S.P.

Jain Institute of Management & Research, Mumbai

Making Sense of It….

Abridged Volume – I

The Economic Forum - 2008

As a part of our endeavour to share with you the very best of the world of economics, we present an
abridged volume of Making Sense of It.

This volume covers all the topics covered under the Making Sense of It emails for the period 22nd
August 2008 to 14th October 2008.

We hope you will find this compilation a useful ready reckoner.

We sincerely thank Prof. Preeta George for her highly valuable inputs.

Eco Forum Committee 2008

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GDP – Gross Domestic Product
What it means?

1) A measure of total investment. ‘Gross’ indicates that it is measured without subtracting

any allowances for ‘Capital Consumption1’; ‘domestic’ that it measures activities located
inside the country regardless of their ownership. It thus includes activities carried on in the
country by foreign owned companies and excludes activities of firms owned by residents but
carried out abroad. ‘Product’ means that it is a measure of the real output produced rather
than output absorbed by residents. GDP is reported at both current prices and constant
prices (Indexed prices).

Source: Oxford Dictionary of Economics

Faculty Speak: "GDP is a measure of the value of all goods and services produced in an
economy in a year. This value is also equal to the incomes of those who have contributed to
this value, which of course turns out to be the total income of all factor resources."

Extra
1
Capital Consumption: Loss of value of capital due to use ageing or obsolescence. (In simpler
terms, Depreciation)

Where to find: Most commonly found in Economy section of ET

Making Sense of it…. (22 Aug, 2008)

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Components of GDP - Consumption
What it means?

GDP is a measure of the value of all goods and services produced in an economy in a year.
The expenditure method is the most common method to measure and understand GDP.

GDP = Consumption + Gross Investment + Government Spending + (Exports - Imports)

i.e. GDP = C + I + G + (X-M).

Here is explanation to the first component.

Consumption Expenditure (C) is money spent by households and businesses on purchase of

goods & services in the economy in the current year. It includes most personal expenditure
of households such as food, rent, and medical expenses and so on.

Where to find: Most commonly found in Economy section of ET

Making Sense of it…. (26 Aug, 2008)

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Components of GDP - Investment
What it means?

GDP is a measure of the value of all goods and services produced in an economy in a year.
The expenditure method is the most common method to measure and understand GDP.

GDP = Consumption + Gross Investment + Government Spending + (Exports -Imports)

i.e. GDP = C + I + G + (X-M).

Here is the explanation to the second component.

Gross Investment (I) represents spending on creating new capital goods, before making any
allowance for 'capital consumption' or depreciation. "Investment" thus represents the
money spent by households and businesses on the acquisition of "Investment Goods", i.e.
goods which are designed to be used for further production as opposed to consumption.

Gross Investment minus Capital Consumption is "Net Investment". Capital Consumption

a.k.a Depreciation is an estimate of the loss of the value of capital goods through wear and
tear, the passage of time, or technical obsolescence.

Where to find: Most commonly found in Economy section of ET

Making Sense of it…. (August 29, 2008)

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Components of GDP – Government
Spending
What it means?

GDP is a measure of the value of all goods and services produced in an economy in a year.
The expenditure method is the most common method to measure and understand GDP.

GDP = Consumption + Gross Investment + Government Spending + (Exports-Imports)

i.e. GDP = C + I + G + (X-M).

Here is the explanation to the third component.

Government spending or government expenditure is classified by economists into three

main types.

1. Government purchases of goods and services for current use are classed as
government consumption.

2. Government purchases of goods and services intended to create future benefits, such
as infrastructure investment or research spending, are classed as government investment.

3. Government expenditures that are not purchases of goods and services, and instead
just represent transfers of money, such as social security payments, are called transfer
payments.

The first two types of government spending, namely government consumption and
government investment, together constitute one of the major components of gross
domestic product.

Where to find –

1. www.finmin.nic.in

2. The Budget Document

3. Document on the Economic Survey released every year

Making Sense of it…. (September 1, 2008)

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Foreign Exchange Reserves
What it means?

Liquid assets held by a country’s central bank for the purpose of intervening in the foreign
exchange market, is called a foreign exchange reserve. These liquid assets can be in the
form of gold, foreign currencies, or foreign government bonds. This also includes the
reserves maintained by the country in a special account in IMF (international monetary
fund).

Foreign Exchange Reserves are funded by two major transactions; Transactions of trade, and
transactions of capital.

Transactions of trades are nothing but earnings from export of merchandise and services.

Transaction of capital, involves receipts in the form of FDI, FII, and remittances from
individuals abroad.

