock of debt was equivalent to 115% of the gross domestic product. The debt
problem was further compounded by the fact that nearly three-fourths of the government debt was held by
foreign institutions, particularly foreign banks. Not only was the high fiscal deficit a problem, it was also
camouflaged by derivative hedging. Reportedly, investment banks misled investors into investing in
government bonds of Greece by being secretive about the actual state of affairs. The rating agencies played
accomplice and allegedly failed to assess the correct fiscal position.
Who bailed out Greece?
Greece reached an agreement with IMF, the European Commission and the European Central Bank on a
rigorous programme to stabilize its economy with the support of a $145-billion financing package against which
the Greek government was required to implement fiscal measures, structural policies and financial sector
reforms. Some of the points of the reform package were reducing the fiscal deficit to 3% by 2014, pensions
and wages to be reduced for three years, government entitlement programs had to be curtailed and social
security benefits cut.
ET in the Classroom: ESSENTIAL COMMODITIES ACT
The Prime Minister will soon hold a meeting of chief ministers to discuss the alarming food price situation and
review the implementation of Essential Commodities Act (ECA). ET looks at the ECA and how it can help
combat the rising prices of food articles.
So, under-recovery on diesel looks higher this year. In other words, oil companies want a higher price for diesel
partly because some refineries in other countries were shut down. Apart from this, oil companies also charge a
customs duty and a marketing margin, in addition to marketing cost, to calculate underrecovery. These are
profits, not costs.
Can oil companies be at a disadvantage by linking prices to under-recovery?
Yes. This may happen next year. In 2010, very little new refining capacity was added in Asia, while demand
was strong. Next year, China and the Middle East will add about 1 million barrels per day of refining capacity.
This is expected to increase supply of products and deflate refining margins. As a result under-recovery is
expected to fall.
ET in the Classroom: Leave Travel Allowance
What is Leave Travel Allowance?
Leave Travel Allowance (LTA) is the part of the remuneration granted to employees by the employer to provide
for personal travel expenses incurred during the year. Apart from the employee, it covers travelling expenses of
spouse, children as well as dependent parents and siblings. Further, the exemption is restricted to two children
born on or after October 1, 1998. There is no restriction on the number of children born before this date.
How does LTA save on tax outgo?
Under section 10 (5) of the Income-Tax Act, if an employee who is in receipt of LTA undertakes a journey
within the country, s/he can claim the value of the allowance exempt from income tax. For the purpose, the
individual should have been on leave for the period during which the journey was undertaken.
Can you claim it every year?
No. The exemption can be claimed only twice in a block of four calendar years. The current block has started
from January 1, 2010, and will last until December 31, 2013. The previous one ended on December 31, 2009. If
you do not avail of the concession in any particular block or undertake just one journey, you become entitled to
carry forward one journey to the next block. However, this has to be utilised in the first year of the new block.
For instance, if you availed of the concession just once instead of twice between January 1, 2006 and December
31, 2009, then you are allowed to carry forward the unused one into the subsequent block (2010-2013),
provided you undertake the journey in 2010 itself. A point to be noted here is that even if you dont avail of the
concession at all during a particular block, you can carry forward only one entitlement to the next block.
Can the entire amount be claimed as an exemption?
The exemption will depend on certain criteria specified. Firstly, it is the lower of the actual expenses incurred
and the allowance granted by your employer. Lets assume your LTA is Rs 10,000, but you end up spending Rs
15,000 on travelling. In such a case, the exemption will be allowed to the extent of Rs 10,000. Conversely, if
your LTA stands at Rs 15,000 and your actual expenses amount to Rs 10,000, you will still be entitled to a
deduction of only Rs 10,000.
Other parameters that decide the extent of exemption?
If you have opted to fly to the destination, an amount not exceeding the economy class airfare of the national
carrier by the shortest route to that city would be admissible as deduction. In case you are travelling by road or
rail, the cost of first class air-conditioned ticket to the destination by the shortest route would constitute the
benchmark. Besides, if your travel plan entails visiting multiple places during the trip, the destination farthest
from your place of residence would be taken into account for determining the exemption amount.
What if the travel bills are not submitted before the deadline?
If you fail to submit your travel bills pertaining to LTA claim with your employer within the time prescribed,
your employer would consider the amount of LTA paid as taxable and deduct income tax at the rate applicable
to you. However, you can claim LTA exemption at the time of filing your income tax return.
funds and the overnight call money rates are high and above the repo rate, banks approach the RBI to borrow
under the repo window.
Therefore, the repo rate becomes an effective policy tool as it would help bring down the rates in the overnight
market. The reverse hap-pens when money market rates fall below the reverse repo rate. Banks then park
surplus funds with the RBI through a reverse repo trans-action. As a result, when there is excess liquidity in the
system, the reverse repo is more effective. When liquidity is tight and banks need short-term funds from the
RBI to manage mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to the
system the reverse repo would become the operative policy rate as the RBI would be draining out funds from
the system.
Why is a narrow rate corridor desirable?
A narrow rate corridor means that short-term interest rates in the call money market will move within that band.
This band was earlier 150 basis points, which has now been lowered to 125 basis points. Effectively, the
narrower rate corridor will mean there will be less volatility in short term rates.
