Paying income tax has become very common to all of us and we do it regularly. Though we have little confusion on the various procedures involved in filing the returns, we are pretty clear with Income Tax. Are you aware that apart from your income tax returns, you may also be required to file wealth tax returns?
Yes, every individual, who has wealth exceeding Rs 15 lakh, is required to pay wealth tax as well as file a return of wealth tax with the revenue authorities by July 31 every year, immediately following the end of the previous year (the previous year runs from April 1 to March 31). Currently, the wealth tax rate is 1%.
Wealth refers to (as per Tax laws terminologies), is the value of prescribed assets of an individual as reduced by debts owed in respect of assets. Therefore, if the asset is valued at Rs 30 lakh and the outstanding loan against the asset is Rs 14 lakh, the amount that would be considered as wealth would be Rs 16 lakh.
An important point to note is that the value for the purpose of wealth-tax would be the value of the assets as on the last day of the respective previous year (i.e., March 31). There are prescribed guidelines that need to be followed for valuation of the assets. So let us consider an example for a better understanding. Avinash owns the following assets as on March 31, 2008: One residential house valued at Rs 30 lakh; one motor car valued at Rs 5 lakh; a bank balance of Rs 1.5 lakh; shares valued at Rs 28.5 lakh and gold jewellery valued at Rs 10 lakh.
Would this mean that Avinash has wealth of Rs 75 lakh and he has to pay a wealth-tax of Rs 75000? (I.e. 1% of 75 lakh as mentioned above, it should be noted that only wealth exceeding Rs 15 lakh is taxable).
Thankfully the answer is No! While the definition of assets covered under wealth tax is extremely wide, fortunately a description has been provided for assets that fall within the purview of wealth-tax (both covered as well as exemptions thereto have been defined). Broadly, the following assets are considered as part of the taxable wealth of an individual: House, motor car, jewellery, cash in hand in excess of Rs 50,000, urban land (that is land situated, within the jurisdiction of municipality and having a population of 10,000 and more or in any area within such distance from the local limits of any municipality) and yachts, boats and aircraft.
Therefore, in the above example, shares and the bank balance are not covered as taxable assets. In addition to this, even the covered assets enjoy certain exemptions. Typically, the wealth tax is only applicable on non-productive assets. Thus, where the aforesaid assets are used for commercial purposes (like boats and aircraft) or held as stock for trading purposes (like jewellery and motor car), they are not liable to wealth tax. One must be careful in examining the exemptions that are available in respect of each asset. Let us for instance, look closely at the definition of house. Your own house, in which you reside, is not an asset subject to wealth tax, nor is a plot of land owned by you provided that it does not exceed 500 sq meters. A house held as stock in trade or used for own business or profession is also exempt, as are commercial complexes. If a residential property has been let out for 300 days or more in the previous year, the same is also exempt from wealth-tax.
Therefore, in Avinash’s case, even the residential house is exempt from wealth tax (and only the car and jewellery are finally liable to wealth tax). After all this, Avinash would only be liable to pay wealth tax on the value of Rs 15 lakh, the wealth tax amounting to a mere Rs 15,000.
You must also note that dispersing ownership of the asset amongst family members may not exempt you from being taxed. Similar, to the income tax provisions, there are provisions for clubbing where assets transferred by an individual to his spouse, sons wife or to a person for the benefit of spouse or sons wife without adequate consideration form part of his/her wealth and not the transferees. While resident Indians are liable to wealth tax on their global wealth, foreign citizens please note that your assets situated in India are also liable to wealth tax in India.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=110&aid=110&acat=&ahead=Wealth%2520Tax%2520%e2%80%93%2520Do%2520you%2520need%2520to%2520pay%3f
Sunday, June 27, 2010
Saturday, June 26, 2010
A Guide to Investments
A lot of people have asked me how to invest in stocks, mutual funds or other securities. I thought of putting across a brief guide on how to invest in any security.
How to invest in stocks?
To invest in stocks, one need to have a Demat account with a registered bank such as ICICI, Citi, HDFC and SBI or a brokerage firm such as IndiaBulls, ShareKhan and IndiaInfoline. There is another way of investing stocks as well – asks your broker to do invest in stocks on your behalf. However, trading through demat account is more safe, less costly, transparent and convenient.
Once you have your Demat account, you can buy, sell, transfer and transact shares online without any hassle. However, it is always advisable to so some basic research on stocks before investing in them.
How to invest in mutual funds?