Experts believe that the value of reserves should be able to fund the country’s import bills
for up to 3 months, and thereby denote that value as the optimal value. However this may
largely be relegated only to an ideal case, as most reserves are either way over or under that
level.

Foreign Reserves of notable states is as under: Source Wikipedia.com

Rank Country/Monetary Authority Billion USD (end of month) Change in year 2007
1 People's Republic of China $ 1809 (June) +43.3%
2 Japan $ 1004 (April) +8.7%
3 Russia $ 597 (August 01) +56.8%
— Eurozone $ 563 (March) +16.6%
4 India $ 297 (August 22) +64.4%
5 Taiwan $ 291 (July) +2.7%
6 South Korea $ 260 (April) +9.7%
7 Brazil $ 204.194 (Aug 14) +105.9%
8 Singapore $ 176 (April) +19.1%
9 Hong Kong $ 160 (April) +14.6%
10 Germany $ 144 (April) +20.3%

Large reserves of foreign currency allow a government to manipulate exchange rates -

usually to stabilize the foreign exchange rates to provide a more favourable economic

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environment. In theory the manipulation of foreign currency exchange rates can provide the
stability, but in practice this has not been the case.

There are costs in maintaining large currency reserves. Fluctuations in exchange markets
result in gains and losses in the purchasing power of reserves. Even in the absence of a
currency crisis, fluctuations can result in huge loses. For example, China holds huge U.S.
dollar-denominated assets, but the U.S. dollar has been weakening on the exchange
markets, resulting in a relative loss of wealth fro China.

Extra:

Foreign Exchange Reserves are used as a country’s defence against fluctuations in its
currency value. If the Dollar is gaining against the INR and say reaches 45 INR to a dollar,
then the RBI may intervene, by selling some dollars out of its reserves, and thereby provide
support to the INR at that level and provide and indicator to the market. This is generally
what is meant by RBI intervention or central bank intervention.

Making Sense of it…. (8 Sept, 2008)

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 Balance of Trade
What it means?

The balance of trade or Trade Balance or net exports (symbolized as NX) is the difference
between the monetary value of exports and imports in an economy over a certain period of
time. A positive balance of trade is known as a trade surplus and consists of exporting more
than is imported; a negative balance of trade is known as a trade deficit or, informally, a
trade gap.

Balance of Trade is the largest component of the country's balance of payment. Factors that
can affect the balance of trade figures include:

• Prices of goods manufactured at home (influenced by the responsiveness of supply)

• Exchange rates

• Trade agreements or barriers

• Other tax, tariff and trade measures

• Business cycle at home or abroad.

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

DEPARTMENT OF COMMERCE
ECONOMIC DIVISION
EXPORTS & IMPORTS : (PROVISIONAL)
JULY APRIL-JULY
EXPORTS (including re-exports)
2007-2008 50331 194689
2008-2009 70018 248498
%Growth 2008-2009/ 2007-2008 39.1 27.6
IMPORTS
2007-2008 74091 306946

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 2008-2009 116276 421541
%Growth 2008-2009/ 2007-2008 56.9 37.3
TRADE BALANCE
2007-2008 -23760 -112257
2008-2009 -46258 -173043
*Figures (in Rs Crores) for 2007-08 are the latest revised whereas figures
for 2008-09 are provisional.

Making Sense of it…. (12 Sept, 2008)

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Current Account Deficit

What it means?

The difference between a nation's total exports of goods, services and transfers, and its
total imports of them. Current account balance calculations exclude transactions in financial
assets and liabilities.

A Current Account Deficit occurs when a country's total imports of goods, services and
transfers are greater than the country's total export of goods, services and transfers. This
situation makes a country a net debtor to the rest of the world. Contrarily, a Current
Account surplus is when a country's total imports of goods, services and transfers is lesser
than the country's total export of goods, services and transfers. This situation makes a
country a net creditor to the rest of the world. Hence current account surplus increases a
country's net foreign assets by the corresponding amount, and a current account deficit
does the reverse.

A substantial current account deficit is not necessarily a bad thing for certain countries.
Developing counties may run a current account deficit in the short term to increase local
productivity and exports in the future. This shall be taken up in more detail in further
discussions of “Word a Day”.

India has a current account deficit of 1.04 billion dollars for the fourth quarter of 2007-08
against a surplus of $4.25 billion a year ago. With this, according to data released by Reserve
Bank of India, the current account deficit has risen by 77 per cent to touch $17.4 billion,
constituting 1.5 per cent of GDP last fiscal, against $9.8 billion or 1.1 per cent of GDP in
2006-07.

[Unpublished]

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Country’s Capital Account
What it means?

