Financial System Project

7/29/2019 Financial System Project

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The Indian Financial System

SynopsisInflation And Its Effect On Our Economy


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Table of Contents

Topic of Discussion

The Indian Financial System: An Overview

1. The Financial System : An Introduction2. Financial System: Functions and Implementation

3. Financial Tools And Instrumentations4. Components of Financial System-An Introduction

Core Project

1. Inflation : An Introduction2. Effects of Inflation3. Causes of Inflation

4. Inflation rate of India and other countries


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INDIAN FINANCIAL SYSTEM

Financial System is an institutional framework existing in a country to enable

financial transactions. There are three main parts in Indian financial system. They are

as follows:

Financial assets comprises of loans, deposits, bonds, equities, etc.Financial institutions such as banks, mutual funds, insurance companies, etc.Financial markets include money market, capital market, forex market, etc.

Regulation is another aspect of the financial system. The regulatory authorities are

RBI, SEBI, IRDA, and FMC.
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The economic development of a nation is reflected by the progress of the various

economic units, broadly classified into corporate sector, government and household

sector. While performing their activities these units will be placed in a

surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a deficit. A

financial system or financial sector functions as an intermediary and facilitates the flow

of funds from the areas of surplus to the areas of deficit. A Financial System is a

composition of various institutions, markets, regulations and laws, practices, money

manager, analysts, transactions and claims and liabilities.

The word "system", in the term "financial system", implies a set of complex and

closely connected or interlined institutions, agents, practices, markets, transactions,

claims, and liabilities in the economy. The financial system is concerned about money,

credit and finance-the three terms are intimately related yet are somewhat different

from each other. Indian financial system consists of financial market, financial

instruments and financial intermediation. These are briefly discussed below;


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FINANCIAL MARKETS

A Financial Market can be defined as the market in which financial assets are created

or transferred. As against a real transaction that involves exchange of money for real

goods or services, a financial transaction involves creation or transfer of a financial

asset. Financial Assets or Financial Instruments represents a claim to the payment of a

sum of money sometime in the future and /or periodic payment in the form of interest

or dividend.

Money Market- The money market ifs a wholesale debt market for low-risk, highly-

liquid, short-term instrument. Funds are available in this market for periods ranging

from a single day up to a year. This market is dominated mostly by government, banks

and financial institutions.

Capital Market - The capital market is designed to finance the long-term

investments. The transactions taking place in this market will be for periods over a

year.

Forex Market - The Forex market deals with the multicurrency requirements, which

are met by the exchange of currencies. Depending on the exchange rate that is

applicable, the transfer of funds takes place in this market. This is one of the most

developed and integrated market across the globe.

Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short,

medium and long-term loans to corporate and individuals.

India has a financial system that is regulated by independent regulators in the sectors of

banking, insurance, capital markets, competition and various services sectors. In a

number of sectors Government plays the role of regulator.

Ministry of Finance, Government of India looks after financial sector in India. Finance


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Ministry every year presents annual budget on February 28 in the Parliament. The

annual budget proposes changes in taxes, changes in government policy in almost all

the sectors and budgetary and other allocations for all the Ministries of Government of

India. The annual budget is passed by the Parliament after debate and takes the shape

of law.

Reserve bank of India (RBI) established in 1935 is the Central bank. RBI is regulator

for financial and banking system, formulates monetary policy and prescribes exchange

control norms. The Banking Regulation Act, 1949 and the Reserve Bank of India Act,

1934 authorize the RBI to regulate the banking sector in India.

India has commercial banks, co-operative banks and regional rural banks. The

commercial banking sector comprises of public sector banks, private banks and foreign

banks. The public sector banks comprise the State Bank of India and its seven

associate banks and nineteen other banks owned by the government and account for

almost three fourth of the banking sector. The Government of India has majority shares

in these public sector banks.

India has a two-tier structure of financial institutions with thirteen all India financial

institutions and forty-six institutions at the state level. All India financial institutions

comprise term-lending institutions, specialized institutions and investment institutions,

including in insurance. State level institutions comprise of State Financial Institutions

and State Industrial Development Corporations providing project finance, equipment

leasing, corporate loans, short-term loans and bill discounting facilities to corporate.

Government holds majority shares in these financial institutions.

Non-banking Financial Institutions provide loans and hire-purchase finance, mostly for

retail assets and are regulated by RBI.


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Insurance sector in India has been traditionally dominated by state owned Life

Insurance Corporation and General Insurance Corporation and its four subsidiaries.

Government of India has now allowed FDI in insurance sector up to 26%. Since then, a

number of new joint venture private companies have entered into life and general

insurance sectors and their share in the insurance market in rising. Insurance

Development and Regulatory Authority (IRDA) is the regulatory authority in the

insurance sector under the Insurance Development and Regulatory Authority Act,

1999.

