ET in Classroom Economics

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ET in Classroom articles

Source:http://articles.economictimes.indiatimes.com


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ET Bureau Feb 2, 2010, 03.58am IST

What are capital controls?

Foreign capital inflows in the form of loans and equity that are allowed in arestricted form are said to be controlled. Many countries which had closedeconomies had imposed severe restrictions on foreign capital. However, asthese economies started opening up in the 80s, capital controls were eased,facilitating free flow of capital and ensuring integration with global financialmarkets.

What are capital inflows?

From the perspective of balance of payments a country's external sector

balance sheet foreign currency inflows are broadly divided into currentaccount and capital account flows. While current account flows arise out oftransactions in goods and services and are permanent in nature, capitalaccount flows are essential in various kinds of loans and equity investments,which can be reversed. That is why policy makers have to keep a close eyeon capital flows.

What are the kind of capital inflows in India?

These would include inflows through foreign borrowings by Indiancorporates and businesses, NRI deposits and portfolio flows from

institutional investors into the stock markets Loans to government and short-term trade credit are also included.

What has been the extent of dismantling of capital controls in India?

India had controls on both capital account transactions as well as on thecurrent account with the local currency fixed by the central bank. However,since 1991, when structural changes to the Indian economy were carried out,

ET in the Classroom: Capital Controls


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the rupee was first made convertible on the current account. Subsequently,capital controls were eased. In 1994, a big shift took place with thegovernment allowing foreign portfolio investments. Ov1er a period of time,foreign direct investment norms and overseas borrowing norms were eased.

Why are policy makers thinking of reimposing controls?

Though allowing foreign capital allows firms in a capital scarce economy toaccess cheaper resources to finance their growth plans, the flip side is that itpresents risks to value of the country's currency as well as managing localliquidity arising out of such inflows (as the central bank buys the foreigncurrency and pumps in local currency).

Dependence on foreign capital could leave a country vulnerable to risks,arising out of a abrupt reversal of flows. With many emerging economiesremaining relatively unscathed after the global financial crisis, there has

been a surge in such inflows, leading to an appreciation in their currencies,including in India. But inflows beyond the absorptive capacity of aneconomy pose other challenges such as high demand side inflation.

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ET in the classroom: Various types of Tax


Taxes come in various shapes and sizes, but primarily fit into two little slots.

DIRECT TAX

This is the tax that you, I (and India Inc) directly pay to the govern-ment forour income and wealth. So income tax, wealth tax, and STT are all directtaxes.

INDIRECT TAX

This one's a double whammy: It's essentially a tax on our expenditure, andincludes customs, excise and service tax. It's not just you who thinks thisisn't fair - governments too consider this tax 'regressive', as it doesn't checkwhether you're rich or poor. You spend, you pay. That's precisely why most

governments aim to raise more through direct taxes.

MAKING YOU PAY

The various taxes that the government levies

CORPORATION (CORPORATE) TAX

It's the tax that India Inc pays on its profits.

TAXES ON INCOME OTHER THAN CORPORATION TAX

It's income-tax paid by 'non-corporate assessees' people like us.

FRINGE BENEFIT TAX (FBT)

No free lunches here. If you want the jam with the bread and butter, you'dbetter pay for it. In the 2005-06 Budget, the government de-cided to tax allperks what is calls the 'fringe benefit' given to employees. No longer


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could companies get away with saying 'ordinary business expenses' andescape tax when they actually gave out club memberships to theiremployees. Employers have to now pay a tax (FBT) on a percentage of theexpense incurred on such perquisites.

SECURITIES TRANSACTION TAX (STT)

If you're dealing in shares or mutual funds , you have to loosen those pursestrings a wee bit too. STT is a small tax you need to pay on the total amountyou pay or receive in a share deal. In the 2004-05 Budget, the governmentdid away with the tax on profits earned on the sale of shares held for over ayear (known as long-term capital gains tax) and replaced it with STT.

CUSTOMS

Anything you bring home from across the seas comes with a price. By

levying a tax on imports, the government's firing on two fronts: it's filling itscoffers and protecting Indian industry.

UNION EXCISE DUTY

Made in India? Either way, there's no escape. In other words, this is a dutyimposed on goods manufactured in the country.

SERVICE TAX

If you text your friend a hundred times a day, or can't do with-out the

coiffeured look at the neighbourhood salon, your monthly bill will show upa little charge for the services you use. It is a tax on services rendered.

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ET in the classroom: Non-tax sources of income for the government


Non-tax Revenues

Any loan given to state governments, public institutions and PSUs earninterests and this forms the most important item under this head. Thegovernment also receives dividends and profits received from PSUs. It alsoearns income for the various services it provides. Of this, the railways is a

separate ministry, though all its receipts and expenditure are routed throughthe consolidated fund.

Capital Receipts

Receipts in the capital account of the consolidated fund are divided intothree broad heads public debt, recoveries of loans and advances, andmiscellaneous receipts.

Public Debt

Since everything the government does is on behalf of the people, itsborrowings eventually are the burden of the people. In budget parlance, thedifference between borrowings (public debt receipts) and repayments(public debt disbursals) during the year is the net accretion to the publicdebt. Public debt can be split into two heads, internal debt (money borrowedwithin the country) and external debt. The internal debt comprises TreasuryBills, market stabilisation scheme, ways and means advances, and securitiesagainst small savings.

Treasury Bills (T-Bills)

These are bonds (debt securities) with maturity of less than a year. These areissued to meet short-term mismatches in receipts and expenditure. Bonds oflonger maturities are called dated securities.

Market Stabilisation Scheme (MSS)


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The scheme was launched in April 2004 to strengthen RBI's ability toconduct exchange rate and monetary management. These securities issuedunder MSS are not to meet the government's expenditure but to provide theRBI with a stock of securities with which it can intervene in the market tomanage liquidity.

Ways & Means Advances (WMA)

RBI is the banker for both the central and state governments. Therefore, itprovides funds to manage mismatches in the governments' receipts andpayments in the form of WMAs. Now, RBI wants the government to issueshort-term securities to meet temporary needs.

Securities Against Small Savings

The government meets a small part of its loan needs by appropriating small

savings collection by issuing securities to the funds that manage suchschemes.

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ET in the Classroom: Fiscal Consolidation


What is fiscal consolidation

A conscious policy effort is needed by the government to live within itsmeans and thereby bring down the fiscal deficit and public debt. It includes,among other things, efforts to raise revenues and bring down wastefulexpenditure such as subsidies . As a larger mandate, it also involves the

participation by state governments in the process. But the whole initiative isplanned as a long-term exercise by the government through a road map forfiscal reform rather than through a single Budget announcement. This isparticularly true for a country like India where the government's expenditureis way beyond its revenues, forcing it to borrow.

Why do rating agencies often express their concern about it?

Just as a borrower's creditworthiness depends on her indebtedness, acountry's rating is often linked to its fiscal deficit. Fiscal consolidationefforts are looked at positively by sovereign-rating agencies. This is becauseit gives them an indication of a country's financial strength and hence, itsability and capacity to service the debt it raises. Many a time, even thoughan economy has grown well or its other indicators, such as external sectorstrength, are buoyant, it does not get a good rating only on the ground ofpoor efforts at fiscal consolidation.

How is India placed on fiscal consolidation ranking?

For many years, India ranked low on fiscal consolidation. However, from2003 onwards , the government made conscious efforts to bring down its

fiscal deficit and public debt after it passed the Fiscal Responsibility andBudget Management (FRBM) Act. This enabled the government to pursuefiscal reforms aimed at committing to a pre-decided level of deficit.

Though its efforts went off well in the initial years, government financesslipped in the last two years as it was forced to provide fiscal sops initiallyto tackle high inflation and then to contain the impact of the global financialcrisis of 2008-09 that hit the real economy hard. As a result, through its


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fiscal stimulus package, it had to announce several fiscal concessions andalso increase expenditure on account of some sops. This ended in a furtherworsening of the country's finances.

