Behind the Scenes of Trade Execution

Trade Life Cycle (Behind the scenes of Trade Execution)

“After discussing different entities such as Broker, Depositories, Depository Participant, Exchanges required for a trade execution of stock, last time we ended on a note where in you mentioned that a trade executed today takes 2 days settle, why is der a delay of 2 days”, asked Apurva over the weekly skype session.  “India has come a long way in terms of a trade execution, the trade required more than 2 days to execute earlier but now India is at par with the international standards of trade settlement of 2 days”, I started explaining her.

We have seen the functioning of different entities such as Broker, Depositories, Depository Participant, and Exchanges in isolation in our previous conversations, let us see the linkage between these entities and their logical sequence. This trade life cycle is popularly known as “T+2” settlement process, which means it takes 2 days for a trade to settle after it has been executed. “This means the trade life cycle has two stages, execution and settlement, correct?” Apurva looked confused. “Execution and settlement are part of the trade life cycle but apart from them we also of a stage of “Clearance” about which we have not talked much”. So the three stages of trade executions are

1.      Trade Execution

2.      Trade Clearance

3.      Trade Settlement

 Let us discuss them one by one

Trade Execution

The trade execution starts with buyer and seller of the securities sending their buy and sell instruction to the exchange via a broker.  As discussed last time, investor needs to maintain a Demat account with the depository participant and trading account with a broker. Since the broker usually also acts as a DP, user maintains both account the same entity with linked savings account. Broker forwards the buying and selling instructions given by investor to the exchange (NSE or BSE or MCX-SX).

The job of the exchange is of a match maker. If exchange finds matching buy and sell instruction, it confirms the same to respective brokers which gives confirmation to the investors. This concludes trade execution and trade is said to be executed.

Sometime a investor, especially institutional investors, gives the custody of their securities to a third party. This third party is known as a “Custodian”. If this is the case then the custodian sets aside the required Cash/Securities for the transaction. The trade execution day is referred as Day “T”.

Trade Clearance.

The entire process of the stock buying/selling could be risky. What if after the trade is matched and the buyer does not have the required balance in his linked savings account or the seller does not have the required securities in his Demat account? After all the seller and buyer don’t know each other and it is the exchange who acts as a mediator for both. So it is the responsibility of exchanges in a way to restore confidence in the investors Hence to guarantee the trade after its execution, we have an entity called as “Clearing House” which are generally subsidiary of these exchanges.

The capital market regulator SEBI has said that National Securities Clearing Corporation Ltd (NSCCL- subsidiary of NSE), Indian Clearing Corporation Ltd (ICCL- subsidiary of BSE) and MCX-SX Clearing Corporation Ltd (MCX-SXCCL – subsidiary of MCX-SX) are the only qualified central counterparties (QCCPs) in the Indian securities market.

The clearing house typically breaks the trade in 2 parts. This means clearance house acts as seller for buyer investor and buyer for the investor selling the security. So in case the seller of the security does not have the required securities the clearing house will buy the securities in the open market and gives it to the buyer. In case buyer does not have required cash available for buying the security then the clearing house will payout cash to the seller.

Apart from acting as a counterparty to each side of the trade, the clearing house also performs operation of “Netting”. E.g. Between investor A and Investor there are multiple buy and sell on given day, A owes B ₹ 10,000 and B owes A ₹ 15,000; after netting B owes ₹ 5,000. Netting reduces settlement risk.

So after Day T, the exchange forwards the matched instructions to clearing house which performs netting, splits the trade into two trades and gets custodial confirmation on T+1.

Trade Settlement

This is the final phase of the trade life cycle. On T+2 days the Seller sends the security to the Clearing House and Buyer sends the cash to the clearing house. This is known as “Pay In”. After receiving the Pay In, the clearing cooperation performs a “Pay Out” i.e. transfers the cash to seller and security to the Buyer.

“It was interesting to know the behind the scenes of the trade life cycle, I now know why it takes 2 days for a trade to settle”, said Apurva and we ended the conversation on that note.

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All you wanted to know before you start investing in Stock Markets

Starting Investment in Stock Markets

It was time to for yet another skype session. After understanding the need for companies to go public it was time to discuss; who, when and how can one invest in the stock market. “Can I start investing in stock markets, it’s still some months before I turn 18”, asked Apurva.  Ideally the law requires you to be 18 years old to start investing in the stock market on your own, but there is a provision under which your parents can open account for you acting as a custodian. How does a share look like? Is it similar to the currency we carry for monetary transaction? Where can one open account for investing stocks, if one already has a savings account can he store his shares in the same account?  Apurva had some many questions in her mind and we decided to tackle all the questions one by one.

