The Economic Times -ET In The Classroom – Archives – 2 (Economics Concepts Explained)

 

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 theEconomic Times. I have just consolidated all of them here for the benefit of the readers.

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.

This is part -2 of the archives. Read and spread the knowledge. Click here for Archives-1

ET in the classroom: Quantitative Easing II

 

What is quantitative easing II?

The term became fashionable post the global economic crisis in 2008, following which most governments across the globe had to pump in huge amount of liquidity in the markets to tide over the crisis. Quantitative easing is the process of infusing money into the system by creating ‘new money’ and eventually buying financial assets like bonds and corporate debt from financial institutions in the country. This is done by central banks through what is popularly known as open market operations. The idea essentially is to make adequate money in the system to spur consumption demand in any economy.

Quantitative easing II is the popular phrase used in the context of American economy these days as the US Federal Reserve Board is touted to go for another round of quantitative easing to consolidate the recovery of the American economy, which has slowed down because of fundamental reasons such as lower consumption and job losses and escape of capital to other economies.

What does it mean for India?

Quantitative easing II could flood emerging economies with the dollars, thus making the dollars cheaper and, hence, the US exports competitive while forcing other related currencies to appreciate on account of increase in capital inflows. There is speculation that Federal Reserve chairman Ben Bernanke will push for a fresh infusion of about a trillion dollars into the markets this week, by way of buying bonds, which will push up bond prices and bring down the yields, and the bond markets in India would react accordingly.

Since economies like China and Singapore have closed doors, or are at best cautious in their regulation of capital flows, India is likely to see a gush of capital flows, which is likely to push up the stock prices, and might eventually call for capital control from regulatory authorities.

What are economists saying?

The expert opinion is mixed on this. Nobel Laureate Paul Krugman, who has been a vehement critic of US policies, seems to be favouring QE II. Higher commodity prices will hurt the recovery only if they rise in real terms, he said. And they’ll only rise in nominal terms if QE succeeds in raising real demand. And this will happen only if QE II is successful in helping economic recovery, he said in a recent media interview.

Another Nobel prize winner, Joseph Stiglitz, who was formerly the chief economist with World Bank, feels that the Fed and its advocates are falling into the same trap that led us into the crisis in the first place. Their view is that the major lever for the economic policy is the interest rate, and if one just gets it right, one can steer this. That didn’t work.

It forgot about the financial fragility and how the banking system operates. They’re thinking the interest rate is a dial you can set, and by setting that dial, you can regulate the economy. In fact, it operates primarily through the banking system, and the banking system is not functioning well. All the literature about how the monetary policy operates in normal times is pretty irrelevant to this situation.

Nouriel Roubini, who gained fame after his prediction of the global economic crisis of 2008, thinks further quantitative easing will have little effect on the US growth in 2011. He regards QE II as the wrong way to go. An excessive, permanent increase in money, in his view, is an indirect manipulation of the exchange rate.

 

 

ET in a Classroom: Beggar Thy Neighbour Policy

 

What is beggar thy neighbour policy?

The beggar thy neighbour policy refers to a policy that aims at addressing one’s own domestic problems at the expense of others — trading partners in particular.

What are the instances of such a policy?

The most popular forms of a beggar thy neighbour policy are in the areas of foreign trade and currency management. Conventionally, countries often impose tariff barriers and restrict imports to protect their domestic industries. However, with globalisation, such practices are not popular.

But to achieve its domestic policy objective, for instance, encouraging exports, central banks devalue or encourage the depreciation of their own currencies compared to its trading partners to retain their respective competitive edge. Sometimes economies compete in encouraging appreciation of their currencies to tame inflation at the expense of hurting income in the exporting countries.

Is China adopting a beggar thy neighbour policy?

Many economists, especially in the US, say China has deliberately kept the value of its currency low to forge ahead in exports. But in this case, more than the competitors, the importing country, US, is complaining because more than anything else, cheap Chinese imports are hurting its domestic economy.

How do current economies policies compare?

Currently, the raging concern among most emerging market economies in Aisa is spiralling inflation on account of rising global commodity prices. Central banks in most economies, including India’s, are (though not necessarily planned) encouraging appreciation of their respective currencies.

This is helping them curtail inflation arising out of imported goods as imposing tariff barriers is perceived to be against the principles of free trade. Such a practice hurts export earnings of the countries from where such imports are sourced. But the impact also depends on how crucial such exports are for each economy.

What are the limitations of such a practice?