Again, there are two ways of investing in mutual funds. First, you can invest online using your Demat account or through online banking account of your banks such as HDFC Online, ICICI and SBI. You will require an online account, either Demat or Savings, and a PIN (Personal Identification Number). Second way of investing is through brokers. These brokers may be banks such as ICICI and HDFC or financial planning companies such as Bajaj Capital.
Using online services, you can purchase, redeem, switch, view your account details, view your portfolio valuation and download account statements without any effort. These services are just a click away. However, in case of brokers when you redeem your investments you get your money as cash or get deposited in your account.
How to invest in Gold?
Investment in gold can be done directly through ownership, or indirectly through certificates, accounts, spread betting, derivatives or shares.
1. Gold Bars or Coins: Physical investment in gold should be either in gold coins or bars. However, it should always be bought from banks which certify the quality of gold. Moreover, only buy government-certified gold coins or bars and preferably the purity level should be 99.9 as they are easy to sell. All leading banks such as ICICI and HDFC provides such an investments.
2. Gold Certificates: A certificate which represents ownership of gold bullion held by a financial institution for convenient and safe storage. There is a fee for storage and insurance. Again leading banks provide such a service.
3. Gold Futures: Gold contracts are the hottest commodities traded in the Indian market. It is traded on MCX (Multi Commodity Exchange) Gold has become the largest traded commodity in India’s domestic futures market as a large number of traders are taking delivery of the yellow metals through the futures route. This can be done by opening an account with brokerage firms such as Bonanza Online.
4. Gold ETFs: You may not be able to touch and feel your Yellow metal through ETFs, but they are perhaps the safest method of buying and owning gold. ETF stands for Exchange Traded Funds. These are generally open-ended funds i.e. they are traded on the exchange just like stocks. There are quite a few ETFs in the market namely- Reliance, Kotak, UTI Gold ETF to name a few. For investment in ETFs, please read “How to invest in mutual funds” above.
How to invest in commodity?
Commodity trading is nothing but trading in commodity spot and derivatives (futures). Commodity derivatives are traded on the National Commodity and Derivative Exchange (NCDEX) and the Multi-Commodity Exchange (MCX). Gold, silver, agri-commodities including grains, pulses, spices, oils and oilseeds, mentha oil, metals and crude are some of the commodities that these exchanges deal in.
You can invest in commodity through derivative markets only. At present in India ETFs in commodity is not allowed except Gold. Thus, you have to go through commodity traders or brokers such as Bonanza Online who invests in commodity traders.
How to buy insurance?
You can buy insurance either through underwriters (i.e. those who design and manage plans) such as HDFC, ICICI and Kotak or through brokers and third parties such as Agents, Howden India and IndiaInfoline. You need to fill up an application form with the concerned party and make an annual payment called as “policy payment”. It is extremely simple – you just have to call any of these banks and somebody will touch base with you. You may even monitor your insurance plan online. HDFC Standard Life provides you such a facility.
How to invest in government bonds or securities?
Individuals can invest in government bonds in two ways: directly and indirectly. People can directly buy government securities through Kisan Vikas Patra or National Savings Certificate.
If you want to invest in bigger government issues such as infrastructure bonds or oil bonds you have to use the direct route i.e. mutual funds. There are a number of mutual funds which invest only in fixed income securities or a mix of securities and equities. For more information on this, please read “How to invest in mutual funds” above.
How to invest in corporate bonds?
Corporate bonds are “bonds” issued by companies either private limited or public companies. If you want to invest in corporate bonds you have to do it through mutual funds. There are a number of funds which invest in high investment grade bonds (BBB- or above) or junk bonds.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=115&aid=250&ahead=A%2520Guide%2520to%2520Investments
How to invest in stocks?
To invest in stocks, one need to have a Demat account with a registered bank such as ICICI, Citi, HDFC and SBI or a brokerage firm such as IndiaBulls, ShareKhan and IndiaInfoline. There is another way of investing stocks as well – asks your broker to do invest in stocks on your behalf. However, trading through demat account is more safe, less costly, transparent and convenient.
Once you have your Demat account, you can buy, sell, transfer and transact shares online without any hassle. However, it is always advisable to so some basic research on stocks before investing in them.
How to invest in mutual funds?
Again, there are two ways of investing in mutual funds. First, you can invest online using your Demat account or through online banking account of your banks such as HDFC Online, ICICI and SBI. You will require an online account, either Demat or Savings, and a PIN (Personal Identification Number). Second way of investing is through brokers. These brokers may be banks such as ICICI and HDFC or financial planning companies such as Bajaj Capital.
Using online services, you can purchase, redeem, switch, view your account details, view your portfolio valuation and download account statements without any effort. These services are just a click away. However, in case of brokers when you redeem your investments you get your money as cash or get deposited in your account.