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

Capital Account = Foreign Direct Investment + Portfolio Investment + Other Investments

Where Foreign Direct Investment is given as = Increase in foreign ownership of domestic

assets - Increase of Domestic ownership of foreign assets,

Portfolio Investment = Net Purchases of Investment Instruments by Foreigners across asset

classes,

And Other Investments Include = loans taken, given and re-payed etc.

To attract Foreigners to invest in the country, the government works on setting up an

attractive business environment, and takes policy measures that fosters business expansion.
Generally lowering tax rates are one of the primary measures that attract foreign money
into the country. Other Eco-Political factors like liquid secondary markets, easy norms follow
the pattern.

Extra:

Many Countries control the outflows and inflows in this account by various measures. These
measures could be in the form of restricting purchase of assets by foreigners or by placing a
lower limit on the time unto which the investment cannot be liquidated. Such measures are
in effect taken to prevent the flight of capital. The first signs of a flight of capital are in the
form of depreciating currency.

India which has seen its currency depreciate from 39 to 46 to a dollar is currently
experiencing this phenomenon. This is due to changes in FII Flows, which have turned
negative on FII’s selling their Indian Investments in the secondary market.

Statistically India’s Balance of Payments: That is Current Account + Capital Account is given
as under:

(It clearly shows the way India is financing its import led growth, by having a Capital Account
Surplus and a Current Account Deficit.)

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 India’s Balance of Payments
(US $ million)

Item 2006- 2006-07 2007-

07 P 08
April- April- July- Oct.- Jan- April-
March June PR Sept. PR Dec. PR March P June P
Merchan 1,27,090 29,674 32,700 30,664 34,052 34,960
dise
Exports
Merchan 1,91,995 46,620 48,562 47,529 49,284 56,540
dise
Imports
Trade -64,905 -16,946 -15,862 -16,865 -15,232 -21,580
Balance
(-7.1)
Services 1,19,163 24,643 25,597 31,658 37,265 31,432
Receipts
Services 63,867 12,264 14,565 17,568 19,470 14,549
Payment
s
Services, 55,296 12,379 11,032 14,090 17,795 16,883
net
-6
Current -9,609 -4,567 -4,830 -2,775 2,563 -4,697
Account
(-1.1)
Capital 46,215 10,946 7,100 10,280 17,889 15,897
Account
(net)*
of which:

Foreign 8,437 1,416 2,426 2,558 2,037 461

Direct
Investm
ent
Portfolio 7,062 -505 2,152 3,569 1,846 7,458
Investm
ent
External 16,084 3,959 1,458 3,994 6,673 7,048
Commer
cial
Borrowin
gs +
Short- 3,275 417 1,554 -316 1,620 1,048
term
Trade
Credit
External 1,770 49 337 633 751 258
Assistanc
e
NRI 3,895 1,231 797 1,236 631 -447
Deposits

Making Sense of it…. ( 19 Sept, 2008)

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Currency Convertibility
What it means?

Simply put, Convertibility can be defined as the ease with which a country's currency can be
converted into any other currency.

Currently the rupee is fully convertible on the Current A/C. In other words, Indian residents
are legally permitted to make and receive trade-related payments -- receive dollars (or any
other foreign currency) for export of goods and services and pay dollars for import of goods
and services, make sundry remittances, access foreign currency for travel, studies abroad,
medical treatment and gifts, etc.

However, India is yet to embrace full Capital A/C convertibility.

Capital account convertibility (CAC) means the freedom to convert local financial assets and
liabilities into foreign financial assets and liabilities at market determined rates of exchange.
This means that capital account convertibility allows anyone to freely move from local
currency into foreign currency and back.

It refers to the removal of restraints on international flows on a country's capital account,

enabling full currency convertibility and opening of the financial system. This means that
there are no restrictions on individuals and firms in terms of the quantum of financial and
other assets which they can acquire overseas.

However in the Indian context this is not the case. For instance, an Indian national doesn't
enjoy unfettered access to equity markets abroad. The maximum investment is capped at
US$ 250,000. Foreign Investment into the country is also not completely unrestricted. For
example, an FII investing in a real estate project has to lock in his funds for a stipulated
period, during which he can't repatriate it to his home country.

Extra:

So, what prevents India from fully embracing Capital A/c convertibility?

The RBI is concerned that complete convertibility could lead to an unwarranted increase in
the currency's volatility, and adversely impacts the real economy. Supporters of this view,
point to the East-Asian financial crisis, as evidence of the same. The likes of Thailand and
Malaysia witnessed a flight of capital in the late 90's. As foreign investors rushed to
repatriate their funds, the domestic currencies collapsed under a deluge of selling pressure.
This wreaked havoc on the local economies. Stock and property prices crashed, and
business confidence plummeted, as investors headed for the exit.

