Wednesday, April 30, 2008

Effects of CRR hike on Inflation seen through money multiplying effect

The Reserve Bank of India, on 29th April 2008, increased the Cash Reserve Ratio (CRR) by 25 basis points (0.25%) to 8.25% as a policy measure to curb inflation in the country.

Cash Reserve Ratio sets the minimum reserve money banks must hold to deposits they own. A CRR of 8.25% means banks have to keep 8.25% of the total deposits they have with them as a cash reserve and shall not lend it to others or use it for any other purposes. In earlier periods this reserve was meant to protect depositor money in case a bank went bankrupt. But nowadays CRR is used as an effective tool in monetary policy to control interest rates and borrowing and is also used by developing countries like India and China to control inflation.

One of the main reasons of inflation is the money supply in the economy. When people have more money in their hands, they tend to pay more for goods and services (Supply vs. Demand) thereby increasing their prices. When CRR is increased, banks will have to keep more money as reserve restricting them to lend that much money into the economy. A CRR hike of 0.25% means Rs. 9000 Crore of extra money has to be kept as reserves, which means that that much money will be taken out from circulating in the economy and from being avaiable in the hands of people for spending. As a result people tend to pay less, making prices of goods and services (or inflation) come down.

This has more implications than what it appears prima facie. Money usually has a multiplier effect. Suppose a bank has Rs. 100 in deposits, with a CRR of 8.25%, it has to keep Rs. 8.25 with them and remaining Rs. 91.75 they can lend to borrowers. The borrower then gives the money to someone (through payment or lending) and the person who receives it (or if the person who receives it gives it to someone else and so on, then the last person who receives it) would deposit it in another bank. The second bank will keep 8.25% of the deposit of Rs. 91.75 and lend Rs. 84.18 to some other borrower. And the cycle continues.

In this way money available with a bank will in turn be available for various other banks for lending, due to the multiplier effect of money described above. Hence money taken away from the banking system through CRR hike will have a much higher effect, as the percolation will cause multiple increase in the overall cash reserve.

Thus higher reserve requirement results in reduced money creation in the economy and is accentuated by the multiplying effect of money. Hence increasing CRR is a highly effective method to reduce money supply in the economy; there by reducing inflation.

Tuesday, April 29, 2008

Personal Loans and debt traps

I get marketing calls from various banks each day which informs me that due to my good credit history with the bank I become eligible for a preapproved Personal Loan for my disposal and is available at the nod of my head. Already bearing the burden of a Personal Loan, I know for sure that it’s the last thing I shall go for and I reply them that I am not interested.

Personal Loans are collateral free loans given out by banks. It’s an unsecured loan and hence banks charge exorbitant interest rates for it. Since the money borrowed using Personal Loans is less compared to other loans, the EMIs appear lesser (else banks will make the tenure higher and make it appear less) and hence people generally don’t think much about the total money they pay to the bank through EMIs over the tenure. There are few things one should know about Personal Loan and these are also the reasons why Personal Loan shall be the last thing one shall resort to while in need of cash.

1. The interest rates banks charge is typically in the range of 20%! Just think about a Gold Loan where the interest rate is around 7%

2. Most Personal Loans come with an initial processing fee of around 2%. Consider a Personal Loan of 1 Lakh, where the processing fee itself will take 2000 bucks off you

3. Banks charge a pre-payment penalty when the Personal Loan is closed before its tenure, which again take money out of you

Thus, despite having a very high interest rate, even more money is extorted by Personal Loans making it one of the costliest of all the loans and thus a debt trap. Hence go for Personal Loans only if there are no other options in front of you.

Monday, April 28, 2008

Of Micro SIPs

For mutual funds having a Systematic Investment Plan (SIP) option, the SIP amount came down to as low as Rs. 500 per month but there were a lot of people out there for whom it was still unaffordable; people who are engaged in daily wage jobs, small businesses etc. and wanted to benefit from the higher returns of equity market.

From April 2007, few fund houses have allowed people to invest in SIPs with money as low as Rs. 50 per month. This could benefit about 330 million paid workers of India who didn’t have access to such investment schemes earlier.