Do other central banks also have rate corridors?
Many developing countries have the rate corridors but central banks in developed and deeper financial markets
have a single rate. In the US, for instance, the Fed Fund rate is the key interest rate. Short term funds are
available at this rate to the eligible borrowers.
ET In the Classroom: Making a Case of Financial Inclusion
What is a business correspondent model?
In 2006, the Reserve Bank of India allowed banks to use non-bank intermediaries as business correspondents, or
business facilitators, to extend banking and other financial services to areas where the banks did not have a
brick and mortar branch present. The objective behind it was to aid the process of financial inclusion and
consequently take banking to the remotest areas of the country and make them bankable.
What do these correspondents do?
The business correspondent is nothing but a bank-in-person, who is authorised to collect deposits and extend
credit on behalf of the bank of small-ticket sizes. He also recovers principal interest of small value deposits, sale
of micro insurance, mutual fund products, pension products, receipt and delivery of small value
remittances/other payment instruments.
Who is eligible to be a banking correspondent?
RBI has allowed a host of entities to act as business correspondents (BCs) of banks. These include NGOs/MFIs
set up under Societies/Trust Acts; societies registered under Mutually-Aided Co-operative Societies Acts, or the
Co-operative Societies Acts of States; Section 25 companies, which are not-for-profit companies; companies in
which NBFCs, banks, telecom companies and other corporate entities or their holding companies do not have
equity holdings in excess of 10%; post offices and retired bank employees, ex-servicemen and retired
government employees.
How is a business facilitator different from a business correspondent?
Very often the term business correspondents is used interchangeably with the term business facilitators
(BFs). But RBI makes a clear distinction between the two. BFs are allowed to undertake only facilitation
services like identification of borrowers, collection and preliminary processing of loan applications, including
verification of primary information, creating awareness about savings and other products, processing and
submission of applications to banks and promoting and nurturing SHGs and follow-up of recovery and debt
counselling. However, facilitation of these services does not include conduct of banking business by BFs, which
is the exclusive function of business correspondents.
Textile machinery, for example, attracted an import duty of only 5% but the 4% SAD resulted in the duty
burden going up to nearly 10%. This led many textile units to prefer the EPCG, but the scenario may change
now in view of the governments decision to abolish SAD.
The government has been modifying the EPCG scheme over the years in line with the demands of the domestic
industry. The first change was the introduction of two windows the first one attracting 15% duty while the
second one attracted 25%. Those who preferred to pay higher duty under the second window had a lower export
obligation. In 95, the government offered duty-free imports under the first window while the duty under the
second was 15%. This was the first time duty-free imports were made available under EPCG.
Since the purpose of the scheme was to allow exporters compete internationally, it was decided to allow them to
buy machinery at internationally-competitive rates. The pent-up demand for imported machinery had peaked at
this point and the domestic industrys initial trouble with competing imports had come to an end. Thereafter, the
government even reduced the import duty on capital goods under the second window to 10% while the first
remained duty-free. Subsequently, the policy was changed in 00 to merge the two windows into one import
capital goods by paying 5% and undertake uniform export commitment.
Who were the major beneficiaries of the EPCG?
The manufacturing industries, especially those who had to import their capital goods, were the main
beneficiaries over the years. The service sector was nowhere in the picture till last year. Now service industries
like hotels can also avail of EPCG imports and fulfill the export obligation through the foreign exchange earned
by them.
This is a major concession for service providers who were ignored over the years. Since services now account
for nearly 50% of the countrys GDP, it is fair to allow service providers to imports goods at internationallycompetitive rates.
The attraction of EPCG has, anyway, diminished over the years and it will be a question of time before the
scheme becomes redundant. Import duties will come down over the years, especially in the case of capital
goods.
It will be curtains for the EPCG scheme once the duty on capital goods comes down to 5%. Going by the pace
at which India is signing free trade agreements, this possibility seems nearer. Like other outdated instruments
like the cash compensatory scheme (CCS) for exporters and the quantitative restrictions (QRs) on imports, the
once-popular EPCG will also exist only on records once the duty reduction materialises over a period of time.
ET in the classroom: The anatomy of layoffs
What are layoffs?
When companies discharge employees either temporarily or permanently because they have no money to pay
them or there is no work for them. The term is also known variously as downsizing, redundancy, right-sizing,
workforce optimisation and redeployment.
Several companies, banks and financial institutions across the world resorted to layoffs during the slowdown
after the collapse of Lehman Brothers in September 2008. In India, the term became more familiar during late
2008 and early 2009.
Are there any warning signs before jobs are shed?
Layoffs are a function of business sentiment. So job losses happen during slowdowns, which are usually
preceded by phases of high inflation.
During a slowdown, job markets tighten up as entities go on austerity drives to lower their administrative and
other costs. Generally, the next phase of critical action deals with rightsizing initiatives. Layoffs are imminent at
this stage.
KYC with foreign broker, foreign bank account to hold funds are too cumbersome for most investors. These
troubles are completely avoided in holding IDRs.
Will Indian investors get equal rights as shareholders?
