okonomist april edition

7/23/2019 Okonomist April Edition

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Issue: Mar 2013

April ’14 Edition



How do General Elections effect our

Indian Economyndia’s ongoing general election will be the largest democratic event in history, with

more than 814 million people entitled to vote to decide the country’s 16th

government. This, however, is not the only record that will be broken when the

world’s largest democracy goes to the polls. According to the Centre for Media

Studies, Indian politicians will spend as much as $4.9 billion during the electoral

contest, which will end in May. The estimate makes this year’s general election the second

most expensive of all time, behind only the 2012 U.S. presidential campaign in which,

according to the U.S. presidential commission, $7 billion was spent.

A study of key economic variables overthe past 30 years shows that economic

activity lost pace significantly every time

there was a general election.

Government spending went up in an

average election year, which tended to

fuel inflation rather than spur growth.

Slowdown during the elections season is

more pronounced because thegovernment fails to take policy decisions

while battling a raft of corruption

charges. This in turn leads to postponed

decisions of the investors in new major

projects as investors key decisions are

completely based on present

government policies.

I

http://www.reuters.com/article/2014/03/09/us-india-election-spending-idUSBREA280AR20140309

http://www.reuters.com/article/2014/03/09/us-india-election-spending-idUSBREA280AR20140309



Government spending too rises in election years although that affects inflation more than

real economic activity. There’s a clear spike in both total and revenue spending in election

years, or if the elections are held in April and May, the just-preceding fiscal year. The

average increase in nominal government spending during election years is 15.84%

compared with 11.38% for non-election years. The effect of government spending also

clearly shows in the fiscal deficit numbers. Average fiscal deficit for the election year is

5.87% compared with 5.08% for the non-

election years.

In many cases, government intervention

in an election year is designed to cater to

special interest groups rather than to

provide a boost to the overall economy.The amount of farm loans given by state-

owned banks was 5-10 percentage

points higher in election years than in

years following an election as suggested

by a research paper by Harvard

University. Political parties buy up

substantial quantities of liquor to

distribute to voters in the days leading

up to the election.

Challenges that will be faced by the new government:

If slow growth continues, revenue

growth could also decline which may

lead to both interest rates and

commodity prices to rise. Any new

government will need to fix finances that

are long unpaid loans, with stressed

loans totalling Rs 601100 crores, or

about 10 percent of all loans. Higher

duties and other restrictions almost

halved gold imports. Gold is still used by

the Indian households to protect their

savings from inflation and to provide

gifts at weddings and on other special

occasions. A new government may face a

factor beyond its control: “the El Ninoweather pattern” typically associated

with weak rains. Forecasted below

average rainfall in the June-September

monsoon could shave 0.50-0.90 %

points off its economic growth forecast

and lead to a spike in consumer inflation.

There are no silver bullets here. Tackling

these issues is still a very big project yet

to be undertaken. But the present

system, based as it is on transactional,

discretionary interaction with the state,

needs to change. Many countries have

successfully transformed similar

systems. The next government must do

what it can to help push India towardsimilar progress.



Raghuram Rajan at the Spring Meetings of the

International Monetary Fund and the World Bank Group

Reserve Bank of India (RBI) Governor Raghuram Rajan recently addressed the SpringMeeting of the International Monetary Fund and the World Bank Group earlier last

month representing the constituencies of Bhutan, India, Nepal and Sri Lanka. Each year

during spring, central bankers from around the globe along with government officials,

and academicians, gather in Washington DC for the Spring Meetings of the IMF and the

World Bank Group. The central idea of the meet is to discuss the progress the work of IMF

and the World Bank group. Other events in the week long summit are seminars, regional

briefings, press conferences, and many other events focused on the global economy,

international development, and the world’s financial markets.

The speech made by Mr. Raghuram Rajan on the topic of ‘Better monetary cooperation

on the global level’ can be divided into the following 4 points:-

1. Creation of a “global safety net”

Sharing stage with the apex bankers from The US, Europe and Brazil, Rajan proposed

creation of a global "safety net" that could provide funds for countries in case of economic

emergency so that they do not block their cash in the forms of reserves to ward off

external shocks. Rajan proposed that the "safety net" should be administered by a

multilateral body such as the IMF.



