The Economic Times ET In The Classroom Archives 1 (Economics Concepts Explained)

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The Economic Times newspaper now and then publishes articles on current economic issues in a question and answer format under the heading ET In The Classroom. They are simple to understand and remember. Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely available on the net. They are the property of the Economic Times. I have just consolidated all of them here for the benefit of the readers. Complete credit is for The Economic Times newspaper for these wonderful articles. For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop solution for getting acquainted with many economic jargon and concepts.

ET in the classroom: What is Islamic finance?

What is Islamic finance? Islamic finance refers to a financial system that is consistent with the principles of Sharia, the sacred law of Islam. It is different from regular banking in that it prohibits earning of interest (or riba) through the business of lending. It also prohibits direct or indirect association with businesses involving alcohol, pork products, firearms and tobacco. It also does not allow speculation, betting and gambling. How does it work? Islamic finance takes the form of Islamic banking and Islamic insurance, also known as Takaful. Islamic banking is done in five ways: 1. Mudarabah, a profit-sharing agreement 2. Wadiah, a safe keeping arrangement

3. Musharakah, or a joint venture for a specific business 4. Murabahah, cost plus arrangement where goods are sold with a pre-determined margin of profit 5. Ijirah, a leasing arrangement Takaful is a form of mutual insurance based on partnership and collective sharing of risk by a group of individuals. How has Islamic banking progressed in recent years? Islamic banking is most prevalent in Malaysia. It is spreading rapidly in West Asia, where the population is predominantly Muslim. New global financial centres such as Singapore, Hong Kong, Geneva, Zurich and London have made changes in regulations to accommodate the Islamic finance industry, which is nearly a trillon dollar in size now. Indian regulations do not allow Islamic banking but the government is considering allowing it. What restricts the growth of Islamic finance? Most banks conducting Islamic operations have a panel of Muslim scholars called Sharia committee or Sharia board, which determines whether a product or practice complies with Islamic provisions. Also, the accounting is done differently for which there is an official standard-setting body known as the accounting and auditing organization for Islamic financial institutions. The strict code makes Islamic banking a very niche product. .

ET in the classroom: Infrastructure debt fund

What is the Infrastructure debt fund or IDF? Infrastructure debt fund is a debt instrument being set up by the finance ministry in order to channelise long-term funds into infrastructure projects which require long-term stable capital investment. According to the structure laid out by the finance ministry, after consultations with stakeholders, infrastructure NBFCs, market regulators and banks, an IDF could either be set up as a trust or as a company. What happens in either of the scenario?

If the IDF is set up as a trust, it would be a mutual fund, regulated by Sebi or the Securities and Exchange Board of India. The mutual fund would issue rupee-denominated units of five years maturity to raise funds for the PPP, or public private partnership projects . In case the IDF is set up as funds, the credit risk would be borne by investors and not the IDF. As a company, it could be set up by one or more sponsors, including NBFCs, IFCs or banks. It would be allowed lower risk-weightage of 50%, net-owned funds (minimum tier-I equity of 150 crore). It would raise resources through issue of either rupee or dollar-denominated bonds of minimum fiveyear maturity. It would invest in debt securities of only PPP projects, which have a buy out guarantee and have completed at least one year of commercial operation. Refinance by IDF would be up to 85% of the total debt covered by the concession agreement. Senior lenders would retain the remaining 15% for which they could charge a premium from the infrastructure company. The credit risks associated with the underlying projects will be borne by IDF. As an NBFC, the fund would be regulated by the Reserve Bank of India. Who would be the major investors? Domestic and offshore investors, mainly pension funds and insurance companies, who have longterm resources, would be allowed to invest in these funds, while banks and financial institutions would act as sponsors. .

ET in the Classroom: Marginal standing facility

What is the marginal standing facility? The Reserve Bank of India in its monetary policy for 2011-12, introduced the marginal standing facility (MSF), under which banks could borrow funds from RBI at 8.25%, which is 1% above the liquidity adjustment facility-repo rate against pledging government securities. The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Banks can borrow funds through MSF when there is a considerable shortfall of liquidity. This measure has been introduced by RBI to regulate short-term asset liability mismatches more effectively. In the annual policy statement, RBI says: The stance of monetary policy is, among other things, to manage liquidity to ensure that it remains broadly in balance, with neither a large surplus diluting monetary transmission nor a large deficit choking off fund flows.

What is the difference between liquidity adjustment facility-repo rate and marginal standing facility rate? Banks can borrow from the Reserve Bank of India under LAF-repo rate, which stands at 7.25%, by pledging government securities over and above the statutory liquidity requirement of 24%. Though in case of borrowing from the marginal standing facility, banks can borrow funds up to one percentage of their net demand and time liabilities, at 8.25%. However, it can be within the statutory liquidity ratio of 24%.

ET in the classroom: Priority-sector lending

What is priority-sector lending? Banks were assigned a special role in the economic development of the country, besides ensuring the growth of the financial sector. The banking regulator, the Reserve Bank of India, has hence prescribed that a portion of bank lending should be for developmental activities, which it calls the priority sector. Are there minimum limits? The limits are prescribed according to the ownership pattern of banks. While for local banks, both the public and private sectors have to lend 40 % of their net bank credit, or NBC, to the priority sector as defined by RBI, foreign banks have to lend 32% of their NBC to the priority sector. What is net bank credit? The net bank credit should tally with the figure reported in the fortnightly return submitted under Section 42 (2) of the Reserve Bank of India Act, 1934. However , outstanding deposits under the FCNR (B) and NRNR schemes are excluded from net bank credit for computation of priority sector lending target/subtargets. Are there specific targets within the priority sector? Domestic banks have to lend 18 % of NBC to agriculture and 10 % of the NBC has to be to the weaker section. However, foreign banks have to lend 10 % of NBC to the small-scale industries and 12 % of their NBC as export credit. However, for the balance, there are a vast number of sectors that banks can lend as priority sector. The Reserve Bank has a detailed note of what constitutes a priority sector, which also includes housing loans, education loans and loans to MFIs, among others. What has been the experience so far?

It has been observed that while banks often tend to meet the overall priority sector targets, they sometimes tend to miss the sub-targets. This is particularly true in case of domestic banks failing to meet their sub-targets for agricultural advances. One of the reasons banks often site for not lending to this sector is that recovery is often difficult. Is there any penal action in case of non-achievement of priority sector lending target by a bank? Domestic banks having a shortfall in lending to priority sector/ agriculture are allocated amounts for contribution to the Rural Infrastructure Development Fund ( RIDF ) established in Nabard. In case of foreign banks operating in India, which fail to achieve the priority sector lending target or subtargets, an amount equivalent to the shortfall is required to be deposited with Sidbi for one year. ..

ET in the Classroom: What the Greek crisis means to the world

Why Does the World Want to Save Greece? No one can quantify the damage to the world if Greece is allowed to sink. But few are willing to risk it either. Such a fear owes its origin to the 2008 crisis. Many economists, policymakers and some within central banks believe that the financial meltdown of 2008 could have been ringfenced, or at least cushioned, if Lehman was bailed out. But since Lehman was an investment bank, and not a commercial bank holding savings of millions, Fed and the US government had thought that the collateral damage from its bankruptcy would be contained within a few blocks of Wall Street, and no one really would lose jobs and take pay cuts. Within months we all found out how wrong they were. Today, no one wants to take a chance with Greece. Leaders across Europe fear that a Greece collapse can start a fire that will engulf continents. How does fear spread when markets are in such a state? Banks impacted by a default may find themselves cut out from the dollar market the engine of global liquidity. As a result, these banks will find it very difficult to roll over their dollar assets as the other banks which are more solvent would be unwilling to lend them. Thats when the world outside financial markets would feel the pinch. Suppose, a French bank that had given a dollar line to the European subsidiary of an Asian company, or to bank in Asia which, in turn, had extended a dollar credit to a local company, would not roll over the credit line

Will a default cause a dollar scarcity? Banks and companies are already holding on to the dollar. A default will only deepen it. Consider the Asian company whose dollar line has been pulled bank. It will somehow try to organise the money by paying a premium. Having sensed a dollar scarcity and fearing that things may turn worse, it will raise more than it needs. When all companies start doing it, there is artificial scarcity. Not just banks, corporates in Greece would also default How will panic boil over to other Euro nations Speculators will target Portugal, and then Italy. The logic is simple: if Germany & ECB do not help Greece, they will also let Portugal and Italy sink. Soon these will be perceived as basket cases and their bonds, stocks and currencies will face a brutal attack from short-sellers. That would be a problem as Italys debt is more than the combined debt of Portugal, Spain and Ireland So, times running out for Greece? Close to $8 billion worth Greek bonds will mature in December. It needs the money before that, failing which a default is inevitable. IMF is willing to lend a little over $8 billion, but only if Greece takes a string of austerity measures. IMF is not spelling out exactly when it will sanction the loan. Some economists fear the IMF pressure can make things difficult for Greece: how will lower consumption help a country which is already doldrums Isnt Germany in a bit of a Catch-22 situation It is. German politicians know that if there was no euro, its currency would have gained so much that their exporters would have been wiped out. It needs the euro. But convincing Germans isnt easy. They dont want to bail out all Europeans, particularly those who dont work hard. Some think Greece should be exiled from EU for a few years to should put their house in order

ET in the Classroom: Interest rate futures

What is the interest rate futures on 91-day treasury bill? Interest rate futures on 91-day treasury bill are interest rate-driven derivative products that help banks, mutual funds and primary dealers to hedge their interest rate exposure on treasury bills. Financial institutions can lock in the interest rate or the yield on the 91-day treasury at a given date when counter parties enter into the interest rate futures contract.

How are they settled? The 91-day T-bill interest rate futures are cash settled. In case of the 91-day treasury bill, the final settlement price of the futures contract is based on the weighted average price/ yield obtained in the weekly auction of the 91-day treasury bills on the date of expiry of the contract. But in case of interest rate futures on the 10-year benchmark government security, the contract is physically settled. How is the product structured? The minimum size of the contract is Rs 2 lakh and the tenor of the contract cannot be more than 12 months, according to market regulator Sebi, which has designed the product and will supervise its trading. The maximum maturity of the contract can be for 12 months. The initial margin is subjected to a minimum of 0.1% of the notional value of the contract on the first day of trading and 0.05 % of the notional value of the contract thereafter. What kind of volumes has the product generated so far? Last week, the average daily trading volume for the 91-day T-Bill IRF was Rs 360 crore. So far, among the exchanges, only NSE has introduced the product for trading. The interest rate futures (IRF) on 91-day TBills clocked a volume of around Rs 730 crore on the National Stock Exchange (NSE) on the first day of trading last Monday. What are the advantages of the interest rate futures? It is a good hedging tool for banks, primary dealers and mutual funds who have huge exposure to these money market instruments such as 91-day treasury bills. There is no securities transaction tax (STT). The initial margins are also lower, which could attract volumes for the product. Interest rate futures can be used by investors to take a directional call on the interest rates or for hedging their existing position. ..

ET in the classroom: Central plan and role of plan panel and finance ministry
The governments budget exercise usually begins with fixing the contribution of the exchequer to the central plan. Though distributed over many schemes, taken together this is the single biggest item of expenditure in the annual budget. ET takes a look at the concept of Central Plan and the budget support to the plan.

What is central plan in the context of the budget? Central or annual plans are essentially the five year plans broken down into five annual installments. Through these annual plans, the government achieves the objectives of the Five-Year Plans. The details of the plan are spelled out in the annual budget presented by the finance minister. But the actual responsibility of allocation funds judiciously amongst ministries, departments and state governments rests with the Planning Commission. What is gross budgetary support, or GBS? The funding of the central plan is split almost evenly between government support (from the Budget) and internal and extra budgetary resources of public enterprises. The governments support to the central plan is called the Gross Budgetary Support, or the GBS. In the recent years the GBS has been slightly more than 50% of the total central plan. How is the GBS figure arrived at? The administrative ministries responsible for various development schemes present their demands before the planning commission. The planning commission aggregates and vets these demand. It then puts forward a consolidated demand before the finance ministry for the budgetary support it needs from the cental excequer. The amount approved by the finance ministry is usually less than that demanded by the planning commission because of the multiple objectives the North Block has to keep in mind will making allocations. The planning commission in turn adjusts the allocated amount among various demands. How do GBS, central plan and plan expenditure differ? Central plan includes the GBS and the spending of the public enterprises that do not figure in the budget. In that sense the governments spending on the central plan is limited to GBS. But the centre also provides funds to states and union territories for their respective plans. This contribution, together with the GBS, makes up the total plan spending of the government for a year. This is about 30% of the total government expenditure.

ET in the Classroom: Self-help group

What is a self-help group (SHG)?

SHG primarily comprises members with homogenous social and economic backgrounds. It is a voluntarily formed group consisting of women, rural labourers, small farmers and micro-enterprises . The concept is akin to the concept of democracy. SHGs are formed by the members, for the members and of the members. The number of members could be as less as five and could even go up to 20. They save and contribute to a common fund which is used to lend to the members. Since they know each other, members do not seek collateral from each other. What are the goals of an SHG? An SHG is seen as an instrument for achieving a variety of goals, including empowering women. Data from Nabard, which pioneered the concept, shows that 90% of members in the SHG are women and most of them do not have any assets. It also helps in developing leadership abilities among the poor, increasing school enrolments, improving nutrition and in birth control. An SHG is generally started by non-profit organisations, such as an NGO with broad anti-poverty agendas. It is also a popular channel of micro-lending by commercial banks, particularly government-run banks. What are the advantages of financing through an SHG? A poor individual benefits enormously being part of an SHG . Raising finance through SHGs reduces transaction costs for both lenders and borrowers. Lenders have to handle only a single SHG account instead of a large number of small-sized individual accounts, borrowers as part of an SHG cut down expenses on travel to the branch to get the loan sanctioned. What are the different ways in which banks fund SHGs? Banks deal directly with individual SHGs . They provide financial assistance to each SHG for lending to individual members. Alternatively, banks provide loans to SHGs with recommendation from NGOs. Here the SHGs are formed by NGOs or government agencies, which raise funds from banks. In this, NGOs would organise the poor into SHGs , undertake training, help in arranging inputs and marketing and assist in maintenance of accounts. ..

ET in the Classroom: Draft Red Herring Prospectus

A company making a public issue of securities has to file a Draft Red Herring Prospectus with Sebi through an eligible merchant banker prior to filing a prospectus with the Registrar of Companies. What is Draft Red Herring Prospectus?

A company making a public issue of securities has to file a Draft Red Herring Prospectus (DRHP) with capital market regulator Securities and Exchange Board of India, or Sebi, through an eligible merchant banker prior to the filing of prospectus with the Registrar of Companies (RoCs). The issuer company engages a Sebiregistered merchant banker to prepare the offer document. Besides due diligence in preparing the offer document, the merchant banker is also responsible for ensuring legal compliance. The merchant banker facilitates the issue in reaching the prospective investors by marketing the same. Where is DRHP available? The offer documents of public issues are available on the websites of merchant bankers and stock exchanges. It is also available on the Sebi website under Offer Documents section along with its status of processing. The company is also required to make a public announcement about the filing in English, Hindi and in regional language newspapers. In case, investors notice any inaccurate or incomplete information in the offer document, they may send their complaint to the merchant banker and / or to Sebi. What does Sebi do with the DRHP? The Indian regulatory framework is based on a disclosure regime. Sebi reviews the draft offer document and may issue observations with a view to ensure that adequate disclosures are made by the issuer company/merchant bankers in the offer document to enable investors to make an informed investment decision in the issue. It must be clearly understood that Sebi does not vet and approve the offer document. Also, Sebi does not recommend the shares or guarantee the accuracy or adequacy of DRHP. Sebis observations on the draft offer document are forwarded to the merchant banker, who incorporates the necessary changes and files the final offer document with Sebi, Registrar of Companies (ROC) and stock exchanges. After reviewing the DRHP, the market regulator gives its observations which need to be implemented by the company. Once the observations are implemented, it gets final approval & the document then becomes RHP (Red Herring Prospectus). How is DRHP useful to investors? DRHP provides all the necessary information an investor ought to know about the company in order to make an informed decision. It contains details about the company, its promoters, the project, financial details, objects of raising the money, terms of the issue, risks involved with investing, use of proceeds from the offering, among others. However, the document does not provide information about the price or size of the offering.

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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 bank function , whereby the objectives of safety and efficiency are promoted by monitoring existing and planned systems, assessing them against these objectives 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) inducing change. In India, the Payment and Settlement Systems Act, 2007, and the Payment and Settlement Systems Regulations, 2008, provide the necessary statutory backing to the Reserve Bank of India for undertaking the oversight function. The central bank manages the various settlements system, including cash, through currency chest and clears cheques, besides various electronic clearing services. What is Electronic Clearing Service? It was among the early steps initiated towards moving to a paperless settlement system by the Reserve Bank of India. The Bank introduced the ECS (Credit) scheme during the 1990s to handle payment requirements like salary, interest, dividend payments of corporates and other institutions . The ECS (Debit) Scheme was introduced by RBI to provide a faster method of effecting periodic and repetitive collections of utility companies. ECS (Debit) facilitates consumers/subscribers of utility companies to make routine 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, a more secure system was introduced for facilitating one-to-one funds transfer requirements of individuals/corporates . Available across a longer time window, the NEFT system provides for batch settlements at hourly intervals, thus enabling a near real-time transfer of funds. Real-Time Gross Settlement (RTGS): It is a funds transfer system where transfer 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 is not subjected to any waiting period.

Gross settlement means the transaction is settled on one-to-one basis without bunching or netting with any other transaction. Once processed, payments are final and irrevocable. This was introduced in 2004 and settles all inter-bank payments and customer transactions above Rs 2 lakh. Clearing Corporation of India (CCIL): The Corporation, set up in April 2001, plays the Central Counter Party (CCP) in government securities, the US 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 between a buyer and a seller gets replaced by two new contracts between CCIL and each of the two parties. This process is known as Novation . Through novation, the counterparty credit risk between the buyer and seller is eliminated 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 organisation for operating various Retail Payment Systems (RPS) in India. NPCI has taken over National Financial Switch (NFS) from the Institute for Development and Research in Banking Technology (IDRBT). The National Financial Switch (NFS) is an inter-bank network managed by Euronet India.

What is an EEFC Account?

Exchange Earners Foreign Currency (EEFC) account is foreign currency-denominated account maintained with banks dealing with foreign exchanges. The Reserve Bank of India introduced this scheme in 1992 to enable exporters and professionals to retain their foreign exchange receipts in banks without converting it into the local currency. Any person residing in India who receives inward remittances in foreign currency or a company with foreign currency earnings can open EEFC account but they dont earn any interest from the deposits and it is a non-interest bearing scheme. What is the minimum balance for EEFC? This is typically a zero-balance account like normal current accounts. In other words, this means no account holder needs to maintain an average or minimum balance in the EEFC account. How does EEFC help exporters or individuals earn foreign currency receipts? As the account is maintained in foreign currency, no depositors are protected from exchange rate fluctuations.