How to invest in Gold?
Investment in gold can be done directly through ownership, or indirectly through certificates, accounts, spread betting, derivatives or shares.
1. Gold Bars or Coins: Physical investment in gold should be either in gold coins or bars. However, it should always be bought from banks which certify the quality of gold. Moreover, only buy government-certified gold coins or bars and preferably the purity level should be 99.9 as they are easy to sell. All leading banks such as ICICI and HDFC provides such an investments.
2. Gold Certificates: A certificate which represents ownership of gold bullion held by a financial institution for convenient and safe storage. There is a fee for storage and insurance. Again leading banks provide such a service.
3. Gold Futures: Gold contracts are the hottest commodities traded in the Indian market. It is traded on MCX (Multi Commodity Exchange) Gold has become the largest traded commodity in India’s domestic futures market as a large number of traders are taking delivery of the yellow metals through the futures route. This can be done by opening an account with brokerage firms such as Bonanza Online.
4. Gold ETFs: You may not be able to touch and feel your Yellow metal through ETFs, but they are perhaps the safest method of buying and owning gold. ETF stands for Exchange Traded Funds. These are generally open-ended funds i.e. they are traded on the exchange just like stocks. There are quite a few ETFs in the market namely- Reliance, Kotak, UTI Gold ETF to name a few. For investment in ETFs, please read “How to invest in mutual funds” above.
How to invest in commodity?
Commodity trading is nothing but trading in commodity spot and derivatives (futures). Commodity derivatives are traded on the National Commodity and Derivative Exchange (NCDEX) and the Multi-Commodity Exchange (MCX). Gold, silver, agri-commodities including grains, pulses, spices, oils and oilseeds, mentha oil, metals and crude are some of the commodities that these exchanges deal in.
You can invest in commodity through derivative markets only. At present in India ETFs in commodity is not allowed except Gold. Thus, you have to go through commodity traders or brokers such as Bonanza Online who invests in commodity traders.
How to buy insurance?
You can buy insurance either through underwriters (i.e. those who design and manage plans) such as HDFC, ICICI and Kotak or through brokers and third parties such as Agents, Howden India and IndiaInfoline. You need to fill up an application form with the concerned party and make an annual payment called as “policy payment”. It is extremely simple – you just have to call any of these banks and somebody will touch base with you. You may even monitor your insurance plan online. HDFC Standard Life provides you such a facility.
How to invest in government bonds or securities?
Individuals can invest in government bonds in two ways: directly and indirectly. People can directly buy government securities through Kisan Vikas Patra or National Savings Certificate.
If you want to invest in bigger government issues such as infrastructure bonds or oil bonds you have to use the direct route i.e. mutual funds. There are a number of mutual funds which invest only in fixed income securities or a mix of securities and equities. For more information on this, please read “How to invest in mutual funds” above.
How to invest in corporate bonds?
Corporate bonds are “bonds” issued by companies either private limited or public companies. If you want to invest in corporate bonds you have to do it through mutual funds. There are a number of funds which invest in high investment grade bonds (BBB- or above) or junk bonds.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=115&aid=250&ahead=A%2520Guide%2520to%2520Investments
Fundamental Analysis
Today I got a query from one of my reader that he wants to know about fundamental analysis, and then I thought of posting the same answer on my site, so that others will also get benefited.
Fundamental analysis is the key and very prominent factor while buying and selling of stocks and securities. This provides a complete analysis of the company, industry and economy related news to the investors. Fundamental analysis can be best compared with our cloths, because while purchasing our cloths we always look at the quality, price and outlook of the cloth; brand value, goodwill and popularity of the company and finally, we start thinking whether it suits to the current season or not.
Fundamental analysis of shares and stocks is a conservative and non-speculative approach based on the “fundamentals”. A fundamental analyst always looks at a three dimensional analysis instead of analyzing what is happening in the Dalal street. The three important dimensional factors are:
The Economy
The Industry
The Company
The Economy Analysis
The Economy analysis is a major factor stands behind the success of any investor. Economic analysis includes the study and understanding of various economic indicators and their possible impact on the stock market. Following are the economic indicators which has impact on the stock market movements:
GNP
Price Conditions
Economy
Housing Construction
Employment
Accumulation of Inventories
Personal Disposable Income
Personal Savings
Interest Rates
Balance of trade
Strength of the Rupee in Forex market
Corporate Taxation (Direct & Indirect)
The Industry Analysis
Every industry has to go through a life cycle with four distinct phases
i) Pioneering Stage
ii) Expansion (growth) Stage
iii) Stagnation (mature) Stage
iv) Decline StageThese phases are dynamic for each industry.