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The opponents of this view believe that the RBI is some what paranoid. They argue that
Capital account convertibility is considered to be one of the major features of a developed
economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as
they can re-convert local currency into foreign currency anytime they want to and take their
money away. At the same time, capital account convertibility makes it easier for domestic
companies to tap foreign markets.

The key lesson here is that in addition to reforms, the sequencing of macro-economic
reforms is crucial. In hindsight, the East-Asian economies, jumped into Capital account
convertibility prematurely. Their financial markets weren't developed enough to handle the
massive flight of capital that ensued.

Even the World Bank has said that embracing capital account convertibility without
adequate preparation could be catastrophic. But India is now on firmer ground given its
strong financial sector reform and fiscal consolidation, and can now slowly but steadily
move towards fuller capital account convertibility.

Making Sense of it…. ( 21 Sept, 2008)

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Monetary Policy
What is monetary policy?

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

Objectives of Monetary Policy

Monetary policy is essentially a stabilisation policy. It is not intended to influence the long-
term growth potential of the economy, but aims at ironing out the fluctuations in the
economy also referred to as business cycles. This is done to minimise fluctuations and
ensure a sustainable mix of growth and inflation in the economy.

Instruments of Monetary Policy

· Alteration of REPO/Reverse REPO Rates

(Repo is short for repurchase agreement. Repo rate is the rate that RBI charges the banks
when they borrow from it. Reverse repo rate is the rate that RBI offers the banks for parking
their funds with it.)

· Changing Reserve requirements (Cash Reserve Ratio, Statutory Liquidity Ratio)

· Open Market Operations

Time Period

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-
September) and a busy season policy (October-March) in accordance with agricultural
cycles. These cycles also coincide with the halves of the financial year.

However, the Monetary Policy has become dynamic in nature as RBI reserves its right to
alter it from time to time, depending on the state of the economy.

Type of Monetary Policy

1. Expansionary Policy increases the total supply of money in the economy. It is used as
tools against unemployment and recession by lowering interest rates

2. Contractionary Policy decreases the total supply of money in the economy; it is used as
a tool against Inflation by raising interest rates.

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How does it work?

As an illustration, consider that an economy is growing too fast. This is also referred to as
overheating of the economy: a situation that typically happens in the boom phase when
GDP (gross domestic product) growth exceeds the long-term growth potential of the
economy. The producers of goods are not able to make enough goods to meet the rising
demand. The resultant demand-supply mismatch creates inflationary pressures in the
economy. This situation is regarded as unsustainable, as the high growth translates into
higher inflation. In this situation, the RBI raises interest rates to depress spending and
reduce the pressure on inflation.

Making Sense of it… ( 01 Oct, 2008)

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Fiscal Policy
What is Fiscal Policy?

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

Objectives of Fiscal Policy

1. To achieve a desirable price level Fiscal policy should be used to remove fluctuations in
price level so that ideal level is maintained.

2. To achieve desirable consumption level

3. To achieve desirable employment level

4. To achieve desirable income distribution

5. To increase the capital formation

6. To divert existing resources from unproductive to productive and socially more

desirable uses.

7. To protect the economy from the ills of inflation and unhealthy competition from
foreign countries.

Instruments of Fiscal Policy

1. Public expenditure

2. Taxes

3. Public debts

4. Seignorage, the benefit from printing money

Types of Fiscal Policy

A neutral stance of fiscal policy implies a balanced budget where G = T (Government

spending = Tax revenue). Government spending is fully funded by tax revenue and overall
the budget outcome has a neutral effect on the level of economic activity.

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An expansionary stance of fiscal policy involves a net increase in government spending (G >
T) through a rise in government spending or a fall in taxation revenue or a combination of
the two. This will lead to a larger budget deficit or a smaller budget surplus than the
government previously had, or a deficit if the government previously had a balanced
budget. Expansionary fiscal policy is usually associated with a budget deficit.

Contractionary fiscal policy (G < T) occurs when net government spending is reduced either
through higher taxation revenue or reduced government spending or a combination of the
two. This would lead to a lower budget deficit or a larger surplus than the government
previously had, or a surplus if the government previously had a balanced budget.
Contractionary fiscal policy is usually associated with a surplus.

How Fiscal Policy Works?

Fiscal policy is based on the theories of British economist John Maynard Keynes.

If an economy has slowed down, unemployment levels are up, consumer spending is down
and businesses are not making any money, a government thus decides to fuel the
economy's engine by decreasing taxation, giving consumers more spending money while
increasing government spending in the form of buying services from the market (such as
building roads or schools). By paying for such services, the government creates jobs and
wages that are in turn pumped into the economy. In the meantime, overall unemployment
levels will fall. With more money in the economy and less taxes to pay, consumer demand
for goods and services increases. This in turn rekindles businesses and turns the cycle
around from stagnant to active.