What is India going to do about it?

Although the government does not borrow overseas, it cannot ignore the fiscas it is now a part of the global economy. The cost of borrowing for privatecorporates which raise money overseas, depends a lot on its home country'ssovereign ratings . It is expected that finance minister Pranab Mukherjeewill roll out a road map for fiscal consolidation during the Union Budget,which includes unwinding of the fiscal stimulus.

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ET in the classroom: Interbank liabilities

ET Bureau Mar 9, 2010, 01.41am IST

How does a bank meet its day-to-day shortfalls of cash?

A bank treasury official's key task is to match the assets of a bank (loanswhich mostly are long term) with its liabilities (that are mainly short term.)Put simply, a bank's liabilities with other banks are its inter-bank liabilities(IBL). These mainly consist of its borrowings in the overnight call money

market and money raised by selling certificate of deposits of other banks.Even interbank CBLO and repurchase (repo) transactions where a bankborrowing overnight funds from another bank is an IBL for the lendingbank. Well, deposits raised from retail investors are part of a bank's totalliabilities.

How is CBLO and repo different from call money?

A bank goes to the Collateralised Borrowing and LendingObligations(CBLO) market if he has government securities and wants to getcash. The repo facility is used if a bank wants to increase his SLR, since abank can get government securities in lieu of the cash deposited. Both arerun by the Clearing Corporation of India and transactions take place on thescreen. However, call money market does not involve exchange ofsecurities. Here cash is borrowed and lent, through telephone calls betweenbanks.

CBLO is becoming popular with market participants in recent years becauseits much more efficient and a secured market (government securities areused as collateral.) In recent months, volumes in CBLO have been in therange of Rs 50,000-75,000 crore daily, while that in market repo and call

money are around Rs 20,000 crore and Rs 10,000 crore everyday.

To what extent can a bank have such liabilities on their books?

In March 2007, RBI limited a bank's IBL to twice its net worth. A higherIBL limit up to 300% of the net worth was allowed for banks whose CRARwas at least 25% more than the minimum CRAR (9%) i.e., 11.25%.


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Why is the regulator concerned?

According to RBI, the liability-side management has its own merits from thepoint of view of financial stability. Controlling the concentration risk on theliability side of banks is therefore as important as controlling the

concentration risk on the asset side. More particularly, uncontrolled IBLmay have systemic implications, even if, the individual counterparty banksare within the allocated exposure. Further, uncontrolled liability of a largerbank may also have a domino effect.

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ET in the classroom: Indian Depository Receipts


What is Indian Depository Receipt (IDR)?

An IDR is a receipt, declaring ownership of shares of a foreign company.These receipts can be listed in India and traded in rupees. Just like overseasinvestors in the US-listed American Depository Receipts (ADRs) of Infosysand Wiproget receipts against ownership of shares held by an Indian

custodian, an IDR is proof of ownership of foreign company's shares. TheIDRs are denominated in Indian currency and are issued by a domesticdepository and the underlying equity shares are secured with a custodian.An Indian investor pays in Indian rupees for the IDR whereas a shareholderin the issuer's home country pays in home currency.

What is the security of the underlying shares? Where will the receipts bedeposited?

The underlying shares for IDRs will be deposited with an overseas custodianwho will hold the shares on behalf of a domestic depository. The domesticdepository will accordingly issue receipts to investors in India. Investorswill get an entry in their demat accounts reflecting their IDR holding.

How will IDRs be issued? Who can participate?

IDRs will be issued to Indian residents in the same way as domestic sharesare issued. The issuer company will make a public offer in India, andresidents can bid the same way as they do for Indian shares. Investorseligible to participate in an IDR issue are institutional investors, includingFIIs but excluding insurance companies and venture capital funds

retail investors and non-Institutional Investors. NRIs can also participate inthe Issue. Commercial banks may participate subject to approval from theRBI.

What are the benefits that Indian investors can look forward to?

Indian individual investors have restrictions on holding shares in foreigncompanies, but IDR gives Indian residents a chance to invest in a listed


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foreign entity. No resident individual can hold more than $200,000 worth offoreign securities, including shares, as per foreign exchange regulations.However, this will not be applicable for IDR. Besides, these additional keyrequisites such as demat account outside India to hold foreign securities,KYC with foreign broker, foreign bank account to hold funds are too

cumbersome for most investors. These troubles are completely avoided inholding IDRs.

Will Indian investors get equal rights as shareholders?

Indian investors have equivalent rights as shareholders. They can vote onEGM resolutions through the overseas custodian. Whatever benefits accrueto the shares, by way of dividend, rights, splits or bonuses will be passed onto the DR holders also, to the extent permissible under Indian law.

Can IDRs be converted?

IDR holders will have to wait for an year after issue before they can demandthat their IDRs be converted into the underlying shares. However thisconversion is subject to certain conditions:

a) IDR Holders can convert IDRs into underlying equity shares only withthe prior approval of the RBI.

b) Upon such exchange, individual persons resident in India are allowed tohold the underlying shares only for the purpose of sale within a period of 30days from the date of conversion of the IDRs into underlying shares

c) Current regulations do not provide for exchange of equity shares intoIDRs after the initial issuance i.e.reverse fungibility is not allowed.

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ET in the classroom: Viability gap funding


What is viability gap funding?

There are many projects with high economic returns, but the financialreturns may not be adequate for a profit-seeking investor. For instance, a

rural road connecting several villages to the nearby town. This would yieldhuge economic benefits by integrating these villages with the marketeconomy, but because of low incomes it may not be possible to charge userfee. In such a situation, the project is unlikely to get private investment. Insuch cases, the government can pitch in and meet a portion of the cost,making the project viable. This method is known as viability gap funding.

How does the scheme work?

VGF is typically provided in competitively bid projects. Under VGF, thecentral government meets up to 20% of capital cost of a project beingimplemented in public private partnership (PPP) mode by a central ministry,state government, statutory entity or a local body. The state government,sponsoring ministry or the project authority can pitch in with another 20%of the project cost to make the projects even more attractive for theinvestors. Potential investors bid for these projects on the basis of VGFneeded. Those needing the least VGF sup-port will be awarded the project.The scheme is administered by the ministry of finance.

Which are the eligible sectors?

Projects in a number of sectors such as roads, ports, airports, railways,inland waterways, urban transport, power, water supply, other physi-calinfrastructure in urban areas, infrastructure projects in special eco-nomiczones, tourism infrastructure projects are generally eligible for viability gapfunding. The government now proposes to add social sectors such aseducation and health to the list.

How does the government benefit?


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The government has limited resources. It can use those funds to buildeverything on its own, but such public funding will take years to cre-ate theinfrastructure that is needed to achieve higher growth. Through viability gapfunding, the same amount of funds can be used to execute many moreprojects through private participation. VGF is in that sense a force

multiplier, enabling government to leverage its re-sources more effectively.

What has been the success rate?

The government has so far approved 199 VGF-supported projects in-volvinginvestment of Rs 170,651 crore by the end of December 2009.

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ET in the classroom: India refuses 'market economy' status to China

ET Bureau Apr 1, 2010, 03.26am IST

India has refused 'market economy' status to China. ET looks at what itmeans for china?

What is a 'market economy' status?

When a country accords market economy status to another country, itrecognises that free market forces of demand and supply are operating there.It accepts that economic variables such as prices and exchange rates are notdetermined by the state. When a country recognises another as a marketeconomy, it will have to accept information on prices supplied by thatcountry while contesting anti-dumping cases.

Why is India refusing to give the status?

India believes that China's corporate governance and accounting systems arenot transparent and the country is not following global best practices in itsfinancial & banking systems and stock markets. It had recently sent aquestionnaire to China seeking information on key issues such as land laws,accounting practices, minimum wages and electricity rates, which was thefirst step towards granting the status. China, however, dismissed the movelabelling the entire issue as a political one.