Is there any prescribed limit of deposits in EEFC? There is no such limit. One can credit his or her entire foreign exchange earnings into this account, subject to some permissible credits. Can one take a foreign currency loan and put it in EEFC? Remittances received on account of foreign currency loan or investment received from abroad cant be deposited in EEFC. What are the permissible credits in this account? a) Inward remittances received by an individual b) payments received by a 100% export-oriented unit, export processing zone, software technology park and electronic hardware technology park c) payments received in foreign exchange by a unit in domestic tariff area for supply of goods to a unit in SEZ d) payment received by an exporter for an account maintained with an authorised dealer for the purpose of counter trade, which is an adjustment of value of goods imported against value of goods exported e) advance remittance received by an exporter towards export of goods or services Can one withdraw in rupees from EEFC account? There is no such restriction on withdrawal in rupees of funds held in an EEFC account. However, the amount withdrawn in rupees cant be converted into foreign currency again and re-credited to the account. Can one make a payment directly from EEFC account? One can make a direct payment from EEFC outside India as per the provisions laid down in FEMA regulations. Fully export-oriented units can also pay in foreign exchange for purchasing goods as per the countrys foreign trade policy. A person residing in India can use the account for paying airfare or hotel expenditure. ..

ET In the Classroom: Making a Case of Financial Inclusion

What is a business correspondent model? In 2006, the Reserve Bank of India allowed banks to use non-bank intermediaries as business correspondents, or business facilitators, to extend banking and other financial services to areas where the banks did not have a brick and mortar branch present. The objective behind it was to aid the process of financial inclusion and consequently take banking to the remotest areas of the country and make them bankable. What do these correspondents do? The business correspondent is nothing but a bank-in-person, who is authorised to collect deposits and extend credit on behalf of the bank of small-ticket sizes. He also recovers principal interest of small value deposits, sale of micro insurance, mutual fund products, pension products, receipt and delivery of small value remittances/other payment instruments. Who is eligible to be a banking correspondent? RBI has allowed a host of entities to act as business correspondents (BCs) of banks. These include NGOs/MFIs set up under Societies/Trust Acts; societies registered under Mutually-Aided Cooperative Societies Acts, or the Co-operative Societies Acts of States; Section 25 companies, which are not-for-profit companies; companies in which NBFCs, banks, telecom companies and other corporate entities or their holding companies do not have equity holdings in excess of 10%; post offices and retired bank employees, ex-servicemen and retired government employees. How is a business facilitator different from a business correspondent? Very often the term business correspondents is used interchangeably with the term business facilitators (BFs). But RBI makes a clear distinction between the two. BFs are allowed to undertake only facilitation services like identification of borrowers, collection and preliminary processing of loan applications, including verification of primary information, creating awareness about savings and other products, processing and submission of applications to banks and promoting and nurturing SHGs and follow-up of recovery and debt counselling. However, facilitation of these services does not include conduct of banking business by BFs, which is the exclusive function of business correspondents. ..

ET in the Classroom: Take-out financing

What is take-out financing? Take-out financing is a method of providing finance for longer duration projects of about 15 years by banks sanctioning medium-term loans for 5-7 years. It is given that the loan will be taken out of books of the financing bank within pre-fixed period by another institution, thus preventing any possible asset-liability mismatch. After taking out the loan from banks, the institution could offload them to another bank or keep it. Though internationally this kind of lending has been in existence for many years, it came to India only in the late 90s. These long-tenure loans were primarily introduced to incentivise banks to lend to the infrastructure sector as banks back then had very little exposure to long-term loans, and also because they did not have adequate resources of similar tenure to create such long-term assets. What does the Reserve Bank rule say? Banks/FIs are free to finance technically feasible, financially-viable and bankable projects undertaken by both public sector and private sector undertakings, provided the amount sanctioned is within the overall ceiling of the prudential exposure norms prescribed by RBI for infrastructure financing. They should also have the requisite expertise for appraising technical feasibility, financial viability and bankability of projects. Which institutions, besides banks, are engaged in this practice? The government promoted Infrastructure Development Finance Corporation, by setting aside a corpus from the union budget, with a primary mandate to promote infrastructure funding. Later, India Infrastructure Finance Company also came up essentially to refinance infrastructure loans of commercial banks. What are the problems with take-out financing? Though take-out financing is a permissible practice in India, the concept has not taken off in a big way. Though the concept in a way addresses the asset-liability issue, regulators still want banks to set aside higher capital for their exposure. Besides, banks are also wary of taking risks such as construction risks, which may delay the project as well as increase its cost. LIQUID COAL Did you know coal can be liquid fuel too?

Coal liquification is seen one of the options to cope up with high crude oil prices. While availability of coal in plenty goes in favour of this process in the energy-scarce scenario, environmental concerns and high cost has so far limited the use of coal-to-liquid (CTL) fuel to an insignificant position except in the case of South Africa. Use of coal for power generation is considered a better option in India as there is no consensus among policy-makers. Lets look at the basic issues related to conversion of coal into liquid fuel. Can coal be converted into liquid fuel? Yes. Coal can be converted into a synthetic liquid fuel and the process is known as coal-to-liquid (CTL) worldwide. Broadly, there are two different methods to convert coal into liquid fuelsdirect and indirect liquefaction. Under the direct method, hydrogen is added to crushed coal and liquid is created with the presence of catalysts. However, further refining of this liquid is needed to achieve liquid fuel with high-grade fuel characteristics. The indirect liquefaction process first gasifies coal using oxygen, steamheating them to very high temperatures. The resultant gas is purified and mixed with water. The liquid fuel that is created can be refined to produce diesel, naphtha, jet fuel, cooking gas and lubricants. Creating this fuel is a very intensive process that requires large amounts of coal, water and energy. Is CTL commercially viable? Skyrocketing price of oil and concern over depleting crude reserves are triggers generating interest in CTL. Ambitious CTL projects are in operation in South Africarun by Sasol, the company that pioneered CTL. Liquid fuel generated from coal caters to 30% of the needs of South Africa. Sasol has patented Fischer Tropsch technology of indirect liquefaction, which converts synthetic gas, extracted from coal, into oil. More than 30 CTL projects across the world are being studied for feasibility, depending on the quality of coal, availability of water and other local conditions. The initial investment in CTL projects is quite high. Is India game for CTL?

The government has studied CTL. The Tata Group, in collaboration with Sasol, made a presentation on a $8-billion indirect liquefaction project using Sasols technology to convert high-ash Indian coal into liquid fuel with a capacity of 80,000 barrels per day of liquid fuel. An inter-ministerial group (IMG) examined the proposal. The Planning Commission rejected the idea, saying that coal be better used for electricity generation rather than making liquid fuels. The IMD discussion also led to a view that those wishing to set up CTL projects should bid for coal blocks, competing with other users. Finally, the government offered three blocks of coal in Orissa with cumulative reserves of about six billion tonnes for the project to private players. There were 22 applicants including Reliance Group and the Tatas. The eligibility criteria says the applicant company should have a minimum net worth of $1 billion, besides having a tie-up with the proven technology providers. The IMG has to decide which companies would be allowed to implement CTL projects. What is CTLs impact on the environment? Green lobbies are fighting against CTL tooth and nail, alleging that Sasol has a questionable environmental and social record in South Africa. They advocate higher investment in renewable resources like wind energy and solar energy, rather than opting for CTL. Liquefying large coal reserves will release huge amounts of carbon dioxide, a greenhouse gas. Proponents of this technology say the gas can be captured and stored underground. The cost of carbon capture and storage will impact the economics of CTL. Coal liquification requires vast amounts of water too and this has led to concerns in water-deficient areas.

The Economic Times ET In The Classroom Archives 5 (Economics Concepts Explained)

Archives -1 Archives -2 archives 3 Archives 4 Archives 5

The Economic Times newspaper now and then publishes articles on current economic issues in a question and answer format under the heading ET In The Classroom. They are simple to understand and remember. Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely available on the net. They are the property of theEconomic Times. I have just consolidated all of them here for the benefit of the readers. Complete credit is for The Economic Times newspaper for these wonderful articles. For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop solution for getting acquainted with many economic jargon and concepts.

ET in the classroom: New concepts & ideas in Budget 2013

The budget for 2013-14 introduced some new concepts and ideas. ET explains some of these items. SERVICE TAX VOLUNTARY COMPLIANCE ENCOURAGEMENT SCHEME A one-time amnesty for those who have collected service tax but not deposited the same with the government. Those service tax providers that have not filed service tax return since October 2007 can disclose true liability and get an interest or penalty waive off. COMMODITIES TRANSACTION TAX (CTT): This is on the lines of securities transaction tax levied on sale and purchase of shares on stock exchanges. The tax will be levied on nonagricultural commodities futures at 0.01 per cent of the trade value, the same rate as that on equity futures. INVESTMENT ALLOWANCE A tax break given to companies for high value investment in plant and machineries, over and above depreciation benefits enjoyed by them. A company investing Rs 100 crore or more in plant and machinery during the April 2013 to March 2015 will be entitled to deduct an investment allowance of 15 per cent of the investment. This is expected to see enormous spill-over benefits to small and medium enterprises. INFLATION-INDEXED BONDS The government hopes this will help increase financial savings instead of buying gold. In the recent years the rate of return on debt investmentshas often been below inflation, which effectively means that inflation was eroding savings. Inflation indexed bonds provide will provide returns that are always in excess of inflation, ensuring that price rise does not erode the value of savings.

ET in the classroom: Goodwill Impairment (2013)

What is goodwill impairment? Goodwill is a set of unidentifiable intangible assets through which an enterprise is suppose to derive future economic benefits, explains Arijit Barman

What constitutes goodwill? It is generally recognised or booked in a transaction where a business is being purchased by one entity from another. It is the excess of the total consideration paid for the business over the value of all its other assets and liabilities (referred to as net assets). Under the Indian accounting framework, goodwill can originate in a merger or acquisition through a high court-prescribed scheme or it may be recorded on account of consolidation of acquired entity by the holding company or when a group of assets are purchased for a lump-sum consideration. Indian GAAP prohibits capitalisation of internally generated goodwill. When is goodwill written off, or impaired? Just like an asset on a balance sheet, a company is continuously required to assess the value of the goodwill. It is generally tested for impairment on an annual basis unless there is a significant change in the business environment. Goodwill is written off when the carrying value of the group of assets is higher than value in use or net realizable value less costs to sell. Value in use is generally determined through a discounted cash flow method whereas realizable value is determined through marketbased inputs. What can cause goodwill impairment? Adverse effect of changes in technology, markets and economic or legal environment Adverse interest rate movements Evidence of obsolescence or physical damage to the companys assets Significant changes in the enterprise; say, plans to discontinue or restructure ops, plans to dispose of an asset before expected date Actual net cash flows or operating profit or loss flowing from the asset/ company are significant ly lower than those budgeted Negative publicity about a firm can create goodwill impairment, as can the reduction of brandname recognition. What is the difference between amortisation and goodwill impairment? Amortisation is the systematic reduction of the carrying amount over its useful life. It is similar to depreciation. If goodwill arises on account of an M&A then it is generally required to be amortized within five years unless a higher period can be justified. Impairment is generally carried out in respect of goodwill arising on account of consolidation of legal entities or a slump sale. This is required at an annual frequency unless we have triggers to do it on a quarterly or half-yearly basis. Where do goodwill writeoffs get reflected?

They are reduced from the carrying amount of goodwill in the balance sheet with a corresponding entry in the profitand-loss account. Are indian companies mandated to conduct goodwill tests? Indian companies are generally required to assess at each balance sheet date whether there is any indication the goodwill is impaired or not. If one or more indications exist, then the company is required to carry out impairment testing on a more frequent basis, quarterly or half-yearly.

ET in the classroom: Why banks need to follow KYC rules?

Money laundering by banks and insurance companies is more widespread than earlier thought, another expose by an online news website has revealed. This development is bound to force banks to undertake a fresh round of verification of the identity of almost all account holders, an exercise called Know your Customer. ET explains what a KYCentails: WHAT IS KYC? Banks undertake this exercise to verify the identity of their customers. The KYC exercise aims to prevent banks from being used, intentionally or unintentionally by criminal elements, for money laundering. DOES KYC APPLY TO ALL CUSTOMERS? Yes. KYC is applicable to every individual who wants to have any business relationship with the bank. This means, any individual wanting to open an account (savings or current account and recurring or fixed deposit), get a bank draft, open a locker, receive any benefits on account of financial transactions, remittance or wire transfer, and apply for a loan. DOES IT HAVE ANY LEGAL BACKING? Yes. The KYC norm has been validated under Section 35A of the Banking Regulation Act, 1949, and Rule 7 of the Prevention of Money-Laundering Rules, 2005. Any violation of these norms could attract severe penalty under the BR Act. WHAT IS NEEDED FOR A KYC CHECK? KYC has two components: identity and address. While PAN and voter card, driving licence and any other identity document that satisfies the banks requirements serve as proof of identity, a copy of passport, electricity or phone bill or bank account statement are accepted as proof of address. DO BANKS OPEN ACCOUNTS FOR THOSE WITHOUT AN ADDRESS PROOF? Yes. But such individuals have to submit an identity document along with a utility bill of the relative with whom the prospective customer is living and a declaration from the relative that the said person is a relative.

CAN KYC NORMS BE RELAXED? To ensure financial inclusion, a low-income group customer without identity and address proofs can open a bank account with an introduction from another account holder who has fulfilled the banks KYC procedure. However, the balance in all his accounts taken together is not expected to exceed 50,000 and the total credit in all the accounts taken together is not expected to exceed 1 lakh. The introducers account with the bank should be at least six months old and should show satisfactory transactions. IS KYC COMPLIANCE A ONE-TIME EXERCISE? No. Banks can ask customers to re-submit fresh identification and address proof to update their records. They can also ask for additional documents if they have doubts about some transaction in order to prevent the account from being used for money laundering, terrorist or criminal activities. HAVE BANKS BEEN PENALISED FOR KYC NORM VIOLATIONS? Yes. The RBI has penalised HDFC Bank, ICICI Bank, Citibank andStandard Chartered Bank.

ET in the Classroom: How Chit funds and crooks raise so much money
Before it became a political slogan, Ma Mati Manush was an open-air folk play that enthralled rural Bengal. Whats now unfolding in Bengal is a sad vaudeville that threatens to destroy lives and livelihoods. Here we bring you upto speed on the goings on. How does a bunch of crooks raise so much money? Lay investors compare returns with post office saving schemes. Anything that looks dramatically better is irresistible to them. Ads, advertorials, word-of-mouth campaigns, collection outlets in every nook and corner, and hefty margins to collection agents work wonders. But arent there restrictions? Theres a way out. These are neither deposits, nor loans, nor bonds, nor stocks. The person who invests may be given a title to a tiny slice of land the company buys or promises to buy. Its as bizarre as collecting money against teak or sandalwood saplings that would be worth crores ten years later. Is that how chit funds operate? No way. Chit funds business model is different. Say, each member in a group of 20 puts in Rs1 lakh to create a corpus of Rs2 core. The fund conducts an auction and members bid to borrow. The winner say the one quoting a 40% discount would borrow Rs1.2 crore, but has to pay back Rs2 crore after 20 months. The pieces of paper on which the discounts are scribbled in the auction are called chits.

How did the bubble burst? Saradha indulged in sharp practices of paying huge agent commission as high as 30% and investing illiquid assets like land. It could not generate abnormal returns that were promised after paying agents and another 10-15% to staff and in ads. Money raised in 2008 was coming up for repayment and no fresh funds could be raised to repay as the word was out that Saradha was in trouble. One hears of various entities that raise money There are Nidhis or benefit companies in the South, but they are much smaller in size. Here, one has to become member by paying a token fee. Members can deposit money as well as borrow. Like chit funds, there is no cap on money that can be raised. Are there ways to sidestep regulations? An influential Andhra businessman tried it a few years ago by using an HUF (or Hindu undivided family) entity to raise collections. It was a unique structure where beneficiaries of the HUF were family members, but depositors were general public. There was no explicit ban on this. But the then state government opposed it. What about the Sahara model? Sahara raised money by issuing optionally fully convertible debentures to crores of investors. But others cant take this route any more with the Supreme Court backing Sebi that such securities have to be listed and regulatory approval is a must if number of investors is more than 50. Is it end of road for shoddy operators? It will be tougher for them. But public memory is short. And, scamsters stay ahead of rule makers. In a country as large as India, its almost impossible to stop cheat funds.

ET in the classroom: Qualified foreign Investors get direct entry

On January 1, the government decided to allow Qualified Foreign Investors, or QFIs, to invest directly in the Indian equities market, a move which it hopes will help boost capital inflows. Who are qualified foreign investors? Qualified foreign investors, or QFIs, can be individuals, groups or associations based abroad who are allowed by the government to invest directly in mutual funds and stocks of Indian companies.

Last year, the government opened a new window for this class of investors to buy into Indian mutual funds directly. It has now gone one step further and allowed them to buy into stocks, too, just like registered foreign institutional investors or nonresident Indians, or NRIs. Are QFIS a separate class of foreign investors compared to FIIs? Qualified Foreign Investors will be distinct from foreign portfolio investors and non-resident Indians. A QFI can, for instance, be a foreign individual investor in Singapore or Russia, who can buy into stocks of a Tata groupcompany or Coal India or any other listed stock after fulfilling the Know Your Customer norms through an Indian depository participant and obtaining the approval of the RBI. QFIs can buy up to 5% of the paid-up capital of a company, with the overall limit capped at 10% in a company. And these investment limits are separate or over and above that for FIIs and NRIs. How does it help by opening up the markets to one more category of investors? Indian policy makers reckon that a diverse set of investors in the local markets will help ensure more capital inflows, reduce market volatility and deepen the markets. It would also mean facilitating the entry of a set of relatively wealthy investors who could not access the Indian markets as there were regulatory restrictions on their entry. For a long time, the government and regulators kept foreign individual investors at bay owing to concerns relating to money laundering and due diligence. With restrictions in place, foreign individual investors had to either buy into Indian stocks through Participatory Notes, or PNs, or invest in India-focused offshore funds. By allowing a new set of investors, the government and regulators are hoping that it will lead to more inflows at a time when capital inflows have virtually dried up.