RBI also regulates foreign exchange under the Foreign Exchange Management Act

(FERA). India has liberalized its foreign exchange controls. Rupee is freely convertible

on current account. Rupee is also almost fully convertible on capital account for non-

residents. Profits earned, dividends and proceeds out of the sale of investments are

fully repatriable for FDI. There are restrictions on capital account for resident Indians

for incomes earned in India.

Securities and Exchange Board of India (SEBI) established under the Securities and

Exchange aboard of India Act, 1992 is the regulatory authority for capital markets in

India. India has 23 recognized stock exchanges that operate under government

approved rules, bylaws and regulations. These exchanges constitute an organized

market for securities issued by the central and state governments, public sector

companies and public limited companies. The Stock Exchange, Mumbai and National

Stock Exchange are the premier stock exchanges. Under the process of de-

mutualization, these stock exchanges have been converted into companies now, in

which brokers only hold minority share holding. In addition to the SEBI Act, the

Securities Contracts (Regulation) Act, 1956 and the Companies Act, 1956 regulates the

stock markets.


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INTRODUCTION OF THE TOPIC

INFLATION is a rise in the general level of prices of goods and services in

an economy over a period of time. When the general price level rises, each unit of

currency buys fewer goods and services. Consequently, inflation also reflects erosion

in the purchasing powerof money a loss of real value in the internal medium of

exchange and unit of account in the economy. A chief measure of price inflation is

the inflation rate, the annualized percentage change in a general price index (normally

the Consumer Price Index) over time.

Inflation's effects on an economy are various and can be

simultaneously positive and negative. Negative effects of inflation include a decrease

in the real value of money and other monetary items over time, uncertainty over future

inflation may discourage investment and savings, and high inflation may lead to

shortages ofgoods if consumers begin hoarding out of concern that prices will increase

in the future. Positive effects include ensuring central banks can adjust nominal interest

rates (intended to mitigate recessions), and encouraging investment in non-monetary

capital projects.

By inflation one generally means rise in prices. To be more correct inflation is

persistent rise in the general price level rather than a once-for-all rise in it, while

deflation is persistent falling price.These days economies of all countries whether

underdeveloped, developing as well developed suffers from inflation. Inflation or

persistent rising prices are major problem today in world. Because of many reasons,

first, the rate of inflation these years are much high than experienced earlier periods.

Second, Inflation in these years coexists with high rate of unemployment, which is a

new phenomenon and made it difficult to control inflation.
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A situation is described as inflationary when either the prices or the supply of money

are rising, but in practice both will rise together. In the Keynesian sense True inflation

begins when the elasticity of supply of output in response to increase in money supply

has fallen to zero or when output is unresponsive to changes in money supply. If there

is full employment then condition will of clearly inflationary, if there is increase in the

Money Supply.

Inflation can take many form as:

Deflation: is the opposite of inflation when fall in prices occurs.

Disinflation: is process of bringing down prices moderately from their high level.

Stagflation: is state where there is stagnation as well as inflation both side by side as

prevailed in India in 1974-75 and 1979-80.

Hyperinflation: If inflation gets totally out of control (in the upward direction), it can

grossly interfere with the normal workings of the economy, hurting its ability to supply

goods. Hyperinflation can lead to the abandonment of the use of the country's currency,

leading to the inefficiencies of barter.

Depending upon the reason of inflation, it can be divided in many types as-

(1.) Demand-Pull inflation: This represents a situation where there is increase in

Aggregate Demand for resources either from the government or the entrepreneurs orthe households. Result of this is that the pressure of Demand cant be met by the

Currently available Aggregate Supply which result in Aggregate Demand > Aggregate

Supply which is bound to generate inflationary pressure in the economy.
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(2.) Cost-Push inflation: This represents the condition where even though there is no

increase in Aggregate Demand, prices may still rise. This may happen if the costs of

especially wage cost rise.

(3.) Structural inflation: This type of inflation occurs because of change in structure ofeconomies as happened in India from Agricultural Structure i.e. Green Revolution to

Industrialization. Thus because of change in Economic Structure gives rise to increase

in prices thus generate inflationary pressure.

Inflation is very unpopular happening in an economy. Opinion survey conducted in

India, USA and many other countries reveal that inflation is the most important

concern of the people as it badly affects their standard of living. So why it is called

Inflation is enemy number one.

India is facing the problem of inflationary pressure because of the increase in

Aggregate Demand while Aggregate Supply is respectively constant. The inflationary

pressure faced by Indian Economy is due to Demand-Pull inflation i.e. Aggregate

Demand > Aggregate Supply.