Is the issue economic or political?

The issue is both economic and political. China has the maximum cases of

dumping -- exporting goods at prices lower than those prevailing in itsdomestic market -- against it. India does not want to give the marketeconomy status to China as it would then have to accept all information onlocal prices supplied by China while framing its dumping cases.

At present, India fights anti-dumping cases against China on the basis ofprices prevailing in third countries exporting the same product to India.Refusing to recognise China as a market economy also suits India politically


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at the moment because of the renewed tension on the border. A few yearsback when political relations with China were better, the ministry ofexternal affairs was trying to convince the commerce department to grantthe status to the country.

Is India breaking multilateral trade rules?

Not at all. As per China's accession contract with the World TradeOrganisation (WTO), members are not obligated to recognise China as amarket economy till 2016. Only about 60 countries have given China thestatus. These countries include members of the 10-member Asean, whichhas a free trade agreement with China.

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ET in the Classroom: Strips: get the right view


What is STRIPS?

It is an acronym for Separate Trading of Registered Interest and Principal ofSecurities. Stripping is an act of detaching the interest payment couponsfrom a bond and treating the coupons and the body as separate securities.Each security so created, entitles its owner to a specified cash return on a

specific date. These are known as 'zero coupons' or 'zeros' because there areno periodic interest payments on each instrument. After stripping, the zero-coupon bonds trade in the market at a discount and are redeemed at a pre-determined face value.

For example, a 20-year bond with a face value of Rs 1,000 and a 10%interest rate could be stripped into its principal and its 40-semi-annualinterest payments. The result would be 41 separate zero coupon instruments,each with its own maturity date. The principal would be worth Rs 1,000upon maturity, and each interest coupon of Rs 100, or one-half the annual

interest of 10% on Rs 1,000. Each of the 41 distinct securities so createdwould be traded separately until its maturity date at prices determined by themarket.

How is it useful?

STRIPS are usually preferred by market players who have a certain cashrequirement at a fixed time. Buying the zero-coupon bonds can help themfulfil that requirement without worrying about the fluctuation in prices.Since there are no periodic interest payment, a bond holder does not have toworry about the need for reinvestment of intermediate cash flows.

For the larger market too, Strips are beneficial since they will lead to thedevelopment of a market-determined zero coupon yield curve (ZCYC). Inits recent release opertaionalising STRIPS from April 1, RBI saidinstruments should also appeal to retail investors, given the simplicity ofsuch securities.

How will it be done?


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Stripping is to be carried out at RBI through an automated process withinthe Negotiated Dealing System (NDS) the debt-trading platform.Requests for stripping is to be generated and approved by marketparticipants on the NDS, which will thereafter flow to a chosen PrimaryDealer (PD) for authorisation, RBI release said. Initially, STRIPS are to be

tradable only in the OTC market and reported on NDS.

What is the experience of STRIPS abroad?

It was in February 1985 that the US Treasury introduced STRIPS intendedprimarily to reduce the cost of financing the public debt "by facilitatingcompetitive private market initiatives." Zeros have since become mostpopular for investments on which taxes can be deferred, such as individualretirement accounts and pension plans, or for non-taxable accounts.

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ET in the classroom: Government bond auctions


ET helps you know all about government bond auctions.

What was the need for bond auctions?

As the country started reforming its financial markets in the 90s, the needwas felt to put an end to "automatic monetisation" of fiscal deficit the

practice of printing more money when government expenses overshotrevenues. The abolition of monetisation led to significant increases inmarket borrowings of the government. Putting in place a systematic processfor auction of government securities (G-sec) was the central bank's nextchallenge.

What was the system that was put in place?

Today, everytime the government needs money, RBI announces the auctionof government securities through a press notification, and invites bids. Thesealed bids (bids received electronically as well as physically) are opened atan appointed time, and the allotment is based on the cutoff price decided byRBI. Successful bidders are those that bid at a higher price, exhausting theaccepted amount at the cutoff price. For the past one year, RBI has followeda uniform price auction method where all successful bidders pay a uniformprice, which is usually the cut-off price (yield). (Earlier it followed thediscriminatory price auction, in which all successful bidders paid the actualprice (yield) they bid for.)

Are government bonds available in demat?

Government bonds are largely issued in the demat form. But unlike otherbonds, their records are not maintained in either NSDL or CDSL. Recordsof G-secs are maintained in the subsidiary general ledger a demataccount maintained by RBI. Banks and primary dealers hold bonds in thedemat form in SGL while other entities need to open a constituent accountwith banks through which they can hold the bonds. It is also possible to holdthe bonds in a physical form.


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What is the role played by primary dealers in auctions?

Taking lessons from the US, RBI instituted a system of primary dealers inthe 90s STCI and DFHI were the first PDs in the country. These bondhouses underwrite bond auctions , which means they agree to buy securities

if not fully sold, in lieu of small commissions . One day prior to the auction,bids are received from PDs, indicating the amount they are willing tounderwrite and the fee expected.

The auction committee of RBI then examines the bid on the basis of themarket condition and takes a decision on the amount to be underwritten andthe fee to be paid. Today G-secs , State Development Loans & Treasury-Bills are regularly sold by RBI through periodic public auctions . PDs likeICICI Securities, Nomura, Morgan Stanley, STCI underwrite auctions.

Can retail investors participate in G-sec auctions?

Individuals can participate in the auctions on 'non-competitive' basis,indirectly through a scheduled bank or a primary dealer offering suchservices. Here, allocation of the securities is at a price not higher than theweighted average price arrived at on the basis of the competitive bidsaccepted at the auction. FIIs are not allowed to buy G-secs in auctions(primary market ), but can buy them later in the secondary market.

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ET in the Classroom: Asset-liability mismatch

ET Bureau May 6, 2010, 05.24am IST

What is asset-liability mismatch?

Banks' primary source of funds is deposits, which typically have short- tomedium-term maturities. They need to be paid back to the investor in 3-5years. In contrast banks usually provide loans for a longer pe-riod toborrowers. Home loans, for instance, can have a tenure of up to 20 years.

Providing such loans from much shorter maturity funds is called asset-liability mismatch. It creates risks for banks that need to be managed.

What are the consequences of asset-liability mismatch?

The most serious consequences of asset-liability mismatch are interest raterisk and liquidity risk. Because deposits are of shorter maturity they arerepriced faster than loans. Every time a deposit matures and is rebooked, ifthe interest rates have moved up bank will have to pay a higher rate onthem. But the loans cannot be repriced that easily. Because of this fasteradjusting of deposits to interest rates asset-liability mismatch affects netinterest margin or the spread banks earn.

Liquidity issues also arise when loans and deposits have different ma-turities. Depositors have to be repaid when their funds mature, but bankscannot recall their loans. They will have to find new deposits or roll overthose maturing or else they will not be able to service their depositors. In anacute situation they may have to pay really high in-terests to raise funds.

How do banks manage asset-liability mismatches?

Most banks have elaborate institutional arrangement to manage asset-liability mismatches. The interest rate risk is usually managed by pric-ing alarge percentage of loans at variable interest rates that move in tandem withmarket rates. Fixed rate loans are, therefore, usually priced at a huge markup to variable rate loans to entice borrowers to opt for the latter.

This takes care of interest rate risks as loans are linked to a benchmark andrepriced when the benchmark rate moves up. Sophisticated derivatives are


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also used to manage interest rate risk. Liquidity risk involves a more handson management. RBI requires banks to have dedicated asset-liabilitymanagement committees to manage liquidity risks. A careful matching ofcash inflows and out-flows and gap funding are employed to manageliquidity risks.

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ET in the classroom: Offshore Banking Unit

ET Bureau Jun 1, 2010, 03.02am IST

What is offshore banking unit?