Let us start with the question “how does a share look like”. With the advent of technology, it is no longer needed to hold a share in a physical format. Before the technology took over, share of a company used to be in the form of physical form i.e. physical certificate. But there had been many scams where in people involved in the scam came up with fake physical certificates and started trading them in the stock market. This created fake demand for the shares and resulted in the value of these shares which were not in synch with their business fundamentals. No one new why the price of those share kept rising before the scam unfolded and it was decided to convert these share certificate in electronic format. Also since the share certificates were in the physical format there was possibility of them getting lost or getting spoiled with time. Converting these certificate to electronic format resolved all these issues and made it possible for the regulators of the share market to monitor them centrally and avoid any activity that would possibility manipulate the stock market in an illegal manner. The electronic format of the share is also called as dematerialized format. Now we will come to the next point as to where can one store the dematerialized format of the shares. Like you need to have savings account with the bank, we need to have “Demat” account to store the electronic shares. There are 2 central depositories that offer this facility of Demat account. National Securities Depository Limited (NSDL) and the other is the Central Depository Service (India) Limited (CDSL). 

It is difficult for these two depositories to provide the service of depositories in the form of a Demat Account centrally all across India. Hence to facilitate this, these depositories have their agents known as the depository participants, popularly known as “DPs”. These depositary participants need to register with the depositories. The depositories charge the DPs and the DPs intern charge the customers. Apart from one time account opening charge, the DPs can charge only for debit transactions. I.e. a DP can only charge for share transaction in which you buy a share, it cannot charge you for holding a share or transaction when you sell the share. The fee for a debit transaction is based independent of the number of shares traded in that transactions. E.g. irrespective of you sell 1 share or 1000 shares of a company A, the charge will be considered as a single charge since the charge for the entire transaction for the shares of company A. These DPs can be Banks, NBFCs (Non-Banking Financial Companies) or a Broker. Let us try and understand functionalities of a Broker.

Apart from providing the DP service in the form a Demat account, brokers provide service of trading account. Remember that Demat account only allows you to keep the share, acting as a depository. If you want to sell or buy a share you need to have a trading account provided by the broker. The regulator of share market, SEBI (Security Exchange Board of India) allows individual to trade in the share market via brokers only. The brokers need to register with the stock exchanges in order to facilitate stock trading. In India, BSE and NSE are most popular stock exchanges. It’s for a company to decide whether it wants to get listed on NSE or BSE or Both. The price of share on the two exchanges will almost be same but may not be exactly same. These exchanges charge brokers for their service and the brokers in turn charge the customer for trading through the trading account. The charge that brokers charge is known as “Brokerage”. Different brokers can charge different brokerage. Unlike the Demat charges which are based on the per debit transactions, brokerage depends upon the size of the total transaction. The brokerage is a two way affair which means that you will be charged for both Debit and Credit transactions (i.e. Brokerage will be charge both at the time of selling and buying the shares.). Also the brokerage for selling/buying one share will be lesser than that of buying/selling 1000 shares. Apart from the account opening charges, brokers can charge an Annual Maintenance fees for a trading account.

When you buy a share, broker has the responsibility of debiting money from the savings account linked to a trading account and providing it to exchange and putting the shares into your debit account facilitated by the DP. Ideally one can opt for Dmat and trading account from different entity providing the service. And the savings account linked can be a different entity all together. I.e. you could have trading account of ICICI (icicidirect), Demat account from HDFC (HDFC securities) and savings account of SBI. But ideally you would want to have these opened with the single entity. This is because doing this would save some charges for you. Broker/DP and banking from same entity can offer you discount on initial opening charges/maintenance charges, transaction charges. The role of the exchange in this entire transaction is of a Match Maker i.e. matching a buyer’s requirement with that of a seller.

It takes two days for a transaction to be completed. Which means it takes two days for shares to be credited in the account in case you bought the shares or money to be deposited into your account in case you sold shares. We will discuss what happens in these two days some other day. We ended a skype call on this note.

Basics of Stock Market-What are stocks, Why do they exist ??

Basics of Stock Market

“I was watching an interview of Warren Buffet on the news channel the other day. I had not heard about Warren Buffet earlier but after watching his interview when I googled about him I realized he is one of the richest man in the world and is an ace investor who made most of his money just by investing in the Stock Market. What this Stock Market is all about? What is that Warren Buffet could do that many others could not”, Apurva looked very curious over the Skype on the weekly conversion that we missed over the past few weeks.

The stock market is perceived as a money making machine and there is tremendous amount of survivorship bias about the stock market. Survivorship bias means to refer to people who have been successful or survived the bad times. In stock markets there have been many cases where people have lost their hard earned money. “Oh, is that the case? So is it better for a common man to stay away from stock markets in that case”? , asked Apurva. “No. it’s definitely not that way. “, I started explaining her. One has to make informed decision before investing in the stock markets and understand the fact that there are no guaranteed profits on the investments you make. “What do you mean by stocks, why do they exist, where can I buy/sell them, how do I buy them, and which stocks should I buy so that the risk for losing money is minimized? Apurva bombarded me with her questions.

“We will take all the questions one by one. Let us start with what are stocks.” Stocks or Shares or Equity as different people call it, in simplistic terms is a part of ownership in a publicly listed company. Before moving forward let us understand what a “Publicly Listed Company” is. Let us take an example. Suppose you wish to start an Ice-cream parlor with ₹ 20,000 of savings you have. You decide to buy a machinery of Ice-cream Vending Machines which cost ₹ 20,000. You also decide to rent a place near you for which you need to pay ₹ 5,000 rent per month. You also employ a man which serves ice cream to people with a salary of ₹ 3800/month. Cost of making 1 Ice-Cream is ₹ 9 and you decide to sell at ₹ 12 which is selling price by all the ice-cream sellers have in the market. You cannot charge more than ₹ 12 else your customers would go to your competitor.