ET in the classroom: Revenue and spend

In the fourth part of the series, we look at how government meets the gap between revenues and expenditure and how it impacts the economy. FISCAL DEFICIT The rising fiscal deficit has dominated all discussions on the budget. The excess of governments expenditure over its tax and non-tax revenues has to be met with borrowings from the public. This borrowing is called fiscal deficit, which is usually expressed as a percentage of GDP. A high fiscal deficit runs the risk of government cornering the bulk of the savings, leaving little for corporate and other borrowers, or what is called crowding out. Prolonged periods of high fiscal deficit run the risk

of raising interest rates and inflation and depressing growth. A deficit of 3% of GDP is seen as sustainable. In the current year, the government has budgeted a fiscal deficit of 4.6% of GDP. REVENUE DEFICIT Revenue deficit is an important control indicator. All expenditure on revenue account should ideally be met from receipts on revenue account. Ideally, revenue deficit should be zero, else the government debt will keep rising. Revenue deficit means the government is essentially borrowing to consume, a recipe for financial disaster. Ideally, government borrowing should fund asset creation, which will yield returns in the future. PRIMARY DEFICIT The primary deficit is fiscal deficit minus interest payments the government makes on its earlier borrowings. It is another indicator to judge the quality of the government deficit. FINANCING OF FISCAL DEFICIT Market borrowings are the biggest source of funds for meeting the fiscal deficit. The government also takes a portion of the funds raised through small savings by issuing securities to the fund that manages small savings. A part of deficit is also met through external sources of funds. Provident fund accumulations of state government employees is also available for meeting the fiscal deficit. FRBM ACT Enacted in 2003, the Fiscal Responsibility and Budget Management Act had proposed to eliminate revenue deficit by 2008-09. The Act also mandates a 3% limit on fiscal deficit after 2008-09. The 2008 financial crisis and the economic slowdown that followed forced the government to abandon the path of fiscal consolidation. A new fiscal consolidation framework is expected in the budget for 2012-13.

ET in the classroom: KYC norms for MF investments

What is KYC? Client identification process is known as Know Your Customer or Client aka- KYC. Sebi has made it mandatory for all mutual funds to know their clients. This would be in the form of verification of address and identity, providing financial status, occupation and such other demographic information to CDSL Ventures Limited (CVL), a wholly owned subsidiary of Central Depository Services India Limited. Investments equal to and more than Rs 50,000 in a mutual fund portfolio necessarily have to be accompanied by a KYC acknowledgement letter.

How to get KYC compliant? CVL is the designated body to carry out the KYC compliance procedure for mutual fund investors. You have to approach CVL through any of the point of service (POS). The KYC application form is available on the CVL website in the downloads section. One can take a printout of the applicable form. The same is also available on mutual fund websites. Investors need to attach self-attested photocopy of the pan card as identity proof, along with the application form. There is a need of self-attested photocopy of an address proof enlisted by CVL. Alternatively, the investors can also attach true copies attested by a notary or a gazetted officer or a manager of a scheduled commercial bank of a multinational foreign bank. Investors need not visit POS in person. The application can be routed through mutual fund distributors or a representative of investors. The original documents are verified at the counter and given back to the applicant or representatives of the applicant. Non-resident Indians also need to undertake the same process. They additionally have to provide certified true copy of their overseas address. If the same is in foreign language other than English, the same has to be translated in English for submission. The documents can be attested by the consulate office or overseas branches of scheduled commercial banks registered in India. POS upon verification of the documents and receipt of duly filled-in application form issues an acknowledgement letter free of cost. The letter needs to be duly stamped and signed by representatives of POS. In the case of joint holdings in a portfolio, all joint holders have to get themselves KYC-compliant. Applications where the investments are in joint names, photocopies of KYC acknowledgement letters of all applicants must be attached with the application form. In the case of investments in the name of minors, the KYC acknowledgement letter of the guardian is a must. What should you do with KYC acknowledgement letter? Please note that neither POS nor CVL will inform about the KYC exercise you have completed in respect of any of the mutual fund houses. It is your responsibility to do so. You can attach a photocopy of KYC acknowledgement letter, along with the application letter, at the time of fresh investments. You can simply write to the fund houses where you have an investment and request them to update your KYC status. Such requests must be accompanied by the photocopies of the KYC acknowledgement letter. You can also attach the photocopy of KYC acknowledgement letter with your request for additional investments in your mutual fund portfolio. A point to note that upon submission of your KYC acknowledgement letter, the mutual fund house will update your status in their books. The address mentioned in your KYC letter will prevail over the

address you have mentioned in your original application. All future correspondence by the fund house will be maintained at the address mentioned in the KYC letter.

ET in the classroom: Forwards contract, over the counter

WHAT IS A NON-DELIVERABLE FORWARD, OR NDF? Non-deliverable forwards are over-the-counter transactions settled not by delivery but by exchange of the difference between the contracted rate and some reference rate such as the one fixed by the Reserve Bank of India. The need for an NDF market arose because there were countries where forwards trading in currencies is not allowed or is allowed with a lot of restrictions that increases the cost of hedging for corporates. Also, such a market was felt necessary for economies with partially convertible currencies. WHERE DO THESE TRADES HAPPEN? WHICH ARE THE PROMINENT CURRENCIES? NDF trading happens in cities such as Singapore, London, New York and Hong Kong. Brazilian Real, Chinese Renminbi, Taiwanese dollar, South Korean won and Indian rupee are among the prominent currencies. WHO TRADES IN NDFS? Hedge funds and foreign institutional investors, which are allowed to hedge only their actual exposure and not potential exposure; global corporations that do their invoicing in Indian rupee but are not allowed to hedge their exposures; and speculators betting on the direction of the rupee without any exposure. HOW DOES AN NDF TRANSACTION OCCUR? An Indian corporate that is registered in, say, Singapore under a different name and has nothing to do with its Indian counterpart legally, may buy dollars from the spot market in India (Mumbai) at, say, 53.60 per dollar (the reference rate) and sell it in the NDF market in Singapore at 54 per dollar (the contract rate), making an arbitrage of 40 paise. The transaction is carried out by a foreign bank that has branches in both Mumbai and Singapore. WILL NDF MARKET MOVEMENTS AFFECT SPOT RATES?

Yes, they do to some extent and mainly through international banks and companies that take offsetting positions in the domestic and overseas books. WILL RBI CURBS ON OVERNIGHT POSITIONS AFFECT NDFS? Yes, it will squeeze international banks that were profiting from the wild currency movements through their positions in the NDF market while pressuring the spot market due to temporary factors. RBI studies had shown weak linkage between the domestic and NDF markets when the currency movements are in a narrow range. WHAT ARE FIXING AND SETTLEMENT DATES? The fixing date is the date on which the difference between the prevailing market exchange rate and the agreed upon exchange rate or the reference rate is calculated.

Budget 2012: All you wanted to know about DTC and other taxes
ETs helps readers navigate through the maze of tax jargon: Direct Taxes: Its the tax individuals & companies pay directly to the govt. Corporation Tax: Its the tax companies pay (30% at present) on their profits. Taxes On Income Other Than Corp Tax: Its income-tax paid by individuals or non-corporate assessees. This ranges from 10% to 30%, depending on income. Securities Transaction Tax ( STT): Applicable if youre dealing in shares or mutual fund units. It was introduced in the 2004-05 budget, replacing the tax on profits earned from the sale of shares held for more than a year (known as long-term capital gains tax). Minimum Alternate Tax (MAT): Indian companies pay 30% tax on profits as per the I-T Act. But tax holidays could lower the outgo. If a companys tax liability is less than 10% of its profits, it has to pay a MATof 15% of book profits. This provision is expected to change once the direct taxes code (explained below) proposals are accepted. Under DTC, MAT will be levied on gross assets. INDIRECT TAXES: Its essentially a tax on expenditure. Considered regressive, this tax does not distinguish between the rich and the poor and hence most governments prefer to raise their revenues through direct taxes. Customs: Anything you bring from abroad comes at a price. By levying a tax on imports, the government achieves twin objectives: it raises revenues and protects local industries. Union Excise Duty : Imposed on goods manufactured in the country.

Service Tax: You pay the govt when you eat out or visit your hairdresser it is a tax on services rendered. Levied on 119 activities. Value-Added Tax: State governments levy this on goods at the point of sale, based on the difference between the value of the output and the value of inputs used to produce it. The aim here is to tax a firm only for the value it adds to the inputs, and not the entire input cost. Thus, VAT helps avoid a cascading of taxes. TAX REFORMS GOODS AND SERVICES TAX: The proposed GST is expected to streamline the indirect tax regime. It contains all indirect taxes levied on goods, including central and state-level taxes. Billed as an improvement on the VAT system, a uniform GST is expected to create a seamless national market. It could also mean lower taxes. DIRECT TAXES CODE: The I-T Act came into effect nearly half a century ago. To account for the new business and activities that have come since then, the government formulated the DTC. It proposes to simplify tax laws and include a new way to calculate taxes on income. Budget Process The governments annual budget is no different from that of a household, only it has a lot more jargon. In a five part series, ET will help readers make sense of the key items of the budget, from revenue account to the much in debate fiscal. In the first part, we explain the basic architecture of the budget: ANNUAL FINANCIAL STATEMENT The ordinary man confuses the finance ministers budget speech for the annual budget. But as laid down in the constitution, the budget actually refers to the annual financial statement tabled in Parliament along with the 13-15 other documents. Divided into three parts Consolidated Fund, Contingency Fundand Public Account it has a statement of receipts and expenditure of each. CONSOLIDATED FUND This is the core of the govts finances. All revenues, money borrowed and receipts from loans it has given flow into this account. All government expenditure is made from this fund. Any expenditure from this fund requires the nod of Parliament. CONTINGENCY FUND All urgent or unforeseen expenditure is met from this ` 500-crore fund, which is at the disposal of the President. Any amount withdrawn from this fund is made good from the Consolidated Fund. PUBLIC ACCOUNT

All money in this fund belongs to others, such as public provident fund. The government is merely working as a banker in respect of this fund. REVENUE RECEIPT/EXPENDITURE All receipts like taxes and expenditure like salaries, subsidies and interest payments that do not entail sale or creation of assets fall under the revenue account. CAPITAL RECEIPT/EXPENDITURE Capital account shows all receipts from liquidating (eg. selling shares in a public sector company) of assets and spending to create assets (lending to receive interest). REVENUE VS CAPITAL The budget has to distinguish all receipts/expenditure on revenue account from other expenditure. So all receipts in, say, the consolidated fund, are split into Revenue Budget (revenue account) and Capital Budget(capital account), which include non-revenue receipts and expenditure. REVENUE/CAPITAL BUDGET The govt has to prepare a Revenue Budget (detailing revenue receipts and revenue expenditure) and a Capital Budget (capital receipts & capital expenditure).

ET in the classroom: All you want to know about Economic Survey

The first Economic Survey was reportedly presented for the financial year 1951-52 and since has been presented every year as a review of the economy by the government. Over the years, the Economic Survey has transformed from a mere representation of facts to a more suggestive document giving out advice. What Is The Economic Survey? The Economic Survey is a yearly report card of the economy put out by the Chief Economic Advisor. It is a comprehensive document that analyses important economic, financial and social developments over the year. Over the years, it has expanded to accommodate more sectors and include more of analytical content. From 362 pages in 2004-05, the survey has grown to a 459 page document in 2010-11 that included separate chapters on prices, financial intermediation, and service, reflecting their importance in the economic debate. What Is The Significance Of The Survey?

In terms of information, the Survey has little usefulness as most of the data presented is already out in the public domain. Its real significance is that it lays down the economic reforms agenda for the country and contains suggestions to the policymakers on the issues that dominate economic discourse. Tabled usually a day before the Union budget for the next fiscal is presented, it is expected that some of the suggestions in the Survey will find their way into the budget. Has The Survey Lived Up To Its Role? Though the Survey is tabled in Parliament by the finance minister, it largely reflects the views of the chief economic advisor. The reforms agenda laid out in the Survey is statement of what ought to do be done without actually going into their political considerations. This is largely the reason the ambitious reforms agenda included in the Survey documents year after year does not usually reflect in the budget presented the next day. But it does lay down the ground for informed debate on various economic issues.

ET in the classroom: Non-inflationary rate of growth

Economist, Nomura In a recent interview to the Wall Street Journal, D Subbarao, governor of the Reserve Bank of India, said Indias Non-inflationary rate of growth had come down since the global financial crisis and now probably stands at around 7%. ET looks at the concept: What is non-inflationary rate of growth (NIRG)? Non inflationary rate of growth is the maximum rate of growth that the Indian economy can achieve without fanning inflationary pressures. It is similar to the concept of potential rate of growth and is crucial input in the monetary decisions. How does this concept work? If an economy is growing faster than its potential rate of growth, capacities tend to get stretched and resources scarcity emerges. Both producers & workers are then able to raise prices and wages because of the high demand for their products & services. These rising prices across the board lead to generalized inflationary pressures. This implies that there exists a rate of growth for an economy at which inflation will be within a particular comfort zone. What is the risk at the moment? India grew by 6.9% in the second quarter that is almost equal to its potential rate of growth estimated by the RBI. A level of growth higher than 7% could translate into another bout of high inflation unless there is investment in capacity creation and easing supply bottlenecks to increase

resource flow. According to theRBI annual bulletin for the year 2010-11, the threshold for inflation was in the range of 4-6%. Lower trend growth is the result of sharp falls in the investment and savings rates, a higher fiscal deficit and a lack of policy reforms. Therefore, concerted efforts to address supply-side bottlenecks are imperative to reverse the decline. says Sonal Varma

ET in the classroom - BEGGAR THY NEIGHBOUR POLICY

What is beggar thy neighbour policy The beggar thy neighbour policy refers to a policy that aims at addressing ones own domestic problems at the expense of others trading partners in particular. What are the instances of such a policy The most popular forms of a beggar thy neighbour policy are in the areas of foreign trade and currency management.Conventionally,countries often impose tariff barriers and restrict imports to protect their domestic industries.However,with globalisation,such practices are not popular.But to achieve its domestic policy objective,for instance,encouraging exports,central banks devalue or encourage the depreciation of their own currencies compared to its trading partners to retain their respective competitive edge.Sometimes economies compete in encouraging appreciation of their currencies to tame inflation at the expense of hurting income in the exporting countries. Is China adopting a beggar thy neighbour policy Many economists,especially in the US,say China has deliberately kept the value of its currency low to forge ahead in exports.But in this case,more than the competitors,the importing country,US,is complaining because more than anything else,cheap Chinese imports are hurting its domestic economy. How do current economies policies compare Currently,the raging concern among most emerging market economies in Aisa is spiralling inflation on account of rising global commodity prices.Central banks in most economies,including Indias,are (though not necessarily planned) encouraging appreciation of their respective currencies.This is helping them curtail inflation arising out of imported goods as imposing tariff barriers is perceived to be against the principles of free trade.Such a practice hurts export earnings of the countries from where such imports are sourced.But the impact also depends on how crucial such exports are for each economy.

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

ET in the classroom: Interest Rate Swap

What is an interest rate swap? An interest rate swap is an over-the-counter (OTC) derivative instrument available in the currency market where counter parties can exchange a floating payment for a fixed payment and vice-versa related to an interest rate. Financial institutions going for foreign borrowings usually buy interest rate swaps to hedge their interest rate exposure due to fluctuating interest rates. These were originally created to allow multinational companies to evade exchange controls. Today, they are used to hedge against or speculate on changes in interest rates. Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate. How does it work? In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counter party. The fixed or floating rate is multiplied by a notional principal amount (say, $1 million). This notional amount is generally not exchanged between counter parties, but is used only for calculating the size of cash flows to be exchanged.

The most common interest rate swap is one where one counter party A pays a fixed rate (the swap rate) to counter party B while receiving a floating rate (usually pegged to a reference rate such as LIBOR London Inter Bank Offered Rate). A pays fixed rate to B (A receives floating rate) B pays floating rate to A (B receives fixed rate). Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 3.784%, in exchange for periodic floating interest rate payments of LIBOR + 70 bps (0.70%). There is no exchange of the principal amount and that the interest rates are on a notional principal amount. The interest payments are settled in net. The fixed rate (3.784% in this example) is referred to as the swap rate. What are the different types of swaps? Being OTC instruments, interest rate swaps can come in a huge number of varieties and can be structured to meet the specific needs of the counter parties. By far the most common are fixed-forfloating, fixed-for-fixed or floating-for-floating. The legs of the swap can be in the same currency or in different currencies. The above example is a specimen of fixed-for-floating swap. Fixed-for-fixed works the same way except that there is no change in the rate used during the date of payment, as does floating-for-floating swap. ET in the classroom: Deposit Insurance

What is deposit insurance? It is a limited level of protection provided by the government to depositors against bank failures. Every bank is mandatorily covered under the level of Deposit Guarantee and the Insurance Corporation of India. It is particularly relevant in countries like India where financial literacy is very low. At a macro-level, its objective is to contribute to the stability of the financial system. Which entities are covered under deposit insurance in India? All commercial banks, including the branches of foreign banks functioning in India, local area banks and regional rural banks are covered under the deposit insurance scheme. Even co-operative banks are covered. The scheme, however, does not cover deposits with NBFCs and company fixed deposits.

What is the amount covered and how is the premium charged? Under the provisions of the DICGC Act, the insurance cover deposits up to Rs 100,000 under the deposit insurance. The premia to be paid by insured banks are computed on the size of their deposits. Insured banks pay advance insurance premia to the Corporation semi-annually, within two months from the beginning of each financial half year, based on its deposits at the end of previous half year. The premium is currently pegged at Re 1 for every Rs 1,000 of the deposits. What types of deposits are covered under the scheme? The Corporation insures all bank deposits, such as savings, fixed, current, recurring, etc., except deposits of foreign governments; deposits of central/state governments, deposits of state land development banks with the state co-operative banks, inter-bank deposits, deposits received outside India. How are the claims settled? In the event of winding up or liquidation of an insured bank, every depositor is entitled to payment of an amount equal to the deposits held by him at all the branches of that bank as on the date of cancellation of registration (i.e., the date of cancellation of licence or order for winding up or liquidation), subject to set-off his dues to the bank, if any. However, the payment to each depositor is subject to the limit of the insurance coverage fixed from time to time.

ET in a classroom: Cheque Truncation System

What is cheque truncation? It is one of the major innovations in cheque clearing after the Magnetic Ink Character Recognition (MICR) cheques introduced in the 80s. Cheque truncation is a system between clearing and settlement of cheques based on electronic images. This form of clearing does not involve any physical exchange of instrument. Bank customers would get their cheques realised faster as local cheques are cleared almost the same day as the cheque is presented to the clearing house, while intercity clearing happens the next day. Besides speedy clearing of cheques, banks also have additional advantage of reduced reconciliation and clearing frauds. It is also possible for banks to offer innovative products and services based on CTS. Why is it needed?