Offshore banking unit (OBU) is the branch of an Indian bank located in aspecial economic zone (SEZ), with a special set of rules aimed at facilitatingexports from the region. As laws define it, it's a "deemed foreign branch" ofthe parent bank situated within India, and it undertakes international banking

business involving foreign currency denominated assets and liabilities. Theconcept comes from the practice prevalent in several global financialcentres. Here an OBU can accept foreign currency for business but notdomestic deposits from local residents. This was conceived to preventcompetition 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 moneymarkets at international rates. So in 2002, RBI instituted OBUs, whichwould be virtually foreign branches of Indian banks. These would beexempt from CRR, SLR and few other regulatory requirements. RBIregulations make it mandatory for OBUs to deal in foreign exchange, sourcetheir foreign currency funds externally, follow all prudential normsapplicable to overseas branches and are entitled for IT exemptions. Thus inmany 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 ofIndia. Also, some have suggested that OBUs as vehicles for extending dollarloans have no use as long as they are restricted to doing business only in thezones in which are they located. This would create an unnecessaryregulatory arbitrage like booking business because there is some arbitrageadvantage on offer. Anyways, ground realities could not be more different.Hardly a handful of banks have set up their OBUs, so the argument looks


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ET in the classroom: Exchange Traded Funds

ET Bureau Jun 2, 2010, 03.34am IST

What are Exchange Traded Funds (ETFs)?

An ETF is a basket of stocks that reflects the composition of an index, likeS&P CNX Nifty, BSE Sensex or the banking index. An ETF's trading valueis based on the net asset value of the underlying stocks that it represents. Itis similar to a mutual fund that you can buy and sell in real-time at a price

that changes during the trading session. ETFs are essentially index fundsthat are listed and traded on exchanges like stocks. They enable investors togain broad exposure to entire stock markets in different countries andspecific sectors with relative ease, on a real-time basis and at a lower costthan many other forms of investing.

What are the type of ETFs?

The two popular ETFs in India are index ETFs and commodity ETFs. MostETFs in India are index funds that hold securities and attempt to replicatethe performance of a stock market index. Nifty Bees, Junior Bees, GoldBees, Bank Bees and Hang Sang Bees are some of the ETFs traded in India.Among the commodity ETFs, gold ETFs are actively traded in India.

What are the advantages and disadvantages of using ETFs?

There are several benefits in investing in ETFs. They can be easily boughtand sold like stocks during trading hours using your demat account with noadditional paperwork. They have lower expense ratio and the minimuminvestment is of one unit. However, unlike mutual funds that do not need ademat account, for buying and selling ETFs you need a trading account.

Also since ETFs, like stocks, are bought through a broker, every time youtrade you also end up paying brokerage for your transaction. However, ETFsallow investors to take the benefit of intra-day movements in the market,which is not possible with open-ended funds.

Take the example of a gold ETF. Buying physical gold and storing itinvolve tedious processes. You will have to pay a mark up to the jewellerand then spend some more get a bank locker. On the other hand, buying,


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selling and storing gold in electronic form is more convenient and price-effective. As ETFs are listed on the exchanges, distribution and otheroperational expenses are significantly lower.

How are ETFs used?

Asset allocation: For individuals it could be difficult to manage assetallocation given the cost involved. ETFs provide investors with exposure tobroad segments of the equity markets. They enable investors to buildcustomised investment portfolios in line with their risk taking ability andtime horizon.

Ride the market rally: Many times, investors need time to make investmentdecisions, like buying a particular stock, but do not want to miss out on theopportunity in the stock markets. At such times they can park their funds inETFs. Because ETFs are liquid, investors can participate in the market rally

while deciding where to invest the funds for the longer-term, thus avoidingpotential opportunity costs.

Hedging Risks: ETF's can be used as hedging vehicle because they can beborrowed and sold short. The smaller denominations in which ETFs traderelative to most derivative contracts provide a more accurate risk exposurematch, particularly for small investment portfolios.

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Conceptually, a stronger yuan should erode competitiveness of China'sexports, making it easier for other countries to compete. This should helpaddress the global trade imbalances China's surplus against deficits ofothers. However, to the extent the appreciation is expected to be verygradual because of the tight trading bands, there is unlikely to be a sudden

change in comparative trade equation or capital flows.

In fact, the People's Bank of China effectively ruled out large scaleappreciation. It said, "With the BOP account moving closer to equilibrium,the basis for large-scale appreciation of the renminbi exchange rate does

not exist."

However, the move will help reduce the tension between the US and China.More importantly, it sends a strong signal about the state of the Chineseeconomy and the sustainability of the global recovery.

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ET in the classroom: RBIs key policy rates

ET Bureau Jul 6, 2010, 02.41am IST

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, thereverse repo rate, the cash reserve ratio (CRR) and the statutory liquidity

ratio (SLR). RBI increases its key policy rates when there is greater volumeof money in the economy. In other words, when too much money is chasingthe same or lesser quantity of goods and services. Conversely, when there isa liquidity crunch or recession, RBI would lower its key policy rates toinject more money into the economic system.

What is repo rate?

Repo rate, or repurchase rate, is the rate at which RBI lends to banks forshort periods. This is done by RBI buying government bonds from bankswith an agreement to sell them back at a fixed rate. If the RBI wants to makeit 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, itreduces 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 fromother banks in the short term. Like the repo, this is done by RBI sellinggovernment bonds to banks with the commitment to buy them back at afuture 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 reduceliquidity in the banking system by increasing the rate at which it borrowsfrom banks. Hiking the repo and reverse repo rate ends up reducing theliquidity and pushes up interest rates.

What is Cash Reserve ratio?


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Cash reserve Ratio (CRR) is the amount of funds that banks have to parkwith RBI. If RBI decides to increase the cash reserve ratio, the availableamount with banks would reduce. The bank increases CRR to impoundsurplus liquidity. CRR serves two purposes: One, it ensures that a portion ofbank 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 alsorequired to maintain a minimum percentage of deposits with them at the endof every business day, in the form of gold, cash, government bonds or otherapproved securities. This minimum percentage is called Statutory LiquidityRatio. The current SLR is 25%. In times of high growth, an increase in SLRrequirement 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 mostinterest rates are delinked from the bank rate. Also, the bank rate is theindicative rate at which RBI lends money to other banks (or financialinstitutions) The bank rate signals the central bank's long-term outlook oninterest rates. If the bank rate moves up, long-term interest rates also tend tomove up, and vice-versa.

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ET in the classroom: Lifestyle Inflation


Rising inflation raises the spectre of an increase in the cost of living. But formost of the Indian middle class with high aspirations, the main reason whytheir salaries are never enough is they acquire expensive tastes and desiresas their salaries rise. Welcome to lifestyle inflation.

What is lifestyle inflation?

Lifestyle inflation indicates the rise in your lifestyle expenses, which youneed to consider even if the headline inflation the data published everyThursday is not soaring. There are two versions of lifestyle inflation. Oneexpensive tastes and desires, which is also the function of choices available,coupled with higher purchasing power. For example, earlier you would havebeen watching movies in a small theatre in your neighbourhood. But now,you would have upgraded to multiplexes. That simply means a jump in yourticket costs from Rs 100 to Rs 250. This jump in lifestyle costs is lifestyleinflation. Another way to define your lifestyle inflation is the nature of your

consumption. For example, if your hobby is to travel and explore the earth,then it is expensive today, considering the soaring oil prices.

Is it a new concept?

Earlier, the concept of lifestyle inflation was not prevalent. The reasonbeing, the growth in income of most individuals was usually 5% over andabove the inflation. Hence, people in earlier generations saw lesser or nosurplus income in the individual's hands. Now, the income grows aminimum of 10% in excess of inflation. Second, the salary structures ofpeople working in the private sector realise higher disposable income as

most companies don't deduct retirement benefits. So, the affordability ismuch higher which makes people succumb to aspirational and peerpressures. Third, people have to actively save and invest to live off theirsavings in future.