So in this process you make ₹ 3 as profit per Ice cream. Two months after you started a business you realize that on an average you sell 100 ice creams a day making ₹ 9000 as revenue. After paying rent and salary of the employee you earn profit of ₹ 200 per month. This continues for next few months and one year after the start of your business, you are very happy with it and by the fact that you have made ₹ 2400 profit in the 1^st year i.e. 12% return on your initial investment of ₹ 20,000. Your total asset base has become ₹ 22,400 (assuming no depreciation of the machine for simplicity). Now you have become ambitious and want to start another shop in the other part of the city. But you have only ₹ 2,400 in cash in hand. For buying the new ice cream vending, you would have to wait for another 8 years.

You would certainly not want to wait that long, would you? So what are the options available? You can ask your parents/relatives for money but they refuse to invest such high amount. You can go to bank and ask for ₹ 20,000 loan, but the bank asks for 15% interest per year as it’s a new business and has the risk that it may or may not work which means you have to give away ₹ 3000 per year which will be a loss making affair for you. There is a third option which is you go to public and request for money.  Why would people give you money for your business? Answer is simple because you are sharing ownership in return. Which means that people who would invest in your business, will be entitled for profits proportional to the ownership that they have. The normal bank savings would give them 4-6% return, Fix Deposit can yield 8-9% return where as your business is currently making 12% with potential of making even higher return on investment. Also since the amount is distributed among many people who would invest your business, the contribution from each can be very small making it affordable.

In our example at the end of one year the business is worth ₹ 22,400. You decide to convert it into 100 shares of ₹ 224 each. Value of ₹ 224 is known as Face value of the share.  Since you want to raise ₹ 20,000, you should ideally issue/create 90 more shares (20,000/224) but you would not do that. Ideally you would hire an Investment Bank to do this on behalf of you. The investment bank runs a process known as “Book Building Process” where it gauges the demand for you shares. Hence the value at which the share would be sold is different than ₹ 224 rather it is usually higher than 224. Why would people pay more than 224 for a share which is worth 224 currently? Because the price of share is not decided by the current prospects rather it is decided by the future prospects the company/business has. As a company, you should come out a document called as “Red Herring Prospectus” in which you tell the prospective investors as to what you intend to do with the money and what are future potentials for your business. Based on the book building process a “Price Band” is decided for the issue of shares to which investor need to subscribe. After the subscription is complete the investment bank then decides the final price of Issue. Since this is the first time you decide to go to public for raising money, this is called as “Initial Public Offer”, IPO.

Let us say in our example we issued 80 shares of ₹ 250 each to raise ₹ 20,000. Now total number of shares is 180 (100 that you own + 80 that people own). The result of IPO is dilution of ownership of the founders or better known as promoters. In your case initially you owned 100% but after the issue you own 55% of the business (100/180). You still own the majority stake in the business and can take the management decisions. The people who invested in your company are called as shareholders who have voting rights which they can exercise for important decision making which required 2/3 majority (67%). Once IPO process is over the Shares are listed on an Exchange where the original investor can sell the share of your business to new investors who would want to invest. In India we have BSE and NSE , which are two popular exchanges where trading takes place. The market value of ₹ 250 changes every day based on many micro and macro factors which we will discuss some other day.

“That answers some of your questions that include what is meant by stocks, why do they exists. We will discuss regarding the other questions you raised such as where & how can one buy/sell them, how does trading take place in the upcoming skype session”, I said to end the skype call.

Time is Money

Time is Money (Time Value of Money)

This week’s Skype session did not have any set agenda. “How are you doing in your studies, you must be enjoying your college life”, I asked Apurva. “Well college life has been exciting for last 2 months but I have my exams starting from next week and I have not started studying. Time is running out and as they say, Time is Money, and if that is true, I have already lost lots of it”, she laughed. “There is a reason behind why they say Time is Money let us discuss that today”, I said. It was time to refresh Corporate Finance lectures that I had taken during the MBA program.

“If I offer you ₹ 100 today and ₹ 105 after one year, which one will you accept?” I asked. “I will accept both”, said Apurva with a huge smile on her face. This answer of hers reminded me that I was dealing with a talented yet very notorious cousin of mine and I had to be very specific in my questions. “I wish I could offer you both but you have to select between either of the choices”, I told her. “If I accept ₹100 today I loose on ₹5 but one year time frame is too long, you might forget about our deal in 1 years’ time which is very risky. I am confused but I trust my brother who is doing his MBA from an IIM so will go for ₹ 105”, she said. “Well that is not how decisions are made in real life, since the cash you are being offered is during two different time periods, it cannot be compared directly as value of money changes with time”, I started explaining her.