Indian investors have equivalent rights as shareholders. They can vote on EGM resolutions through the overseas
custodian. Whatever benefits accrue to the shares, by way of dividend, rights, splits or bonuses will be passed
on to the DR holders also, to the extent permissible under Indian law.
Can IDRs be converted?
IDR holders will have to wait for an year after issue before they can demand that their IDRs be converted into
the underlying shares. However this conversion is subject to certain conditions:
a) IDR Holders can convert IDRs into underlying equity shares only with the prior approval of the RBI.
b) Upon such exchange, individual persons resident in India are allowed to hold the underlying shares only for
the purpose of sale within a period of 30 days from the date of conversion of the IDRs into underlying shares
c) Current regulations do not provide for exchange of equity shares into IDRs after the initial issuance i.e.;
reverse fungibility is not allowed
ET in the Classroom: Real and nominal exchange rates
The rupee has appreciated sharply against the dollar in the last few months, raising some concerns, especially
among exporters. The real issue, economists say, is not the exchange rate as we know, or the nominal exchange
rate, but the effective exchange rate. ET takes a look at the concept of real and nominal exchange rates.
What do real numbers mean?
The word real in economics as opposed to nominal is used to describe a metric, where the impact of
prices has been taken into account. For example, real GDP captures output of goods and services at constant
prices, removing the effect of inflation.
What is real exchange rate?
Real exchange rate can be defined as the rate that takes into account inflation differential between the countries.
Suppose the rupee was trading at Rs 40 to a dollar at the beginning of 2009. Assuming a 10% inflation in the
Indian economy and 5% inflation in the US economy for the whole year, then this model says the rupee should
depreciate by 5% (10%-5%) to Rs 42 to a dollar, other things being equal.
Why is the real exchange rate important?
Competitiveness of a countrys exports is decided not only by the nominal exchange rate, but also relative price
movements in domestic and foreign markets. For instance, even if the nominal exchange of the rupee remains
unchanged with respect to, say, the dollar, Indias exports to the US will become less competitive if inflation in
India is higher than in the US. This means nominal exchange rate will have to be adjusted for effect of inflation.
How is nominal exchange rate adjusted for inflation?
Central banks use the concept of real effective exchange rate, or REER, to adjust nominal effective exchange
rate for inflation. Conceptually, the REER is the weighted average of nominal exchange rates adjusted for the
price differential between the domestic and foreign countries. The price differential, however, is based on the
purchasing power concept. The currencies used are of those countries with which trade is the highest.
How does the RBI calculate REER?
The RBI calculates REER for India. It calculates the value of the rupee with respect to two indices, one
comprising six countries and the other 36 countries with a 2004-05 base. The RBI, however, uses the wholesale
price index-based inflation whereas globally consumer price indices are used. One conceptual flaw with this
model is that it assumes that the base exchange rate is the correct exchange rate or represents the purchasing
power parities accurately, which may not be the case.
The per capita income growth will vary between low to negative, and this over a sustained period of time, when
the economy is spiralling towards a recession again. Lower consumer spending would force producers to lower
their selling prices and thus cut down on its production costs, which will lead to higher rate of unemployment in
the economy.
When was the last major double dip recession?
Between 1980-1982, the US went into one of the double-dip recessions. The economy was in a recession in the
second and third quarters of 1980. It then recovered (by GDP standards) and fell back into recession in the
fourth quarter of 1981 and the first quarter of 1982.
One thing that happened during that time period that the US does not have now is inflation and high interest
rates. Though today, unemployment remains a concern in the US, which could be a trigger for another
recession. However, the Federal Reserve is determined to keep interest rates low throughout 2010.
ET in the classroom: India refuses market economy status to China
India has refused market economy status to China. ET looks at what it means for china?
What is a market economy status?
When a country accords market economy status to another country, it recognises that free market forces of
demand and supply are operating there. It accepts that economic variables such as prices and exchange rates are
not determined by the state. When a country recognises another as a market economy, it will have to accept
information on prices supplied by that country while contesting anti-dumping cases.
Why is India refusing to give the status?
India believes that Chinas corporate governance and accounting systems are not transparent and the country is
not following global best practices in its financial & banking systems and stock markets.
It had recently sent a questionnaire to China seeking information on key issues such as land laws, accounting
practices, minimum wages and electricity rates, which was the first step towards granting the status. China,
however, dismissed the move labeling the entire issue as a political one.
Is the issue economic or political?
The issue is both economic and political. China has the maximum cases of dumping exporting goods at
prices lower than those prevailing in its domestic market against it. India does not want to give the market
economy status to China as it would then have to accept all information on local prices supplied by China while
framing its dumping cases.
At present, India fights anti-dumping cases against China on the basis of prices prevailing in third countries
exporting the same product to India. Refusing to recognise China as a market economy also suits India
politically at the moment because of the renewed tension on the border.
A few years back when political relations with China were better, the ministry of external affairs was trying to
convince the commerce department to grant the status to the country.
Is India breaking multilateral trade rules?
Not at all. As per Chinas accession contract with the World Trade Organisation (WTO), members are not
obligated to recognise China as a market economy till 2016. Only about 60 countries have given China the
status. These countries include members of the 10-member Asean, which has a free trade agreement with China.
