What is going to move the market from here?

The secondary market witnessed a steep downward movement last month. In the period of January 14-22 BSE30 Sensex lost 4100 points incurring a loss of 16,000 billion for the investors. When Nifty futures turned into discount, it created heavy short positions. Investors were not having enough money to meet the margin calls on their future contracts, and brokers were forced to sell in large numbers. The major drain of money from the secondary market happened mainly because of the following reasons-

1. Reliance power IPO, which came with a bid for nearly Rs 11000 Crores and got oversubscribed by 73 times.
   
2. Future Group, which came with IPO to fetch around Rs 490 Crores, got oversubscribed by 133 times.
   
3. FII withdrawal from the market amounted to Rs 13035.7 Crores in the month of January.

Though FII were selling in large volume because of global cues, the major part of domestic money was stuck with the IPO of Reliance and Future Group and no buyer was available in the market.

Now in the month of February, with fed cut in interest rate huge capital inflow is expected through FII’s. Reliance Power has completed the allotment of shares and it has refunded around Rs 1 lakh crores to the bidders. Future Group also refunded the sum for unalloted bids, which is around Rs 50,000 crores. This huge inflow in market is expected to make the market bullish in the short term. But the movement will majorly be decided by the sentiments, and any negative news will turn the market bearish. The concern over the recession in the US economy is going to keep the market volatile and investors need to be cautious about their investment.

Challenges ahead for Indian Monetary Policy

The much expected rate cut by RBI did not happen. In the midst of all the all sorts of speculation, RBI has adopted a policy of wait and watch for the time being. So what’s there left in Indian market in coming days? The impact of differential interest rate is going to have diverse effect. The following heads could be one way to summarize the future move.

More inflow of dollar is expected in the coming months and the huge capital inflow will further complicate the monetary policy. Rupee has already appreciated by almost 12.3% against dollar in last year and further gain could worsen the plight of export industry. Textile industry has already lost more than 50,000 jobs the issue needs to be addressed soon.

We witnessed the lowest inflation of last 5 years in December 2007, but the wholesale price index rose 3.93% in the week ended January 19. This inflation was highest in the last five months. The huge capital inflow in the market from outside is expected to put pressure on inflation. The petroleum price hike also seems imminent and this going to further accelerates inflation. RBI’s stand on keeping the interest rate intact reflects that curbing inflation is of highest priority at this point of time.

Large capital inflow has increased the liquidity in the market and monetary policy has got complicated, RBI needs to be flexible to act on each and every global clue to keep the interest of one and all.

Economic Fundae - Interest Rates

It is a really a good time to start with the economic fundamentals as there is so much happening across the globe with recession and our phenomenal growth story. It becomes easy to see what we are discussing in theory in the real life. Inflation is something most of the developing nation is fighting against. At least in India, the Reserve Bank of India has done a great job in controlling the soaring price rise that happened in 2007. But what are the policy that RBI has at its disposal to control inflation? These are largely the tools and policies different from the fiscal policy.

Before answering this question we will look into one of the important macroeconomic variable which connects the present with the future – Interest Rates. The rates which our bank pay is called as the nominal interest rate and this measure the increase in the value of the money we hold. It can be seen as the amount that we get paid for forgoing the consumption at present.

The other class of interest rates is called the real interest rates which are essentially the increase in the purchasing power. Think of a capital as a corn seed. The increase in value from the seed to the corn is the real increase in value. But due to the general increase in prices of other commodities – inflation our corn will fetch us more money than the actual value. This is called the nominal value which is the real value plus the inflation.
R = I – πe
This equation gives the relationship between the real interest rate and the nominal interest rate & inflation rate.

Why is there a fluctuation in the interest rate? This is dependant on the amount of money in circulation. Now the big question is whether the RBI sets the interest rate or sets the money circulation? It sets the money supply.

It is done through a series of steps called as the open market operations. In this the central bank buys bonds – a debt instrument, in exchange for money, thus increasing the stock of money, or it sells bonds in exchange for money paid by the purchasers of the bonds, thus reducing the money stock.

Now ask yourself this question, what will happen to the exchange rate if the central bank sells $1 billion from its foreign currency reserves?

We fairly understood about the strict monetary policy. Now it is time to see what is happening in the scenario of recession. The U.S central bank has announced a interest rate cut in order to combat the recession. By cutting interest rates the FED would be boosting U.S economy by making it cheaper to borrow. But it has its implication also in the spending habit. This artificial intervention of the central bank is rarely seen unless it is absolutely necessary to do so.

