chapter 10

Indianomics

LEARNING OBJECTIVES

The objective of this chapter is to apprise readers of certain policies and macro indicators/variables of the Indian economy which have a significant impact on India’s currency markets and equity markets and affect the sentiments of global investors who have either invested or are going to invest in India. The contents of this chapter are organized in the following order:

 

1. Types of Policies

2. Indian Data Releases

3. Foreign Investments

TYPES OF POLICIES

For sound and healthy growth of the country there should be a proper balance between demand and supply maintaining an appropriate inflation rate. This is achieved by two types of policies:

1. Monetary policy
2. Fiscal policy

Monetary Policy

This can be explained through an example. Assuming there is less demand or deflationary conditions in the economy than the baseline demand, then, the Central Bank in India (RBI) can intervene and decrease the interest rate in the Indian economy. Such intervention can be brought about by lowering the Repo Rate, CRR or SLR. This would, in turn result in commercial banks lowering their interest rates since the funds available to them through RBI would come at a lower cost. Such a change in monetary policy shall lead to two major effects:

1. The common man shall now prefer to consume rather than save since the interest rate would be lower on deposits. This would lead to more demand in the economy. Increased demand would in turn lead the producers to expand their production capacity and ask for incremental loans from the banks.
2. The incremental loans shall be utilized for capacity expansion resulting in incremental requirement for human labour, which would result in more hiring. Incremental employment opportunities would have cascading effect on their new demands.

In case there are heavy inflationary conditions or heavy demand in the economy, the Central Bank will do the reverse and there will be reverse economic consequences of the same.

The process of monetary control by RBI is shown in detail in Figure 10.1

Effect on Currency Market: When the inflation rises in a country beyond the level desired by the Central Bank, it has been observed that the Central Bank tries to control it by increasing interest rates or controlling money supply from time to time, which in turn affects the currency market of an economy as well. This can be better explained with the help of the following diagram.

The underlying assumptions of Figure 10.2 are as follows:

• Inflation is above the desired level.
• None of the variables which are part of this chain are affected by anything other than higher demand leading to high inflation.
• Stages of growth of economy: Recession, depression, recovery, stable growth or high growth can alter the relationship depicted in Figure 10.2.

Fiscal Policy

Fiscal policy involves fiscal public expenditure by the government which normally leads to increase in fiscal deficit. Fiscal deficit is the ‘difference between expenditure incurred by the government and revenues earned by the government’. The government normally incurs expenditure to increase the demand in case there are deflationary conditions prevalent in the economy. Consequently, the government increases its public expenditure in the form of increased spending on infrastructural capabilities or reduces the taxation rates levied on the common man. This would lead to more employment opportunities and more consumption. The process of fiscal policy is shown in detail in Figure 10.3.

Effect on Currency Market: Whenever the government implements any change in fiscal policy in the country, the currency market is highly affected. This can lead to either appreciation or depreciation of the rupee, depending upon market condition. It could be better explained through the following diagram.

Deficit Conditions Leading to Depreciation of the Indian Rupee: The underlying assumptions of Figure 10.4 are as follows:

• Fiscal deficit is above the level budgeted and desired by government.
• Government expenditure is not going towards productive sectors.
• Stages of growth of economy: Recession, depression, recovery, stable growth or high growth can alter the relationship depicted in the chart.
• None of the variables which are part of this chain are affected by any other external variables.

Surplus Conditions Leading to Appreciation of the Indian Rupee: The underlying assumptions of Figure 10.5 are as follows:

• Fiscal surplus is at level budgeted and desired by the government.
• Government expenditure is reducing on account of non-productive expenditure but the expenditure towards productive sector continues.
• Stages of growth of economy: Recession, depression, recovery, stable growth or high growth can alter the relationship depicted in the chart.
• None of the variables which are part of this chain are affected by anything other than external variables.

INDIAN DATA RELEASES

In India, data on prices are regularly collected by the central and state government departments/agencies for varied purposes. These data form the source of different information compiled in various forms, in accordance to specific needs, by various agencies.

Industrial Production Growth Rate

Date of release	Monthly
Market importance	High

Milieu: The index of industrial production measures the physical output of the nation’s factories, mines and utilities. The industrial sector accounts for less than one-fifth of the economy but for its cyclical variation. The capacity utilization rate reflects the usage of available resources among factories, utilities and mines. A high and rising operating rate may signal that resources are being utilized to their fullest capacity—a warning sign of inflationary pressures.

How Does It Affect the Market? The stock market likes to see healthy economic growth because it translates to higher corporate profits.

The bond market prefers more subdued growth that would not lead to inflationary pressures.

