[Economic Survey Ch1] Investment, Savings, Gold Rush, Inflation Indexed Bonds (Part 2 of 3)

1. INVESTMENT
   • #1: Tight monetary policy
   • #2: Exports declined
   • #3: Policy bottlenecks
   • #4: investment in Valuables
2. DOMESTIC SAVINGS
3. Decline in share-debentures
4. GOLD RUSH
   • Why do people invest in gold?
   • Gold -Current Account Deficit (CAD)
   • How to stop gold rush?
   • Inflation indexed bonds
5. Mock Questions

INVESTMENT

• The private sector is the major source of investment in the country.
• Within the private sector there are two categories of investors

1. Private corporate sector
2. Households (aam aadmi)

From both type of investors, less investment is coming. (according to Economic Survey). Why? There are four reasons:

#1: Tight monetary policy

• Monetary policy = steps taken by RBI to control money supply.
• Repo rate = RBI gives short-term loans to its clients (mostly banks) @this rate.
• So when repo rate =increased= cost of borrowing increased for the banks. And they transfer this cost by increases the final interest rate on car / home / business loans.
• Between 2010 and 2011 period, the RBI raised the repo rate by 375 basis points (bps).
• cost of borrowing increased = less people borrowing money to invest in business.
• Due to this tight monetary policy (+inflation), the Production of consumer durables declined significantly.
• Because inflation is high. So a family’s most income goes in buying milk, petrol, gas, schooling, house rent, electricity etc.
• Given RBI’s tight monetary policy (=increasing repo rate), so home/car loan EMI and interest rates also increased.= bike/car purchases decreased.

#2: Exports declined

• In the first world countries (US, UK etc.) the impact of recession is still present. So their consumers have less money to spend (compared to previous years.) therefore, demand of indian products in internation market = decreased.
• This is second reason for lower private investment. (if businessman is not getting export-demand, then he has no rason to invest more money in expanding his operation, buying new warehouse, factories, machinaries etc.)
• The World Economic Outlook (WEO) Update released by the IMF, says India’s trading partners (US/EU etc.) are growing at low rate, hence Indian exports also declined

#3: Policy bottlenecks

• Business projects worth thousands of crores are delayed because
• Environmental clearance
• Land acquisition, farmers agitations.
• municipal permission
• supply of raw materials
• Because of ^these, large number of projects are stalled / pending file approvals especially in the projects related to electricity, roads, telecommunication services, steel, real estate, and mining.
• This reduces IIP.
• This also discourages new investment. = less incoming dollars = rupee weakens indirectly.
• This also increases non-performing assets (NPAs). Particularly in textiles, chemicals, iron and steel, food processing, construction, and telecommunications.

#4: investment in Valuables

• Due to inflation, sharemarket volatility = nowadays, people invest in “valuables”.
• Valuables = Paintings, precious metals, gold, diamond, silver and jewellery carved out of such metals and stones.
• These are called non-productive investment. (because it just stays in your bank locker / home locker. Money should remain in circulation : from aam-aadmi to bank to businessmen/loans.)
• So, Overall investment is slowed down because nowadays people are investing in such non-productive investment: mostly in gold.

DOMESTIC SAVINGS

Domestic savings, come from three sources

1. Households
2. private corporate sector
3. public sector.

Savings Rate

• Savings rate = Gross domestic savings divided by GDP @Market price.
• If we look at the savings rate,

Household (aam-aadmi)’s savings can be subdivided into

• Usually, most of the household savings go into bank deposits. And Pension –provides funds don’t get much. However, there has been some upward movement in the share of pension and provident funds during 2008-9 and 2009-10. Why?
• Because 6^th Pay Commission implementation = disposable income of government servants increased. And they’re the significant contributors to these pension / provident funds

Decline in share-debentures

If you look at the data, you can see a trend: Household savings going into sharemarket

• So why did it increase in 90s and then suddenly declined?
• Because in 90s, the sharemarket was less volatile (=it did not go up and down very frequently). And if you invested money, you could get around 20% return on it, per year.
• Fastforward to 2000s: now share market is very volatile and you get barely 10% return on investment= not good.

• Thus a combination of lower returns + higher volatility= less savings going into sharemarket.

Implication?

• When you combine above phenomenon with inflation = it is not very attractive to invest in share market.
• + bank deposits not giving enough returns.
• So people fall back to the “safe” investment = gold.

