Finad module1

Macro Economics and
Indian financial system

FINAD Module 1

FINAD Module 1 Macro Economics and Indian financial system

Contents

1. Importance of macroeconomics in the financial sectors
2. Business cycles
3. Global economic linkages
4. Inflation and Interest rate
5. Structure of Indian Financial System
6. Role of Government
7. Role of Central Bank
8. Measures of Economic activities
9. Monetary and Fiscal polices
10. Current Account and Trade account

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FINAD Module 1 Macro Economics and Indian financial system

Introduction

Business firms are micro units operating in the macro economy. Macro economic issues
impact business. Changes in the macro economic environment produce profound
consequences in financial markets. Understanding the macro economy and financial
markets is important for a financial professional. This module explains, in very simple
terms, various macroeconomic concepts and a gives a glimpse of the behavior of the
macro economy. This understanding would help financial professionals comprehend the
working of the macro economy and how it impacts business. A successful professional is
one who applies this understanding to think ahead and formulate strategies for likely
future scenarios.

Economic theory can be broadly divided into two categories: Microeconomics and
Macroeconomics. Microeconomics is a study of the micro parts of the economy. It studies
the behavior of individual economic agents such as individual consumers, business firms
etc. Macroeconomics, on the other hand, looks at the economy as a whole. It deals with
aggregate economic behavior of a nation, a region or the global economy. In other words,
macroeconomics deals with economy-wide phenomena such as inflation, unemployment,
and economic growth.

Importance of macroeconomics in the financial sectors

For people in finance, understanding macroeconomics is very important because each
of the major macroeconomic factors such as growth, inflation, business cycles etc. have
strong impact on the financial markets. Macroeconomics tells us about what determines
level of output in an economy, how are employment and prices determined, how money
supply affects rate of interest, how monetary and fiscal policies affect the economy etc.

 Macroeconomics studies various macro aggregates such as savings, investment,
economic growth, money supply, price levels, interest rates etc. and their inter-
relationships.

 Macroeconomics analyzes how and why different countries are growing at different
rates and suggests how countries can accelerate their growth rates.

 Macroeconomics studies business cycles and offers anti-cyclical policies.

 Macroeconomics gives insights into why inflation rises or falls and what policies help
avoid periods of high inflation or deflation.

 It analyses how changes in policy can affect different macroeconomic variables.

 Macroeconomics explains the risks and opportunities that arise in different
macroeconomic situations.

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FINAD Module 1 Macro Economics and Indian financial system

Business cycles

Economic activity is not linear; it is cyclical. Business cycles are periodic expansions and
contractions in the level of economic activity. Business cycles cause changes in the level
of economic activity such as production, output, employment, price level etc. Potential
changes in the level of economic activity impact stock markets. By linking economic cycles
to the stock market, a series of “road maps” can be constructed which will enable
investors to identify which global markets are likely to show out-performance. At different
points in the cycle, different sectors of the market will under-perform or out-perform. The
duration of a business cycle can be several months or even many years. These
fluctuations in economic activity usually do not follow a predictable pattern. The upward
phase of the business cycle is called boom and downward phase is called recession.

Global economic linkages

World economies are increasingly linked to each other due to globalization. Balance of
trade, balance of payments, capital flows like FDI and FPI have profound economic
significance. Macroeconomic trends in large economies can cause major economic
consequences for other economies. Foreign capital flows play a very important role in the
financial markets of developing countries and hence is becoming an increasingly important
aspect of the economy of these countries.

Trends and fluctuations in the financial markets have a strong impact on the rest of
the economy. Some examples of such transmission can be observed during the financial
crises. In the United States, weaknesses in the financial sector stemming from a sudden
and substantial decline in the prices of real estate, led to a downturn for the entire
economy. This created a global recession. Governments of all major countries had to
undertake serious coordinated policy measures to pull their economies out of recession.

Structure of Indian Financial System

Any country needs a system to regulate, supervise, monitor and control the players,
intermediaries, and the investors etc. who take part in the financial markets in the
system. So, we can define financial system as a set of institutions, instruments and
markets, which foster savings and channel them to their most efficient use. The system
consists of individuals (savers), intermediaries, markets and users of savings. Further, an
efficient system alone can promote national priorities. An example of the national priority
deciding the development in the financial markets is infrastructure development and need
for longer duration financial resources through instruments such as deep discounted
bonds to meet this requirement.

Constituents of the Indian Financial System

The Government of India, Ministry of Finance, heads the Indian financial system. The
ministry in turn is bifurcated into various departments like the Department of Economic
Affairs, the Department of Company Affairs etc.