ET in a classroom: Laffer curve
The direct taxes code bill, recently tabled in the Lok Sabha, proposes to bring down the effective tax rates for
individuals and corporates. The government hopes this will increase tax collections. In the developed world, it
is being debated if tax rates should be increased to cut high deficits. The UK has already raised rates. The
economic principle that drives the debate is Laffer Curve. ET takes a look at the concept.
In a rising interest rate scenario, a bank often has to borrow at higher rate and is unable to shift the entire
incremental cost of borrowing to its customers. So the percentage increase in interest expense is more than that
in interest earned. And the difference between them, which is known as net interest income (NII) in banking
parlance gets compressed.
On the other hand, in a falling interest rate scenario, a bank normally improves its spread leading to high growth
in NII. In a rising interest rate scenario, the market value of banks investments fall, as price of investment is
inversely proportional to interest rate.
So a bank has to book losses on investment. In Indian context, banks have made huge strides in increasing the
share of non-fund based revenue, which includes revenue from distribution of insurance and mutual funds,
revenue from investment bank related activities like debt syndication and etc.
Such non-fund based revenue comes under other income, which contributes an important share to a banks
bottom line today.
What are the key items that determine the efficiency of a bank?
Be it a bank or any other company, its efficiency is measured by how well it utilises its assets. So in a banks
case return on assets (RoA) is very important measure to separate the wheat from the chaff.
The return from assets should not come at the cost of comprising the asset quality. And therefore, what
percentage of loan-book are non-performing assets (NPA) is another most important criterion. NPA is often
expressed as a percentage of advances.
Another important criterion to measure a banks efficiency is net interest margin (NIM), which is a measure of
spread between the interest rate at which a banks lend and borrows.
In Indian context, a 3% NIM is considered as a benchmark level. Among large banks, only a handful
includingHDFC Bank, Punjab National Bank & Axis Bank has been able to maintain that level of NIM. Banks
improve their NIM by controlling their cost of funds, which in turn is done by improving the share of low cost
current account and saving account (CASA) deposits in total deposits.
What are the other factors that display strengths or weaknesses of a bank?
A low NPA indicates high asset quality and vice versa. Apart from it, capital adequacy ratio (CAR) shows
whether the bank has sufficient capital to grow in short to medium term. Since banking is a capital-intensive
business, the regulator requires banks to maintain a minimum percentage of their assets as capital. As per
Reserve Bank of India (RBI) regulation, Indian banks have to maintain a minimum CAR of 9%. Most of the
Indian banks meet this regulatory requirement.
A capital adequacy ratio of higher than 9% indicates that the bank has sufficient capital to grow for sometime
without bothering to raise more funds. So a high CAR provides a kind of cushion to the bankers.
ET in the classroom: Compulsory licensing
ET explains Compulsory licensing, a provision that allows governments to override Patent rights
What is compulsory licensing?
Compulsory licensing is a process through which a government allows the local industry to produce drugs under
patent protection without the permission of the patent holder. While the global agreement on intellectual
property, the Trade Related Intellectual Property Rights (Trips) under the WTO, says that a patent holder will
have the sole right to give permission to produce its patented products on payment of a license fee, flexibilities
have been given to countries to address public health concerns by issuing compulsory licenses.
When can a government issue compulsory licenses?
These could be issued to address any public health concern as considered appropriate by the issuing country.
The Trips Agreement gives a country the freedom to decide when it wants to issue such licenses and it does not
necessarily have to be an emergency. It is generally issued for producing life-saving medicines to ensure their
availability at low prices.
Does compulsory licensing strip a patent holder off the right to collect license fees on patented products
or process?
Not at all. Companies that are issued compulsory licenses to produce a patented product have to pay adequate
remuneration based on the economic value to the patent holder, but there is no elaboration on what the value
is.
Why has India not been issuing compulsory licenses? Why has it suddenly woken up to the need?
While the Indian Patents Act provides for issuing of compulsory licenses, the procedural guidelines and the
policy framework for the same are not in place. India had been taking it easy so far, as it had a flexible patent
regime till 2005, which granted protection only to processes and not the final product. This allowed other
producers to manufacture generic versions using a different method.
However, ever since there was a switch-over to the more stringent product patent regime in 2005 (under which
a patented product cannot be produced through any other process) to meet the countrys commitments under
Trips, the country has been facing a shortage of life-saving drugs such as anti-cancer medicines and prices of
patented versions have been going up. This prompted the DIPP to float a note on compulsory licensing inviting
comments on how the country should go about implementing it.
Can compulsory licenses be issued for exporting to other countries?
Compulsory licenses are generally issued for producing for the domestic market. However, during the Doha
ministerial meet in 2001 the WTO recognised that there are countries which do not have manufacturing
capacities and allowed such countries to import generic versions from other countries by issuing compulsory
licenses.
ET in the classroom: All about rate corridor
In the monetary policy on Wednesday, the RBI raised the repo rate by 25 basis points to 5.75% and the reverse
repo rate by 50 basis points to 4.5%. This has narrowed the rate corridor from 150 basis points to 125 basis
points. ET demystifies the concept of rate corridor.
What are repo and reverse repo rates?