Effect on Currency Market: Whenever IIP (Index of Industrial Production) shows a positive trend, the whole economy responds in a positive manner. Figure 10.6 illustrates the likely behaviour of the Indian Rupee in case of rising index of industrial production. The two underlying assumptions to the below chain working as depicted, are as follows:

1. None of the variables which are part of this chain are affected by anything other than IIP.
2. Stages of growth of an economy: Recession, depression, recovery, stable growth, or high growth can alter the relationship depicted in the chart.

Consumer Price Index

Date of release	Monthly
Market importance	High

Milieu: The consumer price index (CPI) is a measure of the average price level of a fixed basket of goods and services purchased by consumers. The index comprises of categories like food and beverages, housing, apparel, transportation, medical care, recreation, education and communications, and other goods and services.

How Does It Affect the Market? CPI helps keep a check on inflation. Rising inflation affects the economy in a very adverse manner.

Example

In an economy that has started booming, more people make more money. They start buying more. Stores notice this and raise their prices. So the workers demand more money, the company pays more money, and the stores keep on raising prices. Without any checks or balances, this economic boom can send the inflation through the roof. A CPI report can show this, and encourages the government and RBI to take some strict measures and keep inflation under control.

The CPI can sometimes be affected by a large hike in price of one commodity. For example, if there is a huge hike in oil prices, this affects transportation, heating and food, and cuts into retail sales because of the squeeze on workers’ budgets. In that case, one major commodity jumping in price can create a domino effect. The CPI gives critical information about a nation and its economy that can translate to directly affecting a nation’s currency in the Forex market.

In India, however, data on CPI relates to different segments of the population rather than the entire population. With a view to addressing this issue, the Reserve Bank of India prepared an approach paper on CPI (Urban) and CPI (Rural). Subsequently, the Central Statistical Organisation (CSO) has taken up the work for generating data on CPI (Urban) and CPI (Rural).

In India, there are four different types of CPI indices. They are as follows:

1. CPI industrial workers
2. CPI urban non-manual employees
3. CPI agricultural labourers
4. CPI rural labour

Effect on Currency Market: Consumer Price Index affects the currency market profoundly. Increasing CPI or decreasing CPI can affect the appreciation as well as depreciation of the rupee. Decreasing CPI has an opposite impact on the economy as compared to the rising CPI. The given figure depicts the likely behaviour of the Indian Rupee in case of rising CPI. The two underlying assumptions to the below chain working as depicted, are as follows:

1. None of the variables which are part of this chain are affected by anything other than CPI.
2. Stages of growth of economy: Recession, depression, recovery and stable. Growth or high growth can alter the relationship depicted in the chart.

Figure 10.7 assumes that rising CPI is above the desired CPI in the economy.

Wholesale Price Index

Date of release	Weekly
Market importance	Very high

Milieu

• The index that traces the relative changes in the price of an individual good (or a market basket of goods) over time.
• It is also substituted for the annual average inflation at times.
• It gives an idea of the week-to-week fluctuations in the prices of all the traded commodities in the country as a whole.
• It is calculated for wholesale prices in which the quantities of the base year and current year are different.

How Does It Affect the Market?

In Terms of Currency

• High WPI leads to erosion in the currency’s value.
• It results in the loss of purchasing power of the currency, leading to depreciation of the currency.
• Thus, it means that the currency depreciates in relation to the currency of other countries.
• This leads to a weakening performance of the sectors which are import dependent and boost the export dependent companies.

In Terms of Interest Rates

• A very high inflation leads to a contractionary monetary policy by the RBI.
• This leads to reduction in the total money supply in the system which results in the upward movement of the interest rates.
• The rationale behind the hike in interest rates is that it reduces the money supply, hence the demand for goods and services reduces. Inflation is mainly an outcome of too much money chasing too few goods.
• Thus, with the hike in interest rates, consumption demand partly switch to investment demand and lead to a reduction in inflation.
• The hike in interest rates has a dual impact on corporate profitability because of
  • Higher cost of capital.
  • Lower realizations because of reduction in the demand for it’s product.

Difference between CPI and WPI

• WPI essentially measures the price changes from the production side and not from the consumption side and hence it is a lop-sided viewpoint of consumers.
• WPI measures inflation at each stage of production while CPI measures inflation only at the final stage of production which brings a calculation fallacy in WPI through double counting.
• WPI does not reflect the actual price hike, which the consumer pays because it measures the general level of price changes at the level of either the wholesaler or at the producer and does not take into account retail margins.
• WPI gives very little weightage to the food component which actually is one of the most important components of CPI.

Note

• The WPI is published on a weekly basis and the CPI, on a monthly basis.
• In India, inflation is calculated on a weekly basis using WPI.
• WPI affects the currency market in a very similar manner to that of CPI.

Balance of Trade (BOT)

Balance of trade figures are the sum of the money, gained by any economy by selling exports and deducting the cost of buying imports. They form part of the balance of payments, which also includes other transactions such as international investment.