Money today is not same as money tomorrow it is actually worth more than in the future. Between ₹100 today and ₹100 one year after, ₹ 100 today is more valuable. In the offer that I made to you, it becomes even more difficult to compare because you need to compare ₹100 with ₹ 105 after one year which is comparing Apple with Oranges. Hence in order to compare the same, we need to compare both of them on a single time period which can be either one year hence or today. Let us compare them one year hence. What will be the value of the ₹ 100 today after one year? It depends on the earning potential of ₹100. You can put ₹100 today in the bank account with 4% saving rate which will give you ₹ 104 after 1 year or you can put it in a Bank FD for 1 year with the bank rate of 9% and get ₹ 109. If you are like Warren Buffet, the ace investor, you can also invest the amount in the equity market and get possible 15% return i.e. ₹ 115 , but  if the market performed badly the way it did in 2008 due to crisis you might see negative 15% return which will end up ₹ 85 in your hand after one year. Now the important thing is which of these will you compare with ₹ 105 which is confirmed amount that I will pay you if you decide to go for that option? Will it be ₹ 104(Saving), ₹109 (Fix Deposit), ₹ 115 (Equity when Good), ₹85 (Equity when Bad). If you consider saving/Equity when performed badly then ₹ 100 today is not a good option as its value one year hence is less than ₹ 105 and if you consider Fix deposit or Equity performance during good times, ₹ 100 today is good option as its value after one year is more than ₹ 105.

“It is like a KBC question with four options, do I get any lifeline? I go with a “Skypofriend” and would want to get this answer from my MBA cousin brother”, Apurva with a smile on her face again, managed to have a go at me yet again. She was in tremendous form today I thought. “The correct answer will be ₹ 109, please lock it”, I continued with a smile. We need to see a risk free opportunity with a maximum earning potential. The equity option with 15% return is maximum earning opportunity but has tremendous risk involved in it while the 4% saving rate is risk free but not maximum. Hence given the options fixed deposit rate is the maximum earning risk free opportunity and should be considered and with 9% rate ₹100 today, due to compounding it would be ₹ 100*1.09 i.e. ₹ 109 which is greater than ₹ 105 and hence it is wiser to accept ₹ 100 today than accepting ₹ 105 after one year.  Instead of giving 105 after one year if I would have given you ₹ 50 in year 1 and ₹ 60 in year two it becomes slightly more complicated. Now you have to compare all the cash flow in year 2. So ₹ 100 two years from now would be ₹ 100*(1.09)² i.e. ₹118.8 due to compounding. ₹ 50 would be would ₹ 50*1.09 i.e.₹ 54.5, due to compounding of 1 year. So now you are comparing ₹ 118.8 with ₹ (54.5+60=114.5). Since ₹118.8 is greater than ₹ 114.5, you would go for ₹ 100 today.

Now instead of comparing both the options in future time period it is better to compare them as of today since you have to make the decision today. The final result would be same but it is more meaningful for decision making. It means to compare between ₹ 100 today and ₹ 105 one year hence, instead of finding out value of ₹ 100 one year hence and comparing it with ₹ 105, now you need to find present value of ₹105 which you will receive one year hence. The way we did compounding in earlier case now we need to discount the future payment to the present value and compare. With the same 9% rate we now need to discount ₹ 105 which would be received one year hence to today. Hence sometimes 9% is also called as discount rate. To discount 105 to present value we need to divide 105 by 1.09 which is ₹ 96.33. Now it is ₹ 100 today vs. ₹ 96.33 today and obvious choice is ₹ 100 today. In the second example we discussed we would have to discount (divide) ₹ 50 by factor of 1.09 (i.e. ₹ 45.87) and ₹ 60 by factor of (1.09)² (i.e. 50.5) total of which comes out to be ₹96.37 (50.5+45.87=96.37) and it is less that 100 hence you would select ₹ 100 today. The end result is same as we had got earlier.

Managers of the large corporations use this method to select the project. They compare the initial investment that they would make in the project against the cash flow that the project would generate in future. If the sum of the discounted future cash flow to present is greater than the initial investment then they would go for the project. The important thing here to note is the real world situation is slightly more complicated as the discount rate we discussed does not remain constant. Manager of corporations need to predict these future discount rates as per the macro economic conditions and continuously check the viability of the project.

“I now understand how to compare different cash flow occurring at different time intervals. It was interesting to know that money cannot be compared on absolute terms in isolation with time. Indeed “Time is Money”, said Apurva. I wished her all the luck for her upcoming exams and ended the call on that note.

Image Reference: http://www.aziende-news.com/valore-del-tempo/

Islamic Banking

It was time for the weekly Skype session with Apurva and as promised I had to take her to the world where there is no concept of Interest Rates. “How is it possible that the banks would lend out money but would not charge interest on it, what is in it for banks then, how will they survive?”, the questions came like bullets from the machine gun. “Islamic Banking is a concept which works on the principal of Non-Interest”, I started explaining her.