If inflation is too strong, the economy may need a slow down. In such a situation, a
government can use fiscal policy to increase taxes in order to suck money out of the
economy. Fiscal policy could also dictate a decrease in government spending and thereby
decrease the money in circulation. Of course, the possible negative effects of such a policy
in the long run could be a sluggish economy and high unemployment levels. Nonetheless,
the process continues as the government uses its fiscal policy to fine tune spending and
taxation levels, with the goal of evening out the business cycles.

Difference between Monetary Policy & Fiscal Policy

Monetary policy is typically implemented by a central bank, while fiscal policy decisions are
set by the national government. The former brings about a change in the economy by
changing money supply and interest rate, whereas fiscal policy is a broader tool with the
government.

Making Sense of it…. ( 10 Oct, 2008)

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Purchasing Power Parity
This purchasing power exchange rate equalizes the purchasing power of different currencies
in their home countries for a given basket of goods.

A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the
United States. PPP takes into account this lower cost of living and adjusts for it as though all
income was spent locally. In other words, PPP is the amount of a certain basket of basic
goods which can be bought in the given country with the money it produces.

This concept has been used over the last few years in the form of cost arbitrage. For
example, many American and European Pharmaceutical companies such as Novartis,
Sandoz, and Pfizer have set up their factories in India to manufacture medicines at almost
1/5th the cost as compared to manufacturing the same in USA or Europe. Theoretically it
would mean that one dollar would be equivalent to Rs. 9 on PPP Basis. (Considering that
USD 1 = Rs. 45). Theoretically, this would mean that there would be massive inflow of
dollars in India, thereby leading to excess of supply of dollars in India, thereby leading
to appreciation of the Rupee against the dollar. This should continue till the rupee
appreciates to the extent of Rs. 9 for each US dollar. However this does not practically
happen since there can be marked differences between PPP and market exchange rates due
to market disruptions like government policy, speculation, regulations etc.

For example, in 2005 the one United States dollar was equivalent to about 7.6 Chinese yuan
theoretically this means to buy a particular basket of products in USA will cost USD 1. The
same basket in China shall cost 7.6 Chinese yuan.

However the same is not necessarily true since practically the exchange rate on PPP basis
should have been USD 1 = 1.8 yuan (as per World Bank reports). This could give rise to
possibilities of arbitrage. That is one can buy a particular basket of products in China for
Yuan 1.8, export and sell it in the USA for USD 1 and come back and convert it into Chinese
yuan again and get Yuan 7.6 in the bargain. However on a macro level, these possibilities of
arbitrage are effectively taken care of by measures such as import duties, anti-dumping laws
etc.

This discrepancy has large implications; for instance, GDP per capita in the People's
Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. (This means
while the GDP per person in China is USD 1800, by the same USD 1800, he can buy goods
worth USD 7204 had he been in the USA. This is frequently used to assert that China is the
world's second-largest economy, but such a calculation would only be valid under the PPP
theory.)

At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP
figure is only US$30,615. This means that even though a particular basket of products in
Japan costs USD 37,600, the same can be bought in the USA for USD 30,615. Hence for
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proper comparison it is necessary to equate the PPP of all countries in the same
denomination, in this case USD.

India:

Even though our GDP has just recently crossed USD 1 Trillion per annum, the GDP on a PPP
basis is USD 3.2 trillion. This makes India the fourth largest economy in the world by PPP
basis just after USA, China and Japan. Using data of nominal GDP, India ranks 12th largest.
(Nominal GDP means the one which is reported and does not contain any adjustments by
way of PPP or other parameters)

This would mean that the GDP per capita (on PPP basis) is around USD 2,740 considering a
population of approximately 1.1 billion. However India ranks at approximately 126th place
in that regard on nominal basis (per capita income is USD 965) with China being at 99th
place. The primary reason for the same is the large populations of the respective countries.

Making Sense of it…. ( 14 Oct, 2008)

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Making Sense of it….

( 16 Nov, 2008)

Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and
services. It is measured as annual percentages increase though the Consumer Price Index. As
inflation rises, every rupee you own buys a smaller percentage of a good or service.

Inflation can also be described as a decline in the real value of money—a loss of purchasing
power.

There are two main causes/types of Inflation:

1. Demand-Pull Inflation:

This is too much money chasing too few goods". In other words, if demand is
growing faster than supply, prices will increase. This usually occurs in growing
economies.

2. Cost-Push Inflation:

When companies' costs go up, they need to increase prices to maintain their profit
margins. Increased costs can include things such as wages, taxes, or increased costs
of imports.