In certain cases, such a policy may prove counter productive. If, for instance, even the competing country counters one policy move, of say, depreciation (to protect exports) then such a practice may not have desirable results, especially the country’s imports are not price elastic (the imports are essential and not dependent on prices) and instead could end up hurting the trade balance through higher import price and resulting in inflation in such economies.

 

 

ET in the classroom: Systematic Transfer Plan

 

What is STP?

Mutual funds not only manage our money but also offer us various easy to use tools that are aimed at improving our investment experience.

Most of us know systematic investment plan, where we invest at regular intervals. But few are aware of systematic transfer plan (STP).

Under STP, at regular intervals, an amount you opt for is transferred from one mutual fund scheme to another of your choice. Typically, a minimum of six such transfers are to be agreed on by investors.

You can get into a weekly, monthly or a quarterly transfer plan, as per your needs.

You may choose to transfer a fixed sum from one scheme to another. The mutual fund will reduce the number of units equal to the amount you have specified from the scheme you intend to transfer money. At the same time, the amount such transferred will be utilised to buy the units of the scheme you intend to transfer money into, at the applicable NAV. Some fund houses allow you to transfer only the capital appreciation to be transferred at regular intervals.

How is it useful?

STP is a useful tool to take a step by step exposure into equities or to reduce exposure over a period of time. Say you have Rs 10 lakh to invest in equity over a period of time. You could put this amount in the liquid fund of a mutual fund or a short-term bond fund. This gives an opportunity to earn a better than saving bank account rate 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: RBI’s 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 bank’s 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 conducive 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 want 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 world’s 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.

How does it help?

The flood of cheap money causes asset prices to rise i.e. the price of shares, real estate etc. The notional high wealth, together with cheap and easy credit, encourages people to spend. Quantitative easing also helps devalue the currency, thereby encouraging exports further and increasing the level of activity in the economy. The final consequence is increased demand resulting in ramping up of production, which, in turn, creates more jobs in the economy.

Why is it important in the current scenario?

Quantitative easing could potentially ward off deflationary expectations and kickstart an uncertain economy. But in today’s globalised world, cheap money from developed economies may flow into emerging economies and fuel asset bubbles and inflation there. Brazil has been struggling to deal with the rising tide of inflows . India, too, is keeping an eye on increasing forex inflows.

 

ET in a Classroom: Stock Valuation

 

What are the various analytical approaches for valuation of stocks?

For investing, an investor can use an approach based on either fundamental analysis, technical analysis or quantitative analysis.

What is Fundamental Analysis?

It is the process of looking at a company’s business from an investment point of view. The process involves analysing a company’s management capabilities, its competitive advantages, its competitors and the markets it functions in.

As part of the analysis, you would look at examining key financial ratios like the net profit margins, operating margins, earnings per share and so on.

After examining the key ratios of a business, one can come at a conclusion about the financial health of a stock and determine the value of the stock. It further focuses primarily on the valuation of a company and its relationship with the current share price.

Combining all this, the analyst arrives at a valuation for a stock. Fundamental analysts believe that it is possible to estimate the true value of a company using these financial valuation methodologies.

If the share price is trading below the value arrived at by a fundamental analyst, investors should buy the stock, in anticipation of the share price rising to the true value in the future. Conversely, if the share price is higher than the estimated true value, investors should sell.

What is Technical Analysis?

This technique focuses on the past to predict the value of the future, using share prices and volumes traded in a stock. It does not look at fundamentals or financial results at all. Technical analysts believe that all information about a company is factored into the share price.

According to them, share price behaviour is repetitive in nature and hence can be used to predict future share price movements. Based on historical share price data of a company, technical analysts identify share price levels that act as support or resistance.

They try to identify support, resistance and breakout levels for stocks. Technical analysts also use various technical indicators and chart patterns to help them determine probable future share price movements.

What is quantitative analysis?

With the advent of computers, a third type, namely quantitative analysis, has come up. Quantitative analysis seeks to understand behaviour by using complex mathematical and statistical modelling, measurement and research. It is a process of determining the value of a security by examining its numerical, measurable characteristics like sales, earnings and profit margins.

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?

 

China’s 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 China’s phenomenal growth, but the country’s 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 yuandenominated 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.

 

ET in the classroom: The A-Z of 4G technology

 

What is LTE?