Though MICR technology helped improve efficiency in cheque handling, clearing is not very speedy as cheques have to be physically transported all the way from the collecting branch of a bank to the drawee bank branch. The CTS is more advanced and more secure. Many countries have sought to address this issue with cheque truncation, in which the movement of the physical instruments is curtailed at a point in the clearing cycle, beyond which the process is completed, purely based only on the electronic data and images of the cheques. What has been the international experience in this regard? Denmark and Belgium are pioneers in CTS. They adopted complete cheque truncation system more than two decades ago. Sweden is the typical example for having achieved complete truncation where all the cheques can be presented and encashed at any branch; irrespective of the bank on which they are drawn. CTS also takes care of the needs of future electronic transactions. What has RBI and banks done? RBI has already enabled CTS to be fully functional in New Delhi. Soon even cheque clearing in Chennai will be settled through CTS. Banks have also taken steps to introduce appropriate technology to facilitate this system. What are the salient features of CTS? The physical cheque is truncated within the presenting bank itself. Settlement is generated on the basis of current MICR code line data. These images will be archived electronically and be preserved for eight years. A centralised agency per clearing location will act as an image warehouse for the banks.

ET in the Classroom: Capital Controls

What are capital controls? Foreign capital inflows in the form of loans and equity that are allowed in a restricted form are said to be controlled. Many countries which had closed economies had imposed severe restrictions on foreign capital. However, as these economies started opening up in the 80s, capital controls were eased, facilitating free flow of capital and ensuring integration with global financial markets.

What are capital inflows? From the perspective of balance of payments a countrys external sector balance sheet foreign currency inflows are broadly divided into current account and capital account flows. While current account flows arise out of transactions in goods and services and are permanent in nature, capital account flows are essential in various kinds of loans and equity investments, which can be reversed. That is why policy makers have to keep a close eye on capital flows. What are the kind of capital inflows in India? These would include inflows through foreign borrowings by Indian corporates and businesses, NRI deposits and portfolio flows from institutional investors into the stock markets Loans to government and short-term trade credit are also included. What has been the extent of dismantling of capital controls in India? India had controls on both capital account transactions as well as on the current account with the local currency fixed by the central bank. However, since 1991, when structural changes to the Indian economy were carried out, the rupee was first made convertible on the current account. Subsequently, capital controls were eased. In 1994, a big shift took place with the government allowing foreign portfolio investments. Over a period of time, foreign direct investment norms and overseas borrowing norms were eased. Why are policy makers thinking of reimposing controls? Though allowing foreign capital allows firms in a capital scarce economy to access cheaper resources to finance their growth plans, the flip side is that it presents risks to value of the countrys currency as well as managing local liquidity arising out of such inflows (as the central bank buys the foreign currency and pumps in local currency). Dependence on foreign capital could leave a country vulnerable to risks, arising out of a abrupt reversal of flows. With many emerging economies remaining relatively unscathed after the global financial crisis, there has been a surge in such inflows, leading to an appreciation in their currencies, including in India. But inflows beyond the absorptive capacity of an economy pose other challenges such as high demand side inflation.

ET in the Classroom: Understanding Aviation Industry Jargon

Aviation business is riddled with gobbledygook such as code-sharing and business aviation to name a few. ET simplifies and explains the industry lexicon. What is passenger seat factor (PSF)? Does a high PSF suggest better performance? The passenger seat factor is a percentage measure of seat occupancy on a flight. However, in itself, a high PSF does not mean that the airline is making money. The flights could be having high occupancy because of the low fares offered. What is code-sharing ? Why do airlines enter into such arrangements? Each airline is identified by a code assigned to it. Code-sharing is a marketing alliance between two carriers. Under such an arrangement, an airline can sell seats in its own name on sectors it does not have operations by booking tickets on the flight operated by the airline with which it has a codesharing pact. For example, if a person intending to fly to Berlin has gone to Air Indias website then he or she would find a flight even if the national carrier does not operate to the German capital. The passenger would locate a Lufthansa flight on Air Indias website as the two have a code-share agreement. Without the arrangement, airlines would lose traffic to bigger rivals. Such an arrangement is extremely beneficial for smaller airlines.

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

Archives -1 Archives -2 archives 3 Archives 4 Archives 5

The Economic Times newspaper now and then publishes articles on current economic issues in a question and answer format under the heading ET In The Classroom. They are simple to understand and remember.

Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely available on the net. They are the property of theEconomic Times. I have just consolidated all of them here for the benefit of the readers. For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop solution for getting acquainted with many economic jargon and concepts. This is part -2 of the archives. Read and spread the knowledge. Click here for Archives-1

ET in the classroom: Quantitative Easing II

What is quantitative easing II?

The term became fashionable post the global economic crisis in 2008, following which most governments across the globe had to pump in huge amount of liquidity in the markets to tide over the crisis. Quantitative easing is the process of infusing money into the system by creating new money and eventually buying financial assets like bonds and corporate debt from financial institutions in the country. This is done by central banks through what is popularly known as open market operations. The idea essentially is to make adequate money in the system to spur consumption demand in any economy. Quantitative easing II is the popular phrase used in the context of American economy these days as the US Federal Reserve Board is touted to go for another round of quantitative easing to consolidate the recovery of the American economy, which has slowed down because of fundamental reasons such as lower consumption and job losses and escape of capital to other economies. What does it mean for India? Quantitative easing II could flood emerging economies with the dollars, thus making the dollars cheaper and, hence, the US exports competitive while forcing other related currencies to appreciate on account of increase in capital inflows. There is speculation that Federal Reserve chairman Ben Bernanke will push for a fresh infusion of about a trillion dollars into the markets this week, by way of buying bonds, which will push up bond prices and bring down the yields, and the bond markets in India would react accordingly. Since economies like China and Singapore have closed doors, or are at best cautious in their regulation of capital flows, India is likely to see a gush of capital flows, which is likely to push up the stock prices, and might eventually call for capital control from regulatory authorities. What are economists saying?

The expert opinion is mixed on this. Nobel Laureate Paul Krugman, who has been a vehement critic of US policies, seems to be favouring QE II. Higher commodity prices will hurt the recovery only if they rise in real terms, he said. And theyll only rise in nominal terms if QE succeeds in raising real demand. And this will happen only if QE II is successful in helping economic recovery, he said in a recent media interview. Another Nobel prize winner, Joseph Stiglitz, who was formerly the chief economist with World Bank, feels that the Fed and its advocates are falling into the same trap that led us into the crisis in the first place. Their view is that the major lever for the economic policy is the interest rate, and if one just gets it right, one can steer this. That didnt work. It forgot about the financial fragility and how the banking system operates. Theyre thinking the interest rate is a dial you can set, and by setting that dial, you can regulate the economy. In fact, it operates primarily through the banking system, and the banking system is not functioning well. All the literature about how the monetary policy operates in normal times is pretty irrelevant to this situation. Nouriel Roubini, who gained fame after his prediction of the global economic crisis of 2008, thinks further quantitative easing will have little effect on the US growth in 2011. He regards QE II as the wrong way to go. An excessive, permanent increase in money, in his view, is an indirect manipulation of the exchange rate.

ET in a Classroom: Beggar Thy Neighbour Policy

What is beggar thy neighbour policy? The beggar thy neighbour policy refers to a policy that aims at addressing ones own domestic problems at the expense of others trading partners in particular. What are the instances of such a policy? The most popular forms of a beggar thy neighbour policy are in the areas of foreign trade and currency management. Conventionally, countries often impose tariff barriers and restrict imports to protect their domestic industries. However, with globalisation, such practices are not popular.

But to achieve its domestic policy objective, for instance, encouraging exports, central banks devalue or encourage the depreciation of their own currencies compared to its trading partners to retain their respective competitive edge. Sometimes economies compete in encouraging appreciation of their currencies to tame inflation at the expense of hurting income in the exporting countries. Is China adopting a beggar thy neighbour policy? Many economists, especially in the US, say China has deliberately kept the value of its currency low to forge ahead in exports. But in this case, more than the competitors, the importing country, US, is complaining because more than anything else, cheap Chinese imports are hurting its domestic economy. How do current economies policies compare? Currently, the raging concern among most emerging market economies in Aisa is spiralling inflation on account of rising global commodity prices. Central banks in most economies, including Indias, are (though not necessarily planned) encouraging appreciation of their respective currencies. This is helping them curtail inflation arising out of imported goods as imposing tariff barriers is perceived to be against the principles of free trade. Such a practice hurts export earnings of the countries from where such imports are sourced. But the impact also depends on how crucial such exports are for each economy. What are the limitations of such a practice? In certain cases, such a policy may prove counter productive. If, for instance, even the competing country counters one policy move, of say, depreciation (to protect exports) then such a practice may not have desirable results, especially the countrys imports are not price elastic (the imports are essential and not dependent on prices) and instead could end up hurting the trade balance through higher import price and resulting in inflation in such economies.

ET in the classroom: Systematic Transfer Plan

What is STP?

Mutual funds not only manage our money but also offer us various easy to use tools that are aimed at improving our investment experience. Most of us know systematic investment plan, where we invest at regular intervals. But few are aware of systematic transfer plan (STP). Under STP, at regular intervals, an amount you opt for is transferred from one mutual fund scheme to another of your choice. Typically, a minimum of six such transfers are to be agreed on by investors. You can get into a weekly, monthly or a quarterly transfer plan, as per your needs. You may choose to transfer a fixed sum from one scheme to another. The mutual fund will reduce the number of units equal to the amount you have specified from the scheme you intend to transfer money. At the same time, the amount such transferred will be utilised to buy the units of the scheme you intend to transfer money into, at the applicable NAV. Some fund houses allow you to transfer only the capital appreciation to be transferred at regular intervals. How is it useful? STP is a useful tool to take a step by step exposure into equities or to reduce exposure over a period of time. Say you have Rs 10 lakh to invest in equity over a period of time. You could put this amount in the liquid fund of a mutual fund or a short-term bond fund. This gives an opportunity to earn a better than saving bank account rate of return. You than start an STP where every month a predetermined amount will be invested into an equity fund. This helps in deploying funds at regular intervals in equities with minimum timing risk.

ET in the classroom: RBIs key policy rates

ET guides you through the key policy rates of the Reserve Bank of India What are the key policy rates used by RBI to influence interest rates? The key policy or signalling rates include the bank rate, the repo rate, the reverse repo rate, the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). RBI increases its key policy rates when there is greater volume of money in the economy. In other words, when too much money is chasing

the same or lesser quantity of goods and services. Conversely, when there is a liquidity crunch or recession, RBI would lower its key policy rates to inject more money into the economic system. What is repo rate? Repo rate, or repurchase rate, is the rate at which RBI lends to banks for short periods. This is done by RBI buying government bonds from banks with an agreement to sell them back at a fixed rate. If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. The current repo rate is 5.50%. What is reverse repo rate? Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. Like the repo, this is done by RBI selling government bonds to banks with the commitment to buy them back at a future date. The banks use the reverse repo facility to deposit their short-term excess funds with the RBI and earn interest on it. RBI can reduce liquidity in the banking system by increasing the rate at which it borrows from banks. Hiking the repo and reverse repo rate ends up reducing the liquidity and pushes up interest rates. What is Cash Reserve ratio? Cash reserve Ratio (CRR) is the amount of funds that banks have to park with RBI. If RBI decides to increase the cash reserve ratio, the available amount with banks would reduce. The bank increases CRR to impound surplus liquidity. CRR serves two purposes: One, it ensures that a portion of bank deposits are always available to meet withdrawal demand, and secondly, it enables that RBI control liquidity in the system, and thereby, inflation by tying their hands in lending money. The current CRR is 6%. What is SLR? (Statutory Liquidity Ratio) Apart from keeping a portion of deposits with RBI as cash, banks are also required to maintain a minimum percentage of deposits with them at the end of every business day, in the form of gold, cash, government bonds or other approved securities. This minimum percentage is called Statutory Liquidity Ratio. The current SLR is 25%. In times of high growth, an increase in SLR requirement reduces lendable resources of banks and pushes up interest rates. What is the bank rate? Unlike other policy rates, the bank rate is purely a signalling rate and most interest rates are delinked from the bank rate. Also, the bank rate is the indicative rate at which RBI lends money to other banks

(or financial institutions) The bank rate signals the central banks long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.

ET in a Classroom: Currency Peg

As China and the US tussle over the value of the Yuan, ET helps you deconstruct the issue. What is a currency peg? There are various ways in which the price of one currency against another is arrived at. In a pegged exchange rate, the value of the currency is fixed with respect to another currency, usually the US dollar. In other words, it is the rate the country or the central bank of the country maintains as the official exchange rate. Chinese currency, for example, is pegged at 6.83 yuan to the dollar. How is the currency peg maintained? Currency pegs work only when the central bank has the muscle to intervene in the market to check the currency from going beyond a permissible band. It should be able to supply the market with enough dollars in the event of a huge demand at the pegged rate and in the event of too much supply be ready to buy dollars from the market. It implies that the central bank must have large foreign exchange reserves. China has foreign currency reserves of nearly $2.5 trillion. How does a currency peg help ? Countries go for a pegged exchange rate to have stability in the foreign exchange market. China had also effectively gone to a dollar peg in July 2008 keeping its currency steady at 6.83 yuan to a dollar as it fought the global economic crisis. The stable currency creates a conducive environment for investments as investors do not fear losses on account of currency fluctuations. Exports benefit as appreciation is kept in check. However, there are numerous instances of currency pegs causing financial crises. Pegged values are difficult to maintain if the central bank is not in position to intervene and defend the peg. Why is the US so bothered about the currency peg? The US believes that China accumulates its huge current account surplus (to the tune of 8% of GDP) and the US, its current account deficit (to the tune of 2.9% of GDP) because its currency is

undervalued, making its exports to the US cheap and its imports from the US expensive. The US blames the pegged yuan for the resultant global imbalance, and want the yuan to appreciate. A bit of history From 1997 to mid-July 2005, Chinese currency was pegged to the US dollar. On 21 July 2005, China ended the peg to the US dollar and switched to a crawling peg linked to a basket of currencies. The renminbi gradually appreciated over 20% over the next three years. In July 2008, China went back to the dollar peg, bringing the Yuan appreciation to an end. Yuan is now valued a 6.83 to a dollar with a plus/minus 0.5% fluctuation.

ET in the classroom: Quantitative easing

The US seems ready for another round of quantitative easing to boost growth, employment generation and consumer spending. There is consensus among economists and policymakers in the worlds largest economy that the Federal Reserve should target a higher level of inflation to spur growth. ET takes a look at the concept of quantitative easing. What is quantitative easing? Central banks usually stimulate a slowing economy by cutting interest rates, which encourage people to spend by borrowing more or discouraging them to save. But with interest rates in the developed world already close to zero, that option is no longer available. In such situations , the central banks resort to pumping money directly into the economy, a process known as quantitative easing. It is done by buying bonds usually government paper but can also be private bonds from banks and financial institutions. The developed countries used quantitative easing to spur growth in the aftermath of the financial meltdown of 2008. What is the idea behind quantitative easing? At any given point of time there is a fixed amount currency /money chasing products and services available in the economy. The idea essentially is to get more money into the system chasing the same amount of produce to drive up their prices. In the case of quantitative easing, the bondsellers will receive money that has not been in circulation, which will increase the money supply in the system. As the money in the economy increases the demand for different products rises. How does it help?

The flood of cheap money causes asset prices to rise i.e. the price of shares, real estate etc. The notional high wealth, together with cheap and easy credit, encourages people to spend. Quantitative easing also helps devalue the currency, thereby encouraging exports further and increasing the level of activity in the economy. The final consequence is increased demand resulting in ramping up of production, which, in turn, creates more jobs in the economy. Why is it important in the current scenario? Quantitative easing could potentially ward off deflationary expectations and kickstart an uncertain economy. But in todays globalised world, cheap money from developed economies may flow into emerging economies and fuel asset bubbles and inflation there. Brazil has been struggling to deal with the rising tide of inflows . India, too, is keeping an eye on increasing forex inflows.

ET in a Classroom: Stock Valuation

What are the various analytical approaches for valuation of stocks? For investing, an investor can use an approach based on either fundamental analysis, technical analysis or quantitative analysis. What is Fundamental Analysis? It is the process of looking at a companys business from an investment point of view. The process involves analysing a companys management capabilities, its competitive advantages, its competitors and the markets it functions in. As part of the analysis, you would look at examining key financial ratios like the net profit margins, operating margins, earnings per share and so on. After examining the key ratios of a business, one can come at a conclusion about the financial health of a stock and determine the value of the stock. It further focuses primarily on the valuation of a company and its relationship with the current share price. Combining all this, the analyst arrives at a valuation for a stock. Fundamental analysts believe that it is possible to estimate the true value of a company using these financial valuation methodologies.

If the share price is trading below the value arrived at by a fundamental analyst, investors should buy the stock, in anticipation of the share price rising to the true value in the future. Conversely, if the share price is higher than the estimated true value, investors should sell. What is Technical Analysis? This technique focuses on the past to predict the value of the future, using share prices and volumes traded in a stock. It does not look at fundamentals or financial results at all. Technical analysts believe that all information about a company is factored into the share price. According to them, share price behaviour is repetitive in nature and hence can be used to predict future share price movements. Based on historical share price data of a company, technical analysts identify share price levels that act as support or resistance. They try to identify support, resistance and breakout levels for stocks. Technical analysts also use various technical indicators and chart patterns to help them determine probable future share price movements. What is quantitative analysis? With the advent of computers, a third type, namely quantitative analysis, has come up. Quantitative analysis seeks to understand behaviour by using complex mathematical and statistical modelling, measurement and research. It is a process of determining the value of a security by examining its numerical, measurable characteristics like sales, earnings and profit margins. Pure quantitative analysts look only at numbers with almost no regard for the underlying business. Although even fundamental analysis look at numbers from a balance sheet, their primary focus is always the underlying business, the environment in which the company is operating and so on. Quantitative analysts create mathematical algorithms, which help them arrive at buy and sell decisions. Which is the best? The different analytical tools have different uses. For instance, fundamental analysis could be used to identify companies with a possibility of strong earnings growth in the future. Technical analysis could be used to decide when to buy this stock. When you combine technical and fundamental analysis it is called techno-fundamental research. Depending upon your style and time frame of investment you could choose among them.

ET in the classroom: Care for a Dim Sum?