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FINAD Module 1 Macro Economics and Indian financial system

The Indian financial system consists of:

 The financial markets
 The statutes governing the various segments of the financial markets
 The statutory authorities responsible for regulating, supervising, monitoring

and controlling the markets and its components
 The financial intermediaries
 Specialized organizations
 Agents operating in different segments of the financial markets

 Financial instruments/securities issued in the markets to raise resources

The financial markets
The financial markets consist of:

 Money markets – maximum duration of 12 months
 Capital markets – Minimum duration 12 months and maximum duration

could be even 20-25 years
 Foreign exchange markets
 Insurance market
 Banking
 Mutual funds

The money markets and capital markets in turn do have “Primary market” and
“Secondary market”. Primary market is the new issue market dealing in issue of financial
instruments by companies and others that want to raise financial resources from the
market. Secondary market refers to that market where the financial instruments issued in
the Primary market are traded.

Segments of money market:

Call money market

Call money is a very short-term instrument used in inter-bank operations. The duration is
from one day to fourteen days. Only scheduled commercial banks are permitted to be
borrowers in this market. While some banks will be borrowers, some others will be
lenders. There is no specific market place. Deals are done over the phone.

Commercial paper:

Issued by companies and Public Sector Undertakings for their working capital
requirement. This is a promissory note issued by companies requiring short-term funds
(say from 15 days to 180 days or six months). Maximum period is twelve months. The

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FINAD Module 1 Macro Economics and Indian financial system

six-month commercial paper can be extended for a further period of six months, making a
total of 12 months.

Commercial bills: Discounted by banks and Non-banking Financial Institutions. These are
short-term bills usually not exceeding 90-120 days covering commercial transactions in
the private sector.

Treasury bills: Issued by Government of India through the RBI for meeting budgetary
deficits. These are for fixed maturity periods ranging from 91 days to 364 days.

The Reserve Bank of India controls the money markets in India. It is known as money
market regulator.

Role of Government

The government plays many important roles in the overall economic system of a country.
Though India is slowly moving towards a market based economic system, there is hardly
any sector in the economy that is not touched by the government. In fact, even in most
developed countries with highly developed markets, the role of the government continues
to be important, as can be seen below.

 Providing a platform for improving economic efficiency

A well functioning legal and stable political system is essential for markets to
operate efficiently. The basic role of the government is to provide these facilities.
Secondly, there are many sectors that fail to attract any major private investment
as they may not be profitable in the short and medium run. Examples of such
sectors include education and healthcare services. It is the role of the government
to invest in these sectors. The government also plays a regulatory role in regulating
prices in certain industries such as drugs and pharmaceuticals.

 Ensuring an equitable distribution of income

Distribution of income arising out of completely market driven economic forces
can potentially lead to serious imbalances in an economy. If income inequality
becomes too large in an economy, it creates both social and economic tension in
the system. The government uses its taxation policies to deal with this situation.

 Stabilizing the economy through economic policies

When the economy slows down or faces major economic crises, the government
intervenes through appropriate fiscal policies.

 Conducting international economic policies.

As the economy of a country gradually becomes more integrated with the
global economy, the government plays a key role in facilitating and monitoring this
integration, so as to maximize the potential benefits for the country. This requires a
number of coordinated policy responses; including gradual removal of trade

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FINAD Module 1 Macro Economics and Indian financial system

barriers, measures to attract foreign capital into the country, work with other
nations to protect the global environment etc.

Role of Central Bank

In India, the Reserve bank of India (RBI) is the central bank. The Reserve Bank,
established through the Reserve Bank of India Act, 1934 commenced its operations in
1935. It draws its powers and responsibilities through other legislations also such as the
Banking Regulation Act, 1949. The important roles RBI perform in the Indian economy
are:

 Issuer of Currency.

It issues coins and currency notes.
 Supervisor of the Financial System.

The RBI it prescribes regulations for sound functioning of banks and financial
institutions, including non-banking finance companies. It promotes best practices in
risk management and corporate governance to protect depositors’ interest and to
enhance public confidence in the financial system of the country.

 Banker to the Government.

RBI maintains accounts of central and state governments. It performs
merchant banking function for the central and the state governments.

 Bankers’ Bank

RBI ensures adequate liquidity in the financial system and in individual
banks, on a daily basis. When a financially troubled bank looks for funds, the RBI
becomes the ‘lender of the last resort’ for such banks.

 RBI conducts monetary policy ensuring price and exchange rate stability.

Inflation and Interest rate

Inflation denotes a rise in general level of prices. More specifically, inflation refers to the
rate of general price increase over a period of one year. For example, if we say that the
current inflation is 8 percent, it means the general price level has increased by 8 percent
over the last one year.