You as an investor is advised to invest in an industry that is either in a pioneering stage or in its expansion (growth) stage. Its advisable to quickly get out of industries which are in the stagnation stage prior to its lapse into the decline stage. The particular phase or stage of an industry can be determined in terms of sales, profitability and their growth rates amongst other factors.
The Company Analysis
There may be situations where the industry is very attractive but a few companies within it might not be doing all that well; similarly there may be one or two companies which may be doing exceedingly well while the rest of the companies in the industry might be in doldrums. You as an investor will have to consider both the financial and non-financial aspects so as to form a qualitative impression about a company. Some of the factors are
History of the company and line of business
Product portfolio's strength
Market Share
Top Management
Intrinsic Values like Patents and trademarks held
Foreign Collaboration, its need and availability for future
Quality of competition in the market, present and future
Future business plans and projects Tags - Like Blue Chips, Market Cap - low, medium and big caps
Level of trading of the company's listed scripts
EPS, its growth and rating vis-à-vis other companies in the industry.
P/E ratio
Growth in sales, dividend and bottom line.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=12&aid=24&acat=&ahead=Fundamental%2520Analysis
Fundamental analysis is the key and very prominent factor while buying and selling of stocks and securities. This provides a complete analysis of the company, industry and economy related news to the investors. Fundamental analysis can be best compared with our cloths, because while purchasing our cloths we always look at the quality, price and outlook of the cloth; brand value, goodwill and popularity of the company and finally, we start thinking whether it suits to the current season or not.
Fundamental analysis of shares and stocks is a conservative and non-speculative approach based on the “fundamentals”. A fundamental analyst always looks at a three dimensional analysis instead of analyzing what is happening in the Dalal street. The three important dimensional factors are:
The Economy
The Industry
The Company
The Economy Analysis
The Economy analysis is a major factor stands behind the success of any investor. Economic analysis includes the study and understanding of various economic indicators and their possible impact on the stock market. Following are the economic indicators which has impact on the stock market movements:
GNP
Price Conditions
Economy
Housing Construction
Employment
Accumulation of Inventories
Personal Disposable Income
Personal Savings
Interest Rates
Balance of trade
Strength of the Rupee in Forex market
Corporate Taxation (Direct & Indirect)
The Industry Analysis
Every industry has to go through a life cycle with four distinct phases
i) Pioneering Stage
ii) Expansion (growth) Stage
iii) Stagnation (mature) Stage
iv) Decline StageThese phases are dynamic for each industry.
You as an investor is advised to invest in an industry that is either in a pioneering stage or in its expansion (growth) stage. Its advisable to quickly get out of industries which are in the stagnation stage prior to its lapse into the decline stage. The particular phase or stage of an industry can be determined in terms of sales, profitability and their growth rates amongst other factors.
The Company Analysis
There may be situations where the industry is very attractive but a few companies within it might not be doing all that well; similarly there may be one or two companies which may be doing exceedingly well while the rest of the companies in the industry might be in doldrums. You as an investor will have to consider both the financial and non-financial aspects so as to form a qualitative impression about a company. Some of the factors are
History of the company and line of business
Product portfolio's strength
Market Share
Top Management
Intrinsic Values like Patents and trademarks held
Foreign Collaboration, its need and availability for future
Quality of competition in the market, present and future
Future business plans and projects Tags - Like Blue Chips, Market Cap - low, medium and big caps
Level of trading of the company's listed scripts
EPS, its growth and rating vis-à-vis other companies in the industry.
P/E ratio
Growth in sales, dividend and bottom line.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=12&aid=24&acat=&ahead=Fundamental%2520Analysis
Equity Linked Savings Scheme
Definition:
ELSS refers to Equity Linked Savings Scheme. ELSS as the name clearly suggests is a savings scheme linked to equity markets. It is a type of mutual fund, which additionally offers tax benefits to the investors.
Key Features and benefits of ELSS are:
ELSS is a fund with a lock-in period of 3 years.
It offers tax benefit to the investors under section 80c of the income tax Act up to a maximum limit of 1 Lac per annum.
Investment has to be for long term, any expectation of short term gains is not appropriate.
Involves a little bit of risk because of equity allocation.
ELSS helps an investor to get addicted to investments and savings by offering systematic investment option.
ELSS is very beneficial to salaried people.