Gold Rush

• Demand for gold has been rising worldwide
• gold prices in international market are calculated in US$. And these gold prices have doubled since 2008.
• India has traditionally been a major absorber of world gold.
• Gold has been a combination of investment tool and status symbol in India
• Gold imports are positively correlated with inflation. (meaning, if inflation increases then gold imports will definitely increase.)

Why do people invest in gold?

1. Share market is volatile (fluctuates a lot). And it doesn’t offer attractive return at the moment.
2. To invest in share market / mutual funds, you need PAN CARD + DEMAT Account. Many people still don’t have it. = With limited access to financial instruments, financial markets, especially in the rural areas.
3. Rural people don’t have awareness about Mutual funds, pension-provident funds etc.
4. Inflation is high. So the profit (return) offered on back savings, fixed deposits, pension-insurance funds = not attractive.
5. When you combine these factors: most people prefer to invest in gold / silver.

Thus, rising demand for gold is only a “symptom” of more fundamental problems in the economy (inflation, lack of financial awareness etc.)

• Anyways, what’s the big deal? let the people invest in gold, after all its their money!
• The big deal is, if people had invested money in banking / finance sector, then that money could be given to some needy businessmen, he’ll open / expand his factory = more employment + more production =good for economy.
• But if people just purchase gold/ silver = that money stops moving. It just sits in their locker = bad for economy.

Another problem => gold rush = high CAD.

Gold -Current Account Deficit (CAD)

• High CAD = bad, because it weakens the rupee.
• There are two main villains responsible for India’s current account deficit: 1) gold import 2) crude oil import.
• Given the energy requirements, we cannot stop / reduce the crude oil import, else it’ll badly affect economy.
• Then solution is obviously: reduce gold import. But how?

How to stop gold rush?

• One solution = increase duty on gold import. But problem= people will start smuggling. Then Government will not get any import duty at all.
• Therefore, Economy survey suggests following things

1. Underlying motive for gold rush = high inflation. So first, Government should curb the inflation.
2. Second problem is lack of financial instruments available to the average citizen, especially in the rural areas. (they don’t have PAN card, DEMAT account or knowledge  of how to invest in sharemarket/ mutual funds etc.). So Government should take initiatives to increase the financial awareness, financial inclusion.
3. Government should introduce inflation indexed bonds. (then it is more attractive to invest in bonds, otherwise 9% return is not good, if there is 11% inflation!)

Inflation indexed bonds

• Normal “bonds” work in this fashion: 10%, 2017
• Meaning you give me Rs.100 right now. I’ll pay you Rs.10 as interest every year until 2017 and then I’ll return the principle (Rs.100).
• Ok but what if there get so high inflation in 2017 that even cheapest ballpoint pen costs Rs.500! Then getting back the Rs.100 principle hardly benefits you. Because of this reason, nowadays people prefer to invest in gold rather than in shares/ bonds/ mutual funds etc.
• But in “inflation indexed bonds”, the principle is linked with Inflation index. So, if from 2013 to 2017, inflation increased by 30% then you get 30% more principle (=100 original + 30) =Rs.130. this is good because your investment is protected from inflation.

Mock Questions

Q1. Correct statement about Indian economy?

1. Gold imports are negatively correlated with inflation
2. Gold imports are inversely correlated with inflation
3. Gold imports are positively correlated with inflation
4. Gold imports are not correlated with inflation.

Q2. Which of the following is/are responsible for excessive gold consumption in India?

1. Inflation.
2. Lack of access or awareness about financial markets.
3. High Volatility in share market.
4. High rate of returns on investment in share market.

Choice

1. Only 1 and 2
2. Only 1, 2 and 3
3. Only 1, 2 and 4
4. All of above.

Q3. The Economic Survey suggested that Inflation indexed bonds should be introduced in India. What will be the primary benefit of such bonds?

1. It’ll help curbing the fiscal deficit.
2. It’ll help reducing the NPAs of public sector banks.
3. It’ll help decreasing the excessive gold consumption.
4. None of above.

Q4. Incorrect statements about savings in India?

1. It comes from three sources: households, private corporate sector and public sector.
2. Savings rate has been above 30% in recent years.
3. bank deposits, life insurance funds, pension and provident funds, shares and debentures are examples of physical savings.
4. None of above.