It has been observed that inflation the world over has generally remained in the
positive territory, implying that the general price level typically rises. There have however
been exceptions, when there have been sustained decline in the price level of goods and
services. This phenomenon is called deflation. For example, if we say that the current
deflation rate is 4 percent, it means that the inflation is -4 percent. In other words, the
general price level has fallen by 4 percent over the last one year.

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FINAD Module 1 Macro Economics and Indian financial system

Primarily, two types of price indices used are – Wholesale Price Index (WPI) and
Consumer Price Index (CPI). Inflation measured through wholesale price index is called
wholesale price inflation or headline inflation and inflation measured through consumer
price index is called consumer price inflation.
Interest Rates

Interest rate is the price demanded by the lender from the borrower for the use of
borrowed money. In other words, interest is a fee paid by the borrower to the lender on
borrowed cash as a compensation for forgoing the opportunity of earning income from
other investments that could have been made with the loaned cash. Thus, from the
lender’s perspective, interest can be thought of as an “opportunity cost’ or “rent of
money” and interest rate as the rate at which interest (or ‘opportunity cost’) accumulates
over a period of time. The amount lent is called the principal.

Interest rate is typically expressed as percentage of the principal and in annualized
terms. From a borrower’s perspective, interest rate is the cost of capital. In other words,
it is the cost that a borrower has to incur to have access to funds.

Inflation and interest rate

When the price level rises, each unit of currency can buy fewer goods and services than
before, implying a reduction in the purchasing power of the currency. So, people with
surplus funds demand higher interest rates, as they want to protect the returns of their
investment against the adverse impact of higher inflation. As a result, with rising inflation,
interest rates tend to rise. The opposite happens when inflation declines.

Measures of economic activity

GDP

Gross Domestic Product is the money value of all goods and services produced in the
domestic territory of a country in one year. GDP is obtained by multiplying all goods and
services produced in the domestic territory of a country with its market price. i.e. GDP =
Amount of goods and services produced x Market price
E.g. GDP of India in the Year 2010 is 55, 74,449 Crores.

Real and Nominal GDP

Since GDP is the multiple of Product and Price, GDP of a nation can increase in two ways:
a. Increase in production
b. Increase in price

When there is increase in production we can say that there is genuine growth in the
country. But when GDP increase due to increase in prices, there is no actual increase in
production, or no actual growth. When there is increase in GDP due to rise in prices, we
deduct the effect of Inflation( rise in prices) to find the real growth in GDP. This is called
Real GDP. The GDP value before deducting the effect of inflation is the Nominal GDP.

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FINAD Module 1 Macro Economics and Indian financial system

GNP and NNP

Gross National Product (GNP) at factor cost is arrived at by adding the net factor income
from abroad to the GDP at factor cost. GDP and GNP are calculated at current market
prices and also at constant prices.

The Net National Product (NNP) is the net production of goods and services in a
country during the year. NNP is simply GNP adjusted for depreciation charges. NNP gives
an idea of the net increase in the total product of the country. It is helpful in the analysis
of the long run-run problem of maintaining and increasing the supply of physical capital in
the country.

Index of Industrial Production (IIP)

IIP is an index which shows the growth rates in different industry groups of the economy
in a stipulated period of time. IIP is a composite indicator that measures the growth rate
of industry groups classified under,

 Broad sectors, namely, Mining, Manufacturing and Electricity
 Use-based sectors, namely Basic Goods, Capital Goods and Intermediate Goods.
 Currently IIP figures are calculated considering 2004-05 as base year.

Monetary and Fiscal policies

Monetary Policy

It is RBI’s policy that governs the supply of money in the economy, which is controlled
through instruments such as interest rates and reserve requirements (CRR) for banks. For
example, to control high inflation, RBI can raise interest rates thereby reducing money
supply.

Repo

Repo (Repurchase) rate also known as the benchmark interest rate is the rate at which
the RBI lends money to the commercial banks for short term. When the repo rate
increases, borrowing from RBI becomes more expensive. If RBI wants to make it more
expensive for the 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. Repo is raised to
curb inflation and reduced to stimulate the economy during low inflation or deflation.

Reverse Repo

Reverse Repo rate is the short term borrowing rate at which RBI borrows money from
banks. The Reserve bank uses this tool when it feels there is too much money floating in
the banking system. An increase in the reverse repo rate means that the banks will get a
higher rate of interest from RBI. As a result, banks prefer to lend their money to RBI
which is always safe instead of lending it others (people, companies etc) which is always
risky.