Up to March 31,2005 an investor could claim only rebate under Section 88 if invested in ELSS and the maximum amount that could be invested in ELSS was only Rs.10,000/-. But from March 31, 2006 the investment limit in ELSS has been increased to Rs.1, 00, 000/- and this entire investment is eligible for deduction under sec 80C of Income tax Act, 1961.
Comparison between ELSS and ULIPs:
ULIPs and ELSS works almost in the similar way as both offers tax benefit. Money will be mostly invested in the equity markets in both the cases. I would like to put before few points which differentiates ULIPs and ELSS.
ELSS plans are offered by Asset Management Companies, where as ULIPs are mostly offered by Life Insurance Companies.
ELSS plans does not offer switching facility, but ULIPs offers switching facility to the investors, which helps an investor to safe guard his money in the time of market fluctuations by allowing the switch over of funds from equity to debt instruments.
The fund management charges in ELSS would always be higher than ULIPs.
SIP in ELSS is not convenient to investors, as money invested on monthly basis has to be locked for three years from the date of investment of the respective monthly investment. Where as in case of ULIPs investment amount and its return can be taken back after completion of 3 years from the date of first monthly investment made.
The Investment strategy of ELSS is not that strong when compare to the ULIPs as the investment strategy of ULIPs are governed by law.
Advantages of ELSS over NSC and PPF
Main advantage of ELSS is its short lock-in period. Maturity period of NSC is 6 years and PPF is 15 years.
Since it is an equity linked scheme earning potential is very high.
Investor can opt for dividend option and get some gains during the lock-in period.
Investor can opt for Systematic Investment Plan.
Some ELSS schemes also offer personal accident death cover insurance.
Provides 30 to 40% returns compared to 8% in NSC and PPF.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=11&aid=98&ahead=Equity%2520Linked%2520Savings%2520Scheme
ELSS refers to Equity Linked Savings Scheme. ELSS as the name clearly suggests is a savings scheme linked to equity markets. It is a type of mutual fund, which additionally offers tax benefits to the investors.
Key Features and benefits of ELSS are:
ELSS is a fund with a lock-in period of 3 years.
It offers tax benefit to the investors under section 80c of the income tax Act up to a maximum limit of 1 Lac per annum.
Investment has to be for long term, any expectation of short term gains is not appropriate.
Involves a little bit of risk because of equity allocation.
ELSS helps an investor to get addicted to investments and savings by offering systematic investment option.
ELSS is very beneficial to salaried people.
Up to March 31,2005 an investor could claim only rebate under Section 88 if invested in ELSS and the maximum amount that could be invested in ELSS was only Rs.10,000/-. But from March 31, 2006 the investment limit in ELSS has been increased to Rs.1, 00, 000/- and this entire investment is eligible for deduction under sec 80C of Income tax Act, 1961.
Comparison between ELSS and ULIPs:
ULIPs and ELSS works almost in the similar way as both offers tax benefit. Money will be mostly invested in the equity markets in both the cases. I would like to put before few points which differentiates ULIPs and ELSS.
ELSS plans are offered by Asset Management Companies, where as ULIPs are mostly offered by Life Insurance Companies.
ELSS plans does not offer switching facility, but ULIPs offers switching facility to the investors, which helps an investor to safe guard his money in the time of market fluctuations by allowing the switch over of funds from equity to debt instruments.
The fund management charges in ELSS would always be higher than ULIPs.
SIP in ELSS is not convenient to investors, as money invested on monthly basis has to be locked for three years from the date of investment of the respective monthly investment. Where as in case of ULIPs investment amount and its return can be taken back after completion of 3 years from the date of first monthly investment made.
The Investment strategy of ELSS is not that strong when compare to the ULIPs as the investment strategy of ULIPs are governed by law.
Advantages of ELSS over NSC and PPF
Main advantage of ELSS is its short lock-in period. Maturity period of NSC is 6 years and PPF is 15 years.
Since it is an equity linked scheme earning potential is very high.
Investor can opt for dividend option and get some gains during the lock-in period.
Investor can opt for Systematic Investment Plan.
Some ELSS schemes also offer personal accident death cover insurance.
Provides 30 to 40% returns compared to 8% in NSC and PPF.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=11&aid=98&ahead=Equity%2520Linked%2520Savings%2520Scheme
Inflation - its causes and effects on the economy
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can also be described as a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account and the monetary store of wealth. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time.
When I was a kid my grandparents used to tell me – “Son, in our time we use to take money (paisa) in pockets and carry goods to home in bags. But in your age you will carry money (rupees) in bags and carry goods to home in your pocket”. He was so right! This is inflation –which reduces the purchasing power of common man.