Chinas growing affluence and influence over the world economy has created huge demand for assets denominated in yuan, the basic unit of the renminbi. China is also keen to globalise its currency to offset any losses to its record foreign exchange reserves due to weakness of the dollar. This has led to the creation of the Dim Sum bond market in Hong Kong. ET explains the concept. What Is A Dim Sum Bond? A bond denominated in yuan and issued in Hong Kong. Derived from a traditional Chinese cuisine that offers a variety of small eats, Dim Sum bonds are issued by Chinese government and companies as well as foreign entities. What Makes Dim Sum Bonds Attractive For Investors? Investors across the world are looking for opportunities to make money out of Chinas phenomenal growth, but the countrys stiff capital controls prohibit them from investing in Chinese debt. Dim Sum bonds offer an avenue to such investors. Investors are rushing to the Dim Sum market on expectations that Beijing will continue to let the yuan appreciate. Exposure to yuan-denominated assets also provides an alternative to bonds issued by western governments and companies and fits well with the Principle of Diversification, that a portfolio containing different assets and kinds of assets carries lower risk. Lower interest cost is also encouraging companies to raise money through the Dim Sum market. Last month, IDBI Bank became the first issuer of Dim Sum bonds from India. It sold 650 million yuan ($102 million) of three-year bonds priced at a fixed coupon of 4.5% per annum. The bank said it cut a percentage point off its dollar funding costs by going to the Dim Sum market. Reports say infrastructure lender IL&FS is also planning to raise $100 million through yuandenominated bonds. Is There A Limit On Such Issuances By Indian Entities? Recently, the yuan was added to the list of currencies in which Indian companies can raise funds overseas, in addition to dollar, euro, pound and yen. Indian firms can raise an equivalent of $1 billion in yuan. How Big Is the Dim Sum Bond Market? The Dim Sum market has risen from 10 billion yuan in 2007 to more than 100 billion yuan. Analysts forecast the market to grow beyond 300 billion yuan in 2012. Where can Indian Issuers deploy The Proceeds?

Indian issuers can deploy the money for capital expenditure within China and use the proceeds for settling trade accounts. They can also enter into swap contracts to get other currencies. However, if the money is to be brought back to India, companies will have to comply with the External Commercial Borrowing guidelines set by the Reserve Bank of India.

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

What is LTE? LTE, or Long Term Evolution , is the latest wireless mobile broadband technology that will power future 4G, or fourth generation, networks designed primarily for data transmission at unprecedented speeds. It uses spectrum to carry data traffic, just as we need roads to carry vehicular traffic. Spectrum may be likened to a highway of airwaves on which mobile signals travel. Since LTE uses wider chunks of spectrum, data speeds on LTEbased 4G networks are nearly four times faster than on 3G. An iPad user, for instance, will be able to watch videos at LTE speeds of 300 Mbps while a laptop user will be able to download a chunky 25MB file in seconds if adequate spectrum is available. LTE is also a scalable bandwidth technology that works alongside 2G and 3G. So a 3G operator can easily upgrade his network to LTE. WHEN WAS IT DEVELOPED? LTEs genesis goes back to November 2004, when a workshop was held by the 3GPP (3rd Generation Partnership Project) in Toronto to define Long Term Evolution . The 3GPP was a global alliance of top telecom associations who tried to identify the next wave of mobile tech after UMTS, the 3G technology based on GSM. IS LTE BETTER THAN WiMAX? Wireless communication happens over paired or unpaired spectrum. Paired spectrum is two equal chunks of airwaves for sending and receiving information while unpaired spectrum is a single strip of airwaves meant to either receive or send information. Voice signals travel over paired spectrum while data communications works better on unpaired spectrum as people download more than upload. WiMAXhad an edge as long as it was the sole wireless technology working commercially over unpaired spectrum . But the WiMAXparty crashed when an LTE variant, TDD-LTE which also worked over unpaired spectrum arrived.

Whats more, leading vendors unveiled compatible gear commercially in 2010. This LTE variant was heralded by the worlds top telcos as the coolest technology for highspeed data communications on the go. WiMAXsuffered a body blow when big telcos across China, India and the US also embraced TDD-LTE . Commercialisation of TDD-LTE devices hit fast-track after Qualcomm pitched for wireless broadband spectrum in the 2010 auction and won 20MHz of BWA airwaves in four circles. Even WiMAXbackers like Clearwire in the US and Yota in Russia warmed up to LTE. Ditto with WiMAXgear vendors like Nokia and Cisco. IS TDD-LTE CATCHING ON IN INDIA? Not as yet. But that said, the first seeds of an LTE ecosystem were sown when Bharti Airtel joined some of the worlds top LTE backers at Mobile World Congress 2011 in Barcelona to launch the Global TD-LTE Initiative (GTI). Global deployment of this technology was in fact at the heart of last years auction of BWA airwaves in India. But the big challenge to fast-track deployment of TD-LTE in India is the paucity of compatible devices andsmartphones. Only Qualcomm has launched TDD-LTE multi-mode devices. NSN is slated to unveil 4G devices by the time LTE network rollouts start happening in India by December 11 to early-2012 .

ET in the classroom: Offshore Banking Unit

What is offshore banking unit? Offshore banking unit (OBU) is the branch of an Indian bank located in a special economic zone (SEZ), with a special set of rules aimed at facilitating exports from the region. As laws define it, its a deemed foreign branch of the parent bank situated within India, and it undertakes international banking business involving foreign currency denominated assets and liabilities. The concept comes from the practice prevalent in several global financial centres. Here an OBU can accept foreign currency for business but not domestic deposits from local residents. This was conceived to prevent competition between local and offshore banking sectors. What was the need for OBUs? In addition to providing power, tax and other incentives to SEZs, policymakers felt a need to provide SEZ developers access to global money markets at international rates. So in 2002, RBI instituted

OBUs, which would be virtually foreign branches of Indian banks. These would be exempt from CRR, SLR and few other regulatory requirements. RBI regulations make it mandatory for OBUs to deal in foreign exchange, source their foreign currency funds externally, follow all prudential norms applicable to overseas branches and are entitled for IT exemptions. Thus in many respects, they are free from the monetary controls of the country. What price, freedom from regulations? In the eight years that they have been operational, concerns have been raised that, funding by OBUs to SEZs would lead to increase in external debt of India. Also, some have suggested that OBUs as vehicles for extending dollar loans have no use as long as they are restricted to doing business only in the zones in which are they located. This would create an unnecessary regulatory arbitrage like booking business because there is some arbitrage advantage on offer. Anyways, ground realities could not be more different. Hardly a handful of banks have set up their OBUs, so the argument looks very far fetched. SEZ, itself as a concept has been struggling, given the issues that SEZ developers have faced over acquiring land from farmers. What is the future of OBUs? Most international financial centres still house OBUs, so saying they are not required may be incorrect. However, some analysts have said OBUs are losing relevance at a time of increasing globalisation. They say OBUs will be of no use after the economy opens up fully and the rupee is fully convertible. These experts argue for one or two OBUs, instead of having several of them spread across the country.

ET In The Classroom: Public Debt Office

What is a public debt office? A public debt office or a debt management office is an autonomous government agency which acts as the investment banker to the government and raises capital from the markets for the government.

It formulates the borrowing calendar for the government and decides upon the maturities of the securities to be issued on behalf of the government. A public debt office works separately from the central bank and has nothing to do with the formulation of the monetary policy or setting interest rates. What are the conflicts of interests if the body that formulates the monetary policy also acts as the Centres investment banker? There are certain inherent conflicts of interest when the agency, which raises funds for the government, also manages its monetary policy and regulates interest rates. The basic conflict of interest is between setting the short-term interest rates and selling government securities. The Reserve Bank of India, like a good merchant banker to the government, sells bonds at high prices. At lower interest rates or yields, it runs the risk of adding to inflationary concerns. Another area of concern is that RBI is also the regulator of all banks, which means the central bank could arm-twist the banks to buy bonds at higher prices or for longer tenors. For a very long time now, economists have been arguing in favour of an independent debt management office, which in the Indian discourse is called National treasury management agency or debt management agency, so that RBI can be relieved of the burden of being the Centres investment banker.

What is the practice in advanced economies? Developed economies such as the UK, the US and New Zealand, already have independent public debt offices in place. Former RBI governors have time and again complained about the difficulties in managing government debt while trying to keep interest rates high to rein in inflation. Does India have a debt management office? The finance ministry had proposed setting up of the debt management agency in its 2007-08 Budget. A series of expert committees have recommended the establishment of the debt management agency. These include groups headed by the former finance secretary Vijay Kelkar, former World Banker Percy Mistry and ex-IMF chief economist Raghuram Rajan. A draft legislation had also been created by the Jahangir Aziz Working Group. While presenting the Budget for 2011-12, finance minister Pranab Mukherjee had announced the governments intention to introduce the bill for an autonomous debt management office in the next financial year.

How is it expected to be structured? The agency is likely to be an autonomous body under the administrative control of the finance ministry. The central bank will be on the management committee of the agency. A middle office or MoF is already working in the finance ministry that prepares the borrowing calendar of the Centre. A mid-office would constitute a single comprehensive database about all liabilities and guarantees of the government of India. For now, the 21 public debt offices of RBI continue to function. The structure and functions of the debt management office have been discussed and reworked on for three years now but little sense of urgency has been seen. .

ET in the Classroom: Non-competitive bidder

What is non-competitive bidding in dated government securities? The Government of India conducts periodic auctions of government securities and of the total amount notified for auctions, a certain portion is kept aside for the non-competitive bidder, or the small and medium investors. Non-competitive bidding means a person would be able to participate in the auctions of dated government securities without having to quote the yield or price in the bid. That saves him the worry, about whether the bid will be on or off-the-mark. How is the process useful? It helps deepen the government bonds market by encouraging wider participation and retail holding of government securities. It enables the participation of individuals, firms and other mid-segment investors who neither have the expertise nor the financials to participate in auctions. RBI gives such investors a fair chance of assured allotments of government securities. Who can be referred to as the non-competitive bidder? RBI allows individuals or firms, provident funds, corporate bodies or trusts who do not have current account (CA) or subsidiary general ledger (SGL) account with the Reserve Bank of India. Regional Rural Banks (RRBs) and Urban Co-operative Banks (UCBs) can also apply under the noncompetitive bidding scheme.

Eligible investors have to place their bid through a bank or Primary Dealer (PD) for auction. Each bank or PD, on the basis of firm orders, submits a single bid for the total sum of non-competitive bids on the day of the auction. The bank or PD will furnish details of individual customers, viz., name, amount, etc., along with the application. The non-competitive bidding facility is available only in dated central government securities and not in treasury bills. What happens if the total amount offered for bidding via non-competitive bidding basis exceeds the amount allotted? In case the amount bid by PDs on behalf of the investors is more than the reserved amount through non-competitive bidding, allotment would be made on a pro-rata basis. For example, the amount reserved for allotment in an auction in noncompetitive basis is Rs 15 crore. The total amount of bids for noncompetitive segment is Rs 20 crore. The partial allotment percentage is =15/20=75%. That is, each bank or PD, who has submitted non-competitive bids received from eligible investors will get 75% of the total amount submitted.

ET in the classroom: Potential growth rate

The countrys policymakers seem to be fighting a losing battle with Inflation. Some economists link the persistently high prices to the pace of economic growth. They say Indian economy is expanding at a rate beyond its potential growth rate. ET examines the concept and its relationship with prices: What is the potential rate of growth of an economy? Potential output is broadly the maximum output growth that an economy can sustain over the medium to long term without stoking inflation. In a recent report on India, the International Monetary Fund (IMF) estimates Indias potential growth rate at 7-8%. What factors decide the potential growth rate? There are two major determinants of the potential rate at which an economy can grow in the long run. One is the rate of increase in key inputs such as labour and capital, while the other is the rise in productivity. Within the two key inputs, labour has a bigger say in determining the potential growth rate.

The increase in labour supply through an increase in number of workers or the numbers of hours put by a given number of workers and an increase in labour productivity will result in an increase in the long-term potential growth rate. Anything that aids productivity increases can help boost potential growth rate. Infrastructure investments and skilling of labour can raise Indias potential growth rate because the country has ample labour supply. How does growing faster than the potential rate cause inflation? The overall demand in the economy picks up due to fast growth and more resources are used to meet higher demand. After a point, the economy may not find enough inputs to meet the demand, leading to an increase in prices. If there is surplus capacity in the economy then it can grow above the potential rate for a while. But for an economy already working at full capacity, excessive demand results in increase in the price level. The IMF says India was growing at a rate faster than its potential rate in 2007-08, but because of the financial crisis in early 2009 substantial slack emerged in economy. It says the quick rebound from the crisis has exhausted that slack and now there is a risk of high inflation if the Indian economy grows too fast.

ET in a classroom: How are poverty numbers calculated

Widespread poverty is the biggest challenge for Indias policymakers. The government has drawn criticism for its inability to tackle the menace despite high economic growth. Some estimates place the number of poor at 40% of the population. ET looks at how poverty numbers are generated: How is the poverty line defined? The concept of poverty is associated with socially perceived deprivation with respect to basic human needs. Historically, India has followed a poverty line, which is based on a minimum number of calories that an individual should consume and a rupee amount was calculated on this basis. The existing rural and urban official poverty lines were originally defined in terms of per capita total consumer expenditure (PCTE) at 1973-74 market prices and is adjusted over time and across states for changes in prices.

The method still retains the original 1973-74 all-India reference poverty line baskets (PLB) of goods and services. These PLBs were derived separately for rural and urban areas, anchored in per capita calorie norms of 2400 (rural) and 2100 (urban) per day. People whose PCTE is below the required minimum are considered to be below the poverty line. What is the international poverty line? The common international poverty line is based on an income of around $1 a day. In 2008, the World Bank revised the figure to $1.25 at the 2005 purchasing power parity. What is the new way to define the poor? As the earlier estimates of poverty have been largely perceived as inadequate, a committee led by Suresh Tendulkar came up with a new way to define the poor. Tendulkar moved away from calorie anchor while testing the adequacy of actual food expenditure. The method uses same consumption basket for rural and urban poor, but applies different price levels of rural and urban areas to arrive at the poverty estimate. The major departure from the original method is the provision for including expenditure on health and education. Does India need to redefine poor? With India hitting a high growth trajectory, the living standards and consumption patterns in both urban and rural areas have changed, while existing data continues to use consumption baskets that reflect trends prevalent in 1973-74. Earlier poverty mechanisms also assumed that basic social services like health and education would be supplied by the state, therefore even as both were covered in base year 1973-74, no account was taken for the change in the proportion of expenditure in these services since then. ..

ET in the Classroom: Competition

Why is competition important? What is its economic rationale? Competition, according to economic theory, forces firms to develop new products, services and technologies which would give consumers greater choice and better products. If more and more firms deal in a similar product, consumer choice widens. This causes product prices to drop below the level that would be if there were no competition; that is, if there was just one firm (monopoly) or a few firms (oligopoly). How is competition measured?

Competition is generally measured by calculating concentration ratios . Concentration ratios indicate whether an industry consists of a few large firms or many small firms. Two of the most commonly used metrics are the Herfindahl Hirschman Index (HHI) and the N-firm concentration ratio. Herfindahl Hirschman Index: Under the HHI, the market share of each firm in a relevant sector is squared and added to arrive at a statistical measure of concentration. The value of the index varies from close to 0, indicating nearly perfect competition, to 10,000, indicating the presence of just one firm, a monopoly. HHI = s1 2 + s2 2 +3 2 + + sn 2 (Where sn is the market share of the nth firm, and s varies from close to zero to 100). N-firm concentration ratio: This method measures the dominance of the biggest firms in a particular sector. N in this case is the number of firms being considered. A four-firm concentration ratio, for instance, would just sum up the market shares of the four biggest firms in the market. Fewer firms having a large market share would indicate less competition. How are these measures used? In the US, mergers are scrutinized by analysing concentration ratios. Generally, a market with a HHI of less than 1,000 is considered competitive . A market with a HHI in the 1,000-1 ,800 band is moderately concentrated. A measure of 1,800 and more indicates a highly concentrated market. As a general rule, mergers that increase HHI by more than 100 points in concentrated markets raise antitrust concerns and invite further scrutiny by authorities.

ET in the Classroom: Asset classes

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

This practice helps banks know the strength of its credit portfolio. If there is a risk of non-payment of loans or defaults, banks would start focusing on their credit monitoring act and take corrective measures. According to classifications, banks make provisions to take care of the fallout of a default. What are the broad classifications prescribed by the regulator, the Reserve Bank of India? The RBI has classified assets into four broad categories. These are prescribed by the Bank for International Settlements, an inter-governmental body of central banks. However, each central bank is allowed to tweak the definition as per their loan market. Standard asset Asset where borrowers pay their interests on the loan as per the schedule is a standard asset. Sub-standard asset A sub-standard asset is one which has remained an NPA for a period less than or equal to 12 months. An NPA or a nonperforming asset is one where a borrower fails to pay the interest on the loan for three consecutive months. Doubtful asset An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months. Loss asset When banks see little possibility of recovering the loan, it becomes a loss asset for the bank. Banks or auditors consider this as a loss for the bank. What are the provisioning requirements for these assets? For loss assets, if kept in the book of banks, 100% of the outstanding has to be provided for. For doubtful assets, if the loan asset has remained in the doubtful category for 1 year, then the provisional requirement is 20%. If it has stayed there for a period of 1-3 years, it calls for a provisional coverage of 30%.

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

Policy anomalies and lack of consensus on what constitutes infrastructure have undermined efforts to spur creation of physical assets. A look at the current status and the need to define infrastructure. How is infrastructure defined in India? There is no clear definition as of now. A broad meaning of the term is based on a series of reports and observations made by different government agencies and committees. A commission chaired by C Rangarajan in 2001 attempted to define infrastructure according to six characteristics: natural monopoly, high sunk costs, non-tradability of the output, non-rivalry in consumption (which implies benefit of public good can be extended to additional consumers without any huge additional cost), possibility of price exclusion and bestowing externalities on society. However, these characteristics were not considered absolute. For taxation purposes, the income-tax department considers companies dealing with electricity, water supply, sewerage, telecom, roads & bridges, ports, airports, railways, irrigation, storage (at ports) and industrial parks or SEZs as infrastructure. However, special tax benefits are also given to sectors like fertilizers, hospitals and educational institutions, adding to the confusion. The Reserve Bank of India and the Insurance Regulatory and Development Authority have also tried to define infrastructure and identify sectors. Why is a precise definition of infrastructure needed? A clear understanding of what is covered under the rubric of infrastructure is necessary for policy formulation, setting of targets, and monitoring projects to ensure consistency and comparability in the data collected and reported by various agencies. Moreover, the emphasis on infrastructure has led to the government extending many incentives and tax benefits to infrastructure companies. Without a proper definition these benefits can be misused. What is the international norm? Globally, too, defining infrastructure has been an arduous task. The US and most European countries have defined infrastructure sectors for tax purposes. There is no consistency across the developed world on what constitutes infrastructure. Many countries have also identified sub-sectors like core infrastructure, social infrastructure, retail infrastructure, and urban and rural infrastructure. How is India approaching the issue?

The finance ministry will identify the sectors primarily based on the characteristics set out by the Rangarajan committee with some additional requirements. Based on the criteria, the finance ministry is likely to notify 25 sectors as infrastructure. These sectors will be eligible for tax incentives, viability gap funding and will be covered by regulatory framework for infrastructure which will include levy of user charges. ..

