Economy & Capital Markets Basics of Macroeconomics

1. Economy & Capital Markets Basics of Macroeconomics September 18, 2009

2. Introduction Macroeconomic tools & stock markets Many people invest in stocks and some of them might be even successful but only few people understand why the stock market reacts to the announcements made by the Government and the RBI. You might have heard Bank Rate, Repo Rate, Cash Reserve Ratio (CRR), Tax Cuts, Government Spending, inflation and many more words these days and whenever some major announcement comes from RBI regarding these, SENSEX and NIFTY either goes up or comes down. Why? These are all Macroeconomic tools at the Disposal of Government of India to keep the Economy in Balance. Along with these, stock markets also react to various economic data released by the government. These include, weekly Inflation, Monthly Index of Industrial Production, Quarterly GDP. As nearly 70% of Indian population stays in rural India and depends largely on agriculture for their earnings, progress of monsoon (During June-September period) also impacts sentiments in stock markets. We are hereby explaining key Macroeconomic data that impact sentiments in stock markets. This brief introduction is not for people who know Macroeconomics well to whom it might not be useful but for retail investors who have the interest to learn how the Macroeconomic environment is linked with Stock market. Macroeconomic tool used by RBI is Monetary Policy. The Government uses Fiscal Policy to manage economy. In recent past, responding to the global economic recession, government has also used “Stimulus Package” which derives inputs from both these policies to have “Multiplier Effect” on the economy. We are giving below how these tools work and how the economy improves and it’s bearing on Stock Markets. September 18, 2009

3. Key Terms Monetary Policy Monetary Policy is an “Economic Lever” by which RBI keeps the money supply under control to keep the Economy in balance – money supply and inflation at the optimum levels. Monetary Policy is also used to manage interest rates at the optimum levels. RBI’s oversight and adoption of prudent norms has ensured that the Indian banking sector is in good shape. There are various options for the RBI under Monetary Policy and some are as follows. September 16, 2009

4. Key Terms Cash Reserve Ratio (CRR) It’s a percentage of money that a commercial bank must keep with RBI as a reserve. At present the CRR is 5%. This means if SBI receives Rs 100 as a deposit; it must keep Rs.5 as a reserve with the RBI and will have Rs. 95 for loaning. How does CRR affect money supply and stock market? Here is how. Suppose RBI hikes the CRR to 10 %. Then SBI must keep Rs. 10 as a reserve with RBI and it will have only Rs. 90 to give loans instead of Rs.95, which reduces the available currency in the market. The stock market will react based on the prevailing market sentiment to this change but mostly downside. Suppose the CRR comes down to 3% means the bank will now have Rs. 97 to give loans which in turn increases the currency supply in the market and stock markets move up to this kind of news (Because companies can get credit at cheaper rates without hindrance which reduces the cost of capital and the company Earnings Per Share (EPS) improve). September 16, 2009

5. Key Terms Repo/Reverse Repo Open Market Operations and Repo/ Reverse Repo Rate If the RBI feels that available currency in the market is less, then it purchases government securities or bonds to temporarily create more money supply and vice versa. Repo/Reverse Repo rate is a rate at which it transacts the securities and bonds with commercial bank to create or destroy money supply. Repo rate is the rate at which the RBI buys government securities from the market to infuse liquidity in the system.  Reverse repo rate is the rate at which the RBI absorbs excess bank funds by selling government securities in the market. If liquidity is abundant in the system, then reverse repo becomes the key policy rate, but when liquidity is scarce and banks borrow from RBI, the repo rate is the policy rate. A cut in repo rate is a signal to banks to pare their lending and deposit rates but its effectiveness depends on liquidity in the system. September 18, 2009

6. Key Terms Fiscal Policy We all show eagerness to the budget announcements. Why? Because government defines the path for the economy and aggregate demand to travel, through budget and the whole idea of spending is based on Keynesian economics. So, the fiscal policy is a tool by which government influences it’s spending and tax related issues. This concept is as simple as our family spending. There are three situations as follows. Optimum Budget. Under optimum budget Government spending = Government income (Taxes). Suppose government collects Rs. 1000 crore as a Tax means, just like our family, the government can spend only Rs. 1000 crores. If the government is able to provide all the facilities to its citizens within this amount, then that’s where, economy is in optimum.Surplus Budget. Government spending <= Government Taxes. This is a dream situation where the government collects Rs. 1000 crores in Taxes but it requires only lets say 750 crores to provide all the facilities for its citizens. Cont…. September 18, 2009

7. Key Terms Fiscal Policy Deficit Budget. Government spending >= Government Taxes. This is our familiar situation where the government collects Rs. 1000 Crores in Taxes but requires Rs. 1500 Crores to provide all the facilities for its citizens. Where does the government go for the additional Rs.500 Crores? Well, that’s when government sells securities and bonds to mobilize money by promising a fixed interest income to you and definitely not to make you or me rich if you felt that way. Government also gets loan from IMF, Asian Bank and other agencies. How the hell government will repay that Rs. 500 Crores? Just like we start a business by getting loan from SBI thinking our business will generate enough income to repay the loan, the government also thinks, the additional spending will stimulate the economy by “Multiplier Effect”. Stimulus Package The idea of “Stimulus” Package originates under this principle. Since, the government thinks that additional spending will improve the economy by “Multiplier Effect”, the stock markets react positively thinking company earnings will go up and thus stock prices.