The table given below shows the top 5 countries with high levels of Inflation:

It's a miracle as to how Zimbabwe economy is still surviving. A sausage sandwich sells for
Zimbabwean $50 million. A 15-kg bag of potatoes cost Zimbabwean $260 million. But then,
Zimbabwean $50 million is roughly equal to US$ 1!

While considering the actual rate of growth in terms of GDP we need to see the general
inflation rate in the economy.

Example:

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If GDP of a country has increased from USD 100 million to USD 120 million with the general
rate of inflation being 5% then the actual rate of growth in GDP terms is not 20% (20/100)
but 13% (15/105).

Problems with Indian Inflation Rate

§ In India, inflation is calculated on a weekly basis every Friday based on Wholesale

Price Index (WPI).WPI is the index that is used to measure the change in the average
price level of goods traded in wholesale market. In India, price data for 435
commodities is tracked through WPI which is an indicator of movement in prices of
commodities in all trades and transactions.

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

Variations to inflation:

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

Stagflation is the combination of high unemployment and economic stagnation with

inflation.

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Making Sense of it….

( 25 Nov, 2008)

Liquidity Adjustment Facility

What is liquidity adjustment facility (LAF)?

It is a mechanism by which the Reserve Bank of India (RBI) draws out funds from the money
market at a time of surplus and infuses liquidity whenever there is a temporary shortage.
The RBI achieves this by getting banks and primary dealers to bid for funds if there is a
shortage and by borrowing from them if there is a surplus. RBI introduced this scheme on
5th June 2000 and revised it again in 2001-02.

Reasons for introduction of LAF

Amongst its many functions, Reserve Bank of India also acts as the banker of last resort. In
this role, the central bank has to ensure that it can inject funds into the system to help
participants tide over temporary mismatches of funds. Refinance, as it used to happen
earlier was at a fixed rate which was largely divorced from the cost of equivalent short-term
funds in the market. This gave rise to a non-egalitarian distribution of interest rates in the
short end of the curve. Further, the amounts that could be borrowed were determined by a
preset limit. To do away with the deficiencies, RBI moved to an auction system of repos and
reverse repos to suck-out and inject liquidity to the market. The three broad objectives of
LAF are as follows:
· To give RBI greater flexibility in determining both the quantum of adjustment as also
the rates by responding to the system on a daily basis.
· To help RBI ensure that the injected funds are being used to fund day-to-day liquidity
mismatches and not to finance more permanent assets.
· To help RBI set a corridor for short-term rates, which should ideally be governed by
the reverse-repo (top band), and repo (lower band) rates. This would impart greater stability
in the markets.

How does it do this?

The Financial Markets Committee, consisting of the operational Departmental Heads, which
meets every day in the morning to assess market conditions, is responsible for decisions
relating to the LAF. The Committee meets again at 12 noon to assess the bids received
under LAF. The exact quantum of liquidity to be absorbed or injected and the accompanying
repo and reverse repo rates are determined by the Committee after taking into

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consideration, the liquidity conditions in the market, the interest rate situation and the
stance of monetary policy. The decisions are based on a myriad factors including net inflows
and outflows on account of forex operations, current account balances of the banks against
the CRR requirements, open market operations, redemption of loans and coupon payments,
announcement of new issues by the government, un-drawn liquidity support on account of
export refinance, collateralised lending facility to banks and level I refinance to PDs and the
overall situation of the call money market. The rate of interest however is determined on
the basis of the bids received from the market.

LAF Scheme Features

· Eligibility
All Scheduled Commercial Banks (excluding Regional Rural Banks) and Primary Dealers (PDs)
having Current Account and SGL Account with RBI, Mumbai will be eligible to participate in
the Repo and Reverse Repo auctions.
· Minimum bid size
To enable participation of small level operators in LAF and also to add further operational
flexibility to the scheme, the minimum bid size for LAF is Rs.5 crore and in multiples of Rs.5
crore thereafter.

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Making Sense of it….

( 26 Nov, 2008)

Demand Liabilities and Time Liabilities

Demand Liabilities of Banks include all liabilities which are payable on demand. They may
come at any time.

Demand Liabilities include:

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

Time Liabilities are those which are payable otherwise than on demand.

Time Liabilities include:

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

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Making Sense of it….

( 28 Nov, 2008)

Cash Reserve Ratio

What is Cash Reserve ratio (CRR)?

The Cash Reserve Ratio (CRR) refers to the liquid cash that banks have to maintain with the
Reserve Bank of India (RBI) as a certain percentage of their demand and time liabilities.
For example if the CRR is 10% then a bank with net demand and time deposits of Rs
1,00,000 will have to deposit Rs 10,000 with the RBI as liquid cash. At present the CRR is
5.5%

To which banks is CRR applicable?