But there are certain things that could affect the popularity of micro SIPs. PAN card being made mandatory for mutual fund investments by SEBI, distributors not pushing micro SIP due to lower commissions involved, longer SIP terms of around 60 months are few of them. But looking at the revenues that micro SIPs could rake in for Asset Management Companies due to its scale, let’s hope that this shall become a success, increasing the savings power of the average Indian and also making our equities market much bigger and stronger than they are now.

Friday, April 25, 2008

How is WPI inflation rate calculated in India?

With inflation rate surging to new heights, the term is more in the news than ever in India. While leaving aside the debate on whether India should adopt CPI (Consumer Price Index) based inflation calculation rather than the current WPI (Wholesale Price Index) based one, let’s find in detail how inflation rate is calculated in India; which is the WPI based inflation rate.

What is inflation?
Inflation rate of a country is the rate at which prices of goods and services increase in its economy. It is an indication of the rise in the general level of prices over time. Since it’s practically impossible to find out the average change in prices of all the goods and services traded in an economy (which would give comprehensive inflation rate) due to the sheer number of goods and services present, a sample set or a basket of goods and services is used to get an indicative figure of the change in prices, which we call the inflation rate.

Mathematically, inflation or inflation rate is calculated as the percentage rate of change of a certain price index. The price indices widely used for this are Consumer Price Index (adopted by countries such as USA, UK, Japan and China) and Wholesale Price Index (adopted by countries such as India). Thus inflation rate, generally, is derived from CPI or WPI. Both methods have advantages and disadvantages. Since India uses WPI method for inflation calculation, let’s go in to the details of WPI based inflation calculation.

How is WPI (Wholesale Price Index) calculated?
In this method, a set of 435 commodities and their price changes are used for the calculation. The selected commodities are supposed to represent various strata of the economy and are supposed to give a comprehensive WPI value for the economy.

WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, let’s assume the base year to be 1970. The data of wholesale prices of all the 435 commodities in the base year and the time for which WPI is to be calculated is gathered.

Let's calculate WPI for the year 1980 for a particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1970 = Rs 5.75 and in 1980 = Rs 6.10

The WPI of wheat for the year 1980 is,
(Price of Wheat in 1980 – Price of Wheat in 1970)/ Price of Wheat in 1970 x 100

i.e. (6.10 – 5.75)/5.75 x 100 = 6.09

Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09 = 106.09.

In this way individual WPI values for the remaining 434 commodities are calculated and then the weighted average of individual WPI figures are found out to arrive at the overall Wholesale Price Index. Commodities are given weight-age depending upon its influence in the economy.

How is inflation rate calculated?
If we have the WPI values of two time zones, say, beginning and end of year, the inflation rate for the year will be,

(WPI of end of year – WPI of beginning of year)/WPI of beginning of year x 100

For example, WPI on Jan 1st 1980 is 106.09 and WPI of Jan 1st 1981 is 109.72 then inflation rate for the year 1981 is,

(109.72 – 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for the year 1981 is 3.42%.

Since WPI figures are available every week, inflation for a particular week (which usually means inflation for a period of one year ended on the given week) is calculated based on the above method using WPI of the given week and WPI of the week one year before. This is how we get weekly inflation rates in India.

Characteristics of WPI
Following are the few characteristics of Wholesale Price Index

  • WPI uses a sample set of 435 commodities for inflation calculation

  • The price from wholesale market is taken for the calculation

  • WPI is available for every week

  • It has a time lag of two weeks, which means WPI of the week two weeks back will be available now

  • There are certain arguments in the open saying that the government shall adopt Consumer Price Index (CPI) method for inflation calculation, which gives a more correct picture. More of that in another post...

    Related Articles
    - Commodities and their weight-ages in WPI calculation of India
    - Inflation rates of India (2009)
    - Inflation rates of India (2008)
    - Base year and number of commodities used for inflation calculation in India
    - The magic of Inflation

    Wednesday, April 23, 2008

    Is India growing; really?

    Recently I read this article by Pankaj Mishra in The New York Times. Though written way back in 2006, with its inferences, the article leaves behind a lot of questions for the reader regarding where exactly the Indian economy stands; questions those are relevant even today.

    Quoting from the article,
    Recent accounts of the alleged rise of India barely mention the fact that the country's $728 per capita gross domestic product is just slightly higher than that of sub-Saharan Africa and that, as the 2005 United Nations Human Development Report puts it, even if it sustains its current high growth rates, India will not catch up with high-income countries until 2106.