Measuring Inflation
In major economies, inflation is measured by CPI, which is Consumer Price Index. CPI is a measure of the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation. Two basic types of data are needed to construct the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled periods from a sample of households.
In other words, Inflation is calculated as percentage change in CPI in two periods. Hence,
Inflation (%) = (CPI2- CPI1)*100/CPI1
Where, CPI1 = CPI in the previous period and CPI2 = CPI in the current period
India uses a different price index called the Wholesale Price Index (WPI) to calculate the rate of inflation in our economy. It is quite similar to Consumer Price Index, but uses whole sale prices instead of retail consumer prices. WPI is the index used to measure changes in the average price levels in the wholesale market. Data on 435 commodities is tracked through WPI, in India, which is an indicator of movement in prices. I share the common view of other economists who believe WPI, as a measure of inflation, is flawed. India should switch to CPI, which has been adopted by most developed countries.
There are several other ways of measuring inflation as well. They are GDP price deflator, Producer Price Indices and Commodity Price Indices. However, they are not commonly used.
Flaws of WPI
Former RBI governor once explained why India does not use CPI as a measure of inflation. The CPI data is not released as frequently as WPI data. WPI data is released almost weekly and sometimes at most biweekly, where as CPI data is released once in a month. There is also a lot of lag in collating all the CPI data. There is another problem with the CPI data in India. We don’t have a single CPI data, but four different CPI figures relating to agriculture goods, urban manual labor and non-urban labor etc. There is no discipline in when these different figures are released and with what frequency. So government of India has a genuine reason in not going for CPI based inflation.
WPI based calculation is full of flaws. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. The WPI that was constituted in 1993-94 has virtually remained unchanged since then, and it has lost quite a bit of its relevance while calculating inflation. Some of the WPI commodities include coarse grains that go into making of livestock feed but they continue to be considered while measuring inflation. The sole reason why many unimportant commodities continue to remain included is possibly because data on their prices was available!
Causes of Inflation
Let’s get back to our discussion on the fundamentals of inflation. Economists believe that inflation is a monetary phenomenon. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.
1. Over-expansion of money supply i.e. excess liquidity in the economy leads to inflation because “too many money would be chasing too few goods”.
2. Expansion of Bank Credit Rapid expansion of bank credit is also responsible for the inflationary trend in a country.
3. Deficit Financing: The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.
4. A high population growth leads to increase in demand and money income and cause a high price rise.
5. Excessive increase in the price of fuel or food products due to political, economic or natural reasons will lead to inflation for short- as well as long-term.
For example – We all remember that price of crude went up from $50 to $140 within two years. Almost every industry including agriculture, transportation and manufacturing depends on crude for its operation. Any excessive increase in the price of crude leads to increase in cost of good and services i.e. inflation.
Another example – China and India consist of almost 34% of the world’s population. As the economy in these two countries are growing at a rate of over 9%, people are consuming more and more goods due to increased income and better life. Demand for those goods and services has led to a high inflationary environment in these countries.
States of Inflation
There are different states of inflation which is characterized based on its value as well as variation from the previous value.
1. Hyperinflation – It is a very high rate of inflation, usually a rate in excess of 50%. History has some excellent examples of hyperinflation. In Germany, inflation exceeded 1 million % in 1923. It was said that a horse cart full of money would not buy even a newspaper. Right now, Zimbabwe is having an inflation of 1 million %. They have to issue currency of $500 Million dollar (I am not kidding!!) which could only buy a lunch at McDonalds.
2. Deflation – It is the decrease in the general price level of goods and services only when annual inflation is below 0% resulting in the real value of money. Hence, it is sometimes called “negative inflation”. Japan suffered from deflation for almost a decade in 1990s. To control recession and Central Bank of Japan was forced to have a negative interest rate on deposit for over a decade.
3. Disinflation – It refers to a time when the rate of change of prices is falling while the inflation rate is positive. For example – if the inflation rate comes down from 3% to 2%, we would say it is disinflation. In India, we have a disinflation because inflation has come down from a high of 13% to 6% and it is still dropping.
4. Stagflation – It is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. Stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.
Effects of Inflation on economy
As we know Inflation is the increase in the price of general goods and service. Thus, food, commodities and other services become expensive for consumption. Inflation can cause both short-term and long-term damages to the economy; most importantly it causes slow down in the economy.
1. People start consuming or buying less of these goods and services as their income is limited. This leads to slowdown not only in consumption but also production. This is because manufactures will produce fewer goods due to high costs and anticipated lower demand.