The figures are usually split into visible and invisible balance. The visible balance represents the physical goods and invisible balance represents other forms of trade, for example, the service economy.

A positive balance of trade is known as a trade surplus and consists of more exports (in financial capital terms) than imports. A negative balance of trade is known as a trade deficit and consists of importing more than one export. Neither is necessarily dangerous in modern economies, although large trade surpluses or trade deficits may sometimes be a sign of other economic problems.

Other factors which affect BOT are as follows:

• Prices of goods manufactured at home (influenced by the responsiveness of supply)
• Exchange rates
• Trade agreements or barriers
• Other tax, tariff and trade measures

Note

According to the data from the WTO’s latest International Trade Statistics 2010, India has the world’s third largest merchandise trade deficit after the United States and the United Kingdom.

 

Trade Surplus

Trade surplus is a condition in which a country has a positive balance of trade. Countries enjoying more money flowing in than going out have a trade surplus in their balance of trade. This includes both, money for the products the country exports as well as the money which is spent by the foreigners visiting the country. A country can have the benefits of trade surplus only when it has more exports than imports. Exports include goods and services produced in a country and sold to one or more countries. When a nation has a trade surplus, it commands a lot of control over the movement of its currency, reducing the foreign exchange risk for other nations.

How Does It Affect the Market? A trade surplus indicates that there is more demand for the products of other nations, i.e., exports of a country, rather than the demand for foreign products and services within the country. Consequently, there exists a higher employment rate within the country which results in increased standard of living. Thus, positive balance of trade or trade surplus plays an important role in the economic growth of the country.

Trade surplus, apart from influencing the level of employment within the country, also affects the price index and inflation rate of the economy. As the demand for a country’s goods and services increases, producers increase their output to meet the increased demand. This, in turn, generates additional income that augments the growth of the country’s economy. When the economy grows, the output or gross domestic product increases and citizens can afford a more expensive lifestyle.

Just like the two sides of a coin, there are drawbacks of trade surplus as well. A rise in the net exports will force producers to meet foreign demand by increasing the number of labourers and raw material. Increased demand will increase the cost of wages and cost of capital, which eventually will increase the cost of production. This leads to raised retail prices of goods and services. Therefore, as the trade surplus increases so does inflation.

Effect on Currency Market Trade surplus can have both positive and negative impact on the currency market of a country. The positive impact of the same has been explained through Figure 10.8. The two underlying assumptions to the following chain working as depicted are as follows:

1. None of the variables which are part of this chain are affected by anything other than trade surplus.
2. Stages of growth of economy: Recession, depression, recovery, stable growth, or high growth can alter the relationship depicted in this chart.

Figure 10.8 assumes that rising trade surplus is good for the economy. However, certain negative sides or implications of the rising trade surplus are as follows:

• Extreme local currency appreciation leading to decline in export competitiveness.
• Extreme local currency appreciation leading to decline in reserve value and loss on account of revaluation.
• Higher trade surplus on account of decline in import demand shows slow down in the economy.

Trade Deficit

Trade deficit occurs when the value of a country’s import exceeds its export for a specific period of time, usually a year. Trade deficit can occur in both developing as well as advanced countries. The United States, for example, has been running a trade deficit for many years. While a trade surplus contributes to the GDP of a nation, a trade deficit reduces it. Also a long-term trade deficit is considered to be a wealth destroyer that can trigger job losses, increase debts and lead to possible speculative attacks on currency; however, economists’ state that a controlled short-term trade deficit is manageable and in some cases it is also necessary for the growth and development of the country.

How Does It Affect the Market? Trade deficit, although, may be required in a flourishing economy but it can also trigger repercussion during recessionary phase. For instance, the U.S. trade deficit pertaining to goods and services rose to USD 27.6 billion in March 2009. Japan is also combating high trade deficit. In January 2009, its deficit of JPY 952.6 billion indicated that the global recession had weakened the country’s exports.

A recessive economy endeavours to generate more employment and raise the demand for domestic products by propelling exports. Hence, a trade deficit has numerous implications for a country’s domestic business cycle and economic situation.

A trade deficit has a dampening effect on the economy as it slows down the growth and increases unemployment as the demand for workers decreases. Whether a deficit has a negative or positive effect depends on who is being affected. Increasing the foreign trade deficit, for example, can be good from the viewpoint of the individual consumer because he would end up paying lower prices for goods. Producers and wage earners, however, would be adversely affected.

Another measure of trade surplus and trade deficit is how they relate to the business cycle of any economy. If a country finds itself in a strong expansion, one strategy is to import more and to provide more price competition. This limits inflation and provides a more varied supply of goods and services than is normally available. On the other hand, during recession, the economy would be better served by exporting more, thus creating more demand and more jobs.

