Monetary Policy: 2008

MEASURES ANNOUNCED

• Repo Rate increased by 50 bps from 8.5 per cent to 9 per cent
• CRR to be hiked by 25 bps to 9 per cent with effect from August 30, 2008
• Bank Rate kept unchanged at 6 per cent
• Reverse Repo Rate under the liquidity adjustment facility (LAF) kept unchanged at 6 per cent

OBJECTIVES

• To ensure credit growth at 20 per cent and deposit growth 17.5 per cent
• Get inflation down from current 11.89-12 per cent to 7 per cent by March 31, 2009. On medium-term, bring it down to 3 per cent.
• Emphasise credit quality as well as credit delivery, in particular, for employment-intensive sectors, while pursuing financial inclusion.
• Moderate monetary expansion and plan for money supply growth of 17 per cent in FY09.
• Help the growth of non-food credit, including investments in shares, bonds, debentures and commercial paper to reach around 20 per cent.
• Give liquidity management priority in the hierarchy of policy objectives.
• Bring about 17.5 per cent growth in aggregate deposits
• Banks should focus on stricter credit appraisals on a sectoral basis

REASONS FOR THE MEASURES

Domestic:

• Y-o-Y basis, CPI-based inflation for agricultural and rural labourers grew to 8.8 per cent and 8.75 per cent respectively in June 2008 from 7.8 per cent and 7.5 per cent a year ago.
• Money supply (M3) increased by 20.5 per cent y-o-y on July 4, 2008, lower than 21.8 per cent a year ago.
• The price of the Indian basket of crude oil increased from $99.4 per barrel in March 2008 to $141.5 on July 3, 2008 before declining to $121.9 on July 25, 2008.

International:

• Exports increased by 21.7 per cent in US dollar terms during the first two months of the current financial year, as compared to 24.2 per cent in the corresponding period of the previous year.
• Imports rose by 31.8 per cent as compared to 37.9 per cent in the corresponding period of the previous year.
• POL imports increased by 48.6 per cent on account of the surge in crude oil prices as compared to 25.7 per cent in the corresponding period of the previous year. As a result, the merchandise trade deficit widened to $20.7 billion during April-May 2008.
• During the current financial year up to July 25, 2008, the rupee depreciated by 5.4 per cent against the dollar, by 5 per cent against the euro, by 5.2 per cent against the pound sterling and by 1.3 per cent against the Japanese yen.

Sourec : RBI Press Release

foreign exchange reserve: India

Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations. Large reserves of foreign currency allow a government to manipulate exchange rates – usually to stabilize the foreign exchange rates to provide a more favourable economic environment.                                                                                                                                                                                                           

India’s total foreign exchange reserve have increased from USD 5.8 billion at the end of March 1991 to USD  313 billion plus  at the end of April 2008. The spectacular rise in reserves has drawn attention to the issue of what is an adequate level of reserve for the country.  Several factors may explain how much foreign exchange reserves a country wants to hold.  

One factor is related to the size of international financial transactions that occur there; that is, reserves holdings are likely to increase both with the size of the country’s population and with its standard of living.  

Volatility of international receipts and payments, insofar as reserves are intended to help cushion the economy; that is, reserve holdings are likely to increase with more volatility in a country’s export receipts.  

A third factor is vulnerability to external shocks; reserve holdings are likely to increase with a country’s average propensity to import, which is a measure of the economy’s openness and vulnerability to external shocks.  

Finally, a country’s tolerance for greater exchange rate flexibility should reduce its demand for reserves, because its central bank would not need a large reserve stockpile to manage a fixed exchange rate; therefore, reserve holdings are likely to be lower the more variable the country’s exchange rate is.

There is a growing debate about the need to hold so many reserves. Those who support holding large reserve balances argue that the cost of doing so is small compared to the economic consequences of a sharp depreciation in the value of the currency that is often associated with financial crises in emerging markets.  

With a large stockpile of foreign exchange reserves, a country’s monetary authority can buy up its currency in the foreign capital markets, which helps to uphold its value.

Currency Valuation: forces on play

What are Currency Appreciations and Depreciations?

If nominal exchange rates change so that one Dollar buys more Rupees, then the dollar has appreciated in nominal terms. And the Rupee has correspondingly depreciated in nominal terms because a Rupee can buy fewer U.S. Dollars.

If the real exchange rate between the U.S. and India changes, which can occur because of changes in the nominal exchange rate or relative goods prices in the two countries, or both, then there is a real (purchasing power) appreciation of one currency relative to the other.

What Determines Exchange Rates?

Nominal exchange rates are determined by supply and demand in the foreign exchange market—the market for international currencies. Suppliers and demanders of currencies trade in the foreign exchange market, and trading determines prices (i.e., nominal exchange rates). 

The exchange rate between the dollar and the rupee varies from minute to minute as participants in the foreign exchange markets adjust the amounts of currencies they demand from and supply to the market. Those adjustments are responses to changes in economic conditions or news that might influence future conditions. Economic conditions  (See :Indian Trade and Its Impact on Economy) that seem most relevant to exchange rate determination include relative interest rates, inflation rates (see Inflation: Impact on Economy), and output-growth rates across countries.