The CRR is applicable to all scheduled banks including the scheduled cooperative banks and
the Regional Rural Banks (RRBs).

There is no minimum or maximum level of CRR that needs to be fixed by the RBI.

Does RBI impose on penalty on banks for defaulting on CRR deposits?

RBI doesn't pay any interest on the funds held with it as CRR. The RBI has the authority to
impose penal interest rates on the banks in respect of their shortfalls in the prescribed
CRR.

According to Master Circular on maintenance of statutory reserves updated up to June

2008, in case of default in maintenance of CRR requirement on daily basis, which is
presently 70 per cent of the total CRR requirement, penal interest will be recovered at the
rate of three 3% per annum above the bank rate on the amount by which the amount
actually maintained falls short of the prescribed minimum on that day.

If shortfall continues on the next succeeding days, penal interest will be recovered at a rate
of 5% per annum above the bank rate. In fact if the default continues on a regular then RBI
can even cancel the bank's licence or force it to merge with a larger bank.

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How is CRR used as a tool of credit control?

CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of bank
deposits, however over the years it has become an important and effective tool for directly
regulating the lending capacity of banks and controlling the money supply in the economy.

When the RBI feels that the money supply is increasing and causing an upward pressure on
inflation, the RBI has the option of increasing the CRR thereby reducing the deposits
available with banks to make loans and hence reducing the money supply and inflation.

What impact does CRR have on interest rates?

Let's understand this with an example. Suppose at present, the total amount of deposits
with banks is Rs 10, 00,000 and the CRR is 5%. i.e. Rs 50000 is held by banks with RBI as
reserves. Now every one percentage point cut in CRR means the banking system will have
nearly Rs 10,000 more available for lending. As more money chases the same number of
borrowers, interest rates come down. Thus a fall in CRR reduces interest rates and a rise in
CRR increased interest rates.

Limitations

CRR is a crude monetary policy tool. It is used in India since there is limited capital account
convertibility and domestic banking system isn't sufficiently evolved. More advanced
economies don't change the CRR often. Their capital accounts are open, and their banking
systems more evolved.

For example: China's currency is not fully floating, rather its value fluctuates in a narrow
band. Also, it has restricted capital account convertibility. It was faced with a deluge of
foreign inflows, enticed by China's growth prospects. These inflows are converted into yuan,
adding to domestic liquidity. This domestic liquidity cant find a sufficient outlet since China's
Capital account is not fully convertible. This surfeit of domestic liquidity in turn fuels
commodity and asset price inflation. This is a headache for the Central bank trying to control
inflation. The banking system is not very well developed, despite the Central Bank raising its
policy rate; Chinese banks were on a lending spree.

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Making Sense of it….

( 2 Dec, 2008)

Statutory Liquidity Ratio

What is SLR?

SLR is Statutory Liquidity Ratio. It's the percentage of Demand and Time Maturities that
banks need to have in any or combination of the following forms:
i) Cash
ii) Gold valued at a price not exceeding the current market price,
iii) Unencumbered approved securities (G Secs or Gilts come under this) valued at a price as
specified by the RBI from time to time.

The maximum limit of SLR is 40% and minimum limit of SLR is 25%. Following the
amendment of the Banking regulation Act(1949) in January 2007, the floor rate of 25% for
SLR was removed. Presently the SLR is 24% with effect from 8 November, 2008.

Objectives of SLR

1. To restrict the expansion of bank credit.

2. To augment the investment of the banks in Government securities.
3. To ensure solvency of banks. A reduction of SLR rates looks eminent to support the
credit growth in India.

What is the difference between SLR and CRR?

What SLR does is it restricts the bank's leverage in pumping more money into the economy.
On the other hand, CRR, or cash reserve ratio, is the portion of deposits that the banks have
to maintain with the RBI. Higher the ratio, the lower is the amount that banks will be able to
use for lending and investment.

The other difference is that to meet SLR, banks can use cash, gold or approved securities
where as with CRR it has to be only cash. CRR is maintained in cash form with RBI, where as
SLR is maintained in liquid form with banks themselves.

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What does a reduction in SLR mean?

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

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Repo Rate and Reverse Repo Rate
(6th December, 2008)

Repo Rate

Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is
the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help
banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI
becomes more expensive. A point to be noted in this case is that RBI Repo rate is a rate at
which RBI will provide liquidity to the banks, for a collateral (viz G-Secs.). This also means
that this becomes a ceiling rate for this type of funding, and the banks can approach others
banks for the same, who will perform this activity at a lower rate.