Thus to curb inflation need to fill the gap between Aggregate Demand and Aggregate

Supply. For this either need to increase AS or decrease AD that can hamper economic

development. Thus to increase AS is the best tool which can be used. To increase AS

either need to increase production capacity of all current production unit of to build

new production plants. But as quoted in an survey done by RBI that all the production

plants are running at their full production capacity thus all resources all-full employed

the other way is to built new plant but to do this will take at least 18months to 2years.

Thus meanwhile need to decrease Money Supply, which is opted by RBI.

As in short run its not possible to meet the gap between AD and AS thus RBI is

planning to decrease liquidity by reducing Money Supply from the market. For this it


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has been planned that by decreasing CRR, repo rate and reverse repo rate Liquidity

from the market will be drained.

CRR: Cash Reserve Ratio is the percentage of deposit that a commercial bank need to

keep with RBI by which RBI control liquidity in the market and create Money Supply.Currently CRR is 6.5% in the Indian Context.

Repo Rate: is the rate at which RBI lends money to other commercial Banks.

RBI planned that Liquidity from the market can be drained by decreasing money

supply and to do so it is increasing CRR, repo rate, reverse repo rate and taking other

measure like that. But interest is that whether hike to CRR and other factors will curb

inflation and what are the other factors, which are influencing inflation.

Inflation Is Caused Due To Several Economic Factors:

When the government of a country print money in excess, prices increase tokeep up with the increase in currency, leading to inflation.

Increase in production and labor costs, have a direct impact on the price of thefinal product, resulting in inflation.

When countries borrow money, they have to cope with the interest burden. Thisinterest burden results in inflation.

High taxes on consumer products, can also lead to inflation. Demands pull inflation, wherein the economy demands more goods and services

than what is produced.

Cost push inflation or supply shock inflation, wherein non availability of acommodity would lead to increase in prices


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THE PROBLEMS DUE TO INFLATION WOULD BE

When the balance between supply and demand goes out of control, consumerscould change their buying habits, forcing manufacturers to cut down production.

The mortgage crisis of 2007 in USA could best illustrate the ill effects ofinflation. Housing prices increases substantially from 2002 onwards, resulting in

a dramatic decrease in demand.

Inflation can create major problems in the economy. Price increase can worsenthe poverty affecting low income household,

Inflation creates economic uncertainty and is a dampener to the investmentclimate slowing growth and finally it reduce savings and thereby consumption.

The producers would not be able to control the cost of raw material and laborand hence the price of the final product. This could result in less profit or in

some extreme case no profit, forcing them out of business.

Manufacturers would not have an incentive to invest in new equipment and newtechnology.

Uncertainty would force people to withdraw money from the bank and convert itinto product with long lasting value like gold, artifacts.


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MEASURES TO CONTROL INFLATION

A variety of methods have been used in attempts to control inflation:-

1. Monetary policy:-

Monetary policy is the process by which the monetary authority of a country controls

the supply of money, often targeting a rate ofinterest for the purpose of

promoting economic growth and stability.[1]The official goals usually include

relatively stable prices and low unemployment. Monetary theoryprovides insight into

how to craft optimal monetary policy.

Monetary policy is referred to as either being expansionary, or a contractionary, where

an expansionary policy increases the total supply of money in the economy more

rapidly than usual, and a contractionary policy expands the money supply more slowly

than usual or even shrinks it. Expansionary policy is traditionally used to try to

combat unemployment in a recessionby lowering interest rates in the hope that easy

credit will entice businesses into expanding. Contractionary policy is intended to

slow inflation in hopes of avoiding the resulting distortions and deterioration of asset

values.

Monetary policy is contrasted with fiscal policy, which refers to: taxation, government

spending, and associated borrowing

2.Consumer Price Index

The Consumer Price Index or CPI is a measure of the prices of consumer goods and

services bought at retailprices. This includes food, fuel, clothing and pharmaceuticals.

The percentage change in CPI measuresinflation. To compile the Consumer Price

Index, a predetermined set of goods, forming a typical basket of goods bought by an

average urban consumer, is selected. All the items are weighted according to the
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percentage ofincomethat households spend per category. An average of thechange in

the prices of these items is calculated on a monthly basis. Core CPI excludes food and

energy prices, which are often volatile, and is an indicator of the headline inflation rate.

Uses of Consumer Price Index

Apart from measuring inflation, the index is useful in indicating the need to adjust:

wages to keep pace with a rise in thecost of living

pensions

regulated prices

tax brackets to avoid increases in the rate of taxes induced by inflation

3.GDPdeflator

GDP,gross domestic product, deflator is a method to menstruate the price change of

all new domestic goods and services in the economic system. It gives the net value of

all goods and services procured over a specific time.

Like consumer price index,GDPdeflator doesn't rely upon a constant market basket.

The basket is changeable, so new consumption patterns can be shown through this

deflator according to the people's reaction to the changing market prices.