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FINAD Module 1 Macro Economics and Indian financial system

Repo rate signifies the rate at which liquidity is injected in the banking system by
RBI, whereas Reverse Repo rate signifies the rate at which the central bank absorbs
liquidity from the banks. Reverse Repo Rate is linked to Repo Rate; with the former 1 %
higher thn the latter.

Cash Reserve Ratio(CRR) and Statutory Liquidity Ratio (SLR)

Major currency reserve in the economy will be with the banking system including Reserve
Bank and the commercial banks. To control the excess money supply in the economy, RBI
instructs commercial banks to keep certain amount of its deposits as cash in RBI account.
Commercial bank does not get any interest on this deposit.This is called Cash Reserve
Ratio CRR. Currently it is 4%.

SLR (Statutory liquidity ratio) - Besides the CRR, banks are required to invest a
portion of their deposits(now 21.50%) in first class securities or government securities as
part of their statutory liquidity ratio (SLR) requirements.

Hence the banks can lend money which is left with them after parking in the form of CRR
and SLR.

Liquidity Adjustment Facility (LAF)

Major lending and borrowing between RBI and commercial banks happen through Liquidity
Adjustment Facility. LAF consitutes Repo and Reverse Repo .i.e. Repurchase Agreements
which involve submiting first class securities as collateral for borrowing money.Repo is the
rate that commercial banks pay RBI for the money they receive from RBI. Reverse Repo is
the Rate that RBI pays Commercial Banks for the amount deposited by Commercial Banks
with RBI.Government securities are set as collateral in repo transactions. Always Repo
rate will be higher than Reverse Repo. The difference between these rates is called LAF
Corridor. Repo rate under the liquidity adjustment facility (LAF) is presently at 7.25%. The
Reverse repo rate is presently at 6.25%.

Reverse Repo rate was an independent rate till 03/05/2011. However, in the
monetary policy announced on 03/05/2011, RBI has decided that from then onwards the
Reverse Repo Rate will not be announced separately, but will be linked to Repo rate and it
will always be 100 bps below the Repo rate (till RBI decides to delink the same)

Marginal Standing Facility (MSF)

The concept of Marginal Standing Facility was announced by RBI wef 03/05/2011
(However implemented wef 09/05/2011). At that time it was decided that Marginal
Standing Facility i.e. MSF rate will be linked to Repo rate and will be 100 bps above the
Repo Rate (till RBI decides to change the same). WEF 15/07/2013, RBI has announced
that from then onwards the MSF Rate will be 300 basis points above the Repo Rate. Once
again MSF rates were revised wef 20/09/2013 to 9.50%, which is 200 bps above the Repo
Rate. RBI has put a cap for the amount that a commercial bank can borrow from RBI.
Usually it is 1% of a banks time deposits. Over and above that limit, if a commercial bank

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FINAD Module 1 Macro Economics and Indian financial system

requires funds, it can borrow from RBI through Marginal Standing Facility (MSF). Generally
MSF rate is 1% more than repo rate. Hence MSF > Repo Rate > Reverse Repo Rate.

Bank Rate

This is the long term rate (Repo rate is for short term) at which central bank (RBI) lends
money to other banks or financial institutions. If the bank rate goes up, long-term interest
rates also tend to move up, and vice-versa. When bank rate is hiked, banks hike their
own lending rates. Current bank rate is 8.25%

Fiscal Policy

Fiscal policy is the policy of the government regarding taxation, public expenditure and
borrowing. Fiscal policy is implemented through the budget.

Current Account and Trade account

We are now living in a globalised economy where there is increased level of integration
between countries. Countries engage in exports and imports. This creates surplus or
deficit in trade and payments.

Balance of Payments is a summary statement of all the transactions that a country does
with other countries during a calendar year. This Balance of Payment account has two
components.

 Current Account
 Capital Account

Current Account

Includes transactions of exports and imports in goods (Merchandise) and services,
transfer of funds from non-residents and the interest income earned on foreign
investments by Indian investors. If there is more export than import, and there is positive
net fund flow from other countries, we can say the country's Current Account is in surplus.
If there is more imports and more trasfers happening outwards, then there will be Current
Account Deficit.

Capital Account – Includes transactions where there is flow of capital from one country to
another in the form of FDI ( Foreign Direct Investment), FII ( Foreign Institutional
Investment) and ECB ( External Commercial Borrowings).

Trade Deficit and Trade Surplus

Trade between nations happen both in goods as well as services. If there is excess of
exports over imports, then it is trade surplus. And if imports exceed exports, it will result
in trade deficit.

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