Please do not confuse it with the call money rate, as that rate is for non-collateralised
funding.

RBI Repo Rate Behaviour in the year 2008

RBI Cut the Repo Rate to 6.5 % today, (6th Dec,2008) not reflected in the graph

Source Bloomberg.com

Reverse Repo Rate

Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from
banks. Banks are always happy to lend money to RBI since their money is in safe hands. An
increase in Reverse repo rate can cause the banks to transfer more funds to RBI. It can cause
the money to be drawn out of the banking system. Here again, this rate becomes the floor
rate for banks to absorb liquidity from other banks, as at this rate the banks having
additional liquidity can directly deposit their funds with RBI.

Reverse Repo Rate Behaviour in the year 2008

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RBI Cut the Rev Repo Rate to 5% today, (6th Dec, 2008) not reflected in the chart.

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Pegged Float, Managed Flat, Free float

Free Float / Managed Float / pegged

The story of valuation of exchange rate is intricately connected with two major philosophies
all over the world.

They are:

1. Pegged Rates

2. Floating Rates

I. Pegging of the currency:

The Bretton Woods System was adopted in 1944 immediately upon the conclusion of World
War II. The ideology adopted was that of "Pegged currency exchange rates"

Pegged Currency exchange rates means the value of a currency is fixed with reference to a
reference currency.

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

II. Floating Rate Regime:

This concept consists of basically two options,

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 a. Free float currency

b. Managed Float currency

A. Managed Float / Dirty Float:

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

The RMB is now moved to a managed floating exchange rate based on market supply and
demand with reference to a basket of foreign currencies. The daily trading price of the U.S.
dollar against the RMB in the inter-bank foreign exchange market would be allowed to float
within a narrow band of 0.3% around the central parity published by the People's Bank of
China (PBC); in a later announcement published on 18 May 2007, the band was extended to
0.5%. Hence, if the value of the renminbi to the dollar was RMB 8 for USD 1, it would
effectively mean a range of RMB 7.98 to RMB 8.02 for USD 1. (0.5% band).

Implication:

The RMB would not be allowed to depreciate below 8.02 nor will it be allowed to appreciate
more than RMB 7.98 per USD.

B. Free Float / Clean Float:

Free float currency regime effectively means, central banks of any country would not under
any circumstances interfere in the foreign exchange markets. The determination of the
exchange rate of one country with reference to another shall be done purely on the basis of
market forces.

About 19% of the economies have adopted Free Float regime, about 22% of the economies,
especially the smaller ones have adopted the Fixed Peg Arrangement and 27% including
India and China have adopted the managed float system of foreign exchange currency
valuation.

For an economy to be said to have adopted a free float strategy, they should have desisted
from interfering in the forex markets since a few years.

Countries like Canada have stopped interfering in their exchange markets since 1997. The
same is true for USA and other developed economies who have adopted the free float

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policy religiously. However it is understood that the Bank of England does at regular
intervals enter the forex markets for stabilisation of the pound against other currencies.

C. Following are the advantages OF THE DIFFERENT CURRENCY FLOAT REGIMES

Fixed:

Monetary discipline.

Limits speculation.

Reduces uncertainty.

No link between trade imbalances and exchange rates.

Floating:

Monetary policy autonomy.

Smooth trade balance adjustments.

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Debt Monetisation
13th December, 2008

What is debt monetization and how does it work?

1. Suppose the government runs a deficit. As an example, let government spending on

goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes
from all sources be $9,000 so there is a $1,000 deficit.

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

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

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

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

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

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

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

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

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

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

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Market Stabilization Scheme
(15th December, 2008)

What is Market Stabilization Schemes (MSS)?

· The Government issues treasury bills and/ or dated securities under the MSS in
addition to its normal borrowing requirements, for absorbing liquidity from the
system that arises due to imbalance of capital flows. These will have all the
attributes of existing treasury bills and dated securities. This scheme was introduced
in FY 2004-05.

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

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

· The amounts raised under the MSS is held in a separate identifiable cash account
titled the Market Stabilisation Scheme Account (MSS Account) which is maintained
and operated by the RBI. The amounts credited into the MSS Account is
appropriated only for the purpose of redemption and/ or buy back of the treasury
bills and / or dated securities issued under the MSS. The payments for interest and
discount are not made from the MSS account. The receipts due to premium and / or
accrued interest are not credited to the MSS account.

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· The treasury bills and dated securities issued for the purpose of the MSS is
matched by an equivalent cash balance held by the Government with the RBI. Thus,
there will only be a marginal impact on revenue and fiscal balances of the
Government to the extent of interest payment on treasury bills and/ or dated
securities outstanding under the MSS.

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