Interpretation:

The GDP deflator can be depicted mathematically by this equation given below:

GDP deflator = ( Nominal GDP / Real GDP)*100.
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Nominal GDP: In a nominal GDP, inflation is not taken into account or consideration.

It is evaluated on the basis of the current market price.

Real GDP: Real GDP is computed by taking the market price of some base year.By

measuring t the nominal GDP of a base year price level 2 the real GDP is calculated.

Real values are adjusted for different price level in a year.

By dividing the nominal GDP with GDP deflator, the real GDP is computed, and

hence, deflates the nominal GDP. Actually, the difference between the deflator and

a price index, like the CPI, is not huge. GDP deflator almost gives the accurate

measurement of changing prices in the overall economy.

Utility:

The GDP deflator can be seen as a conversion factor that transfigure the Real GDPinto Nominal GDP.

GDP deflator gives the construction of an implicit index of price level for one year. It is used to calculate the rate of inflation or deflation.
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FIXED EXCHANGE RATES

A fixed exchange rate, sometimes called a pegged exchange rate, is a type ofexchange

rate regime wherein a currency's value is matched to the value of another single

currency or to a basket of other currencies, or to another measure of value, such

as gold.

A fixed exchange rate is usually used to stabilize the value of a currency against the

currency it is pegged to. This makes trade and investments between the two countries

easier and more predictable, and is especially useful for small economies where

external trade forms a large part of their GDP.

It can also be used as a means to control inflation. However, as the reference value

rises and falls, so does the currency pegged to it. In addition, according to theMundell

Fleming model, with perfect capital mobility, a fixed exchange rate prevents a

government from using domestic monetary policy in order to

achievemacroeconomic stability.

3. Wage and price controls:-

Measures taken by a government underits incomes policy to control wages in an

attempt to checkcost-push inflation and wage-push inflation. Collective governmental

effort to control the incomes oflaborand capital, usually by limiting increases in

wages and prices. The term often refers to policies directed at the control ofinflation,

but it may also indicate efforts to alter the distribution of income among workers,

industries, locations, or occupational groups.

4.Gold standard:-

A monetary system in which both the value of a unit of the currency and the quantity

of it in circulation are specified in terms of gold.If two currencies are both on the gold

standard, then the exchange rate between them is approximately determined by their

two prices in terms of gold
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INTRO:

The Indian economy weathered the global crisis of 2008-09 quite well. But Indian

economy has clearly seen a spurt of inflation. The effect of inflation on financial

market is complex, but it generally leads to an increase.

As inflation increases, the price of the stock, like other prices of goods in the economy,

will generally rise as well. Inflation can have various effects on a company's health.

While some companies may be uninjured or even benefit from inflation, others may be

seriously harmed if customers can no longer afford their products. Even as much of the

developed world is still quite some distance from its pre-crisis growth rate, several

emerging market economies(EMEs) have made up the lost ground relatively quickly.

Rising inflation make hard for the investors to estimate their future returns and also

safe guard their investments. Risk is a Characteristic feature of most of commodity and

capital markets.

This paper attempts various options available to mitigate and manage this inflation risk

through Derivatives. A derivative Security is a financial contract whose value is

derived from the value of something else, such as a stock price, commodity price, an

exchange rate, an interest rate or index of prices (inflation).Derivative securities

provide them a valuable set of tools for managing this risk.


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CRASHED FINANCIAL MARKETS

Financial stock market in the world trembled due to Liquidity crisis. Indian stock

market is stated as Sensitive Exchange which shortly known as SENSEX. It is volatile

to such an extent that single and small good or adverse news can affect it well.

Significant amount of foreign investment have been made in India through stock

market. Various modes of investments in Indian companies are made through P-Notes,

Global Depository Receipts, American Depository Receipt and direct investments.

Needs of funds in domestic market and cheaper stocks of home companies lead foreign

investors to make heavy sell in our market. Failure of Lehman brothers and other

biggis were sufficient for domestic investors to perceive slowdown to the greater

extent. The effect was that the market fall up-to 8000 app. from highest end i.e. 21000

points in January 2008. No doubt strong fundamentals and adequate influence of stable

government and RBI have caught investment back to country. During the period RBI

put ban on P-notes which also affected market on large extent. One of the arguments is

also made by research people that ban on P-notes affected much because black money

was routed through these P-notes. Heavy derivatives losses and permanent reduction invalue of the investments on balance sheet of the companies have made them

unattractive.

Not only the value of current investments slashed down but it had badly affected

primary markets. This had restricted new flow in market. Since January 2008 after

issue of Reliance power no company was able to successfully excess primary market.

Well reputed companies like Tata Motors was also compelled to finance it deal through

bank finance. Recently in July 09, Adani power, a company of Adani group had

initiated action to access primary market by IPO.