Rajan pointed out that the Emerging markets absorbed a huge inflow of investment in

response to the global recession as central banks in developed nations sharply reducedinterest rates, sending investors flooding towards countries like India, Turkey and

Argentina for higher yields. But as the developed nations recovered they increased the

interest rates making the emerging currencies gasping for breath, the situation that was

very much visible in India’s case last year. The INR in August had plummeted to an all -

time low over signals that the US Federal Reserve would taper QE that had injected

hundreds of billions of dollars into the system to revive the economy.

Rajan was highly critical of the industrial countries and quoting an IMF report said:

"Industrial countries are going to do what they have to do; emerging markets

have to adjust. I think we need language which is more even-handed. It's not that

emerging markets have infinite ability to adjust and so we should keep that in

mind going forward."

However, the ECB president Vitor Constancio disapproved of the statement made by

Rajan and argued that the developing economies were much closer to full employment

than rich nations. Although Rajan had received cold reception, on the idea of creating aglobal safety net, from his counterparts from developed economies, his suggestion of

creating a reserves plan and better system of emergency funds was welcomed.

He proposed that a multilateral body provide cash to central banks to ease pressures on

countries to build up currency reserves as a buffer against sudden outflows. In such a

structure, credit risk would be minimal and could do away with the bilateral swap lines

which are prevalent between many countries.

2. Impartial international assessor

The RBI governor went on to propose the appointment of "an impartial international

assessor" who could examine and warn of the effects of unconventional central bank

monetary policies on the global economy.

He proposed that the impacted country should file a complaint with the assessor and the

assessor should investigate the charges in the light that if the institution accused has

followed the ‘rules of the game’ and if the assessor feels that the policy hampers the global

welfare, diplomatic international pressure should be used to cease such policies.



3. Global Stability Mechanism and Short-Term Liquidity Line

Rajan also voiced a mechanism for Global Stability and Short-Term Liquidity Line at theIMF, suggesting that, it should focus on countries that cannot fall back on their own

liquidity arrangements.

4. Rajan’s criticism of the Federal reserve

Rajan criticized the U.S. Federal Reserve

for not taking into account the impact of

its monetary policy on emerging

economies. The episode when the Fed

hinted at winding down their then-$85

billion-a-month bond-buying program

outraged the developing economies and

saw its heavy criticism.

The Fed's policies, adopted gradually in

the aftermath of the 2008 global financial

crisis, had multiplied the emerging

market assets, as the investors flooded in

their money in the emerging markets in

wake of lower interest rates in the

developed economies but hit India hard

last year when investors feared the U.S.

central bank would start unwinding its

QE program.

The RBI was however wary of the

consequences of the tapering of Fed’s

monetary stimulus starting in Decemberand had bought dollars well in advance

and increased the forex reserves to curb

volatility in the rupee after the tapering

started and has hence successfully seen

off what would have been a more

turbulent quarter for the Indian

economy.

In the just-concluded financial year, the

country's forex reserves crossed $300

billion-mark, the highest since December

2011.For the week to March 28, the

reserves rose by a staggering $5.038

billion to $303.673 billion, the second

highest in the fiscal. During the period,

foreign currency assets also jumped by

$5.011 billion to $276.406 billion.

Although the forex reserves have been

growing steadily, Rajan insisted that no

amount of forex reserves are enough to

make the economy immune to the

currency fluctuations and unfavorable

external shocks until they are able to

match up to the levels of China which

stood at a whopping $3.66 trillion at the

end of 2013, making it the largest in theworld, while at the best of times, India

could not shore up more than $322

billion.

‘Now that the US stimulus is winding down, the Fed is attempting to telegraph a rate rise around the

middle of 2015, that could spell more trouble for emerging markets’ warned Dr Rajan.

Rajan criticized the Fed for not including in its January policy statement any mention of

the volatility in emerging markets, reiterating that the fed was least bothered about

what was happening abroad, especially in the emerging markets.



Repo and Reverse RepoTo understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is

important to understand the role they play in banking. Repo and Reverse Repo are

basically instruments used by the RBI to influence the total monetary base of banks.

To get a grip on this, it is important to understand how banks work and what the term

monetary base means. Banks engage in a practice called Fractional Reserve Banking

(FRB) wherein a bank lends many multiples of the actual cash in hand. This cash they

have is monetary base.