When does it affect you?


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The lifestyle inflation bug hits individuals who are in the range of 30-45years. This is the age where individuals stretch themselves to buy the latestcar or the LCD TV even if that siphons off their bank balance. They areready to take higher EMIs for their Honda City and subsequently replace itwith a Toyota Corolla even before completing the loan tenure. If an

individual is over 40 years, they show more maturity and just look at a carmore from the utility perspective than the status symbol. Also, an individualdoesn't expect as sharp an increase in his income at this age as in his thirties,experts say.

How do I provide for it in my investments?

Whenever you invest in an instrument, compute the future value afteraccounting for an inflation of 8-10% to get accurate results. Fixed deposits,PPF or NSC assure safe returns, but are not capable of beating the inflation.Real estate, gold, and equity are considered good hedges against inflation on

a long-term basis. It's crucial to provide a certain mark-up at the planningphase itself. For retirement planning, every individual has to do a certainloading on the numbers today based on their lifestyle to get the requiredfuture value. Again, this loading has to vary from period to period so as toreflect true value.

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ET in the classroom: Clash over ULIPs


The dust is yet to settle on a very public spat between market regulator SEBIand insurance watchdog IRDA over regulation of unit-linked insuranceplans, or Ulips. The RBI is opposing a joint committee under the financeminister, envisaged to settle jurisdiction disputes on hybrid products.

ET brings you the story so far.

Dispute over ULIPs

Ulips are hybrid instruments where a part of the amount paid by sub-scribersis invested and a small portion goes towards insurance pre-mium. SEBIpassed an order in April this year saying that regulation of Ulips should beits responsibility rather than IRDA's, as the funds were mostly invested instock markets. Sebi had justified it by saying that in some of the products90% of the money was channelised into markets and not insurance.

On April 9, it had banned 14 insurance companies from selling ULIPswithout its approval, saying they needed to register with the marketregulator. This was opposed by IRDA, which asked insurance compa-nies toignore the directive. The finance ministry intervened and asked both sides toseek legal recourse to the problem.

How was the dispute settled?

The President promulgated an ordinance last month clarifying that lifeinsurance business includes Ulips, which meant that IRDA would con-tinueto regulate Ulips. Four Acts -- RBI Act 1934, Insurance Act 1938, Sebi Act

1992 and Securities Contract Regulations Act 1956-- had to be amended forthe purpose. The decision was taken just days before the Supreme Court wasscheduled to hear the matter on July 8.

What is the new controversy surrounding the joint committee envisaged bythe ULIP ordinance?


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In a bid to ensure that similar disputes that may arise in the future are takencare of, the ordinance provided for a joint mechanism headed by the financeminister, two other government representatives and the four regulators, forsettling conflicts over hybrid products.

What are the RBI's concerns?

The RBI has said that it the central bank had certain reservations andconcerns relating to the ordinance. Reportedly, the central bank feels that thedispute resolution mechanism worked out can undermine the autonomy ofthe regulators. It is more inclined towards the current mechanism for disputeresolution, --the non-statutory High Level Co-ordination Committee onFinancial Markets chaired by the RBI gover-nor. It is holding discussionswith the finance ministry on the issue.

What is the way ahead?

The government has to move a bill in Parliament in the monsoon ses-sion ofparliament to get the ordinance, a temporarily law, passed into a law. Thegovernment can make changes when it moves the bill or allow the ordinanceto lapse by not moving the bill altogether.

What were fallouts of the dispute?

It prompted the IRDA to look within and reform ULIPs by issuing freshguidelines. Ulips launched after September 1, 2010 will have lower charges,guaranteed returns, longer lock-in period and larger insurance cover.

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ET in the classroom: All about rate corridor


In the monetary policy on Wednesday, the RBI raised the repo rate by 25basis points to 5.75% and the reverse repo rate by 50 basis points to 4.5%.This has narrowed the rate corridor from 150 basis points to 125 basispoints. ET demystifies the concept of rate corridor.

What are repo and reverse repo rates?

Repo rate is the rate of interest charged by the central bank when banksborrow money from it. It is the tool through which the RBI in-fuses fundsinto the system by lending to banks against pledging of securities.

The reverse repo is the rate the RBI offers to banks when they deposit fundswith it. The RBI drains out liquidity from the financial system throughreverse repo by releasing bonds to the banks. This is a daily operation by thecentral bank to manage liquidity Over a longer time, the RBI can alsomanage liquidity through open market operations.

What is an interest rate corridor?

Interest rate corridor refers to the window between the repo rate and thereverse repo rate wherein the reverse repo rate acts as a floor and the repo asthe ceiling. Ideally, rates in the overnight interbank call money market,where lending and borrowing is unsecured, should move within thiscorridor. However, when banks are short of funds and the overnight callmoney rates are high and above the repo rate, banks approach the RBI toborrow under the repo window.

Therefore, the repo rate becomes an effective policy tool as it would helpbring down the rates in the overnight market . The reverse hap-pens whenmoney market rates fall below the reverse repo rate. Banks then park surplusfunds with the RBI through a reverse repo trans-action. As a result, whenthere is excess liquidity in the system, the reverse repo is more effective.When liquidity is tight and banks need short-term funds from the RBI tomanage mismatches, then the repo rate emerges as the effective policy rate.But if liquidity returns to the system the reverse repo would become the


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operative policy rate as the RBI would be draining out funds from thesystem.

Why is a narrow rate corridor desirable?

A narrow rate corridor means that short-term interest rates in the call moneymarket will move within that band. This band was earlier 150 basis points,which has now been lowered to 125 basis points. Effectively, the narrowerrate corridor will mean there will be less volatility in short term rates.

Do other central banks also have rate corridors?

Many developing countries have the rate corridors but central banks indeveloped and deeper financial markets have a single rate. In the US, forinstance, the Fed Fund rate is the key interest rate. Short term funds areavailable at this rate to the eligible borrowers.

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ET in the classroom: Compulsory licencing

ET Bureau Aug 26, 2010, 04.42am IST

ET explains Compulsory licensing, a provision that allows governments tooverride Patent rights

What is compulsory licensing?

Compulsory licensing is a process through which a government allows the

local industry to produce drugs under patent protection without thepermission of the patent holder. While the global agreement on intellectualproperty, the Trade Related Intellectual Property Rights (Trips) under theWTO, says that a patent holder will have the sole right to give permission toproduce its patented products on payment of a licence fee, flexibilities havebeen given to countries to address public health concerns by issuingcompulsory licenses.

When can a government issue compulsory licences?

These could be issued to address any public health concern as consideredappropriate by the issuing country. The Trips Agreement gives a country thefreedom to decide when it wants to issue such licenses and it does notnecessarily have to be an emergency. It is generally issued for producinglife-saving medicines to ensure their availability at low prices.

Does compulsory licensing strip a patent holder off the right to collectlicense fees on patented products or process?

Not at all. Companies that are issued compulsory licenses to produce apatented product have to pay 'adequate remuneration' based on the

'economic value' to the patent holder, but there is no elaboration on what thevalue is.

Why has India not been issuing compulsory licenses? Why has it suddenlywoken up to the need?

While the Indian Patents Act provides for issuing of compulsory licenses,the procedural guidelines and the policy framework for the same are not in


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ET in the classroom: Overnight Indexed Swap

ET Bureau Sep 28, 2010, 05.12am IST

What is an overnight Indexed Swap?

An Overnight Index Swap (OIS) is a derivative instrument (a security wherethe returns are linked to the performance of an underlying instrument) wherereturns under a fixed rate asset are swapped against a pre-determinedpublished index of a daily overnight reference rate for an agreed period of

time.

How does an OIS work?