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THREAT OF CORPORATE DEFAULTS

In addition to above, Indian economy is fairly dependent on external funding which

impaired due to liquidity crisis in rest of the world. Indian companies which

completely depend on US and European economy had suffered and they have to learn

a lesson not to depend only on outside economy, no matter even if they look lucrative.

To strengthen their position in market companies have leveraged themselves and took

advantage of boost during 2003-07. The economic downturn and financial crisis have

threatened to corporate distress and raised question against their solvency especially in

US. As per Global Financial Stability Report April 2009, emerging economies would

face rollover needs of more than $1.8 trillion in 2009. External funding will be

curtailed more sharply that even prospected in the baseline projections in the context of

deteriorating economic prospects and intense global deleveraging. This would also

affect small and medium enterprises as those large borrowers who were dependent on

foreign borrowing would turn to banks for their financial needs. It became double-

sided sword for SMEs as they were huge cut in demand for their products and they

were even unable to maintain their liquidity. It is to remind that growth of the SMEs ismost important for overall growth and development of economy. Rapid deterioration in

exchange rate would further make situation worst by making balance sheet burdened

with heavy repayment liabilities. If we talk about revenue, many large corporate have

sold their receivables to banks and factors with or without recourse. Hence they would

not able to earn premium on those buyers who are sound and pay in time and they

would even spend more interest for liberal recovery of debts.


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CURRENT ACCOUNT AND BALANCE OF PAYMENT

All countries in the world with current account deficits and strong credit cycles are

finding it difficult to bring cost of capital down in the current environment. India is no

different. Increased government expenditure and packages declared had also lead to

lower collection of revenue to create enough liquidity in the market. These leaded to

more current account deficit and also destroyed our path-way to curb current account

deficit expected by 2010. New measures do not change our view on the growth

outlook. Indeed, we remain concerned about the banking sector and financial sector.

The BOP- Balance of Payment deficitat a time when domestic credit demand is very

highis resulting in a vicious loop of reduced access to liquidity, slowing growth, and

increased risk-aversion in the financial system.

Sectoral Effects:-

In total the recession have turned down the growth process and have set the minds ofeconomists and others for finding out the real solution to sustain the economic growth

and stability of the market which is desired for the smooth running of the economy.

Complete business/ industry is in dolled rum situation and this situation persist for a

longer duration will create the small business to vanish as they have lower stability and

to run smoothly require continuous flow of liquidity which is derived from the market.

Effect on various sector of Indian Economy can be summed up as it has mostly

affected companies depending on foreign business i.e. ITies, BPOs, EOUs, and SMEs

etc. and those which were dependent on primary products including infrastructural

material as their raw material. The US slowdown will immensely hit the mid-sized

IT companies and also the big players to some extent. On the higher end, you have


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scenarios where people are cutting back on contracts. They are reducing the fees per

manpower in their contracts. But at the same time they are using IT as a tool to reduce

their overall costs. Perhaps, it is balanced out. There are people who have gone up to

that stage and used IT to reduce their costs because IT is the best way to be used as an

eminent tool for cutting down monetary burden.

The problems of US slowdown have not only impacted the IT sector on all edges, it

has made the Indian manufacturing and energy sector worrisome too. The challenges

that Indian industry is encountering with is a universal problem of rising energy and

fuel cost. It is always followed that as the energy prices go up there is a probability of

recession. The second factor that we see today is the global developments in India. The

textile, garment and handicraft industry are worse affected. Together, they are going to

lose four million jobs by April 2009. According to the Federation of Indian Export

Organization survey there has also been a decline in the tourist inflow lately. IT

industries, financial sectors, real estate owners, car industry, investment banking and

other industries as well are confronting heavy loss due to the fall down of global

economy. Federation of Indian chambers of Commerce and Industry (FICCI) found

that faced with the global recession, inventories industries like garment, gems, textiles,

chemicals and jewellery had cut production by 10 per cent to 50 per cent.

In this context Ajay Shankar, Secretary, Ministry of Industry and Commerce opined

that, We take pride in saying that Indian economy is insulated to some extent from the

global environment, which is really not true, because we can very clearly see the

impact of that for the past few months where there is definite indication of economic

slowdown in the country. The slowdown is taking place as the result of rise in the costs

of the materials all over the world, surging commodity prices, the impact of surging

food grain prices. We have been fortunate in case of the food inflation which has been

very high and in seeing that we are able to insulate our consumers from the kind of

food inflation which the rest of the world has experienced until now. Therefore, the


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government tried to use all the means of espousal to reduce inflation as far as the items

of consumption of the common man is concerned. On the flip side this is a global

shock for the high commodity and fuel prices. Moreover, our feeling is that worst is

probably behind us and in the coming months things will definitely work well.

Heavy Expenditure on Infrastructure by various developing countries like China, India,

and Malaysia etc had created Inflationary condition related to infrastructural material.