ET in the Classroom: corporate repo bonds

What is corporate repo bond? Banks, corporate and primary dealers pledge corporate bonds with each other to raise short-term money. It is similar to banks pledging government securities (gsec) with RBI to raise short-term money. Unlike pledging of g-secs, here the borrower who pledges corporate bonds does not receive the entire value of the bond. When did RBI allow repo in corporate bonds? RBI guidelines on repo in corporate debt securities came into effect on March 1, 2010.These guidelines were amended in December 2010 as the market participants demanded a reduction in hair-cut margins. It was reduced from a flat rate of 25% to a band of 10-15%, depending on the rating of the corporate bond. According to the amended guidelines, the settlements had to be made within two days of the deal. How does the repo in corporate bonds work? Investor A, who needs finance for an interim period, can issue these bonds while entering into an agreement with investor B that at a given point of time he would buy back the bond from investor B, though the bond issuer would have to suffer a hair-cut margin of 10-15%, which will vary according to the credit rating of the bond. How active is the repo in corporate bonds in India? Only five deals have been reported so far. Companies that have issued corporate bonds in India are REC, PFC, HDFC and NHB. Why has repo in corporate debt not taken off? Lack of market participation could be because of lenders or issuers maintaining a cautious approach as well as due to lack of proper trade guarantee mechanism. Also, the hair-cut margin of 10-15%,

(which is the margin enjoyed by the investor on the day the agreement is reversed), is still very high from the investors point of view considering the volatility in corporate debt market does not demand such a high hair cut. Interest rate is determined over-the-counter, but there is no mechanism for efficient discovery of prices. There is no centralised clearing agency like the Clearing Corporation of India (CCIL ) for central government securities. .

ET in the classroom: What is stagflation?

Stagflation is an economic situation where the growth rate slows down, unemployment levels remain steadily high & inflation also stays high. What is stagflation? Stagflation, a concept which did not gain acceptance till the 1960s, is described as a situation in the economy where the growth rate slows down, the level of unemployment remains steadily high and yet the inflation or price level remains high at the same time. At the first instance, high inflation and unemployment or slower growth seem like opposites and mutually exclusive. It came to be seen in the 1970s as a situation when the economy has low productivity and yet the goods are highly priced in spite of low unemployment. The term stagflation came to be used for the first time in the British Parliament by Lain Macleod in 1965. Once stagflation occurs it is difficult to deal with. The measure a government usually takes to revive an economy in recession (cutting interest rates or increasing government spending) also increases inflation. Under normal recessionary conditions, inflationary policies are acceptable, but here, given the already high inflation, pushing inflation still higher could mean prices spiralling out of control, thus further hitting productivity and growth. What causes stagflation? The major reasons for stagflation, whenever it has occurred in history, have been-supply shocks or shortages due to unforeseen reasons which push up prices of essential commodities, causing an inflationary situation and at the same time pushing up production costs, as it happened in 1970s in the US. The other reason is failure of the monetary authority to control excessive growth of money supply in the economy and excessive regulation of goods and labour markets by the government. For example, in the 1970s, a similar situation occurred during the global stagflation, where it began with a huge rise in oil prices, but then continued as central banks used stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.

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

ET Classroom: Casa
What is Casa Ratio? Casa is basically the current and savings sccount deposits. Casa ratio is the share of current and savings account deposits to the total deposits of the bank. In India, interest rates paid on current and savings account deposits is administered by banking regulator the Reserve Bank of India. Why are banks keen on garnering a higher share of Casa? Interest rate paid on Casa is much lower compared to other deposits like term deposits or recurring deposits. While banks do not pay any interest on current account, interest paid on savings account deposit is 4%. Banks therefore make maximum effort to increase the share of Casa on their books to reduce their overall cost of deposits. HDFC Bank has the highest share of Casa to total deposits at 52%, followed by the State Bank of India at 48% and ICICI Bank at 45%. What does Casa mean for customers? Recently, RBI increased interest paid on savings account deposits from 3.5% to 4%. Further a year ago, RBI told banks to pay interest on savings deposits on a daily basis rather than paying on the minimum balance maintained by them in six months. As a result, savings account customers earn better returns compared to what they earned a year ago. Further, interest earned on savings account deposits does not attract TDS (tax deduction at source). Interest income above 10,000 a year attracts TDS of 10% in case of term deposits. However, there is no major benefit for current account deposits, which is mainly maintained by corporates and traders. What are the disadvantages of high Casa? These deposits can move out of banks books anytime, leading to asset-liability mismatches. While in case of term deposits, banks are almost certain that the depositor may not withdraw money before the maturity of the deposit and may also renew the deposit on maturity. Further, to finance long-

term projects, banks need to have long-term liabilities on their books to avoid mismatches. Banks cannot rely on Casa deposits to fund long-term loans.

ET in the Classroom: Sovereign debt crisis

What is sovereign debt crisis? Sovereign debt crisis means the sovereign governments borrowing from domestic and external markets is in excess of its capacity to repay, resulting in loan defaults requiring rescheduling of loans or bailout packages from other countries or multilateral institutions such as IMF. How did the Greek crisis originate ? The crisis in Greece surfaced in 2007-08 , when it came to be known that Greece was not in a situation to meet its repayment obligations to its external creditors. The budget deficit of Greece was in the range of 13.6% of its gross domestic product. The stock of debt was equivalent to 115% of the gross domestic product. The debt problem was further compounded by the fact that nearly threefourths of the government debt was held by foreign institutions, particularly foreign banks. Not only was the high fiscal deficit a problem, it was also camouflaged by derivative hedging. Reportedly, investment banks misled investors into investing in government bonds of Greece by being secretive about the actual state of affairs. The rating agencies played accomplice and allegedly failed to assess the correct fiscal position. Who bailed out Greece? Greece reached an agreement with IMF, the European Commission and the European Central Bank on a rigorous programme to stabilise its economy with the support of a $145-billion financing package against which the Greek government was required to implement fiscal measures, structural policies and financial sector reforms. Some of the points of the reform package were reducing the fiscal deficit to 3% by 2014, pensions and wages to be reduced for three years, government entitlement programmes had to be curtailed and social security benefits cut.

The Economic Times ET In The Classroom Archives 3 (Economics Concepts Explained)

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The Economic Times newspaper now and then publishes articles on current economic issues in a question and answer format under the heading ET In The Classroom. They are simple to understand and remember. Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely available on the net. They are the property of the Economic Times. I have just consolidated all of them here for the benefit of the readers. For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop solution for getting acquainted with many economic jargon and concepts.

ET In the CLASSROOM: ESSENTIAL COMMODITIES ACT

The Prime Minister will soon hold a meeting of chief ministers to discuss the alarming food price situation and review the implementation of Essential Commodities Act (ECA). ET looks at the ECA and how it can help combat the rising prices of food articles. What are essential commodities? The government has powers under the Essential Commodities Act, 1955 (EC Act) to declare a commodity as an essential commodity to ensure its availability to people at fair price. The EC Act, 1955 allows the government to control the production, supply, and distribution of these commodities for maintaining or increasing supplies and securing their equitable distribution. Essentially, the act aims to ensure easy availability of important commodities to consumers and check exploitation by traders. How many commodities are covered by the Essential Commodities Act? There are seven broad categories of essential commodities covered by the Act. These are (1) Drugs; (2) Fertilizer, inorganic, organic or mixed; (3) Foodstuffs, including edible oilseeds and oils; (4) Hank yarn made wholly from cotton; (5) Petroleum and petroleum products; (6) Raw jute and jute textile; (7) (i) seeds of food-crops and seeds of fruits and vegetables; (ii) seeds of cattle fodder; and (iii) jute seeds. Recently cotton seed was also included in the list. How does the Act help check price rise? The Act is implemented by the state governments and union territories, leaving the central government to merely monitor the action taken by states in implementing the provisions of the Act. State and UT administrations use the powers of the Act to impose stock or turnover limits for various

commodities and penalise those who hold them in excess of the limit. Stock limits have been imposed in several states for pulses, edible oil, edible oilseeds, rice, paddy and sugar. How effective is the Act? Over the three years 2006-2008 , state and union territory governments prosecuted 14,541 persons under the provisions of EC Act, 1955 and secured conviction in 2,310 cases. In 2009 as on 31 August 2533 persons had been prosecuted and 37 convicted. But, doubts have been raised about effectiveness of the Act time and again. Recently, Parliaments estimates committee asked the government to come out expeditiously with a new legislation for controlling the retail prices of essential commodities such as rice, wheat, pulses, edible oils, sugar, milk and vegetables. http://www.economictimes.indiatimes.com

ET in the classroom: What is underrecovery?

It is the gap between the local price of fuel and what would have been the price if the fuel were imported. Is under-recovery the same as loss? It is a notional loss in revenue to the extent the international price of the fuel is higher. It may or may not be a loss-making proposition to produce the fuel when there is an under-recovery. In case of kerosene, oil companies suffer an under-recovery as well as a loss because the local retail price is much lower than the cost of crude oil. But sale of a product like petrol can still be very profitable at times, even if oil companies are reporting under-recovery of a few rupees a litre. Does a rise in underrecovery make an oil cos operation less profitable? It may not. At times, international crude oil prices remain flat but petrol and diesel prices rise. In such a situation, an Indian refinerys profitability will not change because crude oil costs have not gone up. But under-recovery would have risen because the cost of importing the fuel would have risen. Has the concept of underrecovery exaggerated the problems of oil firms? This year it did. Prices of oil products in Asia rose earlier this year, when a fire shut down a large refinery in Taiwan. This reduced the supply of refined oil products and the change in the demandsupply situation made petrol and diesel more costly.

The Tsunami in Japan and a recent fire at a refinery in Singapore had the same impact. The refining margin for diesel, called crack spread has been $20 a barrel most of this year. In April, diesel margins jumped to a three-year high of $24 per barrel. Last year, it was $10-15. So, under-recovery on diesel looks higher this year. In other words, oil companies want a higher price for diesel partly because some refineries in other countries were shut down. Apart from this, oil companies also charge a customs duty and a marketing margin, in addition to marketing cost, to calculate underrecovery. These are profits, not costs. Can oil companies be at a disadvantage by linking prices to under-recovery? Yes. This may happen next year. In 2010, very little new refining capacity was added in Asia, while demand was strong. Next year, China and the Middle East will add about 1 million barrels per day of refining capacity. This is expected to increase supply of products and deflate refining margins. As a result under-recovery is expected to fall.

ET in the Classroom: Leave Travel Allowance

What is Leave Travel Allowance? Leave Travel Allowance (LTA) is the part of the remuneration granted to employees by the employer to provide for personal travel expenses incurred during the year. Apart from the employee, it covers travelling expenses of spouse, children as well as dependent parents and siblings. Further, the exemption is restricted to two children born on or after October 1, 1998. There is no restriction on the number of children born before this date. How does LTA save on tax outgo? Under section 10 (5) of the Income-Tax Act, if an employee who is in receipt of LTA undertakes a journey within the country, s/he can claim the value of the allowance exempt from income tax. For the purpose, the individual should have been on leave for the period during which the journey was undertaken. Can you claim it every year? No. The exemption can be claimed only twice in a block of four calendar years. The current block has started from January 1, 2010, and will last until December 31, 2013. The previous one ended on December 31, 2009. If you do not avail of the concession in any particular block or undertake just

one journey, you become entitled to carry forward one journey to the next block. However, this has to be utilised in the first year of the new block. For instance, if you availed of the concession just once instead of twice between January 1, 2006 and December 31, 2009, then you are allowed to carry forward the unused one into the subsequent block (2010-2013), provided you undertake the journey in 2010 itself. A point to be noted here is that even if you dont avail of the concession at all during a particular block, you can carry forward only one entitlement to the next block. Can the entire amount be claimed as an exemption? The exemption will depend on certain criteria specified. Firstly, it is the lower of the actual expenses incurred and the allowance granted by your employer. Lets assume your LTA is Rs 10,000, but you end up spending Rs 15,000 on travelling. In such a case, the exemption will be allowed to the extent of Rs 10,000. Conversely, if your LTA stands at Rs 15,000 and your actual expenses amount to Rs 10,000, you will still be entitled to a deduction of only Rs 10,000. Other parameters that decide the extent of exemption? If you have opted to fly to the destination, an amount not exceeding the economy class airfare of the national carrier by the shortest route to that city would be admissible as deduction. In case you are travelling by road or rail, the cost of first class air-conditioned ticket to the destination by the shortest route would constitute the benchmark. Besides, if your travel plan entails visiting multiple places during the trip, the destination farthest from your place of residence would be taken into account for determining the exemption amount. What if the travel bills are not submitted before the deadline? If you fail to submit your travel bills pertaining to LTA claim with your employer within the time prescribed, your employer would consider the amount of LTA paid as taxable and deduct income tax at the rate applicable to you. However, you can claim LTA exemption at the time of filing your income tax return.

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 earn interests and this forms the most important item under this head. The government also receives dividends and profits received from PSUs. It also earns income for the various services it provides. Of this, the railways is a separate ministry, though all its receipts and expenditure are routed through the consolidated fund. Capital Receipts Receipts in the capital account of the consolidated fund are divided into three broad heads public debt, recoveries of loans and advances, and miscellaneous receipts. Public Debt Since everything the government does is on behalf of the people, its borrowings eventually are the burden of the people. In budget parlance, the difference between borrowings (public debt receipts) and repayments (public debt disbursals) during the year is the net accretion to the public debt. Public debt can be split into two heads, internal debt (money borrowed within the country) and external debt. The internal debt comprises Treasury Bills, market stabilisation scheme, ways and means advances, and securities against small savings. Treasury Bills (T-Bills) These are bonds (debt securities) with maturity of less than a year. These are issued to meet shortterm mismatches in receipts and expenditure. Bonds of longer maturities are called dated securities. Market Stabilisation Scheme (MSS) The scheme was launched in April 2004 to strengthen RBIs ability to conduct exchange rate and monetary management. These securities issued under MSS are not to meet the governments expenditure but to provide the RBI with a stock of securities with which it can intervene in the market to manage liquidity. Ways & Means Advances (WMA) RBI is the banker for both the central and state governments. Therefore, it provides funds to manage mismatches in the governments receipts and payments in the form of WMAs. Now, RBI wants the government to issue short-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 such schemes.

ET in the classroom: All about rate corridor

In the monetary policy on Wednesday, the RBI raised the repo rate by 25 basis points to 5.75% and the reverse repo rate by 50 basis points to 4.5%. This has narrowed the rate corridor from 150 basis points to 125 basis points. ET demystifies the concept of rate corridor. What are repo and reverse repo rates? Repo rate is the rate of interest charged by the central bank when banks borrow money from it. It is the tool through which the RBI in-fuses funds into the system by lending to banks against pledging of securities. The reverse repo is the rate the RBI offers to banks when they deposit funds with it. The RBI drains out liquidity from the financial system through reverse repo by releasing bonds to the banks. This is a daily operation by the central bank to manage liquidity Over a longer time, the RBI can also manage liquidity through open market operations. What is an interest rate corridor? Interest rate corridor refers to the window between the repo rate and the reverse repo rate wherein the reverse repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the overnight interbank call money market, where lending and borrowing is unsecured, should move within this corridor. However, when banks are short of funds and the overnight call money rates are high and above the repo rate, banks approach the RBI to borrow under the repo window. Therefore, the repo rate becomes an effective policy tool as it would help bring down the rates in the overnight market . The reverse hap-pens when money market rates fall below the reverse repo rate. Banks then park surplus funds with the RBI through a reverse repo trans-action. As a result, when there is excess liquidity in the system, the reverse repo is more effective. When liquidity is tight and banks need short-term funds from the RBI to manage mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to the system the reverse repo would become the operative policy rate as the RBI would be draining out funds from the system. Why is a narrow rate corridor desirable?

A narrow rate corridor means that short-term interest rates in the call money market will move within that band. This band was earlier 150 basis points, which has now been lowered to 125 basis points. Effectively, the narrower rate corridor will mean there will be less volatility in short term rates. Do other central banks also have rate corridors? Many developing countries have the rate corridors but central banks in developed and deeper financial markets have a single rate. In the US, for instance, the Fed Fund rate is the key interest rate. Short term funds are available at this rate to the eligible borrowers.

ET In the Classroom: Making a Case of Financial Inclusion

What is a business correspondent model? In 2006, the Reserve Bank of India allowed banks to use non-bank intermediaries as business correspondents, or business facilitators, to extend banking and other financial services to areas where the banks did not have a brick and mortar branch present. The objective behind it was to aid the process of financial inclusion and consequently take banking to the remotest areas of the country and make them bankable. What do these correspondents do? The business correspondent is nothing but a bank-in-person, who is authorised to collect deposits and extend credit on behalf of the bank of small-ticket sizes. He also recovers principal interest of small value deposits, sale of micro insurance, mutual fund products, pension products, receipt and delivery of small value remittances/other payment instruments. Who is eligible to be a banking correspondent? RBI has allowed a host of entities to act as business correspondents (BCs) of banks. These include NGOs/MFIs set up under Societies/Trust Acts; societies registered under Mutually-Aided Cooperative Societies Acts, or the Co-operative Societies Acts of States; Section 25 companies, which are not-for-profit companies; companies in which NBFCs, banks, telecom companies and other

corporate entities or their holding companies do not have equity holdings in excess of 10%; post offices and retired bank employees, ex-servicemen and retired government employees. How is a business facilitator different from a business correspondent? Very often the term business correspondents is used interchangeably with the term business facilitators (BFs). But RBI makes a clear distinction between the two. BFs are allowed to undertake only facilitation services like identification of borrowers, collection and preliminary processing of loan applications, including verification of primary information, creating awareness about savings and other products, processing and submission of applications to banks and promoting and nurturing SHGs and follow-up of recovery and debt counselling. However, facilitation of these services does not include conduct of banking business by BFs, which is the exclusive function of business correspondents.

ET in the classroom: Saving private airlines

Why are Indian airlines in the red despite rising passenger traffic? Because of high taxes on fuel and rising operational costs. Moreover, cutthroat competition in the sector prevents airlines from raising ticket prices. Taxes constitute 40% of an airlines total expenditure, far above the global average of 32%. Besides, revenues barely cover operational costs. For instance, operating margin for Kingfisher stands at 0.12 while it is negative for Jet Airways (8.25%) and Spice Jet (-6.7%). Why cant airlines raise fares to cover these costs? Fierce competition in the Indian skies prevents them from doing so. In the case of Jet, cost per available seat km (ASKM) rose to Rs 3.31 in the second quarter of this fiscal compared with Rs 2.74 in the previous quarter. In contrast, revenue passenger km (RPKM) has crawled up to Rs 3.63 from Rs 3.5. So if an airline goes bust, should the government bail it out? The tempting answer is that those responsible for corporate recklessness must bear the consequence, but in real world things are not so simple. Many experts argue that had Lehman Brothers not been allowed to go bust, the financial crisis could have been less damaging. But, a corporate bailout sends

the wrong signal or creates a moral hazard of encouraging more recklessness, the cost of which is borne by the taxpayer. What is moral hazard? In economic theory, the concept of moral hazard comes from the insurance industry where an individual or a company behaves differently when he is protected from a risk than when he is exposed to the risk. The guarantee of insurance can make the insured less risk averse, as he knows he is protected from the financial consequences of his actions. How does the concept apply to bailouts? If a company believes its existence is crucial for the economy or for public good, it may be tempted into taking reckless risks believing that the government will step in to bail it out if it were to land in trouble. Therefore, any rescue of troubled private sector firms makes others believe that they could also be similarly helped out if things went wrong.