Overnight Index Swaps are instruments that allow financial institutions toswap the interest rates they are paying without having to refinance or changethe terms of their existing loan. Typically, when two financial institutionscreate an overnight index swap, one of the institutions is swapping anovernight (floating) interest rate and the other institution is swapping a fixedshort-term interest rate.

For instance; assume there are two companies Company A, which has a$10 million loan where interest is linked to overnight rates and company Bhas a $10 million loan, on which it pays a fixed rate of interest. Nowsuppose Company A expects overnight rates to remain soft and Company Bwants the assurance of a fixed rate. In this case, these two institutions couldcreate an overnight index swap with each other.

To get the swap rolling, both the firms would agree to continue servicingtheir loans, but at the end of a specified time period whoever ends uppaying less interest will make up the difference to the other firm. For

example, if company A ends up paying an average interest rate of 1.5% onits loan and company B ends up paying an interest rate of 2%, then companyA will pay company B the equivalent of 0.3% (2.0-1.5 = 0.5) because,according to their agreement, they swapped interest rates. Of course, ifcompany A ends up paying an average interest rate of 2.4% on its loan andcompany B ends up paying an interest rate of 2%, company B will paycompany A the equivalent of 0.2% (2.4- 2.0 = 0.4) because of the swapcontract.


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What purpose does the OIS-Libor credit spread serve?

The OIS-Libor (London Inter-bank Offer Rate) credit spread is indicative ofthe liquidity in the system. We have considered Libor as it is a globalbenchmark interbank rate. If the OIS-Libor (or Mibor) credit spread is wide,

it signals tightening in the liquidity and a narrower spread signals presenceof liquidity in the system.

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ET in the Classroom: Current account deficit

ET Bureau Sep 30, 2010, 03.34am IST


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India's current account deficit is expected to widen to 3% of GDP in thecurrent financial year. Funding such a large deficit is a concern, but strongcapital flows have so far provided comfort. ET takes a look at the concept ofcurrent account deficit.

What is current account deficit?

A country's current account consists of merchandise trade (exports andimports of goods) and the invisible trade income and expenditure fromexport and import of services, profits earned on investments and remittancesby workers. A deficit would occur when total imports are greater thanexports. A deficit implies that the country is a net debtor to the world.

Where does India stand?

According to the Planning Commission, India's current account deficit is

likely to increase to 3% of the GDP from 2.9% last fiscal. This is largelybecause of the rising and high trade deficit excess of merchandise exportsover imports. It stood at 23-month high of $13 billion in August. The fullyear could see a trade deficit of around $135 billion, which is about 10% ofthe country's GDP, the highest in recent years.

What are the reasons for high trade deficit?

The current account deficit is financed by a combination of portfolioinvestment inflows, long-term capital inflows, remittances from non-residents and overseas borrowings.

What are the risks posed by a widening current account deficit?

An increasing current account can pose serious problems for an economy.Payments are dependent on long-term capital inflows, which, in turn,depend on the growth prospects of an economy. A pause in these flows canlead to payment problems and pressures on the local currency. It can thenencourage outflow of foreign capital.

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ET in the Classroom: Real and nominal exchange rates

ET Bureau Oct 7, 2010, 07.20am IST

The rupee has appreciated sharply against the dollar in the last few months,raising some concerns, especially among exporters. The real issue,economists say, is not the exchange rate as we know, or the nominalexchange rate, but the effective exchange rate. ET takes a look at theconcept of real and nominal exchange rates.

What do 'real' numbers mean?

The word 'real' in economics -- as opposed to 'nominal' -- is used to describea metric, where the impact of prices has been taken into account. Forexample, real GDP captures output of goods and services at constant prices,removing the effect of inflation.

What is real exchange rate?

Real exchange rate can be defined as the rate that takes into accountinflation differential between the countries. Suppose the rupee was trading atRs 40 to a dollar at the beginning of 2009. Assuming a 10% inflation in theIndian economy and 5% inflation in the US economy for the whole year,then this model says the rupee should depreciate by 5% (10%-5%) to Rs 42to a dollar, other things being equal.

Why is the real exchange rate important?

Competitiveness of a country's exports is decided not only by the nominalexchange rate, but also relative price movements in domestic and foreignmarkets. For instance, even if the nominal exchange of the rupee remains

unchanged with respect to, say, the dollar, India's exports to the US willbecome less competitive if inflation in India is higher than in the US. Thismeans nominal exchange rate will have to be adjusted for effect of inflation.

How is nominal exchange rate adjusted for inflation?

Central banks use the concept of 'real effective exchange rate', or REER, toadjust nominal effective exchange rate for inflation. Conceptually, the


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REER is the weighted average of nominal exchange rates adjusted for theprice differential between the domestic and foreign countries. The pricedifferential, however, is based on the purchasing power concept. Thecurrencies used are of those countries with which trade is the highest.

How does the RBI calculate REER?

The RBI calculates REER for India. It calculates the value of the rupee withrespect to two indices, one comprising six countries and the other 36countries with a 2004-05 base. The RBI, however, uses the wholesale priceindex-based inflation whereas globally consumer price indices are used. Oneconceptual flaw with this model is that it assumes that the base exchangerate is the correct exchange rate or represents the purchasing power paritiesaccurately, which may not be the case.

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ET in the Classroom: Currency War


What is currency war ?

The term 'currency war' was used in recent times by Brazil's finance ministerGuido Mantega in the first week of October this year reacting to China'sattempt to protect the yuan from rising too quickly against the dollar. Itcomprises competitive measures by governments to improve their trade by

maneuvering exchange rates. A cheap currency, vis-vis the dollar, adds tothe competitive advantage to the exporter. Countries such as China, Brazil,South Korea and Japan have taken measures to devaluate their currencieswhich would help them boost exports and create jobs. An attempt by thegovernment to prevent its currency from appreciating too steeply and toofast against competing nation is what is seen as currency war betweendifferent countries . The history of currency wars dates back to the Great


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Depression era when major economies devalued their currencies as a part ofa measure to give preference to local goods over imported ones.

What is its impact on Indian economy?

When competitors devalue their respective currencies, domestic exporterstend to lose out on the price advantage on their exportables as buyers preferto buy from a cheaper currency. This in turn hurts income as well as the jobsin the export sector and the prospects for the economy. The central bank atsuch times tries to intervene buy dollars and create an artificial demandfor the dollar, devaluing the value of the rupee in the process and retainsome price advantage for the exporter . But buying dollars involves a fiscalcost as the central bank has to pump in equivalent amount of rupees andagain mop it up by selling bonds. These bonds need to be serviced by thegovernment. This would in turn worsen the fiscal position .

Howdoescurrencywarimpactglobal recovery?

Currency wars are a part of what is described as a 'beggar thy neighbour'policy attempts by a country to solve its economic problems by causingworse difficulties in other markets. When all countries engage in suchpolicies, it turns out to be a race to the bottom. As countries compete todevalue their currencies to save the interest of their exporters, it collectivelyreduces demand for foreign goods, something that world economies cannotafford at a time when the process of global recovery from the after affects ofthe crisis of 2008-09 is still underway. Also , competitive currencydevaluation is happening at a time, when some of the developed economieshave a soft money situation, wherein monetary regulators are on aquantitative easing spree, lowering their interest rates, which is makingemerging economies trying to regulate their inflation an arduous task, asdirection of the capital flows has turned towards them. There is also the fearof a bubble, which will burst once developed economies are back on trackand the flow of capital shrinks. This shrinking is expected to be firstreflected in the currency markets.

What is the current international thinking on the matter?

The United States is looking for global support at forums such as the G20 tothe IMF, so that there can be collective pressure on China to ease up on theYuan. IMF feels that it is the right place to make progress on the currencyquestion . Emerging nations are not very keen to range themselves in thisbattle. Finance minister Pranab Mukherjee has said he urged countries towork towards a consensus as the way forward.