LTE, or ‘Long Term Evolution’ , is the latest wireless mobile broadband technology that will power future 4G, or fourth generation, networks designed primarily for data transmission at unprecedented speeds. It uses spectrum to carry data traffic, just as we need roads to carry vehicular traffic. Spectrum may be likened to a highway of airwaves on which mobile signals travel.

Since LTE uses wider chunks of spectrum, data speeds on LTEbased 4G networks are nearly four times faster than on 3G. An iPad user, for instance, will be able to watch videos at LTE speeds of 300 Mbps while a laptop user will be able to download a chunky 25MB file in seconds if adequate spectrum is available. LTE is also a scalable bandwidth technology that works alongside 2G and 3G. So a 3G operator can easily upgrade his network to LTE.

WHEN WAS IT DEVELOPED?

LTE’s genesis goes back to November 2004, when a workshop was held by the 3GPP (3rd Generation Partnership Project) in Toronto to define ‘Long Term Evolution’ . The 3GPP was a global alliance of top telecom associations who tried to identify the next wave of mobile tech after UMTS, the 3G technology based on GSM.

IS LTE BETTER THAN WiMAX?

Wireless communication happens over paired or unpaired spectrum. Paired spectrum is two equal chunks of airwaves for sending and receiving information while unpaired spectrum is a single strip of airwaves meant to either receive or send information.

Voice signals travel over paired spectrum while data communications works better on unpaired spectrum as people download more than upload. WiMAXhad an edge as long as it was the sole wireless technology working commercially over unpaired spectrum . But the WiMAXparty crashed when an LTE variant, TDD-LTE — which also worked over unpaired spectrum — arrived.

What’s more, leading vendors unveiled compatible gear commercially in 2010. This LTE variant was heralded by the world’s top telcos as the coolest technology for highspeed data communications on the go. WiMAXsuffered a body blow when big telcos across China, India and the US also embraced TDD-LTE

. Commercialisation of TDD-LTE devices hit fast-track after Qualcomm pitched for wireless broadband spectrum in the 2010 auction and won 20MHz of BWA airwaves in four circles. Even WiMAXbackers like Clearwire in the US and Yota in Russia warmed up to LTE. Ditto with WiMAXgear vendors like Nokia and Cisco.

IS TDD-LTE CATCHING ON IN INDIA?

Not as yet. But that said, the first seeds of an LTE ecosystem were sown when Bharti Airtel joined some of the world’s top LTE backers at Mobile World Congress 2011 in Barcelona to launch the Global TD-LTE Initiative (GTI). Global deployment of this technology was in fact at the heart of last year’s auction of BWA airwaves in India.

But the big challenge to fast-track deployment of TD-LTE in India is the paucity of compatible devices andsmartphones. Only Qualcomm has launched TDD-LTE multi-mode devices. NSN is slated to unveil 4G devices by the time LTE network rollouts start happening in India by December ’11 to early-2012 .

 

ET in the classroom: Offshore Banking Unit

 

What is offshore banking unit?

Offshore banking unit (OBU) is the branch of an Indian bank located in a special economic zone (SEZ), with a special set of rules aimed at facilitating exports from the region. As laws define it, it’s a “deemed foreign 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 far fetched.

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 Centre’s 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 Centre’s 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 government’s 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.

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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 non-competitive 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.

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ET in the classroom: Potential growth rate

 

The country’s 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 India’s potential growth rate at 7½-8½%.

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 India’s 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 India’s 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 1973-74 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.

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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.

How are these measures used?

In the US, mergers are scrutinized by analysing concentration ratios. Generally, a market with a HHI of less than 1,000 is considered competitive . A market with a HHI in the 1,000-1 ,800 band is moderately concentrated. A measure of 1,800 and more indicates a highly concentrated market. As a general rule, mergers that increase HHI by more than 100 points in concentrated markets raise antitrust concerns and invite further scrutiny by authorities.

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ET in the Classroom: Asset classes

 

What is asset classification?

In any banking system, loans or assets created by lenders are divided into several qualitative categories. In simple language, the categories reflect how good or bad an asset is in terms of the possibility of default in repayment of loan from a borrower. This practice is known as classification of assets.

How is asset classification important to bankers?

This practice helps banks know the strength of its credit portfolio. If there is a risk of non-payment of loans or defaults, banks would start focusing on their credit monitoring act and take corrective measures. According to classifications, banks make provisions to take care of the fallout of a default.

What are the broad classifications prescribed by the regulator, the Reserve Bank of India?