This has not only weakened Industrial expansion but also severely effected property

market. In fact, the input prices have risen up mainly because of the steel prices that

have surged up. The reason behind the sky-scrapping input costs is not only because of

rising steel prices, but also due to hike in prices of aluminum and copper. Steel prices

have gone up by 40 to 50 percent and aluminum has gone up by 50 percent accurately,

says Dr. S.N. Dash, Secretary, Ministry of Heavy Industries & Public Enterprises.

Investment bankers have gone overboard by giving loans to people, which were more

than their repaying capacity. This crisis could be worse than what has been imagined,

as the banks have not come out with the truth. Its better to go slow on growth and

keep inflation under control rather than bearing inflation with 10 percent GDP (gross

domestic product). Indias progress is remarkable, but it is disheartening to see that it

has been done at the cost of neglecting more than 80 percent of the common people

of India who do not share the success story.

Inflation is a state in the economy of a country, when there is a price rise of goods as

well as services. Inflation is not only caused by an increase in money supply but also is

caused by the expectation of inflation. With the increase in inflation every sector of the

economy is affected. There is a serious effect in interest rates, exchange rates,

investment and last but not the least Stock market. Prices of stock are determined by

the net earnings of the company. It depends on how much profit the company is likely

to make in the near future. Effect of inflation on the stock market is also evident from


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the fact that it increases the rates of interest. If the inflation rate is high interest rate is

also high. In this scenario the creditors will have the tendency to compensate for rise in

the interest rate. This compels the debtors to avail loan at a higher rate of interest.

This affects funds from being invested in the stock markets. With the high input cost

and also lesser market the companys profit is also bound to be reduced resulting fall of

company stock prices.

During inflation, this economic growth is unsustainable and the stock markets face an

inevitable crash since the Economy managers will have to tighten the rope sooner or

later. The rising prices fuelled by inflation rob the investors since there is no

corresponding increase in value. This has a corresponding implication too.

The company's financials get over-stated as a result of inflation, since the revenue and

earnings also rise in the same rate as the inflation and this in combination

with additional value which is generated by the company.

When there is a decline in the inflation, the previously inflated earnings and revenues

likewise gets deflated. When a lot of money is chasing after goods that are fewer in

supply, it happens to be a classic case of inflation

Then the option is to make money more expensive to borrow. The excess capital gets

removed and the cycle of price increase is slowed down. Inflation also impacts the

future expectations of returns from assets. In this situation it is quite necessary that

investors have to protect their income being affected by adopting suitable strategy.

Below highlights some of the strategies that can be adopted to hedge against inflation.


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STRATEGIES TO PROTECT INFLATION RISK IN INDIA

Investors can prepare for unexpected inflation by adopting one of the two strategies.

They are-

a) Hedging the immediate effect

b) Earning a total return that outpaces inflation over time.

As an investor, a substantial portion of the portfolio ought to be in fixed income

securities. Since the inflation erodes the purchasing power, fixed securities are the best

option to counterfoil the market volatility. Even the retirees are advised to keep some

amount of their assets as a stock investment. The interest rate sensitive stocks should

be handled with utmost caution during the inflationary period.

It is important to make a distinction between properly anticipated inflation and

unanticipated inflation. From strategic point of view, investors may wish to consider anallocation of assets that preserve purchasing power during inflationary periods.

Investors should carefully review their financial circumstances and investment goals

before making changes in their portfolio to guard against inflation risk.

Investors should take a total return approach rather than assets based on correlation

with CPI (Consumer Price Index).

By choosing assets with higher expected long-term returns and maintaining broad

diversification, investors can seek to grow real wealth and preserve purchasing power

of their cash.


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Hedging techniques

The following Hedging techniques are suggested to overcome the inflation risk in

Indian financial markets:-

Leading Inflation Hedges:-

These are assets that tend to perform in advance of inflation becoming visible in the

broader economy.

A typically diversified asset portfolio tends to have a greater proportion of leading

hedges since most funds are excessively reliant on the equity risk premium to achieve

their long term stock returns.

.

Contemporaneous hedges:-

These include Inflation linked bonds or inflation swaps. Inflation linked bonds are

insulated against the raise of inflation by explicitly imbedding floating rate of inflation

into the interest coupon that they pay or by adjusting the capital value of the bonds to

reflect the prevailing inflation rate.

Inflation Swap provides investors with price movements in underlying inflation rate. It

works as the exchange of stream of inflation indexed payments/coupon for a stream of

nominal interest payments. These type of hedges are generally over the counter trade

products. Countries like Australia, USA, UK, France and Sweden use such products

Lagging inflation Hedges:-

These are in assets that offer returns following bouts of inflation. For example as

inflation drifts higher, the central banks seek to curb demand by pushing up short term

interest rate. This product was very successful in Australia. Reserve Bank of Australia


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has been able to maintain average inflation rate of 2.9%over the last 10 years with a

corresponding Reserve Bank of Australia cash rate of 5.4%.