Islamic banks work on the Islamic principles where it is not allowed to lend out money to others on interest. Does that mean that banks lend out this money without any profit? No, obviously not!! Every entity is required to generate profits for its survival and that is the prime reason for its existence. But generating profit through interest is not the only way of generating profit. Islamic banking also has profit generating mechanism but it is devoid of the interest component and certainly not the compounding aspect of it. To understand how Islamic Baking works, we need to first understand how the regular commercialize banking with interest and compounding works. Let us say, you want to buy a Tata Nano which costs Rs. 1, 00,000. You go to a Bank, say RBM bank and ask for money. If the interest on the car-loan is 10%. At the end of 2 years, you would have to payback Rs 1, 21,000([1, 00,000 *(1.1)]*(1.1)). The fact that component of 1.1 (1+10%) appeared twice in the calculation is because the interest gets compounded over the tenure of the loan which is two years in this case. You will have to pay a total interest of Rs. 21000 at the end of two years. Alternatively, RBM bank can give you option of making equal payment based on the predefined frequency of payment which can be either Monthly, Semi-Annually or Annually.  

The above method of lending is based on the principle of Risk Transferring. In the above case the ownership of the Tata Nano car is with you till the time you make payment to the bank as decided with the banks. In case you fail to make the payment, the bank will sell off the car and keep the amount with it to recover the loss. This type of lending also has inbuilt issue of money multiplication creating artificial money. Suppose RBM bank lends you Rs. 100000 @10% for 1 year. You find a borrower which is ready to pay interest of 12% but can’t finance his loan through bank due to compliance issue. You decide to take the additional risk for getting 2% on Rs 100000 (i.e. 2000). The borrower who agreed to pay 12% to you finds another borrower who is willing to pay 15%. Like you, he also lends money to him to get 3% on 100000 (i.e. 3000). Though the amount of money in the system is Rs. 1, 00,000 it has changed 3 hands causing money multiplication. The chain of risk transferring will be shattered as soon the last hand in the chain defaults causing entire chain to collapse. This principle of Risk Transferring was the prime reason was 2008 sub-prime crisis which we will discuss some other day. This is not possible with Islamic banking because money is always lent for buying real assets such as home, car, metal etc.

Unlike the commercial banking which works on the principle of risk transferring, the Islamic banking works on the principle of Risk Sharing. The Islamic banking allows charging the predefined fix profit percentage which does not get compounded.  There are different ways of lending under the Islamic Banking that includes Istisna, Musawamah, Murabahah, Musharakah etc. I would try to explain “Musharakah” which is the most used of all and how it is different from the conventional banking. Suppose your father wants to buy a house in which is worth Rs. 14, 00,000. He has Rs. 4, 00, 000 and needs financing of Rs. 10, 00,000.

Consider the case where your father borrows it from conventional commercial bank which charges 10% interest compounded annually. The repayment is to be done as 5 annual payments.

Commercial_Bank_Loan_Repayment_Schedule

The above diagram shows the calculations for payments for Rs. 10, 00,000 loan from the commercial bank.  As it can be seen that the yearly payment to be made to the bank is constant every year. The principal to be paid as part of that payment increases over the years while the interest component to be paid reduces over the years as per the principal outstanding. Bank does not assume any risk such as natural disaster and risk is entirely bared by the borrower. In case of default, bank has the right to sell off the property and recover the money.

Unlike commercial banks, Islamic banks work on the principal of Diminishing Partnership in which share of the bank reduces gradually till the time it is transferred to the borrower. It is based on the principal of risk sharing which in turn corresponds to sharing of profits or sharing of loss. As discussed it does not include interest and works on the basis of fix, predefined profit rate. Islamic bank typically have both internal and external Sharia compliance officer to ensure that the money is lent in accordance with the Sharia principals (e.g. Lending money for alcohol, arms is prohibited). The Islamic bank receives funds from the investors to lend out to which bank gives the expected profit rate. The rate to the investors in expected as it depends on the investment made by the bank to the customers in terms of landings.

Islamic_Banking_Repayment_Structure

The above diagram shows the similar housing loan and payment structure under the Islamic Banking. Borrower makes an yearly payment to bank like that of the commercial banks but the yearly payment made by the borrower reduces every year as with each passing year the borrower increases the ownership stake in the property owned. The part of the annual payment includes the equity payment made by the borrower to regain additional ownership in the property and other part includes the profit paid to the Islamic bank for the equity still owned by the bank). In case of natural disaster or any other issue the borrower forgoes only the part of the equity owned by him and banks bares the risk for part of owned by it. The borrower can sell off his ownership to other borrower who will then continue the payments to the Islamic bank.

“I now understand how Islamic Banking works!! On face of it looks like a better model of lending. I wonder what will happen when it will gain more popularity and entire world will work on the non interest principal”, said Apurva. “There is still long way to go for that, “Musharakah” that we discussed is just part of Islamic banking. We would cover the other parts sometime later.” we ended the Skype call on that note.

Budget Simplified

Unlike the regular weekly Saturday Skype session, the Skype session was planned on Sunday this time owing to the request by Apurva. The Union Budget for financial year FY16 (1^st April 2015 to 31^st March 2016) was presented on the Saturday by the finance minister and she wanted to listen and understand the budget and then discuss the same with me. “There was too much talked about and written about this year’s budget, since this was going to be the first full fledge budget by the newly elected government. I watched the entire budget speech by the finance minister but honestly could not understand much of it. Can you please explain?” the curiosity on the face of Apurva was clearly evident and was obvious too. For most of the common man, budget and terms used in the budget are too technical and their connection with the budget is only through next day’s newspaper, which explains things that will get cheaper and other things that will get costlier for them. But I always felt the need of simplifying the budget for common man, as everyone should understand it from the macro level and know the economic environment, opportunities and challenges in front of the country. “The Budget prepared by Finance Minister is no different than what your mother prepares monthly, budget in simple term corresponds to future planning.”, I started explaining her.