ET IN THE CLASSROOM

Whats EPCG scheme?

The Export Promotion Capital Goods (EPCG) scheme was one of the several export-promotion initiatives launched by the government in the early 90s. The basic purpose of the scheme was to allow exporters to import machinery and equipment at affordable prices so that they can produce quality products for the export market. The import duty on capital goods like all other items was high during that period, inflating the cost of capital goods nearly 50%, so the government allowed exporters to import capital goods at only 25% import duty. For waiver of the remaining portion of import duty, exporters were supposed to undertake an export obligation (a promise to export) which was worked out on the basis of the duty concession obtained. Exporters were given eight years to carry out their commitment to export. Once the export obligation was fulfilled, the owner of the capital goods concerned could sell them or transfer them to another facility. Till the promised export materialised, the owners of the machinery or equipment were barred from even moving the goods concerned out of their manufacturing unit. Did liberalisation of imports have an impact on EPCG? Gradual reduction in import duties, particularly in the case of capital

goods, has been rendering EPCG scheme less attractive. However, till last year, EPCG was preferred by many since the exemption also included 4% special additional duty of customs (SAD) which has been abolished now. Textile machinery, for example, attracted an import duty of only 5% but the 4% SAD resulted in the duty burden going up to nearly 10%. This led many textile units to prefer the EPCG, but the scenario may change now in view of the governments decision to abolish SAD. The government has been modifying the EPCG scheme over the years in line with the demands of the domestic industry. The first change was the introduction of two windows the first one attracting 15% duty while the second one attracted 25%. Those who preferred to pay higher duty under the second window had a lower export obligation. In 95, the government offered duty-free imports under the first window while the duty under the second was 15%. This was the first time duty-free imports were made available under EPCG. Since the purpose of the scheme was to allow exporters compete internationally, it was decided to allow them to buy machinery at internationally-competitive rates. The pent-up demand for imported machinery had peaked at this point and the domestic industrys initial trouble with competing imports had come to an end. Thereafter, the government even reduced the import duty on capital goods under the second window to 10% while the first remained duty-free. Subsequently, the policy was changed in 00 to merge the two windows into one import capital goods by paying 5%

and undertake uniform export commitment. Who were the major beneficiaries of the EPCG? The manufacturing industries, especially those who had to import their capital goods, were the main beneficiaries over the years. The service sector was nowhere in the picture till last year. Now service industries like hotels can also avail of EPCG imports and fulfil the export obligation through the foreign exchange earned by them. This is a major concession for service providers who were ignored over the years. Since services now account for nearly 50% of the countrys GDP, it is fair to allow service providers to imports goods at internationally-competitive rates. The attraction of EPCG has, anyway, diminished over the years and it will be a question of time before the scheme becomes redundant. Import duties will come down over the years, especially in the case of capital goods. It will be curtains for the EPCG scheme once the duty on capital goods comes down to 5%. Going by the pace at which India is signing free trade agreements, this possibility seems nearer. Like other outdated instruments like the cash compensatory scheme (CCS) for exporters and the quantitative restrictions (QRs) on imports, the once-popular EPCG will also exist only on records once the duty reduction materialises over a period of time.

ET in the classroom: The anatomy of layoffs

What are layoffs? When companies discharge employees either temporarily or permanently because they have no money to pay them or there is no work for them. The term is also known variously as downsizing, redundancy, right-sizing, workforce optimisation and redeployment. Several companies, banks and financial institutions across the world resorted to layoffs during the slowdown after the collapse of Lehman Brothers in September 2008. In India, the term became more familiar during late 2008 and early 2009. Are there any warning signs before jobs are shed? Layoffs are a function of business sentiment. So job losses happen during slowdowns, which are usually preceded by phases of high inflation. During a slowdown, job markets tighten up as entities go on austerity drives to lower their administrative and other costs. Generally, the next phase of critical action deals with rightsizing initiatives. Layoffs are imminent at this stage. Is there a way to pre-empt and, thus, avoid job loss? Sometimes organisations resort to layoffs as a natural reaction to slowdown. But instead of such knee-jerk measures, there are many other preventive steps they can take. Proper work-force planning, continuous focus on cost control, multiskilling and creating a positively enabling work culture are some of the ways in which organisations can plan ahead of time so that they do not have to downsize and lay off people during a downturn. How can one cope? Craft a nice resume, circulate it in your professional network and approach headhunters which deal in your specialisation or in your target sectors. Do not hide the pink-slip fact from your near family. Share it with them so that they can provide you emotional support. How does one prepare for a new career? Employees should reflect on their skillset and be clear about their competencies. Telecom and financial services sectors in India have experienced layoffs and workforce deployment in recent months. If certain sectors are not doing well, look for similar options. Those in financial services can explore small and medium enterprises and retail. Those from telecoms can look at anything that can connect B2C social network, e-commerce, technology

companies. Approach the principals and entities who would see close synergy with these profiles and start informal discussions with potential employers or interested parties. Continuous skilling and learning is recommended. There is a need to be entrepreneurial so that in every change one finds newer opportunities and value propositions.

ET in the classroom: No-claim Bonus (NCB)

What is a `No-claim bonus? No-claim bonus (NCB) is a discount in premium offered by insurance companies if a vehicle-owner has not made a single claim during the term of the motor insurance policy. The discount, which is on own damage cover, ie, cover against damage to the vehicle, can go as high as 50% for both 2wheelers as well as 4-wheelers. How much NCB can you enjoy? This discount in the premium is usually 20% for the second year, 25% for the third year, 35% for the fourth year, 45% for the fifth year and 50% for the sixth year. The value of the discount depends upon the insurance claims you have made in that particular year. NCB can be carried forward and will be only allowed provided the policy is renewed within 90 days of the expiry date of the previous policy. What if you sell your car? The no-claim bonus is a reward to the vehicle owner for prudent use of the vehicle. If you sell a 10year old hatchback and purchase a C-segment car, the no-claim bonus will pass on to the new vehicle and you can save considerably on your insurance costs. Can you get the NCB transferred to another insurance company? Yes, subject to evidence in the form of a renewal notice or letter, confirming the NCB entitlement from the previous insurer. What should you do if you renew the policy online? You have to scan and send the cover note to the insurance company online and it will do the needful.

What if you hide your claim history and avail of a no-claim bonus from a new insurance company? Initially, you might succeed in getting a no-claim bonus by hiding your claims history. But insurers are sharing their claims databases and any false declaration will surely be detected.

ET in the classroom: New rules treat GDRs/ADRs on par with shares

Do Global Depository Receipts (GDRs) and American Depositary Receipts (ADRs) currently have voting rights? The GDRs and ADRs in themselves do not have voting rights, but the underlying equity shares do. These shares are held by a depository, which then issues the corresponding receipts (GDRs/ADRs) to investors looking to buy such instruments. So it is the depository that has the voting rights. Whether the holders of the GDRs/ADRs can vote or not depends on the depository agreement between the company issuing the GDRs/ADRs and the depository. During the initial years when GDRs and ADRs came into vogue, the agreement mandated depositories to vote on behalf of the management. But later, the depository agreements were changed so as to allow the GDR/ADR holders to instruct the depository to vote on their behalf. How do ADRs/GDRs work? ADRs/GDRs are issued by companies looking to raise funds overseas. These instruments may represent one, multiple or a fraction of the underlying shares. For instance, if an Indian company wants to issue ADRs, it will deliver the corresponding number of shares to the US depository bank. The depository will then issue receipts to investors who have subscribed to the issue. Depository receipts are transferable instruments, so they can be freely traded on the exchange on which they are listed. They are also fungible, which means the holder of ADRs can instruct the depository to convert them into underlying shares and offload them in the local market (in this case India). What did Sebi say about GDRs/ADRs on Tuesday? Till now, purchases made through GDRs/ADRs did not trigger an open offer by the acquirer even if the 15% threshold was crossed so long as the depository receipts had not been converted into

underlying shares. But on Tuesday, the regulator amended this rule. Anyone now holding ADRs/GDRs with voting rights will have to make an open offer to minority shareholders if his holding touches the 15% limit. Why did the regulator have to make this amendment? Securities lawyers and merchant bankers say the Takeover Regulations relating to ADRs/GDRs were drafted at a time when the depositories always voted on behalf of the management. Now that depository receipt holders have the right to vote, it makes little sense to keep ADR/GDR holdings outside the purview of the Takeover Regulations. How does this amendment affect the Bharti-MTN deal? Bhartis proposed takeover of MTN involved issuing GDRs to the South African telecom firm and its shareholders, which would add up to 27% of Bhartis equity base. In an informal guidance to Bharti in July, the regulator had said that purchases through the GDR route would not trigger an open offer unless the GDRs were converted into shares. But under the new rule, MTN will have to make an open offer for an additional 20% in Bharti. This would make the deal expensive for MTN and also for Bharti, if it wants to get around the new rule. Can Bharti still go ahead with its deal with MTN? It can. For instance, the depository agreement can stipulate that the GDRs will not have any voting rights. This is the most inexpensive way of getting around the new rule. But the key question here is whether MTN shareholders will agree to such an arrangement. The other option for Bharti is to cut down the issuance of GDRs to below 15% and pay more cash to MTN. But that could increase the cost significantly for Bharti.

ET Classroom: Top-up premiums in ULIPs

A top-up premium is something that a policyholder can invest into his ULIP over and above his existing premium payment. If you want to take advantage of a well-performing ULIP, you can increase its investment component by paying an extra premium. Will the sum assured increase in tandem with top-ups?

There is no compulsion to increase the insurance component of the ULIP. But some ULIPs increase the sum assured in accordance with the top-up premium. For example, in ICICI Pru Life Time Maxima, a recently-launched ULIP, the sum assured would be increased by either 125% or 500% of the top-up premium as chosen by the customer. Hence, prepare your policy document carefully. How can you top up a ULIP? You can top up a ULIP anytime during the life of the policy until the total of top-up premiums does not exceed 25% of the total premium paid. Every company clearly defines the minimum top-up amount in the policy document itself. It is usually more than Rs 2,000. But this option is available only for disciplined customers who pay their premiums on time. If your regular premium is due and you pay a top-up premium, the insurance company will direct the additional funds towards the regular premium amount. If the total of top-up premiums exceeds 25% of the total premiums paid, the sum assured of the policy can go up by as much as 125 times of the top-up, depending upon the underwriting requirements of the life insurance company. What are the charges? The premium allocation charge of a top-up plan is anywhere between 1% and 3% and varies from policy to policy. How will I benefit from a top-up premium? You can save on the premium allocation charge by opting for a top-up premium. For instance, you can opt for a low-value ULIP to test the waters. You can then step up your investment component in a staggered manner after monitoring its performance. Secondly, you can benefit from lower premium allocation charges by adopting this approach. For example, the lowest allocation charge of any regular premium of a ULIP available in the market today is 5%, which is still higher than the premium allocation charge of top-up premiums. Ideally, you should avail yourself of the low base effect benefit in the initial years of the policy and top up the policy subsequently. But a word of caution: if your top-ups exceed a limit, the final sum may be subject to tax proceeds at maturity. This clause again varies from policy to policy. Can you opt for partial withdrawal from top-up premiums?

Usually the lock-in-period for each top up premium is three years from the date of payment of that top-up premium for the purpose of partial withdrawals. In fact, some ULIPs do not permit partial withdrawals if top-up premiums are paid in the last three years before maturity date.

ET in the classroom: Mortality Charges

What are mortality charges? Mortality charges are that part of life insurance premium that go towards providing a death benefit cover. In other words, these are the actual cost of insurance in a life policy. In most policies, the bulk of the premium goes towards investing in a savings fund which is returned to the policyholder when the policy matures or the policyholder dies. How are they calculated? Most companies use a table of charges prepared by the Life Insurance Corporation (LIC) since this is the only company which has five decades of experience and consequently has historical data on life expectancy. Since private insurers have been around for a decade, some have made alterations to the rates based on their own experience. Work is on progress on a new mortality table with data from all companies and prices are expected to fall as life expectancy has gone up. Will the policyholder benefit from buying a policy at a young age? Yes. For instance, the life expectancy of a 25-year-old will be higher than that of a 55-year-old, and hence, the former will stand to benefit in terms of lower charges while buying insurance. How will the updated mortality table impact pension policies? Since the life expectancy of the average Indian has gone up, it is likely that you will have to incur a higher cost when it comes to buying whole-life annuities. Those who invest in pension plans will have to use at least two-thirds of the accumulated sum to buy annuities a product where the investor gets regular income for a specified period in return for a lumpsum payment. The savings under a pension plan have to be invested in annuities to avoid them being taxed. One-third of the pension fund value at maturity is made available to the insured for tax free. The balance has to be used for purchase of annuities from any insurer.

The Economic Times ET In The Classroom Archives 4 (Economics Concepts Explained)

Archives -1 Archives -2 archives 3 Archives 4 Archives 5

The Economic Times newspaper now and then publishes articles on current economic issues in a question and answer format under the heading ET In The Classroom. They are simple to understand and remember. Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely available on the net. They are the property of theEconomic Times. I have just consolidated all of them here for the benefit of the readers. Complete credit is for The Economic Times newspaper for these wonderful articles. For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop solution for getting acquainted with many economic jargon and concepts.

ET in a classroom: What is a GDP deflator?

What is a price deflator? A deflator is used to convert data compiled over a period into prices prevailing at an earlier point in time. for example, the current price of a television can be deflated to what it would cost say three years ago. Essentially, a deflator removes the effect of inflation from data, making it comparable across periods. What is the role of price deflator in GDP calculations? Prices are always in a state of flux, but generally move upwards over time. Therefore, a change in prices can give the impression of an increase in the gross domestic product (GDP a measure of national income) even without an increase in the quantity of goods and services produced by an economy. The impact of prices has to be removed to arrive at a true measure of economic growth. A deflator is used to restate output estimates at current prices into what they would be if calculated

with reference to prices in an earlier year. This will give an idea of the real growth in the economy, minus the price effect. Why is GDP deflator considered a good measure of inflation? The ratio between the GDP at current prices and GDP at constant prices gives an idea of the increase in prices of all goods and services with reference to the base year. In that sense it is a more comprehensive measure of inflation than price indices, which are based only on a limited basket of goods collected from select centres. However, the deflator comes with a lag, which limits its usefulness. How is it used in India? In India a combination of WPI and CPI is used as deflator. The usage is dependent on the particular estimate we are trying to deflate. There will be different deflators for private consumption and government consumption. There is a difference in the value of quarterly and year-end deflators. This is due to the fact that prices are not constant. At the year-end we have an overall measure of WPI/CPI, which is used appropriately. This is why year-end estimates of GDP are more reliable than quarterly estimates.

ET in a classroom: Base rate

What is base rate? It is the minimum lending rate that banks can charge their customers from July 1, 2010. So far, all lending rates were pegged to a banks prime lending rate (PLR). Under the existing system, banks charge customers interest rate either above the PLR or below PLR. Thus PLR worked as an anchor rate. From July 1, the base rate will not only replace the PLR as the benchmark, but it will also be the new floor rate below which no bank can lend. Indias largest bank, the State Bank of India, has indicated that it plans to peg its base rate in the range of 7.5-8%. What will happen to loans linked to PLR? Outstanding loans that are linked to PLR will continue to exist alongside the new loans linked to the base rate. As the old loans get repaid or the contract comes up for renewal, the base rate will become the sole benchmark.

From July 1, on all new loans, banks will charge customers at base rate or above base rate, depending on the rating and relationship. As and when the loan contract comes for renewal, banks will link the interest rate to the base rate. Existing customers will also get a choice to migrate to base rate. Customers will not be charged any penalty if they wish to migrate from PLR to base rate before the contract is due for renewal. Why is base rate being introduced? It is aimed at bringing more transparency in the lending market. As of now, the prime customer bargain rate is below PLR while average to risky customers are charged at PLR or above PLR. About 70% of the loan given by banks is at rates below PLR. Some banks have lent at 6% when their PLR is 13%. As a result, a customer who is able to bargain the most get the best rate. In case of base rate, no bank will be able to lend below base rate, making lending rates comparable. What will happen to home loan customers? Home loans are long-term contracts and thus it does not come up for renewal like most other corporates loans. Therefore, banks may give all existing customers a choice to move to a base rate. There are instances of home loans where the interest rate is fixed for initial years and floating rate in following rates. Here, in subsequent years, interest rate is a few basis points below PLR when it moves to floating rate regime. In such cases, the base rate will not implicitly replace PLR. If the loan document, for instance, says after three years home loan will be 300 bps below PLR, it would not mean that the loan would be 300 bps below base rate once the base rate regime comes into being. Because, in any way, no loan can be below the base rate.

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 overseas investors in the US-listed American Depository Receipts (ADRs) of Infosys and Wipro get receipts against ownership of shares held by an Indian custodian, an IDR is proof of ownership of foreign companys shares. The IDRs are denominated in Indian currency and are issued by a domestic depository and the underlying equity shares are secured with a custodian. An Indian investor pays in Indian rupees for the IDR whereas a shareholder in the issuers home country pays in home currency. What is the security of the underlying shares? Where will the receipts be deposited?