As a result the investors are to locking in real rates of return by owning cash. With

addition of margin for active management and with elevated cash rates, absolute return

fixed interest looks a vital strategy for achieving real rates of return and a good

inflation hedge.

Commodity Hedges:-

With the increasing inflation trend the prices of commodities are also bound to go up in

the future time. Hence investing in Commodity Options and Futures are quite

advantageous in the inflationary times. Commodity futures as well as investments in

gold, oil are also good and effective inflation hedges because their returns are

positively correlated with inflation


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NOTE

In many developed financial markets the existence of inflation linked financial

securities provides market based measures of inflation expectation as a measure of

hedge against inflation risk.

Some EME(Emerging Market Economies) like Chile, Israel have been able to develop

an inflation linked government bond market. The government can develop a break

even rate with the following components built in it

(i)Expected inflation during the remaining maturity period of the bonds;

(ii)inflation risk premium and (iii) liquidity premium.

Inflation linked bonds are one of the best ways adopted by several countries in the

world to overcome the inflation risk. Inflation linked bonds are regarded as risk free

asset of choice for a long term pool like a Superannuation fund.

The relevance of an inflation linked security or inflation derivatives is high in a

country like India where the inflation enjoys its own crests and troughs displayinga high volatility. It rose from 5.51% in Jan 2008 to 9.47% in dec 2010


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INDIA INFLATION RATE

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2011 9.30

2010 16.22 14.86 14.86 13.33 13.91 13.73 11.25 9.88 9.82 9.70 8.33 9.47

2009 10.45 9.63 8.03 8.70 8.63 9.29 11.89 11.72 11.64 11.49 13.51 14.97

2008 5.51 5.47 7.87 7.81 7.75 7.69 8.33 9.02 9.77 10.45 10.45 9.70

* The table above displays the monthly average.

Inflation in India touches 10.16% recently and this inflations spreads its hand on

manufactured goods also(As per recent press release.) Situation is worrying the

government. Government announced that RBI will take corrective measures to control

the inflation. The inflation is increasing steadily at a higher rate. It seems to be the

government is not seeing the situation in subtle and always ask RBI to take action.

Also Food inflation jumped to a scorching 18.32% in the week ended December 25,

2010. This was against an already menacing 14% inflation clocked in the previous

week. The main culprits were soaring prices of onions and other vegetables. Experts

expect the RBI to tighten monetary policy to check further escalation in commodity

costs, in its quarterly review on January 25, 2011.

Emerging economies like India, China are not directly affected by factors which were

responsible for crisis in developed economies. No doubt the cascading effect of said

crisis have made situation worst. East Asians like Japan have been hit hard due to

collapse in demand for manufactured products. India would also see severe drop in

export earnings on same footings but it would be able to maintain 1.5 to 2% growth in


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2009 which would further rise to 4% due to its domestic demand. In India, crisis can be

caught from short supply of agricultural products due to adverse climate condition in

2007-08 which was multiplied by rise in population and their use as input in industrial

production. This had factors initiated inflationary phase at higher rate in the economy


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INFLATION TARGETING THE WORLD

EURO AREA INFLATION RATE


2011 2.30 2.40

2010 1.00 0.90 1.40 1.50 1.60 1.40 1.70 1.60 1.80 1.90 1.90 2.20

2009 1.10 1.20 0.60 0.60 0.00 -0.10 -0.70 -0.20 -0.30 -0.10 0.50 0.90

2008 3.20 3.30 3.60 3.30 3.70 4.00 4.00 3.80 3.60 3.20 2.10 1.60


Euro area annual inflation was 2.4% in February 2011, up from 2.3% in January. A

year earlier the rate was 0.8%. Monthly inflation was 0.4% in February 2011. EU

annual inflation was 2.8% in February 2011, unchanged compared with January. Ayear earlier the rate was 1.5%. Monthly inflation was 0.4% in February 2011.

In February 2011, the lowest annual rates were observed in Ireland (0.9%), Sweden

(1.2%) and France (1.8%), and the highest in Romania (7.6%), Estonia (5.5%) and

Bulgaria (4.6%). Compared with January 2011, annual inflation rose in fifteen Member

States, remained stable in three and fell in eight. The lowest 12-month averages4 up to

February 2011 were registered in Ireland (-1.1%), Latvia (0.0%) and the Netherlands

(1.2%), and the highest in Romania (6.5%), Greece (5.0%) and Hungary (4.4%).