It is a very tough task for the finance minister to plan for the entire year’s receipts that the government will generate and expenditure the government should incur so as to have growth oriented, healthy economy. “How does one quantify growth for a country?” asked Apurva. Like for individuals, the way we assess their growth from their income and increase in the income year over year, the country’s growth can be calculated using a parameter called as GDP, Gross Domestic Product. It is calculated as the total amount of goods and services produced in the country. There are different methods of calculating GDP, such as Production method, Income method etc. India adopts production method, but this year there is a slight change in the way GDP of the country would be calculated. Unlike the method used traditionally where the total amount of Goods and services produced were quantified using factor cost, i.e. the cost at which the goods and services were produced, now it will be calculated using the market price. This new method adopted by India is in sync with the international standards of calculating GDP. In FY15 (ending on March 31^st 2015) the total size of India economy is expected to be $2.1 trillion----| Rs. 12600 (000 cr). This real GDP number also indicates growth of 7.4% as compared to the previous year. As per the economic survey of India 2015 presented before the budget day, the growth in the GDP for India, is expected to be 8.5% in FY16 which mean the real GDP for the country will be $2.28 trillion ----| Rs. 136.71 (000 Cr).

“The budget was full of Jargon with terms such as fiscal deficit, revenue deficit, planned expenditure, unplanned expenditure, revenue expenditure/receipts, capital expenditure/receipts etc., can you please explain them to me in simple terms?” asked Apurva. This is when it gets too technical for the common man to decode these jargon and they prefer staying away from it and concentrate on what impacts them. My task was very challenging, I had to keep it as simple as possible.

The diagram above shows over all summary for Outflow and Inflow of rupees for India. Both the inflow and outflow are categorized into Revenue and Capital receipts/expenditure.

The revenue and capital expenditure and further classified into planned and unplanned expenditure.

All the figures are in Rs. crore.

Planned Expenditure

Earlier India had a planning commission, which is now replaced by NITI (National Institute of Transforming India) Aayog which lays down the 5 year central plan for India. The planned expenditure allocation both in revenue as well as capital sector corresponds to amount allocated to implement various schemes detailed in the plan. The planned expenditure also corresponds to grant/assistance to state and union territories.

FY 16: 465003

Unplanned Expenditure

Unplanned Expenditure correspond to amount allocated for expenses required for activities other than one present as part of 5 year central plan.

Non-plan revenue expenditure is accounted for by subsidies, and wage and salary payments to government employees, pensions, police, and economic services in various sectors, other general services such as tax collection, social services, and grants to foreign governments.

Non Plan revenue expenditure also includes interest payments on the previous debt. This debt arises because India has been running fiscal deficit traditionally.

FY16 : 1312471

Fiscal Deficit

Fiscal deficit is total expected outflow (Revenue+ Capital Expenditure) minus total expected inflow (Total Non-debt Capital Receipt + Revenue Receipt for the center). It is important to note that the revenue receipt include those of the center only and revenue receipts for the states are not included. States would include these revenue receipts in their state budget.

It is also important to know that fiscal deficit is different than the Revenue deficit.

FY16: 3.9% of GDP

Revenue Deficit

Revenue deficit refers to the excess of revenue expenditure over revenue receipts and does not include capital expenditure and non-debt capital receipts.

FY16: 2.8% of GDP

Primary Deficit

Primary Deficit = Fiscal Deficit – Interest Payment on the loan raised due to previous deficits.

Primary deficit indicates the absolute deficit in the financial year generated which is devoid of the impact of the loans raised for funding fiscal deficits of the previous years.

Current Account Deficit

Current account deficit as we already know corresponds to different between imports and exports

All the deficits i.e. current account deficit, revenue deficit and fiscal deficit are reported as % of GDP

Revenue Expenditure

Revenue expenditure is for the normal running of the government's department and various services, interest charged on debt incurred by government, subsidies etc.

FY16: 1536045

Capital Expenditure

Expenditure incurred to acquire, build assets, infrastructure or to upgrade existing infrastructure facilities.

FY16: 241429

Revenue Receipts

Revenue receipts corresponds total tax and non-tax receipts collected by the central government.

FY16: 1141574

Tax Receipt

Tax receipts can be income based which is known as direct tax or additional amount to be paid for availing a particular set of services at predefined rate known as indirect tax.

Center FY16: 919842

Direct Tax are for Individual as well for the corporate. In this budget the finance minister has proposed to reduce the corporate tax from 30% to 25% over next four years by discontinuing the exemption present earlier which used to reduce 30% tax to effective 23%. For individuals there is no change in the tax slabs.

Indirect Tax corresponds to different set of taxes such as excise duty, custom duty, service tax, value added tax etc. The indirect tax structure is very complex and government has announced all the different indirect taxes with a single tax known as Goods and Service Tax GST applicable from 1^st April 2016.