The two underlying assumptions to the below chain working as depicted in Figure 10.9 are as follows:

1. None of the variables which are part of this chain are affected by anything other than trade surplus.
2. Stages of growth of economy: Recession, depression, recovery, stable growth or high growth can alter the relationship depicted in this chart.

Figure 10.9 assumes that trade deficit is bad for the economy. However, certain positive sides or implications of the trade deficit are as follows:

• Local currency depreciation leading to rise in export competitiveness.
• Local currency appreciation leading to increase in reserve value and gain on account of revaluation.
• Higher trade deficit on account of increase in import demand shows growth momentum in economy.

Repo and Reverse Repo Rate

A repo or repurchase agreement is an instrument of money market. Usually, the reserve bank (Reserve Bank of India) and commercial bank involve in repo transactions but it is not restricted to these two banks only. Individuals, banks, financial institutes, etc. can also participate in repurchase agreement.

Repo is a collateralized lending, i.e., the banks which borrow money from the RBI to meet short-term needs, have to sell securities, usually bonds to the RBI with an agreement to repurchase the same at a predetermined rate and date. In this way, for the lender of the cash (usually Reserve Bank), the securities sold by the borrower are the collateral against default risk and for the borrower of cash (usually commercial banks), cash received from the lender is the collateral.

The RBI charges some interest rate on the cash borrowed by banks. This rate is usually less than the interest rate on bonds as the borrowing is collateral. This interest rate is called ‘repo rate’. The lender of securities is said to be doing repo, whereas the lender of cash is said to be doing ‘reverse repo’.

In a reverse repo, the RBI borrows money from banks by lending them securities. The interest paid by the RBI, in this case, is called reverse repo rate.

Borrower of funds is called a seller of repo whereas the lender of funds is called a buyer of repo. When the term of the loan is for one day it is known as an overnight repo and if it is for more than one day, it is called a term repo.

The forward clean price of bonds is set at a level which is different from the spot clean price by adjusting the difference between repo rate and coupon earned on the security.

Repo Rate versus Reverse Repo Rate: In a bid to contain inflationary pressures and control liquidity condition in the economy, the RBI keeps on adjusting repo and reverse repo rate as many times as required.

If the RBI wants to make it more expensive for the 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.

If the reverse repo rate is increased, it means the RBI will borrow money from banks and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk).

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.

FOREIGN INVESTMENTS

Investment by citizens and government of one country in the industries of another country or the investment within a country by foreigners is termed as foreign investment.

Kinds of Foreign Investments

International investments or capital flows fall into four principal categories:

1. Commercial loans: Commercial loans, which primarily take the form of bank loans issued to foreign businesses or governments.
2. Official flows: Official flows which generally refer to the forms of development assistance that developed nations give to the developing ones.
3. Foreign direct investment (FDI): Foreign direct investment (FDI) pertains to international investment in which the investor obtains a lasting interest in an enterprise of another country. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of properties, plants or equipment.

   There are two types of FDIs:

   • Inward foreign direct investment
   • Outward foreign direct investment

   FDI is calculated to include all kinds of capital contributions, such as the purchase of stocks, as well as the reinvestment of earnings by a wholly owned company incorporated abroad (subsidiary) and the lending of funds to a foreign subsidiary or branch. The reinvestment of earnings and transfer of assets between a parent company and its subsidiary often constitutes a significant part of FDI calculations.

4. Foreign portfolio investment (FPI): Foreign portfolio investment (FPI) is a category of investment instruments which is more easily traded, may be less permanent, and does not represent a controlling stake in an enterprise. It includes investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise which do not necessarily represent a long-term interest.

Foreign Institutional Investment

Foreign Institutional Investment (FII) refers to outside companies investing in the financial markets of India. International institutional investors must register with the Securities and Exchange Board of India (SEBI) to participate in the market. One of the major market regulations pertaining to FIIs involves placing limits on FII ownership in Indian companies.

A domestic asset management company or a domestic portfolio manager who manages funds raised or collected or brought from outside India for investment in India on behalf of a sub account are deemed to be a FII.

As per SEBI,

Anyone who proposes to invest his proprietary funds or on behalf of ‘broad based’ funds or of foreign corporate and individuals and belongs to any of the following categories can be registered as FII:

• Pension funds
• Mutual funds
• Investment trust
• Insurance or reinsurance companies
• Endowment funds
• University funds
• Foundations or charitable trusts or charitable societies who propose to invest on their own behalf
• Asset management companies
• Nominee companies
• Institutional portfolio managers
• Trustees
• Power of attorney holders
• Banks

 

TEST YOUR UNDERSTANDING

1. Explain in detail ‘monetary policy’ and ‘fiscal policy’.
2. What is the impact of inflation on WPI and CPI?
3. Explain trade deficit and trade surplus and their impact on the market.
4. Explain in detail ‘repo and reverse repo’.
5. Explain foreign investment describing the categories under which foreign investment can come into the country.