8. Key Terms What is Multiplier Effect? • Have a look at two scenarios: • A) Government spending and Tax cuts. • B) Lending or Deposit multiplier. • Government spending and tax cuts- Government spends the “Stimulus” money in infrastructure or other projects. These projects employ additional people (Employment). These employees earn income (Earning) and they buy goods (Spending) with that money. The seller earns income and he spends it to expand his business. To expand his business, he buys more goods and employs more people. This process goes on and on which “Multiply” the effect of initial amount that government spent, hence the name “Multiplier Effect”. • Why Govt does this?- Because tax cut increases the disposable income of a household and since they have more money, they will spend it to buy goods and it will follow the same process explained above Stock markets react positively to “Stimulus” package in anticipation that the economy will get a boost through this “Multiplier Effect”. September 18, 2009

9. Key Terms What is Multiplier Effect? Deposit multiplier: Deposit Multiplier is directly linked with CRR. Suppose Axis bank gets Rs. 100 as a deposit. Then it must keep Rs.10 as a reserve since the CRR is 10%. Axis bank lends remaining Rs. 90 and people borrow it and spend. That money is deposited in another bank and that Bank keeps Rs.9 as reserve in RBI and loans the rest of Rs. 81. This goes on and on till the loan amount reaches Rs. 1000 (Rs. 100 /0.1). Money multiplying money situation September 18, 2009

10. Key Terms Inflation Inflation is a tool to measure growth in prices of various commodities. In India, Inflation numbers are announced by Government every week at 12 noon on Thursday. Inflation is measured by the proportional changes over time in some appropriate index, commonly a consumer price index, or a GDP deflator. Because of changes in the type and quality of goods available, measures of inflation are probably not reliable to closer than a margin of 1 or 2 per cent a year, but if prices rise faster than this there is no doubt that inflation exists. Economists have attempted to distinguish cost and demand inflation. Cost inflation is started by an increase in some elements of costs, for example the oil price explosion of 1973-4. Demand inflation is due to too much aggregate demand. Once started, inflation tends to persist through an inflationary spiral, in which various prices and wage rates rise because others have risen. Inflation leads to fluctuations in interest rates. It also affects buying power of the consumer and consumer delays his buying decisions, which affects topline and bottomline of the companies leading to fluctuations in stock prices. Also due to inflation, investments of individuals get affected and they tend to invest less. This leads to lower flows towards stock markets either directly or through mutual funds/insurance. September 18, 2009

11. Key Terms Index of Industrial Production (IIP) IIP data indicates YoY trends in manufacturing activities of various industrial items included in the index. It helps us in understanding how various sectors are performing. In India, IIP numbers are declared monthly on 12th of every month. Economist and stock market players track these trends to analyze likely production trends going forward. IIP affected due to global recession during October 2008-February 2009 which is directly reflected in weakness of stock markets. From March 2009 onwards we have seen steady improvement in IIP and our markets have also recovered. This indicates close relations of IIP and stock markets. September 18, 2009

12. Key Terms GDP While IIP indicates trends in industrial production, Gross Domestic Production takes into consideration all sections of the economy i.e.- Agriculture, industrial and service sectors growth trends. In India, GDP data is released every quarter and various economists provide their forecast of GDP. Today India is second fastest growing economy after China based on GDP growth and therefore FII’s are pumping their money in India. This helps stock markets with liquidity September 18, 2009

13. Key Terms Fluctuations Along with macroeconomic tools mentioned above, the stock markets also reacts to the fluctuations in oil prices, rupee/$ movement, commodities like Steel, Aluminum, copper, coal price movements, monsoon etc. Commodity price movement: This is because any upward movement in prices of commodities puts pressure on companies consuming these commodities. These companies profit margins get affected and this reflects in their share prices. Currency fluctuations Companies depending on exports/imports get affected by fluctuations in rupee/$ movement. Exporting companies profits takes a hit if rupee appreciates. However, the same situation is beneficial for importing companies. At the same time if $ appreciates exporting companies get benefits while, importing companies suffer. Monsoon: India’s large population depends on agriculture income. Many industries like sugar, tea, food processing etc also depend on agriculture inputs. If India’s monsoon gets affected profitability of these companies also gets affected at the same time, with purchasing power of persons depending on agriculture output coming down gives multiplier effect on companies engaged in industries like auto, FMCG, consumer durable, fertilizers, agrochemicals etc. September 18, 2009

14. Conclusion Hope you now have a better idea about Macroeconomic tools and its association with stock market. Thank You September 18, 2009