2. Banks will increase interest rates as inflation increases otherwise real interest rate will be negative. (Real interest ~ Nominal interest rate – inflation). This makes borrowing costly for both consumers and corporate. Thus people will buy fewer automobiles, houses and other goods. Industries will not borrow money from banks to invest in capacity expansion because borrowing rates are high.
3. Higher interest rates lead to slowdown in the economy. This leads to increase in unemployment because companies start focusing on cost cutting and reduces hiring. Remember Jet Airways lay off over 1000 employees to save cost.
4. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation.
5. Inflation affects the productivity of companies. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.
Inflation Targeting
There are various ways of controlling inflation in an economy. I will discuss two main ways of doing so:
Monetary Policy
The most important and commonly used method is monetary policy. Most central banks use high interest rates and slow growth of the money supply as the traditional ways to fight or prevent inflation. RBI raised CRR, Repo rate and Reverse repo rate to reduce money supply in the economy to fight inflation which was hovering in double digit. High interest rates make borrowing expensive and hence, people as well as corporate borrow less money from banks. This reduced the demand for goods and services such as real estate, automobiles and others.
Fixed Interest Rate
As we know high inflation reduced the value of money. A number of smaller countries who do not have sophisticated banking system rely on tying their currency with that of a developed country. Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-à-vis the currency it is pegged to.
Government Measures
Apart from these two broad methods, government takes some protectionist measures as well to fight inflation. Government may ban export of essential items such as pulses, cereals and oils to support the domestic consumption and hence reduced their prices. Also, government may lower duties on the import of similar items which are having less supply in the economy.
Positive side of inflation
You may be wondering how come inflation is good for economy. A little bit of inflation is not a bad thing. It implies the possibility of higher prices and profits in the future. To the worker, a little bit of inflation may imply rising wages in the future. What I am trying to say is that they are based more on “psychology” than “economics”.
In the next article, I will analyze the inflation situation in India last year, its causes and method adopted by RBI to control it.
Source: http://www.indianmoney.com/article-display.php?cat_id=2&sub_id=21&aid=108&ahead=Inflation%2520-%2520its%2520causes%2520and%2520effects%2520on%2520the%2520economy
When I was a kid my grandparents used to tell me – “Son, in our time we use to take money (paisa) in pockets and carry goods to home in bags. But in your age you will carry money (rupees) in bags and carry goods to home in your pocket”. He was so right! This is inflation –which reduces the purchasing power of common man.
Measuring Inflation
In major economies, inflation is measured by CPI, which is Consumer Price Index. CPI is a measure of the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation. Two basic types of data are needed to construct the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled periods from a sample of households.
In other words, Inflation is calculated as percentage change in CPI in two periods. Hence,
Inflation (%) = (CPI2- CPI1)*100/CPI1
Where, CPI1 = CPI in the previous period and CPI2 = CPI in the current period
India uses a different price index called the Wholesale Price Index (WPI) to calculate the rate of inflation in our economy. It is quite similar to Consumer Price Index, but uses whole sale prices instead of retail consumer prices. WPI is the index used to measure changes in the average price levels in the wholesale market. Data on 435 commodities is tracked through WPI, in India, which is an indicator of movement in prices. I share the common view of other economists who believe WPI, as a measure of inflation, is flawed. India should switch to CPI, which has been adopted by most developed countries.
There are several other ways of measuring inflation as well. They are GDP price deflator, Producer Price Indices and Commodity Price Indices. However, they are not commonly used.
Flaws of WPI
Former RBI governor once explained why India does not use CPI as a measure of inflation. The CPI data is not released as frequently as WPI data. WPI data is released almost weekly and sometimes at most biweekly, where as CPI data is released once in a month. There is also a lot of lag in collating all the CPI data. There is another problem with the CPI data in India. We don’t have a single CPI data, but four different CPI figures relating to agriculture goods, urban manual labor and non-urban labor etc. There is no discipline in when these different figures are released and with what frequency. So government of India has a genuine reason in not going for CPI based inflation.
WPI based calculation is full of flaws. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. The WPI that was constituted in 1993-94 has virtually remained unchanged since then, and it has lost quite a bit of its relevance while calculating inflation. Some of the WPI commodities include coarse grains that go into making of livestock feed but they continue to be considered while measuring inflation. The sole reason why many unimportant commodities continue to remain included is possibly because data on their prices was available!
Causes of Inflation
Let’s get back to our discussion on the fundamentals of inflation. Economists believe that inflation is a monetary phenomenon. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.
1. Over-expansion of money supply i.e. excess liquidity in the economy leads to inflation because “too many money would be chasing too few goods”.