Repo rate is the rate of interest charged by the central bank when banks borrow money from it. It is the tool
through which the RBI in-fuses funds into the system by lending to banks against pledging of securities.
The reverse repo is the rate the RBI offers to banks when they deposit funds with it. The RBI drains out
liquidity from the financial system through reverse repo by releasing bonds to the banks. This is a daily
operation by the central bank to manage liquidity Over a longer time, the RBI can also manage liquidity through
open market operations.
What is an interest rate corridor?
Interest rate corridor refers to the window between the repo rate and the reverse repo rate wherein the reverse
repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the overnight interbank call money market,
where lending and borrowing is unsecured, should move within this corridor. However, when banks are short of
funds and the overnight call money rates are high and above the repo rate, banks approach the RBI to borrow
under the repo window.
Therefore, the repo rate becomes an effective policy tool as it would help bring down the rates in the overnight
market. The reverse hap-pens when money market rates fall below the reverse repo rate. Banks then park
surplus funds with the RBI through a reverse repo trans-action. As a result, when there is excess liquidity in the
system, the reverse repo is more effective. When liquidity is tight and banks need short-term funds from the
RBI to manage mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to the
system the reverse repo would become the operative policy rate as the RBI would be draining out funds from
the system.
Why is a narrow rate corridor desirable?
A narrow rate corridor means that short-term interest rates in the call money market will move within that band.
This band was earlier 150 basis points, which has now been lowered to 125 basis points. Effectively, the
narrower rate corridor will mean there will be less volatility in short term rates.
Do other central banks also have rate corridors?
Many developing countries have the rate corridors but central banks in developed and deeper financial markets
have a single rate. In the US, for instance, the Fed Fund rate is the key interest rate. Short term funds are
available at this rate to the eligible borrowers.
ET in the classroom: New concepts & ideas in Budget 2013
The budget for 2013-14 introduced some new concepts and ideas. ET explains some of these items.
Service tax voluntary compliance encouragement scheme
A one-time amnesty for those who have collected service tax but not deposited the same with the government.
Those service tax providers that have not filed service tax return since October 2007 can disclose true liability
and get an interest or penalty waive off.
Commodities Transaction Tax (CTT):
This is on the lines of securities transaction tax levied on sale and purchase of shares on stock exchanges. The
tax will be levied on nonagricultural commodities futures at 0.01 per cent of the trade value, the same rate as
that on equity futures.
Investment Allowance
A tax break given to companies for high value investment in plant and machineries, over and above
depreciation benefits enjoyed by them. A company investing Rs 100 crore or more in plant and machinery
during the April 2013 to March 2015 will be entitled to deduct an investment allowance of 15 per cent of the
investment. This is expected to see enormous spill-over benefits to small and medium enterprises.
Inflation-Indexed Bonds
The government hopes this will help increase financial savings instead of buying gold. In the recent years the
rate of return on debt investments has often been below inflation, which effectively means that inflation was
eroding savings. Inflation indexed bonds provide will provide returns that are always in excess of inflation,
ensuring that price rise does not erode the value of savings.
ET in the classroom: Goodwill Impairment (2013)
What is goodwill impairment?
Goodwill is a set of unidentifiable intangible assets through which an enterprise is supposed to derive future
economic benefits, explains Arijit Barman.
What constitutes goodwill?
It is generally recognised or booked in a transaction where a business is being purchased by one entity from
another. It is the excess of the total consideration paid for the business over the value of all its other assets and
liabilities (referred to as net assets). Under the Indian accounting framework, goodwill can originate in a merger
or acquisition through a high court-prescribed scheme or it may be recorded on account of consolidation of
acquired entity by the holding company or when a group of assets are purchased for a lump-sum consideration.
Indian GAAP prohibits capitalisation of internally generated goodwill.
There are Nidhis or benefit companies in the South, but they are much smaller in size. Here, one has to become
member by paying a token fee. Members can deposit money as well as borrow. Like chit funds, there is no cap
on money that can be raised.
Are there ways to sidestep regulations?
An influential Andhra businessman tried it a few years ago by using an HUF (or Hindu undivided family) entity
to raise collections. It was a unique structure where beneficiaries of the HUF were family members, but
depositors were general public. There was no explicit ban on this. But the then state government opposed it.
What about the Sahara model?
Sahara raised money by issuing optionally fully convertible debentures to crores of investors. But others cant
take this route any more with the Supreme Court backing SEBI that such securities have to be listed and
regulatory approval is a must if number of investors is more than 50.
Is it end of road for shoddy operators?
It will be tougher for them. But public memory is short. And, scamsters stay ahead of rule makers. In a country
as large as India, its almost impossible to stop cheat funds.
ET in the classroom: Qualified foreign Investors get direct entry
On January 1, the government decided to allow Qualified Foreign Investors, or QFIs, to invest directly in the
Indian equities market, a move which it hopes will help boost capital inflows.
Who are qualified foreign investors?
Qualified foreign investors, or QFIs, can be individuals, groups or associations based abroad who are allowed
by the government to invest directly in mutual funds and stocks of Indian companies.
Last year, the government opened a new window for this class of investors to buy into Indian mutual funds
directly. It has now gone one step further and allowed them to buy into stocks, too, just like registered foreign
institutional investors or nonresident Indians, or NRIs.