The RBI has classified assets into four broad categories. These are prescribed by the Bank for International Settlements, an inter-governmental body of central banks. However, each central bank is allowed to tweak the definition as per their loan market.

Standard asset

Asset where borrowers pay their interests on the loan as per the schedule is a standard asset.

Sub-standard asset

A sub-standard asset is one which has remained an NPA for a period less than or equal to 12 months. An NPA or a nonperforming asset is one where a borrower fails to pay the interest on the loan for three consecutive months.

Doubtful asset

An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months.

Loss asset

When banks see little possibility of recovering the loan, it becomes a loss asset for the bank. Banks or auditors consider this as a loss for the bank.

What are the provisioning requirements for these assets?

For loss assets, if kept in the book of banks, 100% of the outstanding has to be provided for. For doubtful assets, if the loan asset has remained in the ‘doubtful’ category for 1 year, then the provisional requirement is 20%. If it has stayed there for a period of 1-3 years, it calls for a provisional coverage of 30%.

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ET in the Classroom: How is infrastructure defined in India?

Policy anomalies and lack of consensus on what constitutes infrastructure have undermined efforts to spur creation of physical assets. A look at the current status and the need to define infrastructure.

How is infrastructure defined in India?

There is no clear definition as of now. A broad meaning of the term is based on a series of reports and observations made by different government agencies and committees. A commission chaired by C Rangarajan in 2001 attempted to define infrastructure according to six characteristics: natural monopoly, high sunk costs, non-tradability of the output, non-rivalry in consumption (which implies benefit of public good can be extended 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 have 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.

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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.

Why has repo in corporate debt not taken off?

Lack of market participation could be because of lenders or issuers maintaining a cautious approach as well as due to lack of proper trade guarantee mechanism. Also, the hair-cut margin of 10-15%, (which is the margin enjoyed by the investor on the day the agreement is reversed), is still very high from the investors’ point of view considering the volatility in corporate debt market does not demand such a high hair cut. Interest rate is determined over-the-counter, but there is no mechanism for efficient discovery of prices. There is no centralised clearing agency like the Clearing Corporation of India (CCIL ) for central government securities.

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ET in the classroom: What is stagflation?

Stagflation is an economic situation where the growth rate slows down, unemployment levels remain steadily high & inflation also stays high.

What is stagflation?

Stagflation, a concept which did not gain acceptance till the 1960s, is described as a situation in the economy where the growth rate slows down, the level of unemployment remains steadily high and yet the inflation or price level remains high at the same time. At the first instance, high inflation and unemployment or slower growth seem like opposites and mutually exclusive.

It came to be seen in the 1970s as a situation when the economy has low productivity and yet the goods are highly priced in spite of low unemployment. The term ‘stagflation’ came to be used for the first time in the British Parliament by Lain Macleod in 1965. Once stagflation occurs it is difficult to deal with. The measure a government usually takes to revive an economy in recession (cutting interest rates or increasing government spending) also increases inflation.

Under normal recessionary conditions, inflationary policies are acceptable, but here, given the already high inflation, pushing inflation still higher could mean prices spiralling out of control, thus further hitting productivity and growth.

What causes stagflation?

The major reasons for stagflation, whenever it has occurred in history, have been-supply shocks or shortages due to unforeseen reasons which push up prices of essential commodities, causing an inflationary situation and at the same time pushing up production costs, as it happened in 1970s in the US. The other reason is failure of the monetary authority to control excessive growth of money supply in the economy and excessive regulation of goods and labour markets by the government. For example, in the 1970s, a similar situation occurred during the global stagflation, where it began with a huge rise in oil prices, but then continued as central banks used stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.

Is India on the brink of stagflation?

Though the central bank and the Centre have had to revise their growth targets, which have taken a hit due to persistently high double-digit inflation, economists are far from assuming a stagflation like situation in India just as yet. The Reserve Bank of India deputy governor Subir Gokarn has said headline inflation numbers are much higher than the appropriate rate of inflation that will moderate growth but will keep it steady, which according to RBI’s estimates, should be between 5% and 6%.

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ET Classroom: Casa

What is Casa Ratio?

Casa is basically the current and savings sccount deposits. Casa ratio is the share of current and savings account deposits to the total deposits of the bank. In India, interest rates paid on current and savings account deposits is administered by banking regulator – the Reserve Bank of India.

Why are banks keen on garnering a higher share of Casa?

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 government’s 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 stabilise 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 programmes had to be curtailed and social security benefits cut.

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