Who Demands and Who Supplies Currencies in the Foreign Exchange Market?

There are many players in foreign exchange markets. Consider the exchange rate between the Dollar and the Rupee. Who demands Rupees and supplies dollars? The list includes:

Ø  U.S. companies that import from India, they have Dollars but need Rupees to purchase goods produced in India and imported to the U.S.

Ø  U.S. investors who invest in Indian assets.

Ø  Speculators who have Dollars but want Rupees because they believe the Rupee will appreciate.

Ø  Indian companies who remit Dollar profits back from U.S. operations to headquarters in India and want to convert them to Rupees.

 On the other side of the market, who demands dollars and supplies yen? The list includes:

Ø  Indian companies that import from the U.S. They have Rupees but need Dollars to purchase goods produced in the U.S. and imported to India.

Ø  Indian investors who invest in the U.S. They have rupees but need Dollars to purchase assets denominated in Dollars.

Ø  Speculators who have Rupees but want dollars because they believe the Dollar will appreciate.

Ø  U.S. companies who remit Rupees profits back to the U.S. and want to convert them into Dollars.

 

Inflation : Impact on Economy

Understanding inflation is crucial to investing because inflation can reduce the value of investment returns. Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates, to government programs, tax policies, and interest rates.
What is Inflation?
Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

What Causes Inflation?
Economists do not always agree on what spurs inflation at any given time. However, certain forces clearly contribute to inflation.

• Rising commodity prices are perhaps the most visible inflationary force because when commodities rise in price, the costs of basic goods and services generally increase.
• Higher oil prices, in particular, can have the most pervasive impact on an economy. This, in turn, means that the prices of all goods and services that are transported to their markets by truck, rail or ship will also rise.
• Exchange rate movements can presage inflation. As a country’s currency depreciates, it becomes more expensive to purchase imported goods, which puts upward pressure on prices overall.
• Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower rates. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates.

How Can Inflation Be Controlled?
Central banks, attempt to control inflation by regulating the pace of economic activity. Management of the money supply by central banks in their home regions is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy.

• Lowering short-term rates encourages banks to borrow from the central banks and from each other, effectively increasing the money supply within the economy. Banks, in turn, make more loans to businesses and consumers, which stimulates spending and overall economic activity. As economic growth picks up, inflation generally increases. Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, dampens economic activity and subdues inflation.
• Central banks can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the central banks as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity.
• The federal government at times will attempt to fight inflation through fiscal policy. The government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity.

Indian Currency: Impcat of High Crude Price

The fall in the rupee is primarily being attributed to the high crude oil prices, which touched all-time high of over $135 per barrel on May 22, 2008.

India imports 73 per cent of its crude oil requirements, thus raising concerns over its widening trade deficit-the difference between the value of goods and services exported and imported by a country. The trade deficit, which is already estimated to be about 10 per cent of the GDP, will further worsen with the rising crude oil prices as oil importing companies will have to buy a higher amount of dollars to meet their needs.

Falling Indian Currency:
 Uncertainty about global crude oil prices coupled with heavy demand for US dollar from oil majors to pay the higher crude bill.
 Dollar Inflow in terms of FII & FDI money has remained muted since the fall of Indian stock market from its peak in January 2008.
 Rising crude oil prices also have a cascading effect on the already soaring inflation, currently above 8% mark.
 High Trade deficit leading to further devaluation of the currency (According to estimates, a $10 per barrel rise in crude oil prices may lead to the trade deficit moving up by about $6.5-7 billion or 7 per cent).

Impact of falling Currency:
 For export-oriented companies, which were feeling the pain of the appreciating rupee just a few months ago, this reads like good news.
 Will lead to higher cost of imported goods & make some of the capital intensive projects more expensive to execute.
 Will increase the cost of dollar loans taken by companies.

 

India joins trillion-dollar economy club

India also joined the elite club of select countries the US, Japan,

Germany, China, UK, France, Italy, Spain, Canada, Brazil and

Russia which have already managed the feat.  

Incidentally, this trillion-dollar GDP feat came alongside the Indian stock

market crossing the $1 trillion-mark in market capitalisation.

For a country’s stock-market to have market cap equal to its GDP

is also an ‘accomplishment’ which select few stock-markets have

been able to achieve.

Thanks to appreciation of Rupees vis_a_vis Dollar from Rs. 41 to Rs. 39,

but fact remain that we had crossed the psychological level, Sensex also

crossed  the  20,000 level. Yes for the time being we can enjoy.

With this, India has become the first BRIC country where the market cap

of the companies listed on the stock exchange exceeds the GDP of that country.

A word of caution :
A comparison of the market cap with GDP is primarily made to assess

 the valuation levels of the market. The ‘Sage of Omaha’, Warren Buffet

has in an article used the market cap to GDP ratio as a tool to estimate

the overall stock market returns.

He had said in context of US markets that the market cap to GDP ratio

“is probably the best single measure of where valuations stand at any

given moment. If the ratio falls to the 70-80% area, buying stocks is

likely to work very well for you.

If the ratio approaches 200% — as it did in 1999 and a part of ’00 —

you are playing with fire.”

 

Sources : ET, IBEF