Let’s see how money multiplies in the economy: “A” deposited 1000 in Bank. Bank held

10% towards reserve requirements and lends 90% further. The person using 900

will now enter into transaction in the economy and give 900 (assuming full money

usage) for transaction to another person. The person receiving 900 will deposit in

his/her respective bank. His Bank will now keep 10% as reserve and lend rest 90%

i.e. 810 further. Like this, a Rs. 1000 deposit keeps on multiplying . Clearly, any

addition to the monetary base adds to the bank’s ability to make loans.

In India, banks’ monetary base takes 2

forms – CRR (Cash Reserve Ratio) and SLR

(Statutory Liquidity Ratio). CRR is the

amount of actual cash that banks need to

hold with the RBI. It helps in controlling

liquidity in the economy. SLR refers to the

amount (by value) of approved securities

(government bonds, gold and approved,

privately issued financial instruments) that

banks are mandated to hold. It helps banks

to redeem funds at the time when they face

solvency problems and need urgent funds.

Currently, CRR is 4% and SLR is 23%.

Together, they constitute the monetary

base of the Indian banking system.

However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks.

That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement ,

the Repo seller (the bank) sells an approved security to the RBI with the understanding

that at a certain date in the future, the bank will buy the security back from the RBI. Thebank gets cash and the RBI the security.



For instance, a bank may enter into a

repo with RBI, selling a security to RBI

and then tell RBI that I will buy this

security back from you after 3-months.

RBI tells the bank…OK I will pay Rs. 100

for this security now but when you buy it

back from me, please pay me Rs. 103. The

extra Rs. 3 that RBI charges constitutes

the repo rate (translates into 12% pa for

this example) Hence, repos are a form of

“collateralized or secured borrowings”

in which the borrower must place a

collateral with the lender (in this case

RBI). If the borrower does not manage to

buy back the security, the lender can

redeem its collateral value

One would expect that this would not

influence the monetary base because

while the bank gets cash and adds to its

CRR base, it loses possession of the

security and falls behind on its SLR baseand can therefore not lend more. The

interesting part is that this problem in

the way of expanding bank lending is

eliminated by the way the Repo system

works.

Very interestingly, during the term of the

Repo, the bank is allowed to count the

security thus sold to the RBI as part of itsinvestments to fulfill the SLR

requirement. So, the net effect of a Repo

transaction is an addition to the bank’s

cash reserves without falling behind on

SLR requirements. With this, the bank

can now engage in much more lending.

At the end of the term of a Repo, the bank

buys the security back from the RBI at a

price higher than the original sale price.

The difference expressed as a percentage

of the original sale price is the Repo

Rate. Thus, Repo Rate is used to calculate

the price at which the security is bought

back by the bank. It is the equivalent of

an interest paid by the bank to RBI.

It might seem that at the time the bank

buys the security back, its cash reserve

falls. However, the bank can then enter

into a fresh Repo transaction and sell the

security back to the RBI, bringing the

cash reserve back to the higher level. In

this manner, Repo becomes a means for

the RBI to maintain a steady level of

lending to banks.

But all this additional lending would

mean more purchases of securities to

meet SLR requirements. This would

mean the need to deploy cash for thesame. That cash would go outside the

system of lending and reduce the

system’s lending potential. This problem

is solved by what is called the Reverse

Repo.

For example in the case of reverse repo,

the RBI would be the one selling the

security to the commercial bank andtelling it….if you give me Rs. 100 for 3

months today, I’ll pay you Rs. 3 as

interest on it after 3 months and you give

me back this security. So it is actually a

‘repo’ from RBI’s perspective but a

‘reverse’ repo from the commercial

bank’s perspective.



In a Reverse Repo, the RBI sells an approved security to the bank with the understanding

that it will buy it back at a future date at a higher price. The difference between the 2

prices expressed as a percentage of the original selling price (per annum) is called

the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received

by the bank for lending cash to the RBI.

The important point for us to note is that a bank may show securities bought from the

RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the

case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a

fresh Reverse Repo with the RBI.