Are QFIS a separate class of foreign investors compared to FIIs?
Qualified Foreign Investors will be distinct from foreign portfolio investors and non-resident Indians. A QFI
can, for instance, be a foreign individual investor in Singapore or Russia, who can buy into stocks of a Tata
group company or Coal India or any other listed stock after fulfilling the Know Your Customer norms through
an Indian depository participant and obtaining the approval of the RBI.
QFIs can buy up to 5% of the paid-up capital of a company, with the overall limit capped at 10% in a company.
And these investment limits are separate or over and above that for FIIs and NRIs.
How does it help by opening up the markets to one more categories of investors?
Indian policy makers reckon that a diverse set of investors in the local markets will help ensure more capital
inflows, reduce market volatility and deepen the markets. It would also mean facilitating the entry of a set of
relatively wealthy investors who could not access the Indian markets as there were regulatory restrictions on
their entry.
For a long time, the government and regulators kept foreign individual investors at bay owing to concerns
relating to money laundering and due diligence. With restrictions in place, foreign individual investors had to
either buy into Indian stocks through Participatory Notes, or PNs, or invest in India-focused offshore funds.
By allowing a new set of investors, the government and regulators are hoping that it will lead to more inflows at
a time when capital inflows have virtually dried up.
investors can also attach true copies attested by a notary or a gazetted officer or a manager of a scheduled
commercial bank of a multinational foreign bank. Investors need not visit POS in person. The application can
be routed through mutual fund distributors or a representative of investors. The original documents are verified
at the counter and given back to the applicant or representatives of the applicant.
Non-resident Indians also need to undertake the same process. They additionally have to provide certified true
copy of their overseas address. If the same is in foreign language other than English, the same has to be
translated in English for submission. The documents can be attested by the consulate office or overseas
branches of scheduled commercial banks registered in India.
POS upon verification of the documents and receipt of duly filled-in application form issues an
acknowledgement letter free of cost. The letter needs to be duly stamped and signed by representatives of POS.
In the case of joint holdings in a portfolio, all joint holders have to get themselves KYC-compliant.
Applications where the investments are in joint names, photocopies of KYC acknowledgement letters of all
applicants must be attached with the application form. In the case of investments in the name of minors, the
KYC acknowledgement letter of the guardian is a must.
What should you do with KYC acknowledgement letter?
Please note that neither POS nor CVL will inform about the KYC exercise you have completed in respect of
any of the mutual fund houses. It is your responsibility to do so. You can attach a photocopy of KYC
acknowledgement letter, along with the application letter, at the time of fresh investments. You can simply
write to the fund houses where you have an investment and request them to update your KYC status. Such
requests must be accompanied by the photocopies of the KYC acknowledgement letter. You can also attach the
photocopy of KYC acknowledgement letter with your request for additional investments in your mutual fund
portfolio.
A point to note that upon submission of your KYC acknowledgement letter, the mutual fund house will update
your status in their books. The address mentioned in your KYC letter will prevail over the address you have
mentioned in your original application. All future correspondence by the fund house will be maintained at the
address mentioned in the KYC letter.
ET in the classroom: Forwards contract, over the counter
What is a Non-Deliverable Forward, or NDF?
Non-deliverable forwards are over-the-counter transactions settled not by delivery but by exchange of the
difference between the contracted rate and some reference rate such as the one fixed by the Reserve Bank of
India.
The need for an NDF market arose because there were countries where forwards trading in currencies is not
allowed or is allowed with a lot of restrictions that increases the cost of hedging for corporates. Also, such a
market was felt necessary for economies with partially convertible currencies.
Where do these trades happen? Which are the prominent currencies?
NDF trading happens in cities such as Singapore, London, New York and Hong Kong. Brazilian Real, Chinese
Renminbi, Taiwanese dollar, South Korean won and Indian rupee are among the prominent currencies.
Who trades in NDFs?
Hedge funds and foreign institutional investors, which are allowed to hedge only their actual exposure and not
potential exposure; global corporations that do their invoicing in Indian rupee but are not allowed to hedge their
exposures; and speculators betting on the direction of the rupee without any exposure.
How does an NDF transaction occur?
An Indian corporate that is registered in, say, Singapore under a different name and has nothing to do with its
Indian counterpart legally, may buy dollars from the spot market in India (Mumbai) at, say, 53.60 per dollar (the
reference rate) and sell it in the NDF market in Singapore at 54 per dollar (the contract rate), making an
arbitrage of 40 paise. The transaction is carried out by a foreign bank that has branches in both Mumbai and
Singapore.
Will NDF market movements affect spot rates?
Yes, they do to some extent and mainly through international banks and companies that take offsetting positions
in the domestic and overseas books.
Will RBI curbs on overnight positions affect NDFs?
Yes, it will squeeze international banks that were profiting from the wild currency movements through their
positions in the NDF market while pressuring the spot market due to temporary factors. RBI studies had shown
weak linkage between the domestic and NDF markets when the currency movements are in a narrow range.
What are fixing and settlement dates?
The fixing date is the date on which the difference between the prevailing market exchange rate and the agreed
upon exchange rate or the reference rate is calculated.