Non Tax Receipt                                                      

Apart from Tax receipt, government can also generate revenues through means such as auctioning of Telecom Spectrum, Coal Mine Blocks etc.

FY 16: 221732

Capital Receipt

Non Debt Capital Receipts

Capital receipts consists of Non Debt receipts which corresponds to recovery of loan by the Center to State governments & Union Territories and proceeds or by diluting part of (selling off) its stake in public sector companies.

FY 16: 80252

Borrowing

The other part of capital receipts are required to fund the fiscal deficit. This is done by raising of loans the market by means of Bonds, government borrowings from the RBI (raises inflation) & other parties, and loans received from foreign governments.

FY 16: 543607

FY16_India_Inflow_Overview_Data

The above diagram shows the total receipts and expenditures categories wise allocated by the finance minister of India Shri. Arun Jaitley in his budget for FY16.

“I now understand the components of the budget and its significance. I have realized that preparing a budget is not a simple task. I would now be in the position to appreciate my mother who does this exercise monthly for running of our house, Of course running the country would be more difficult I understand! Let us connect next Saturday, I eagerly waiting for you to take me to the world where there are no interest rates, as you had promised during last call, Good Night.”, with those words we ended the Skype call to connect once again next Saturday…

Why does value of currency Change?

It was time for weekly Skype session with Apurva. I had explained her what role does currency have to play in terms of inflation. But more fundamental question remained unanswered, why does the value of currency change?

Why does the value of 1$ change?” the excitement on Apurva’s face was evident clearly. “There are many political and economic factors that govern the movement of the currency of which Interest Rates and Imbalance between Import and Export play a significant role.  In the long run the exchange rate would adjust themselves to the principal of Interest Rate Parity”, I started explaining her. Things would get more technical I knew but my challenge was to keep it as simple as possible.

Let us understand this with an example. Suppose on 1^st of January 2014 1$= ₹ 50. Interest rate in India is 5% and Interest rate in USA is 10% per year. You have ₹ 50000 with you to invest. Let us compare the output of investing the money you have in both US and India. In India at the end of the year you would get ₹ 2500 as an interest and you get 50000+2500=52500 in your hand on 1^st January 2015. If you were to invest the same amount in USA you first have to convert it to $ on 1^st Jan 2014 as banks in USA accept only $ deposits. In that case, you would have $1000 after the conversion. After you invest $1000 in US, you would get $100 as interest so that you would have $1100 on 1^st January 2015. Ideally the end value whether you invest in India or USA should be the same else it would be advantage to invest in USA as it pays higher interest. Therefore $1100= ₹ 52500 which means 1$= ₹47.72.

But this is very theoretical and may or may not hold true in short term. In short term supply/demand of Rupees/Dollar would decide the movement of the currency. India like many other countries import certain goods and commodities that it cannot manufacture e.g. Oil, iPhones. At the same time it also exports food items/handicraft items to other countries.

For imports there would be a demand of the $ (or currency of that country from which imports are made) by supplying rupees. More demand would lead to appreciation of dollar (Rupee depreciates) as we have already know that when there is more demand without increase in the adequate supply the prices would appreciate. In case of exports there would be more demand for Indian Rupee by supply of $ (or currency of the country importing from) and hence Rupee would appreciate, more supply of $ without equivalent increase in demand would lead to depreciation in prices.  So majority of the currency movement is influenced by the imbalance between imports and exports. The imbalance would cause a deficit if the imports are more than exports while it will cause surplus if exports are more than import. The deficit/surplus is called as current account deficit/current account surplus. India traditionally runs current account deficit i.e. its import bills are more than export revenue it generates. But the currency movement is not totally decided by imports/export alone.

Exports are not the only way of supply of $, there are three major sources of $ inflow.

   1.  Remittances :

Remittances are the most reliable and safest source of $ inflow. Remittances refer to the part of the money sent by Indians residing outside of India (NRIs) to their home. Kerala contributes to most of the remittances that come as an inflow in India.

   2.  Foreign Direct Investment (FDI)

This is next reliable sources of inflow. In the case of FDI foreign multinational own stake in Indian companies in bulk. There are restrictions on maximum limits these multinationals can invest in Indian companies which defers sector wise. E.g. the limit is different for retail industry vs. that of the insurance sector. The limits are decided by the government of India and passed by both floors of the parliament. Tough regulatory framework is laid down by the government which the foreign multinationals must comply in order to own the bulk ownership. The ownership can be a majority (>50%) or minority (<50%) as decided by the government. The money invested is relatively nonvolatile as the multinational would again need to follow several stringent norms in order to exit the investment.

  3.  Foreign Institutional Investment. (FII)

This form of inflow of $ is the most volatile and non-reliable source of inflow of $ that can cause extreme currency movements. In this case the foreign institutional investors (large investment firms) can directly own equity ownership in various Indian firms, much like   all retail investors, you and I. The money investment is to gain short term profit from increase in the price of the shares purchased. These FIIs can also pull out money from Indian economy if their economy is struggling and they are in need of cash. Hence this money is also referred as “Hot Money” sometimes which impacts the currency movements significantly in either of the directions.