The main components with the highest annual rates in February 2011 were transport


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(5.7%), housing (4.9%) and alcohol & tobacco (3.5%), while the lowest annual rates

were observed for clothing (-2.6%), communications (-0.4%) and recreation & culture

(0.0%). Concerning the detailed sub-indices, fuels for transport (+0.62 percentage

points), heating oil (+0.23), electricity (+0.11) and gas (+0.10) had the largest upward

impacts on the headline rate, while garments (-0.25) and telecommunications (-0.09)

had the biggest downward impacts.

The main components with the highest monthly rates were recreation & culture (0.9%),

food, housing, transport and hotels & restaurants (all 0.5%), while the lowest were

clothing (-0.5%), alcohol & tobacco (0.0%), health and education (both 0.1%). In

particular, package holidays (+0.06 percentage points), accommodation services and

heating oil (+0.03 each) had the largest upward impacts, while garments (-0.03),

restaurants & cafs and footwear (-0.02 each) had the biggest downward impacts.


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CANADAINFLATIONRATE


2011 2.30 2.20

2010 1.90 1.60 1.40 1.80 1.40 1.00 1.80 1.70 1.90 2.40 2.00 2.40

2009 1.10 1.40 1.20 0.40 0.10 -0.30 -0.90 -0.80 -0.90 0.10 1.00 1.30

2008 2.20 1.80 1.40 1.70 2.20 3.10 3.40 3.50 3.40 2.60 2.00 1.20

* The table above displays the monthly average

Canada's inflation rate rose 2.2% in the 12 months to February, following the 2.3%

increase posted in January. Energy prices rose 10.6% during the 12 months to

February, after posting a 9.0% increase the previous month. Gasoline prices continued

to increase in February, rising 15.7%, after recording a 13.0% increase in the 12

months to January.

Excluding gasoline, the Consumer Price Index (CPI) rose 1.6% in the 12 months to

February, compared with a 1.8% increase in January and also Shelter costs rose 2.2%.

The largest increase occurred in the transportation component, where prices rose 5.1%

in the 12 months to February, after a 4.8% increase in January.

The Bank of Canada's core index advanced 0.9% in the 12 months to February,

following a 1.4% rise in January. The seasonally adjusted monthly core index fell 0.1%

in February, following a 0.1% increase the previous month.


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CHINAINFLATIONRATE


2011 4.90 4.90

2010 1.50 2.70 2.40 2.80 3.10 2.90 3.30 3.50 3.60 4.40 5.10 4.60

2009 1.00 -1.60 -1.20 -1.50 -1.40 -1.70 -1.80 -1.20 -0.80 -0.50 0.60 1.90

2008 7.10 8.70 8.30 8.50 7.70 7.10 6.30 4.90 4.60 4.00 2.40 1.20


China said inflation remained high in February, fueling further doubt about the

government's ability to tackle what officials have called their main economic priority

this year. The consumer-price index in the world's second-largest economy rose 4.9%

in February from the same month last year, the National Bureau of Statistics said on

March 11. Food prices alone rose 11 percent in February.

China's February economic data are distorted by the timing of its Lunar New Year

holiday, which fell earlier in the month this year than in 2010. The holiday, China's

biggest of the year, alters spending patterns, especially for food, limiting the ability of

economists to extrapolate longer-term trends. China's producer price index, a measure

of pipeline inflation pressures, rose 7.2% from a year earlier, up from January's 6.6%

rise and higher than expectations for a 7% rise.


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INDIA VS CHINA

Making an in depth study and analysis of India vs. China economy seems to be a very

hard task. Both India and China rank among the front runners of global economy and

are among the world's most diverse nations. Both the countries were among the mostancient civilizations and their economies are influenced by a number of social,

political, economic and other factors. However, if we try to properly understand the

various economic and market trends and features of the two countries, we can make a

comparison between Indian and Chinese economy.

Going by the basic facts, the economy of China is more developed than that of India.

While India is the 11th largest economy in terms of the exchange rates, China occupiesthe second position surpassing Japan. Compared to the estimated $1.3123 trillion GDP

of India, China has an average GDP of around $4909.28 billion. In case of per capital

GDP, India lags far behind China with just $1124 compared to $7,518 of the latter. To

make a basic comparison of India and China Economy, we need to have an idea of the

economic facts of the countries.

Facts India China

GDP around $1.3123 trillion around 4909.28 billion

GDP growth 8.90% 9.60%

Per capital GDP $1124 $7,518

Inflation 7.48 % 5.1%

Labor Force 467 million 813.5 million

Unemployment 9.4 % 4.20 %

Fiscal Deficit 5.5% 21.5%


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Foreign Direct Investment $12.40 $9.7 billion

Gold Reserves 15% 11%

Foreign Exchange Reserves $2.41 billion $2.65 trillion

World Prosperity Index 88Th Position 58th Position

If we make the analysis of the India vs. China economy, we can see that there are a

number of factors that has made China a better economy than India. And that can be

the reason why inflation rate in India is higher as compared to china.

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