Summarizing the understanding

Bank XYZ hits its lending limit based on

its CRR and SLR. It sees potential for

more lending. It offers RBI a portion of

the securities it holds as part of a Repo

transaction and gets cash. It deploys

23% of this new cash to obtain securities

under the Reverse Repo window from

the RBI, thus keeping the cash within the

system. The bank now gets to create new

money amounting to 1/(CRR+SLR) times

the money borrowed under the Repo

window and lend it out at interest. The

Repo window thus becomes a cheap

source of borrowing for banks.

The impact of a cut in Repo and Reverse Repo Rates

A cut in Repo and Reverse Repo rates

basically reduces the bank’s cost of

borrowing from the RBI to add to its

reserves. It enables banks to either

increase the interest rate spread on

loans made by the bank or offer

borrowers lower rates of interest

without eating into its own interest rate

spread. Thus, a cut in Repo and Reverse

Repo Rates increases the banking

system’s potential by expanding more

loans in a profitable manner.

Impact on Industry

With lower repo and reverse repo rates,

industry gets to borrow more and even

gets to pay lower interest rates on its

borrowing. Therefore, those businesses

that are in a position to secure additional

lending from the banking system will

benefit from lower repo and reverse

repo rates.



Impact on ordinary people

The impact on ordinary people can be

felt in 2 ways. In the nearer term, greater

lending to businesses will lead to more

business investment and employment

opportunities. In the medium and longer

term, however, the dominant factor

influencing ordinary people will be the

increased money supply (inflation),

which will send prices of consumers’

goods soaring, resulting in future

pressure to raise interest rates thus

forcing the pricking of the inflationary

bubble and the onset of the depression.

Impact on the broader economy

In the long-run, reducing Repo and

Reverse Repo rates is harmful for the

economy as it is just a means to lend

reserves to banks, enabling them to

engage in far bigger inflation to

undertake much more credit expansion

through FRB. While this lending will

have some short-term positive effects, in

the long-run, it creates and worsens the

inflationary boom of the familiar boom-

bust cycle. It also sets the conditions for

the inevitable raising of interest rates

thus pricking the inflationary bubble and

triggering the depression.

Conclusion

Thus we see that the policy of reducing

Repo and Reverse Repo rates is

essentially bad for the economy in the

long-run because it greatly aids the

creation of the business cycle. It also

hurts ordinary people by sending prices

soaring. Industry and the banking

system, however, benefit in the short

run. This explains why a policy of

lowering repo and reverse repo rates

finds fairly broad-based support from

the banking industry and general

industry as well.



Some interesting facts about the ongoing elections

1. 814 million Indians are eligible to vote in the ongoing

general elections, a number which is approximately 100

million more than the general elections held in 2009.

2. Third Sex or the transgender community has been

recognized for the first time and the number registered

under this category is 28,314.

3. The estimated cost of the general elections is about $5

billion (or 300 billion rupees), which is 150% more than

the last elections in 2009.

4. Approximately 168 million, or about 20%, of the

voting population is eligible to cast their votes for

the 1st time. The voting criterion in India is 18

years.

5. The election commission ruled that no polling

station should be registered with more than 1500

voters. This decision led to the installation

of 919,000 polling stations with

approximately 3.6 million electronic voting

machines.

6. A staff of 10 million people will be working

on the election duty.

http://www.google.com/url?q=http%3A%2F%2Ftimesofindia.indiatimes.com%2Findia%2FPolls-to-cost-country-Rs-3500-crore-this-year%2Farticleshow%2F30587202.cms&sa=D&sntz=1&usg=AFQjCNGf0pfrHS96OyKyRkr0KkuLPn5NFw

http://www.google.com/url?q=http%3A%2F%2Ftimesofindia.indiatimes.com%2Findia%2FPolls-to-cost-country-Rs-3500-crore-this-year%2Farticleshow%2F30587202.cms&sa=D&sntz=1&usg=AFQjCNGf0pfrHS96OyKyRkr0KkuLPn5NFw



Editors:

Akhil Joshi | Aneesh Porwal | Kaustav Maiti

Neeraj Garg | Ravi Panjwani | Ruchika Bansal

Sharath K.R. | Swati Bhatt | Sweeny Gupta

Do You Know?

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‘Campus-Edition‘ of the okonomist.

So, Pick a topic of your choice (related to business or

economics). Minimum of 500 words and Send in your articles

to [email protected]

If you have that Business/Economics Quotient in you, Then

Flaunt It…!!!

mailto:[email protected]



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