Apart from these sources of $ inflow, the Reserve Bank of India (RBI) also keeps foreign currency in reserve for emergency purpose. It does this by buying the currency from open market time to time. It sells the $ from its reserve when it fills that the currency depreciation of rupee is becoming more volatile and moving beyond the comfort zone of RBI. There are some countries like Hong-Kong which keep their currency constant with respect to the currency of the other currency (often called as pegging of the currency) by selling /buying currency from/into its reserves. India has been following free floating currency and RBI intervenes only when it moves beyond its comfort zone.

“I now understand why does value of the currency change. From every conversation we have had so far, I can understand the fact that interest rate plays a role a critical role in the economy. I wish we had a world where there are no interest rates and we could borrow from a bank and don’t have to pay interest”, said Apurva. “Well, there exists banks that do not charge interest, we will discuss it next time”, I ended the Skype call with Apurva with a promise of taking her to a world where there is no concept of interest rates.

Calculating Inflation and its relation with the Currency

Calculating Inflation and its relation with the Currency

It had been a month since I joined IIM Kashipur to pursue my MBA and I was loving this place already. Hostel life was a completely new experience for me. The fact that tourist attractions like Jim Corbett Park, hill station of Nainital are an hour away from the institute was fascinating. This was the first time I had moved out of Mumbai, away from my family, but technologies such as Skype helped me to break the geographical barriers to great extent.  It was time for me to keep my promise on the deal that I had struck with Apurva and have the weekly Skype session to answer her questions. After the discussion about my life at IIM Kashipur, we started the discussion where we had left.

“Before you tell me the relation between the currency and the inflation, I have been wondering all this while as to how RBI calculates the inflation and concludes whether it is high or low ?”,asked Apurva.

“RBI uses an Index called as Wholesale Price Index (WPI) to calculate inflation”, I started explaining her. It is an index build with the prices the wholesalers have to pay to the manufacturer. This index is an indicative figure whose value can be compared with previous time period such as previous month or previous year. In WPI there are more than 650 goods and commodities whose wholesale price is tracked. These commodities are divided in three main categories which are

1. Primary Articles         2. Fuel and Power           3. Manufactured Products.

These three categories are given weight as per their influence in day to day life of a common Indian Man. Primary Articles are given 20% weight while Fuel and Power are given 15% and Manufactured Products are given 65% weight. Each of these categories have many items with the weight distributed among the category. And as with every index there is a base year whose value is considered to be 100 and new value of index would be calculated based on the base year value. For WPI year 2004 is considered to be base year with the value of 100. Let me explain this with the help of an example. For simplicity, assume there are only three items that existed: Milk, Oil and Sugar.

WPI_Calculation_Simplified

So as per the calculation the WPI inflation is 8.57%. The WPI inflation number is available weekly every Thursday with two weeks of delay. WPI is the main index which is followed by RBI as to decide whether the inflation is in control or not. Apart from WPI, RBI also looks for a Consumer Price Index (CPI) which is a price index calculated based on the prices which end consumers pay to the retailers. This index indicates actual inflation in the hands of consumer and not just for the wholesalers.

“RBI would want WPI inflation to be 0% or even negative, right?” asked curious Apurva. “Not really”, I started explaining her. RBI would want this to be around 3-4% ideally on the consistent basis. RBI also needs to keep a check on the CPI along with WPI. If inflation is 0% then the total output would not grow and working population would not get their promotions and salary hike. We cannot allow the inflation to go beyond a particular bracket because the salary hikes are not consistent for all, i.e. Income is not uniformly distributed while the increased expenditure is! The rich people of the society can afford the inflation but poor people will not be able to afford it as their income levels have not increased compare to increase in the inflation.

                 

“Now that I understand how inflation is calculated can you please tell why the change in the currency would lead to inflation? I mean, why would change in the currency value would increase the price of the goods and commodities?

“It would be unfair to say that the price of the commodities and goods change if there is a change in the currency but it certainly impacts the inflation”.  Let us take an example,Suppose on 1^st of January 2014, 1$= ₹50. Suppose you want to order an iPhone 6 plus from USA since it has yet not been launched in India.Assume that an iPhone 6 plus costs $1000. The US retailer selling the iPhone to you would prefer the payment in $ as USA has currency of $. So you have to pay  ₹ 50000 typically to a Bank or an institution which is into the currency exchange business and buy $1000 and buy the iPhone 6 plus. 2 days after the purchase on 3^rd of January 2014, you show this iPhone to your best friend and now she also wants a similar phone but on 3^rd of Jan 1$= ₹ 60. The iPhone price is still $1000 but now to buy $1000 you have to give ₹ 60000. Even though the price of iPhone stayed $1000 you still experienced inflation. This is because the purchasing power of Indian Currency has reduced.  That is why when the 1$ value changes from  ₹ 50 to  ₹ 60 we say that Indian Rupees has depreciated as the currency cannot buy as much as it could earlier and we say that $ has appreciated because it take more Rupees to purchase similar amount of $.

“I now understand the how inflation is calculated and relationship between the currency and inflation but why does the value of 1$ change?” asked Apurva. "There are many factors that govern the movement of the currency, let us discuss them next time,when we have the Skype session”, I told her. It was already 11.30 in night but like all others studying in IIM, day had just begun, I thought.