The other side is the reduction in the earnings due to the interest rate cut. This will immediately give arbitrage opportunity for investors to borrow money from the U.S banks and invest in a country like India where the interest rates are higher. Sensible isn’t? But is it what our finance minister will also be happy about? We will see in the subsequent article of the critical analysis of the forth coming budget and the interdependency of the various macroeconomic variables we have learnt so far.

Economic Fundae - Fiscal Policy

The big question that our finance ministry will face is how to react to the global recession and our stock market crash. Although these are issues which need correction from various economies, let us see what tools are at hand to control the economic fluctuation. Last year -2007 although we saw our GDP grow more than 8%, we were facing with issues like inflation. The Reserve Bank of India which is the principle organization in command of our economy was taking numerous measures to curtail inflation. What essentially were they doing? What is the role of government in these situations?

Fiscal Policy is use of government spending or tax policy to control aggregate demand-
The taxes that we pay are essentially the source of funds for our government. Now what kind of taxes we pay? Where does the money go?

To understand this we will revisit the equation which is worth remembering
GDP = C + I + G -NX

The G – Government spending composes of two components, the purchases of goods and services & government transfers – which include government spending on individuals without expecting any goods or service. In India we can think of this as the spending towards to rural development and poverty alleviation. But targeting government expenditures simply to reduce poverty is not sufficient; government needs to stimulate economic growth to help generate the resources required for future government expenditures. This becomes the rationale for a budget deficit.

The government can influence the consumer spending by controlling the taxes and the transfers. This is sensible because the more the tax we pay the less is our disposable income – which is our revenues minus the taxes (total income available to spend).

Now why would our government want to control aggregate demand? This is just to control the effects of recession – “Refer Economic Fundae – Business Cycle” or inflationary pressure.

What could it possibly do?
1. Increase government spending
2. A tax cut
3. A increase in government transfers.

This could be the opposite when our government has inflationary pressure.

But remember it is not that easy and it is not that fast to bring in a change. There is also a concept of multiplier to the effect of government spending- it is the ratio of the change in GDP to the change in aggregate spending. In simple terms if you sow Rs 100 you may end up reaping 200!

This multiplier effect may not be there if the government policy is to cut taxes or increase government transfers. This is because not all of the tax benefit you get may be spent, which is given by the marginal propensity to consume.

Now the budget is just a few weeks ahead, we often hear the terms like budget deficit (at least in my generation I have not heard of a budget surplus). What it means? Whether budget deficit is good or bad?

The budget balance is equal to the government savings which is governed by the following equation
S = T – G – TR
T- tax receipts
TR – Transfers

In general, the government runs budget deficits, when there is a recession and surplus when there is economic expansion. In India we have seen the politicians have the habit of wooing the voters by having a tax cut and hence a deficit budget. By doing so, Indian government have run in deep debts. Remember the interest payments for these debts, which are also funded by the taxes that we pay.

Now a novice person like me would think what if the government would print more money to fund the debts. Remember there is always a problem with the inflation.

Now you are all set to think in terms of the finance ministry tools. In the next article we will see how the central bank controls inflation.

Reliance Power IPO subscribed for more than market value of the Portuguese and Czech stock markets (Update 1)

As per Bloomberg, the bid for Reliance Power initial public offer (IPO) exceeded Portugal Market Value. The company is likely to raise more than Rs 10000 crore from this public issue excluding promoters’ contribution. This is the largest IPO in Indian market till date. The company sought to raise around 117 billion Rs ($3 billion) through 228 million shares on offer. The offer had got subscribed within 60 seconds on the day of opening and finally got oversubscribed by 73.04 times as per National Stock Exchange (NSE). The offer received an order worth more than $190 billion, which is equivalent to combined value of Portugal and Czech stock markets.

The 3’rd richest man of India, Mr. Anil Ambani will increase his wealth further with listing of this Stock. Reliance energy has got 50% stake on Reliance Power. Power stocks have driven the market well in the year 2007 and the trend is expected to continue. Reliance Energy share price increased from around 600 Rs in February, 2007 to more than 2400 Rs in January this year. The addition of Reliance Power is expected to receive a good demand in the market when it gets listed early next month.

The issue price was fixed at 450 Rs today (19'th Jan) and is expected to gain 300-400 Rs on the day of listing. With already $45 billion of wealth with him, Anil Ambani might take a leap with this addition in his asset and that could make him the richest person of the world. The next update from Forbes magazine on official ranking of richest people of the world will certainly bringing more Indians among top rankers. According to the earlier update from Forbes, the wealth of Ambani brothers together with L. N. Mittal and K. P. Singh is more than the 40 richest Chinese. This IPO was one of the most talked and coming month might change fortunes of many.