    Nor is India rising very fast on the report's Human Development index, where it ranks 127, just two rungs above Myanmar and more than 70 below Cuba and Mexico. Despite a recent reduction in poverty levels, nearly 380 million Indians still live on less than a dollar a day.

    Malnutrition affects half of all children in India, and there is little sign that they are being helped by the country's market reforms, which have focused on creating private wealth rather than expanding access to health care and education. Despite the country's growing economy, 2.5 million Indian children die annually, accounting for one out of every five child deaths worldwide; and facilities for primary education have collapsed in large parts of the country (the official literacy rate of 61 percent includes many who can barely write their names). In the countryside, where 70 percent of India's population lives, the government has reported that about 100,000 farmers committed suicide between 1993 and 2003.
    [Courtesy: Pankaj Mishra, The New York Times]

    I wish the economic growth of India not just confines to a small section of the society or creating private wealth but shall also comprise of the lower strata to ensure a ‘complete growth’. But above all, I wish the India growth story doesn’t blindfold the real situation of India, succinctly put across by the article. Do read it!

    Tuesday, April 22, 2008

    Top 10 companies of India has compiled a list of the top 10 companies of India, based on FY 2007 sales revenues. Not surprisingly, the list is dominated by oil companies.

    According to them, the top 10 companies are,

    1. Indian Oil Corporation – Rs 201,493.85 Crore*
    2. Reliance Industries^ – Rs 111,264.23 Crore
    3. Bharat Petroleum Corporation – Rs 97,189.37 Crore
    4. Hindustan Petroleum Corporation – Rs 93,912.34 Crore
    5. Oil and Natural Gas Corporation – Rs 75,529.12 Crore
    6. Steel Authority of India Limited – Rs 34,390.93 Crore
    7. National Thermal Power Corporation – Rs 33,875.70 Crore
    8. Tata Motors – Rs 31,999.47 Crore
    9. Tata Steel – Rs 25,117.78 Crore
    10. Sterilite Industries – Rs 24,376.83 Crore

    *1 Crore is equal to 10 million
    ^Reliance Industries doesn’t include all the reliance group of companies

    Monday, April 21, 2008

    Term insurance to become cheaper

    Wait for some time, if you have decided to buy a term insurance. The Insurance Regulatory and Development Authority (IRDA) is looking at ways to promote term insurance as they feel the general attitude among the public to deem insurance as a savings opportunity should change.

    In India, life insurance is generally seen as an investment option rather than a cover for life. As a result we have insurance products like endowment policies, money back policies, ULIP etc from various insurance companies. Previously, I had talked about how inefficient an endowment policy is, where one pays huge premiums for small sum-assured to get a return that’s way less compared to what he/she would get from other investments made for the same period.

    The main reason for the inclination towards savings oriented insurance policies was the lack of other investment options till a few decades back and to a lesser extent, the lack of awareness people had on the alternatives. But now we have quite a few efficient investment opportunities such as mutual funds, realty, commodities, equities etc. that can give a person much higher returns. And hence the affinity towards endowment and money back policies, ULIPs etc. shall come to an end; which triggered the IRDA move.

    IRDA has identified two ways to popularize term insurance, one by incentivizing the insurance company and two, by incentivizing the insurance agent (Agents usually push ULIPs and endowment plans as they provide higher commissions). IRDA would reduce the solvency margin for the insurance company so that the reserves need to be maintained by the insurance company would come down. Thus, the amount to be allocated by the insurance company for writing a term insurance would reduce by 60%, making it cheaper than before.

    Tuesday, April 15, 2008

    Seven things you should know about LTA (Leave Travel Allowance)

  • LTA can be availed twice in a block of 4 years. The block is defined by the government. The current block is 2006 – 2009 and is based on calendar year

  • Only the travel costs (air, rail or public transport, dependent on the employer) can be exempted under LTA

  • If LTA is not claimed in a particular block of 4 years, ‘one’ can be claimed in the ‘first year’ of the next block of 4 years

  • LTA is valid only for travel within India

  • Two LTA claims cant be made in the same year for travels made in the same year

  • If your spouse also has LTA, then both of you can claim two LTAs each in a block of 4 years. So that each year you can have one LTA claim

  • LTA can be claimed for travel done by self, spouse, children, parents and siblings dependent on self. Only thing is self (person who is claiming LTA) has to be present in the travel