Budget 2012: All you wanted to know about DTC and other taxes
ETs helps readers navigate through the maze of tax jargon:
Direct Taxes: Its the tax individuals & companies pay directly to the govt.
Corporation Tax: Its the tax companies pay (30% at present) on their profits.
Taxes On Income Other Than Corp Tax: Its income-tax paid by individuals or non-corporate assessees.
This ranges from 10% to 30%, depending on income.
Securities Transaction Tax ( STT): Applicable if youre dealing in shares or mutual fund units. It was
introduced in the 2004-05 budget, replacing the tax on profits earned from the sale of shares held for more than
a year (known as long-term capital gains tax).
Minimum Alternate Tax (MAT): Indian companies pay 30% tax on profits as per the I-T Act. But tax
holidays could lower the outgo. If a companys tax liability is less than 10% of its profits, it has to pay a MATof
15% of book profits. This provision is expected to change once the direct taxes code (explained below)
proposals are accepted. Under DTC, MAT will be levied on gross assets.
Indirect Taxes: Its essentially a tax on expenditure. Considered regressive, this tax does not distinguish
between the rich and the poor and hence most governments prefer to raise their revenues through direct taxes.
Customs: Anything you bring from abroad comes at a price. By levying a tax on imports, the government
achieves twin objectives: it raises revenues and protects local industries.
Union Excise Duty: Imposed on goods manufactured in the country.
Service Tax: You pay the government when you eat out or visit your hairdresser it is a tax on services
rendered. Levied on 119 activities.
Value-Added Tax: State governments levy this on goods at the point of sale, based on the difference between
the value of the output and the value of inputs used to produce it. The aim here is to tax a firm only for the value
it adds to the inputs, and not the entire input cost. Thus, VAT helps avoid a cascading of taxes.
Tax Reforms Goods and Services Tax: The proposed GST is expected to streamline the indirect tax regime. It
contains all indirect taxes levied on goods, including central and state-level taxes. Billed as an improvement on
the VAT system, a uniform GST is expected to create a seamless national market. It could also mean lower
taxes.
Direct Taxes Code: The I-T Act came into effect nearly half a century ago. To account for the new business
and activities that have come since then, the government formulated the DTC. It proposes to simplify tax laws
and include a new way to calculate taxes on income.
Budget Process
The governments annual budget is no different from that of a household; only it has a lot more jargon. In a five
part series, ET will help readers make sense of the key items of the budget, from revenue account to the much in
debate fiscal. In the first part, we explain the basic architecture of the budget:
Annual Financial Statement
The ordinary man confuses the finance ministers budget speech for the annual budget. But as laid down in the
constitution, the budget actually refers to the annual financial statement tabled in Parliament along with the 1315 other documents. Divided into three parts Consolidated Fund, Contingency Fundand Public Account it
has a statement of receipts and expenditure of each.
Consolidated Fund
This is the core of the govts finances. All revenues, money borrowed and receipts from loans it has given flow
into this account. All government expenditure is made from this fund. Any expenditure from this fund requires
the nod of Parliament.
Contingency Fund
All urgent or unforeseen expenditure is met from this ` 500-crore fund, which is at the disposal of the President.
Any amount withdrawn from this fund is made good from the Consolidated Fund.
Public Account
All money in this fund belongs to others, such as public provident fund. The government is merely working as a
banker in respect of this fund.
Revenue Receipt/Expenditure
All receipts like taxes and expenditure like salaries, subsidies and interest payments that do not entail sale or
creation of assets fall under the revenue account.
Capital Receipt/Expenditure
Capital account shows all receipts from liquidating (eg. selling shares in a public sector company) of assets and
spending to create assets (lending to receive interest).
Revenue Vs. Capital
The budget has to distinguish all receipts/expenditure on revenue account from other expenditure. So all
receipts in, say, the consolidated fund, are split into Revenue Budget (revenue account) and Capital
Budget(capital account), which include non-revenue receipts and expenditure.
Revenue/Capital Budget
The government has to prepare a Revenue Budget (detailing revenue receipts and revenue expenditure) and a
Capital Budget (capital receipts & capital expenditure).
ET in the classroom: All you want to know about Economic Survey
The first Economic Survey was reportedly presented for the financial year 1951-52 and since has been
presented every year as a review of the economy by the government. Over the years, the Economic Survey has
transformed from a mere representation of facts to a more suggestive document giving out advice.
What Is The Economic Survey?
The Economic Survey is a yearly report card of the economy put out by the Chief Economic Advisor. It is a
comprehensive document that analyses important economic, financial and social developments over the year.
Over the years, it has expanded to accommodate more sectors and include more of analytical content. From 362
pages in 2004-05, the survey has grown to a 459 page document in 2010-11 that included separate chapters on
prices, financial intermediation, and service, reflecting their importance in the economic debate.
These were originally created to allow multinational companies to evade exchange controls. Today, they are
used to hedge against or speculate on changes in interest rates. Interest rate swaps are also used speculatively by
hedge funds or other investors who expect a change in interest rates or the relationships between them.
Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value
increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as
rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
How does it work?