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ET in the Classroom: Corporate hedging


What is corporate hedging?

Corporate hedging is a mechanism to protect a firm's exposure to foreignexchange risk. The process is managed by corporate treasury officials andthey work toward maximising forex income and minimising costs. In theprocess, they try to minimise losses from the volatility in the currencymarkets, by covering the exposure. The extent of the foreign currency riskfor a firm depends on the value of the foreign exchange rates, among otherthings.

Why do corporates hedge?

In India, with the Reserve Bank of India moving towards a more market-determined exchange rate since the early 90s, the rupee has become morevolatile against the dollar and other major currencies , forcing them to hedgetheir foreign currency exposure. Another reason why companies attempt tohedge is because they see foreign currency fluctuations as risks that aredirectly linked to the central business in which they operate . Hedgingobjectives vary widely from firm to firm, even though it appears to be afairly common issue faced by corporates . Another reason for hedging theexposure of the firm to its financial price risk is to maintain the

competitiveness of the firm. Sometimes there is an opportunity loss inhedging, which is why some corporates , as a matter of risk managementstrategy, do not.

What are the risks to be hedged?

There risks arising out of transaction with clients and other businessassociated which are called transactional risks. A foreign currency loan


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would yield a different value on conversion, depending on the way currencymarkets are moving. Similarly, an importer faces a currency risk as therecould be a significant movement in currency value from the date on which itcontracted the purchase and prevailing exchange rate on the delivery date.The same logic holds for exporters. Corporates also hedge interest risks as in

the global markets, interest rates are also not steady.

What are the challenges in hedging?

What we have seen recently is the phenomenon of two-way hedging,wherein both the importers as well as the exporters are hedging. This is dueto the unpredictability in the direction of the currency movement. In thecurrent year for instance , we have seen the rupee depreciating against thedollar since mid-April and steeply appreciating against the dollar since mid-August . Hence, today, corporates have to take a critical call on when tohedge and when not to, along with the extent to which it should be hedged

and what hedging instrument should be used to avert an opportunity loss.

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ET in the Classroom: GDP Figures

ET Bureau Nov 25, 2010, 05.37am IST

GDP estimates for the second fiscal quarter will be released next Tuesdayamid increasing concerns over the quality of data, especially after theestimates for the first quarter were revised due to an error in calculation. ET

takes a look at the concept of GDP.

What is GDP?

GDP, or gross domestic product, is the value of all goods and servicesproduced in the economy over a period of time, normally a year. Themeasure excludes intermediate goods, or the goods and services that go intothe production of other goods. This is to prevent double counting as value of


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intermediate goods is already included in the final goods or service. It is agross measure in that value of capital goods that goes into replacement is notnetted out. It is a 'domestic' measure as it does not include income fromabroad.

What is the significance of GDP?

The absolute GDP and its growth are important indicators of the health of aneconomy. While absolute GDP gives an idea of the size and the relativeimportance of a country in the global system, its growth gives an indicationof its future progress. The measure, however , suffers from a number ofshortcomings. The creator of the GDP, Simon Kuznets, had pointed out theflaws while presenting it to the US Congress. "The welfare of a nation canscarcely be inferred from a measurement of national income," he had said.

What are the key shortcomings of the measure?

GDP measures only the overall income generation in the economy. It doesnot tell us to whom the income accrues and where it is spent. A poordistribution can mask islands of underdevelopment. For instance, agriculturehas an 18% share in India's GDP, but the sector supports more than 60% ofthe people, implying that per person share of the national income is very lowfor a vast majority. It also misses out on goods and services which are nottraded such as household work, natural resources and leisure. It is also aquantitative measure that makes no distinction for the quality of nationalincome. For instance , environmentally harmful mining could boost nationalincome but at a huge cost to the society at large.

What other measures make it more meaningful?

A per capita measure of GDP, or the absolute level of GDP divided by thepopulation of a country, pitches the number in relation to the people. Thisnumber gives us a sense of what everybody would be earning if the incomewere distributed equally. Of course, in real situation the income will beunequally distributed. India is among the biggest economies, but low percapita GDP rightly pitches it among the poorer nations. Measures such asHuman Development Index give a qualitative dimension to GDP.

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ET in the classroom: PIGS economies

ET Bureau Nov 30, 2010, 05.53am IST

ET explains the concept of PIGS economies and helps you know about thembetter.

Which are the PIGS countries?

After BRIC Brazil, Russia, India and China, financial market analysts

have now clubbed troubled European economies Portugal, Italy, Greeceand Spain together as PIGS. Each of these economies has been goingthrough sovereign debt crises and the European Union has had to bail themout. However, unlike the BRIC nations, which have a positive connotation,this has a negative feel, and hence, many European investment banks do notprefer using this acronym, though it is popularly used in the media.

What were their individual problems?

Italy tried to pay high wages and had an under-competitive economy, hence,a budget deficit crisis followed. Corruption in the state-run businesses sectorand the near-corporate failure of Alitalia also played a part in the balance ofpayments crisis and the economy consequently crashed. Spain's wage billand economy went the Italy way. It had its bit of a housing bubble and bust.Portugal was hit by the desire to have high wages and the inability tomanipulate national fiscal/currency policy to restart a failing economy. Itsoon lost its favoured status among investors to Slovenia. Greece, on theother hand, had most of the above-mentioned crisis since the Millenniumand took out excessive overseas loans in the hope of restarting its nationaleconomy, especially after the slump in tourism.

How has a variation emerged?

With woes of Ireland, which could be similar in nature to that of the PIGSeconomies, the acronym is now extended to PIIGs to include Ireland as well.Besides the EU, even multilateral agencies like IMF have announced bailoutfor them.


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ET in the classroom: What are sugar futures?

ET Bureau Dec 7, 2010, 06.29am IST

ET deciphers and tells about various aspects of sugar futures

What are sugar futures?

Like any futures contract, sugar futures allow the sale or purchase of sugarat a predetermined price for delivery at a future date. Futures allow physicalmarket stakeholders, including producers, traders, processors, importers andexporters, to hedge themselves against the price volatility and risk. Apartfrom hedgers, speculators participate in a futures market by taking on therisk that hedgers seek to cover themselves against.

A speculator is one who normally tracks the market and takes an informeddecision. In an ideal market, the proportion of hedgers and speculatorsshould be 50:50 but this does not always happen. It remains a fact thoughthat speculators help impart liquidity to a market and reduce the impact costby narrowing the bid (buy)-ask (sell) spread.

How does a sugar futures contract benefit the market?

A seller, who wants to insulate himself from prices falling a month, hence,can sell a monthly contract forward at say Rs 100 for x quantity, while a

buyer, who wants cover against rising prices, could lock in at the sameprice. If the price rises to say Rs 105 a month later, the seller can settle thecontract in cash at a loss of Rs 5, while the buyer makes a paper profit of Rs5 by squaring off (selling what he has bought).

However, the seller can offset the paper loss by selling the same sugar at Rs105 on the spot market since futures and spot price tend to converge uponmaturity. Similarly, the buyer can maintain his margin despite the price rise


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(from Rs 100 to 105) on the spot market, thanks to the paper gain made onthe futures market. The beauty of an active futures market is that it ensuresprice transparency and the exchange guarantees against counterparty defaultrisk, a possibility in the case of an over-the-counter (forward) marketcontract entered into between counterparties.

What is the status of sugar futures in India?

Under intense attack against rising prices, the government suspended sugarfutures in May 2009 for six months, after which it extended the ban, whichit allowed to lapse by September 30, 2010 due to good crop prospects andrationalisation of prices. The regulator of commodity futures trading,Forward Markets Commission (FMC), is set to shortly relaunch sugarcontracts from January 2011. The decision will be taken after a meetingbetween FMC and industry body Indian Sugar Mills Association (ISMA)and commodity exchanges like NCDEX and MCX.

How will a relaunch help?