Economic Fundae - Exchange Rates

In any system it pays to standardize. Essentially this is been the case in every development over the years. We have always tried to find new opportunities in standardizing processes which will improve efficiency.

This can also be seen in the international trade, where people had looked into ways of standardizing the exchange of goods and service. We need to go back to history to see how gold standard worked and what lead to the Bretton Woods system. Much of our worries about raising rupee against dollar dates back to one of greatest move in history by the then President Roosevelt abrogated contracts in which payment was specified in gold.

This system in simple terms made countries to settle their internaional balances in U.S dollars, while the U.S. government redeemed other central banks holdings of dollar for gold at a fixed exchange rate of $35 per ounce. This system came to an end when U.S government was no longer able to redeem dollar for gold in 1971.

Now another question emerges as we probe further into the currency maintained by a country. How will the country decide on their currency?. What should be the growth rate of the currency?. What should be the quantity of the currency?

Gold standard served two purpose, one the domestic standard trying to determine the currency quantity and the rate of growth of money supply. This worked in tandem with the world's gold stock.

Next Gold also provided a standard for the international exchange. Consider the scenario in which U.S fixed the price of gold at $20 per ounce, and the U.K government fixed it at £4 per ounce, then the exhcnage rate equalled $5 per pound. This is called as the fixed exchange regime.

After 1971, we have the floating exchange rate. This works in a simple rule that the central bank of a country will not intervene in the rates set by the market. Hence the demand for a particular currency helps in determining the rates. This demand is because of the larger acceptance of the goods and services of a particular country.

Lets understand the rules of the floating exchange rates more and its interaction with the interest rates and inflation in the subsequent articles.

Economic Fundae - Inflation

Inflation in simple terms is the loss of purchasing power of a currency. If today 10kg of general items can be bought of 100 Rs, then after a year how much money will be required to buy the same amount of goods? Inflation gives an idea of that general increase in price of goods.

There are standard ways to measure inflation such as the Wholesale Price Index (WPI) and Consumer Price Index (CPI). WPI measures the increase in price of basket of goods at the wholesale level. It is measured weekly. CPI gives the measure of the cost of given basket of goods (Wheat, Pulse etc) and services which the consumer has to pay. CPI is always greater than WPI.

Although there are inherent problems with this measure which is largely attributed to the weights attached to the goods and services and also the changing quality which is very hard to quantify. This of course can have huge difference in the policy decisions. There can also be a cumulative wrong measurement due to these inherent problems in scientific methods in economics.

Now if we were to answer what an effect does it has on policy making and the other variables in macroeconomics, we need to understand a bit more of how the Monetary Policy and fiscal policy is taken.

Economic Fundae - GDP

Good Accounting turns data into information!

This article is aimed at people trying to understand the basics of national accounting.

GDP:Gross Domestic Product is the value of all the goods and services produced in the country within a given period. This includes all the goods and services produced in the geographical boundaries of the country irrespective of who produces. The other slight variant is the GNP which include receipts from abroad made as factor payments to domestically owned factor production. For example, part of India's GDP corresponds to the profits made by Hyundai Motors from its Indian operations. But these are part of the Korea's GNP because they are income of Korean-owned capital.

Although the difference is not significant in countries like U.S. it certainly is important where most of the countries labor is abroad working for a multinational company.

The fundamental national accounting equation will be as

Y= C + I + G + NX

Consumption spending by household sector, includes spending on anything under the sky. The only exception being the investment which people make in durable goods.

Then the government purchases are the government spending on the goods and services. Think of anything which government spends like laying roads, providing higher education etc. Again the only exception being the transfer payments. The transfer payments are those which does not get a service in return to government spending. This is logical as they are not a part of any of the current production.

The letter I in the equation refers to the Gross private domestic investment. In simple words, investment is associated with the business sector's adding to the physical stock of capital, which in turn will increase the economy's ability to produce output in the future.

The last term is the Net Exports, the difference between the exports and imports. They are to account for domestic spending on foreign goods and foreign spending on domestic goods. Confused, well we just finished the accounting of the entire nation. There is more than one reason to be confused, like most of our politicians.

Governments budget deficit is often a term we hear particularly in a country like India. This essentially means the difference between the government expenditures and the taxes received. Remember to include transfer payments as a part of government expenditures (which is slightly different from the government purchases)

Quick Fact:

GDP of India: (2007-08): 41,25,725 Crores of Rupees

Without further delay we will introduce you to other macroeconomic variables which are inflation, currency exchange rates, interest rates, monetary system and the business cycles.