In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a
particular currency to the other counter party. The fixed or floating rate is multiplied by a notional principal
amount (say, $1 million).
This notional amount is generally not exchanged between counter parties, but is used only for calculating the
size of cash flows to be exchanged.
The most common interest rate swap is one where one counter party A pays a fixed rate (the swap rate) to
counter party B while receiving a floating rate (usually pegged to a reference rate such as LIBOR - London
InterBank Offered Rate).
A pays fixed rate to B (A receives floating rate)
B pays floating rate to A (B receives fixed rate).
Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of
3.784%, in exchange for periodic floating interest rate payments of LIBOR + 70 bps (0.70%). There is no
exchange of the principal amount and that the interest rates are on a notional principal amount.
The interest payments are settled in net. The fixed rate (3.784% in this example) is referred to as the swap rate.
What are the different types of swaps?
Being OTC instruments, interest rate swaps can come in a huge number of varieties and can be structured to
meet the specific needs of the counter parties. By far the most common are fixed-for-floating, fixed-for-fixed or
floating-for-floating.
The legs of the swap can be in the same currency or in different currencies. The above example is a specimen of
fixed-for-floating swap. Fixed-for-fixed works the same way except that there is no change in the rate used
during the date of payment, as does floating-for-floating swap.
ET in the classroom: Deposit Insurance
What is deposit insurance?
It is a limited level of protection provided by the government to depositors against bank failures. Every bank is
mandatorily covered under the level of Deposit Guarantee and the Insurance Corporation of India. It is
particularly relevant in countries like India where financial literacy is very low. At a macro-level, its objective is
to contribute to the stability of the financial system.
Which entities are covered under deposit insurance in India?
All commercial banks, including the branches of foreign banks functioning in India, local area banks and
regional rural banks are covered under the deposit insurance scheme. Even co-operative banks are covered. The
scheme, however, does not cover deposits with NBFCs and company fixed deposits.
What is the amount covered and how is the premium charged?
Under the provisions of the DICGC Act, the insurance cover deposits up to Rs 100,000 under the deposit
insurance. The premia to be paid by insured banks are computed on the size of their deposits. Insured banks pay
advance insurance premia to the Corporation semi-annually, within two months from the beginning of each
financial half year, based on its deposits at the end of previous half year. The premium is currently pegged at Re
1 for every Rs 1,000 of the deposits.
However, as these economies started opening up in the 80s, capital controls were eased, facilitating free flow of
capital and ensuring integration with global financial markets.
What are capital inflows?
From the perspective of balance of payments a countrys external sector balance sheet foreign currency
inflows are broadly divided into current account and capital account flows. While current account flows arise
out of transactions in goods and services and are permanent in nature, capital account flows are essential in
various kinds of loans and equity investments, which can be reversed. That is why policy makers have to keep a
close eye on capital flows.
What are the kinds of capital inflows in India?
These would include inflows through foreign borrowings by Indian corporates and businesses, NRI deposits and
portfolio flows from institutional investors into the stock markets Loans to government and short-term trade
credit are also included.
What has been the extent of dismantling of capital controls in India?
India had controls on both capital account transactions as well as on the current account with the local currency
fixed by the central bank. However, since 1991, when structural changes to the Indian economy were carried
out, the rupee was first made convertible on the current account. Subsequently, capital controls were eased. In
1994, a big shift took place with the government allowing foreign portfolio investments. Over a period of time,
foreign direct investment norms and overseas borrowing norms were eased.
Why are policy makers thinking of reimposing controls?
Though allowing foreign capital allows firms in a capital scarce economy to access cheaper resources to finance
their growth plans, the flip side is that it presents risks to value of the countrys currency as well as managing
local liquidity arising out of such inflows (as the central bank buys the foreign currency and pumps in local
currency).
Dependence on foreign capital could leave a country vulnerable to risks, arising out of a abrupt reversal of
flows. With many emerging economies remaining relatively unscathed after the global financial crisis, there has
been a surge in such inflows, leading to an appreciation in their currencies, including in India. But inflows
beyond the absorptive capacity of an economy pose other challenges such as high demand side inflation.
ET in the Classroom: Understanding Aviation Industry Jargon
Aviation business is riddled with gobbledygook such as code-sharing and business aviation to name a few. ET
simplifies and explains the industry lexicon.
What is passenger seat factor (PSF)? Does a high PSF suggest better performance?
The passenger seat factor is a percentage measure of seat occupancy on a flight. However, in itself, a high PSF
does not mean that the airline is making money. The flights could be having high occupancy because of the low
fares offered.
What is code-sharing? Why do airlines enter into such arrangements?
Each airline is identified by a code assigned to it. Code-sharing is a marketing alliance between two carriers.
Under such an arrangement, an airline can sell seats in its own name on sectors it does not have operations by
booking tickets on the flight operated by the airline with which it has a code-sharing pact.
For example, if a person intending to fly to Berlin has gone to Air Indias website then he or she would find a
flight even if the national carrier does not operate to the German capital. The passenger would locate a
Lufthansa flight on Air Indias website as the two have a code-share agreement. Without the arrangement,
airlines would lose traffic to bigger rivals. Such an arrangement is extremely beneficial for smaller airlines.