The sugar year is from October to September. The relaunch will give sugarcompanies the option of delivering sugar for future months in case futureprices are trading at a premium to spot prices. It will also give buyers theluxury of locking into futures prices instead of holding sugar in theirgodowns for future needs, which adds to costs in terms of storage,insurance, etc. In the absence of a local futures contract, genuine players areleft with no option but to hedge on overseas exchanges, which increase thecost as they have to hedge against currency price fluctuation.

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ET in the Classroom: Take-out financing

ET Bureau Jan 4, 2011, 07.00am IST

What is take-out financing?


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Take-out financing is a method of providing finance for longer durationprojects of about 15 years by banks sanctioning medium-term loans for 5-7years. It is given that the loan will be taken out of books of the financingbank within pre-fixed period by another institution, thus preventing anypossible asset-liability mismatch. After taking out the loan from banks, the

institution could offload them to another bank or keep it.

Though internationally this kind of lending has been in existence for manyyears, it came to India only in the late 90s. These long-tenure loans wereprimarily introduced to incentivise banks to lend to the infrastructure sectoras banks back then had very little exposure to long-term loans, and alsobecause they did not have adequate resources of similar tenure to createsuch long-term assets.

What does the Reserve Bank rule say?

Banks/FIs are free to finance technically feasible, financially-viable andbankable projects undertaken by both public sector and private sectorundertakings, provided the amount sanctioned is within the overall ceiling ofthe prudential exposure norms prescribed by RBI for infrastructurefinancing. They should also have the requisite expertise for appraisingtechnical feasibility, financial viability and bankability of projects.

Which institutions, besides banks, are engaged in this practice?

The government promoted Infrastructure Development Finance Corporation,by setting aside a corpus from the union budget, with a primary mandate to

promote infrastructure funding. Later, India Infrastructure Finance Companyalso came up essentially to refinance infrastructure loans of commercialbanks.

What are the problems with take-out financing?

Though take-out financing is a permissible practice in India, the concept hasnot taken off in a big way. Though the concept in a way addresses the asset-liability issue, regulators still want banks to set aside higher capital for theirexposure. Besides, banks are also wary of taking risks such as construction

risks, which may delay the project as well as increase its cost.

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ET in the Classroom: Reserve Bank oversight functioning


What is the 'oversight' function of RBI?

The Bank for International Settlements defines oversight as " central bankfunction , whereby the objectives of safety and efficiency are promoted bymonitoring existing and planned systems, assessing them against theseobjectives and, where necessary, inducing change" .

The three key ways in which oversight activity is carried out are through (i)monitoring existing and planned systems; (ii) assessment and (iii) inducingchange. In India, the Payment and Settlement Systems Act, 2007, and thePayment and Settlement Systems Regulations, 2008, provide the necessarystatutory backing to the Reserve Bank of India for undertaking the oversightfunction. The central bank manages the various settlements system,including cash, through currency chest and clears cheques, besides variouselectronic clearing services.

What is Electronic Clearing Service?

It was among the early steps initiated towards moving to a paperlesssettlement system by the Reserve Bank of India. The Bank introduced theECS (Credit) scheme during the 1990s to handle payment requirements likesalary, interest, dividend payments of corporates and other institutions .

The ECS (Debit) Scheme was introduced by RBI to provide a faster methodof effecting periodic and repetitive collections of utility companies. ECS(Debit) facilitates consumers/subscribers of utility companies to makeroutine and repetitive payments by 'mandating' bank branches to debit their

accounts and pass on the money to the companies.

What are the various settlement systems & agencies?

National Electronic Funds Transfer (NEFT) System: In November 2005, amore secure system was introduced for facilitating one-to-one funds transferrequirements of individuals/corporates . Available across a longer time


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window, the NEFT system provides for batch settlements at hourlyintervals, thus enabling a near real-time transfer of funds.

Real-Time Gross Settlement (RTGS): It is a funds transfer system wheretransfer of money takes place from one bank to another on a "real time" and

on a "gross" basis . Settlement in "real time" means payment transaction isnot subjected to any waiting period.

"Gross settlement" means the transaction is settled on one-to-one basiswithout bunching or netting with any other transaction. Once processed,payments are final and irrevocable. This was introduced in 2004 and settlesall inter-bank payments and customer transactions above Rs 2 lakh.

Clearing Corporation of India (CCIL): The Corporation, set up in April2001, plays the Central Counter Party (CCP) in government securities, theUS dollar and the rupee forex exchange (both spot and forward segments)

and Collaterised Borrowing and Lending Obligation (CBLO) markets.

CCIL plays the role of a central counterparty whereby, the contract betweena buyer and a seller gets replaced by two new contracts between CCILand each of the two parties. This process is known as 'Novation' . Throughnovation, the counterparty credit risk between the buyer and seller iseliminated with CCIL subsuming all counterparty and credit risks.

What does the National Payments Corporation of India do?

The Reserve Bank set up the National Payments Corporation of India

(NPCI), which became functional in 2009, to act as an umbrella organisationfor operating various Retail Payment Systems (RPS) in India. NPCI hastaken over National Financial Switch (NFS) from the Institute forDevelopment and Research in Banking Technology (IDRBT). The NationalFinancial Switch (NFS) is an inter-bank network managed by Euronet India.

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ET in the classroom: Central plan and role of plan panel and finance ministry


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The government's budget exercise usually begins with fixing thecontribution of the exchequer to the central plan. Though distributed overmany schemes, taken together this is the single biggest item of expenditurein the annual budget. ET takes a look at the concept of Central Plan and thebudget support to the plan.

What is central plan in the context of the budget?

Central or annual plans are essentially the five year plans broken down intofive annual installments. Through these annual plans, the governmentachieves the objectives of the Five-Year Plans. The details of the plan arespelled out in the annual budget presented by the finance minister. But the

actual responsibility of allocation funds judiciously amongst ministries,departments and state governments rests with the Planning Commission.

What is gross budgetary support, or GBS?

The funding of the central plan is split almost evenly between governmentsupport (from the Budget) and internal and extra budgetary resources ofpublic enterprises. The government's support to the central plan is called theGross Budgetary Support, or the GBS. In the recent years the GBS has beenslightly more than 50% of the total central plan.

How is the GBS figure arrived at?

The administrative ministries responsible for various development schemespresent their demands before the planning commission. The planningcommission aggregates and vets these demand. It then puts forward aconsolidated demand before the finance ministry for the budgetary support itneeds from the cental excequer. The amount approved by the financeministry is usually less than that demanded by the planning commissionbecause of the multiple objectives the North Block has to keep in mind willmaking allocations. The planning commission in turn adjusts the allocatedamount among various demands.

How do GBS, central plan and plan expenditure differ?

Central plan includes the GBS and the spending of the public enterprisesthat do not figure in the budget. In that sense the government's spending onthe central plan is limited to GBS. But the centre also provides funds tostates and union territories for their respective plans. This contribution,


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together with the GBS, makes up the total plan spending of the governmentfor a year. This is about 30% of the total government expenditure.

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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 intoseveral qualitative categories. In simple language, the categories reflect howgood or bad an asset is in terms of the possibility of default in repayment ofloan 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 isa risk of non-payment of loans or defaults, banks would start focusing ontheir credit monitoring act and take corrective measures. According toclassifications, banks make provisions to take care of the fallout of a default.

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

The RBI has classified assets into four broad categories. These are

prescribed by the Bank for International Settlements, an inter-governmentalbody of central banks. However, each central bank is allowed to tweak thedefinition as per their loan market.

Standard asset

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


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Sub-standard asset

A sub-standard asset is one which has remained an NPA for a period lessthan or equal to 12 months. An NPA or a nonperforming asset is one wherea 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 lossasset 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 tobe 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 ithas stayed there for a period of 1-3 years, it calls for a provisional coverageof 30%.

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ET in Classroom Economics