The underlying shares for IDRs will be deposited with an overseas custodian who will hold the shares on behalf of a domestic depository. The domestic depository will accordingly issue receipts to investors in India. Investors will 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 shares are issued. The issuer company will make a public offer in India, and residents can bid the same way as they do for Indian shares. Investors eligible to participate in an IDR issue are institutional investors, including FIIs but excluding insurance companies and venture capital funds retail investors and nonInstitutional Investors. NRIs can also participate in the Issue. Commercial banks may participate subject to approval from the RBI. What are the benefits that Indian investors can look forward to? Indian individual investors have restrictions on holding shares in foreign companies, but IDR gives Indian residents a chance to invest in a listed foreign entity. No resident individual can hold more than $200,000 worth of foreign securities, including shares, as per foreign exchange regulations. However, this will not be applicable for IDR. Besides, these additional key requisites 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 in holding IDRs. Will Indian investors get equal rights as shareholders? Indian investors have equivalent rights as shareholders. They can vote on EGM resolutions through the overseas custodian. Whatever benefits accrue to the shares, by way of dividend, rights, splits or bonuses will be passed on to the DR holders also, to the extent permissible under Indian law. Can IDRs be converted? IDR holders will have to wait for an year after issue before they can demand that their IDRs be converted into the underlying shares. However this conversion is subject to certain conditions: a) IDR Holders can convert IDRs into underlying equity shares only with the prior approval of the RBI. b) Upon such exchange, individual persons resident in India are allowed to hold the underlying shares only for the purpose of sale within a period of 30 days from the date of conversion of the IDRs into underlying shares

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

ET in the Classroom: Real and nominal exchange rates

The rupee has appreciated sharply against the dollar in the last few months, raising some concerns, especially among exporters. The real issue, economists say, is not the exchange rate as we know, or the nominal exchange rate, but the effective exchange rate. ET takes a look at the concept of real and nominal exchange rates. What do real numbers mean? The word real in economics as opposed to nominal is used to describe a metric, where the impact of prices has been taken into account. For example, real GDP captures output of goods and services at constant prices, removing the effect of inflation. What is real exchange rate? Real exchange rate can be defined as the rate that takes into account inflation differential between the countries. Suppose the rupee was trading at Rs 40 to a dollar at the beginning of 2009. Assuming a 10% inflation in the Indian economy and 5% inflation in the US economy for the whole year, then this model says the rupee should depreciate by 5% (10%-5%) to Rs 42 to a dollar, other things being equal. Why is the real exchange rate important? Competitiveness of a countrys exports is decided not only by the nominal exchange rate, but also relative price movements in domestic and foreign markets. For instance, even if the nominal exchange of the rupee remains unchanged with respect to, say, the dollar, Indias exports to the US will become less competitive if inflation in India is higher than in the US. This means nominal exchange rate will have to be adjusted for effect of inflation. How is nominal exchange rate adjusted for inflation? Central banks use the concept of real effective exchange rate, or REER, to adjust nominal effective exchange rate for inflation. Conceptually, the REER is the weighted average of nominal exchange rates adjusted for the price differential between the domestic and foreign countries. The price

differential, however, is based on the purchasing power concept. The currencies used are of those countries with which trade is the highest. How does the RBI calculate REER? The RBI calculates REER for India. It calculates the value of the rupee with respect to two indices, one comprising six countries and the other 36 countries with a 2004-05 base. The RBI, however, uses the wholesale price index-based inflation whereas globally consumer price indices are used. One conceptual flaw with this model is that it assumes that the base exchange rate is the correct exchange rate or represents the purchasing power parities accurately, which may not be the case.

ET in the classroom: Forward Premium

ET takes a look into and explains about forward premium in the foreign exchange market. What is a forward premium in the foreign exchange market? Its the price paid for hedging by buying dollars in the forward market. Forward transactions take place at a premium or discount to the spot rate. The outright forward transactions are over-thecounter transactions undertaken by dealers. In India, it is generally the banks that transact in forward markets. The maturity date agreed upon by the parties generally varies from months to a year or two. But maturities beyond that tend to have wider bid-ask spreads, in other words, tend to be more expensive, so are rare. The forward rate could be in premium or discount, based on the interest rate differential in case of currencies which are fully convertible and in case of partially-convertible currencies, they are determined purely on the basis of demand and supply. For example, in India, the USD/INR forward rate for six months could be in premium or at a discount over the spot rate, based on how liquid the dollar is. What determines forward premium? Countries that have fully-convertible currencies, the forward premium is deduced from their interest rate differentials, respectively. The premium/discount is measured in points, which represent the interest rate differential of the countries to which the currencies belong, for the period of maturity. These points are the quantum of foreign exchange that would neutralise the interest rate differential. Points are subtracted from the spot rate, when the interest rate of the base currency is higher, since the base currency should trade at a forward discount and points are added to the spot rate, when the

interest rate of the base currency is lower, since the base currency is expected to trade at a forward premium. This is, however, only applicable to non-rupee currencies, that are fully convertible. What are currency futures? Exchange-traded currency forward transactions are known as currency futures. Before April 2007, only banks were allowed to trade in currency forwards market through over-the-counter deals. But it was not a structured market, in the sense that it was not traded on an RBI-recognised exchange platform. But in 2007, RBI and Sebi allowed trading of currency futures on the National Stock Exchange. The objective of opening up trading in currency futures on the exchanges was to deepen the futures market by allowing the small retail investors to take a view and hedge their foreign exchange risks. The regulatory authorities in India are on their way to allow trading in currency options on exchanges as well, though it is already available as a product.

ET in Classroom: Double-Dip Recession

Whats a double-dip recession? A double-dip recession refers to a short-lived recovery of an economy from a recession, before it slips back into a recession. In economic terms, when the GDP of an economy goes into the negative, after a brief period of showing positive growth, the economy is said to be faced with a double-dip recession. According to economists, double-dip recessions may also be referred to as W-shaped recession where the two dips in the W represent the double-dip recession, and the quick incline in the middle is the intermediate recovery. What are the indicators of a double-dip recession? Return to negative GDP growth after a partial economic recovery is a sign of the economy entering into a double-dip recession. The equity securities exchanges show bearish sentiments, when markets sense a double-dip recession lurking around the corner.

The per capita income growth will vary between low to negative, and this over a sustained period of time, when the economy is spiralling towards a recession again. Lower consumer spending would force producers to lower their selling prices and thus cut down on its production costs, which will lead to higher rate of unemployment in the economy. When was the last major double dip recession? Between 1980-82, the US went into one of the double-dip recessions. The economy was in a recession in the second and third quarters of 1980. It then recovered (by GDP standards) and fell back into recession in the fourth quarter of 1981 and the first quarter of 1982. One thing that happened during that time period that the US does not have now is inflation and high interest rates. Though today, unemployment remains a concern in the US, which could be a trigger for another recession. However, the Federal Reserve is determined to keep interest rates low throughout 2010.

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

India has refused market economy status to China. ET looks at what it means for china? What is a market economy status? When a country accords market economy status to another country, it recognises that free market forces of demand and supply are operating there. It accepts that economic variables such as prices and exchange rates are not determined by the state. When a country recognises another as a market economy, it will have to accept information on prices supplied by that country while contesting antidumping cases. Why is India refusing to give the status? India believes that Chinas corporate governance and accounting systems are not transparent and the country is not following global best practices in its financial & banking systems and stock markets. It had recently sent a questionnaire to China seeking information on key issues such as land laws, accounting practices, minimum wages and electricity rates, which was the first step towards granting the status. China, however, dismissed the move labelling the entire issue as a political one.

Is the issue economic or political? The issue is both economic and political. China has the maximum cases of dumping exporting goods at prices lower than those prevailing in its domestic market against it. India does not want to give the market economy status to China as it would then have to accept all information on local prices supplied by China while framing its dumping cases. At present, India fights anti-dumping cases against China on the basis of prices prevailing in third countries exporting the same product to India. Refusing to recognise China as a market economy also suits India politically at the moment because of the renewed tension on the border. A few years back when political relations with China were better, the ministry of external affairs was trying to convince the commerce department to grant the status to the country. Is India breaking multilateral trade rules? Not at all. As per Chinas accession contract with the World Trade Organisation (WTO), members are not obligated to recognise China as a market economy till 2016. Only about 60 countries have given China the status. These countries include members of the 10-member Asean, which has a free trade agreement with China.

ET in a classroom: Laffer curve

The direct taxes code bill, recently tabled in the Lok Sabha, proposes to bring down the effective tax rates for individuals and corporates. The government hopes this will increase tax collections. In the developed world, it is being debated if tax rates should be increased to cut high deficits. The UK has already raised rates. The economic principle that drives the debate is Laffer Curve. ET takes a look at the concept. What is Laffer curve? The Laffer curve is the graphical representation of the relationship between tax rates and absolute revenue these rates generate for the government. The principle thought behind the Laffer curve is that a zero tax rate would produce zero revenue and a 100% tax rate would also generate zero revenue, as there would be no incentive to work. This means there must be an optimal tax rate that will yield maximum revenue for the government.

Economist Arthur Laffer discovered this relationship that came be known as the Laffer curve. It is based on the idea that at a particular tax rate evasion will make no sense as the cost, in terms of the money and time going into it, would be higher than benefits. How does the Laffer curve work? There are two effects that come into play whenever the tax rates are changed the arithmetic and the economic effect. Simple mathematics says that other things being equal, if tax rates are lowered, tax revenues will drop in the same proportion. Any increase should also make collections grow, but this happens only up to a point. Economic effect works at a more subtle level and recognises that an unduly high tax rate will mean people will be less inclined to work or will look for ways to avoid taxes. For instance, individuals and companies could think of moving their assets and business to a less taxing jurisdiction. Therefore, arithmetic logic of higher rate leading to greater collections is countered by be adverse economic effects. What is the revenue maximising rate? It is difficult to give a rate as it would vary from country to country. Research has shown different tax rates to be optimal under different circumstances. A country with good compliance machinery and re-strictions on moving assets to other jurisdictions can push the rate high. It would also vary with respect to time. In the short term, tax revenues can be boosted through higher rates, as the visible income will be taxed at higher rate. But over a long term, the high rates would discourage economic activity. A recent paper of the European Central Bank says that the US could increase tax revenues by as much as 30% by raising labour taxes or tax on income and 6% by raising capital income taxes or tax on business. For a select 14 countries of the EU, the benefit from rate hike can be only 8% and 1%, respectively. The study notes that Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation. What is the case in India? Although the current rate of taxes in India is considered moderate, it is felt that lowering the tax rate will increase compliance further, particularly in the case of individuals.

ET in Classroom: Nomination

What does nomination mean? Nomination is the process of appointing a person to take care of your assets in the event of your death. You can appoint a nominee for your bank account, fixed deposit, demat account, or even your house. A nominee could be a family member or a friend or any other person whom you trust. However, since it involves financial matters, you need to chose a nominee with care as the person needs to be reliable enough to take care of your assets in the event of your death. So typically, when you open a savings account or fixed deposit with a bank, they will ask you to fill a form where you need to mention the nominees name. What is the role of the nominee? Though a nominee is an important person, he or she has no rights over the money or assets unless that is specified under the will or the nominee happens to inherit the money. So as such a nominee is a mere custodian of the assets. He is a contact point for the investments. So in the event of a persons death, a bank could get in touch with the nominee for further instructions to act on the account. At the time of claiming the savings, the nominee will have to give a proof of his identity to the relevant authority. How can a nominee be appointed? Only individuals holding accounts either singly or jointly can make nomination. Non-individuals including society, trust, body corporate, karta of Hindu Undivided Family, holder of power of attorney cannot nominate. The nominee appointed has to be an individual only. Only one person can be appointed as a nominee. It is not compulsory to appoint a nominee for each investment of yours. However, it is your interest that you appoint a nominee for your investment so that in the event of your death, there is little difficulty in transferring your assets. So when you make an investment in a fixed deposit, there is a column where you can mention the name of the nominee. Similarly in the case of a mutual fund investment, there is a column where you can appoint a nominee. You can appoint only one person as a nominee. In case you do not appoint a nominee while making an investment, you can also do the same at a later date, by filling the relevant application form and giving it to the bank. Can a minor be made a nominee?

Yes, a minor can be a nominee. In such case, the guardian will sign on behalf of the nominee and in addition to the name and photograph of the nominee, the name, address and the photograph of the guardian must be submitted. Are joint holders of accounts allowed to nominate? Nomination for joint holders is permitted, however, in the event of death of any of the holders the benefits will be transmitted to the surviving holders name. In the case of death of all holders, the benefits will be transmitted to the nominee account.

ET in the classroom: For banks, asset delivery is the key

How is a bank profit and loss statement different from a manufacturing companys profit and loss account (P&L)? As the name suggests, a manufacturing company manufactures a product. The cost involved in the process of manufacturing is the cost of goods. Other incidental costs like salaries, electricity and rent are clubbed under selling, general and administrative expenses. Upon the sale of the goods, net sales are recorded in the accounts. Unlike a manufacturing company, a bank does not manufacture anything. Its an intermediary between a lender and a borrower. Therefore, it accepts deposits and lends advances. Hence, the two most important elements of a banks P&L are interest expense on deposits and interest earned on advances. In a manufacturing companys P&L, other income is a trivial entry including one-off items like profit/loss on sale of assets. However, in a banks P&L, other income includes income from distribution of financial products, income from investment banking related activities, treasury gains and other fee incomes. While a manufacturing company makes a provision for bad customers, a bank makes provision for bad borrowers. What are the factors that contribute to the bottom line of a bank? As a banks business depends upon interest rate at which borrows and then lends it to borrowers, general level of interest in an economy plays a huge part in a banks performance.

In a rising interest rate scenario, a bank often has to borrow at higher rate and is unable to shift the entire incremental cost of borrowing to its customers. So the percentage increase in interest expense is more than that in interest earned. And the difference between them, which is known as net interest income (NII) in banking parlance gets compressed. On the other hand, in a falling interest rate scenario, a bank normally improves its spread leading to high growth in NII. In a rising interest rate scenario, the market value of banks investments fall, as price of investment is inversely proportional to interest rate. So a bank has to book losses on investment. In Indian context, banks have made huge strides in increasing the share of non-fund based revenue, which includes revenue from distribution of insurance and mutual funds, revenue from investment bank related activities like debt syndication and etc. Such non-fund based revenue comes under other income, which contributes an important share to a banks bottom line today. What are the key items that determine the efficiency of a bank? Be it a bank or any other company, its efficiency is measured by how well it utilises its assets. So in a banks case return on assets (RoA) is very important measure to separate the wheat from the chaff. The return from assets should not come at the cost of comprising the asset quality. And therefore, what percentage of loan-book are non-performing assets (NPA) is another most important criterion. NPA is often expressed as a percentage of advances. Another important criterion to measure a banks efficiency is net interest margin (NIM), which is a measure of spread between the interest rate at which a banks lend and borrows. In Indian context, a 3% NIM is considered as a benchmark level. Among large banks, only a handful includingHDFC Bank, Punjab National Bank & Axis Bank has been able to maintain that level of NIM. Banks improve their NIM by controlling their cost of funds, which in turn is done by improving the share of low cost current account and saving account (CASA) deposits in total deposits. What are the other factors that display strengths or weaknesses of a bank? A low NPA indicates high asset quality and vice versa. Apart from it, capital adequacy ratio (CAR) shows whether the bank has sufficient capital to grow in short to medium term. Since banking is a capital-intensive business, the regulator requires banks to maintain a minimum percentage of their assets as capital. As per Reserve Bank of India (RBI) regulation, Indian banks have to maintain a minimum CAR of 9%. Most of the Indian banks meet this regulatory requirement.

A capital adequacy ratio of higher than 9% indicates that the bank has sufficient capital to grow for sometime without bothering to raise more funds. So a high CAR provides a kind of cushion to the bankers.

ET in the classroom: Compulsory licencing

ET explains Compulsory licensing, a provision that allows governments to override Patent rights What is compulsory licensing? Compulsory licensing is a process through which a government allows the local industry to produce drugs under patent protection without the permission of the patent holder. While the global agreement on intellectual property, the Trade Related Intellectual Property Rights (Trips) under the WTO, says that a patent holder will have the sole right to give permission to produce its patented products on payment of a licence fee, flexibilities have been given to countries to address public health concerns by issuing compulsory licenses. When can a government issue compulsory licences? These could be issued to address any public health concern as considered appropriate by the issuing country. The Trips Agreement gives a country the freedom to decide when it wants to issue such licenses and it does not necessarily have to be an emergency. It is generally issued for producing lifesaving medicines to ensure their availability at low prices. Does compulsory licensing strip a patent holder off the right to collect license fees on patented products or process? Not at all. Companies that are issued compulsory licenses to produce a patented product have to pay adequate remuneration based on the economic value to the patent holder, but there is no elaboration on what the value is. Why has India not been issuing compulsory licenses? Why has it suddenly woken up to the need? While the Indian Patents Act provides for issuing of compulsory licenses, the procedural guidelines and the policy framework for the same are not in place. India had been taking it easy so far, as it had a flexible patent regime till 2005, which granted protection only to processes and not the final product. This allowed other producers to manufacture generic versions using a different method.

However, ever since there was a switch-over to the more stringent product patent regime in 2005 (under which a patented product cannot be produced through any other process) to meet the countrys commitments under Trips, the country has been facing a shortage of life-saving drugs such as anti-cancer medicines and prices of patented versions have been going up. This prompted the DIPP to float a note on compulsory licensing inviting comments on how the country should go about implementing it. Can compulsory licenses be issued for exporting to other countries? Compulsory licenses are generally issued for producing for the domestic market. However, during the Doha ministerial meet in 2001 the WTO recognised that there are countries which do not have manufacturing capacities and allowed such countries to import generic versions from other countries by issuing compulsory licenses.

ET in the classroom: All about rate corridor

In the monetary policy on Wednesday, the RBI raised the repo rate by 25 basis points to 5.75% and the reverse repo rate by 50 basis points to 4.5%. This has narrowed the rate corridor from 150 basis points to 125 basis points. ET demystifies the concept of rate corridor. What are repo and reverse repo rates? Repo rate is the rate of interest charged by the central bank when banks borrow money from it. It is the tool through which the RBI in-fuses funds into the system by lending to banks against pledging of securities. The reverse repo is the rate the RBI offers to banks when they deposit funds with it. The RBI drains out liquidity from the financial system through reverse repo by releasing bonds to the banks. This is a daily operation by the central bank to manage liquidity Over a longer time, the RBI can also manage liquidity through open market operations. What is an interest rate corridor? Interest rate corridor refers to the window between the repo rate and the reverse repo rate wherein the reverse repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the overnight interbank call money market, where lending and borrowing is unsecured, should move within this

corridor. However, when banks are short of funds and the overnight call money rates are high and above the repo rate, banks approach the RBI to borrow under the repo window. Therefore, the repo rate becomes an effective policy tool as it would help bring down the rates in the overnight market . The reverse hap-pens when money market rates fall below the reverse repo rate. Banks then park surplus funds with the RBI through a reverse repo trans-action. As a result, when there is excess liquidity in the system, the reverse repo is more effective. When liquidity is tight and banks need short-term funds from the RBI to manage mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to the system the reverse repo would become the operative policy rate as the RBI would be draining out funds from the system. Why is a narrow rate corridor desirable? A narrow rate corridor means that short-term interest rates in the call money market will move within that band. This band was earlier 150 basis points, which has now been lowered to 125 basis points. Effectively, the narrower rate corridor will mean there will be less volatility in short term rates. Do other central banks also have rate corridors? Many developing countries have the rate corridors but central banks in developed and deeper financial markets have a single rate. In the US, for instance, the Fed Fund rate is the key interest rate. Short term funds are available at this rate to the eligible borrowers.