2. Expansion of Bank Credit Rapid expansion of bank credit is also responsible for the inflationary trend in a country.
3. Deficit Financing: The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.
4. A high population growth leads to increase in demand and money income and cause a high price rise.
5. Excessive increase in the price of fuel or food products due to political, economic or natural reasons will lead to inflation for short- as well as long-term.
For example – We all remember that price of crude went up from $50 to $140 within two years. Almost every industry including agriculture, transportation and manufacturing depends on crude for its operation. Any excessive increase in the price of crude leads to increase in cost of good and services i.e. inflation.
Another example – China and India consist of almost 34% of the world’s population. As the economy in these two countries are growing at a rate of over 9%, people are consuming more and more goods due to increased income and better life. Demand for those goods and services has led to a high inflationary environment in these countries.
States of Inflation
There are different states of inflation which is characterized based on its value as well as variation from the previous value.
1. Hyperinflation – It is a very high rate of inflation, usually a rate in excess of 50%. History has some excellent examples of hyperinflation. In Germany, inflation exceeded 1 million % in 1923. It was said that a horse cart full of money would not buy even a newspaper. Right now, Zimbabwe is having an inflation of 1 million %. They have to issue currency of $500 Million dollar (I am not kidding!!) which could only buy a lunch at McDonalds.
2. Deflation – It is the decrease in the general price level of goods and services only when annual inflation is below 0% resulting in the real value of money. Hence, it is sometimes called “negative inflation”. Japan suffered from deflation for almost a decade in 1990s. To control recession and Central Bank of Japan was forced to have a negative interest rate on deposit for over a decade.
3. Disinflation – It refers to a time when the rate of change of prices is falling while the inflation rate is positive. For example – if the inflation rate comes down from 3% to 2%, we would say it is disinflation. In India, we have a disinflation because inflation has come down from a high of 13% to 6% and it is still dropping.
4. Stagflation – It is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. Stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.
Effects of Inflation on economy
As we know Inflation is the increase in the price of general goods and service. Thus, food, commodities and other services become expensive for consumption. Inflation can cause both short-term and long-term damages to the economy; most importantly it causes slow down in the economy.
1. People start consuming or buying less of these goods and services as their income is limited. This leads to slowdown not only in consumption but also production. This is because manufactures will produce fewer goods due to high costs and anticipated lower demand.
2. Banks will increase interest rates as inflation increases otherwise real interest rate will be negative. (Real interest ~ Nominal interest rate – inflation). This makes borrowing costly for both consumers and corporate. Thus people will buy fewer automobiles, houses and other goods. Industries will not borrow money from banks to invest in capacity expansion because borrowing rates are high.
3. Higher interest rates lead to slowdown in the economy. This leads to increase in unemployment because companies start focusing on cost cutting and reduces hiring. Remember Jet Airways lay off over 1000 employees to save cost.
4. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation.
5. Inflation affects the productivity of companies. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.
Inflation Targeting
There are various ways of controlling inflation in an economy. I will discuss two main ways of doing so:
Monetary Policy
The most important and commonly used method is monetary policy. Most central banks use high interest rates and slow growth of the money supply as the traditional ways to fight or prevent inflation. RBI raised CRR, Repo rate and Reverse repo rate to reduce money supply in the economy to fight inflation which was hovering in double digit. High interest rates make borrowing expensive and hence, people as well as corporate borrow less money from banks. This reduced the demand for goods and services such as real estate, automobiles and others.
Fixed Interest Rate
As we know high inflation reduced the value of money. A number of smaller countries who do not have sophisticated banking system rely on tying their currency with that of a developed country. Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-à-vis the currency it is pegged to.
Government Measures
Apart from these two broad methods, government takes some protectionist measures as well to fight inflation. Government may ban export of essential items such as pulses, cereals and oils to support the domestic consumption and hence reduced their prices. Also, government may lower duties on the import of similar items which are having less supply in the economy.
Positive side of inflation
You may be wondering how come inflation is good for economy. A little bit of inflation is not a bad thing. It implies the possibility of higher prices and profits in the future. To the worker, a little bit of inflation may imply rising wages in the future. What I am trying to say is that they are based more on “psychology” than “economics”.
In the next article, I will analyze the inflation situation in India last year, its causes and method adopted by RBI to control it.
Source: http://www.indianmoney.com/article-display.php?cat_id=2&sub_id=21&aid=108&ahead=Inflation%2520-%2520its%2520causes%2520and%2520effects%2520on%2520the%2520economy
Resident Foreign Currency Accounts
Residents with foreign currency can open these accounts. These include people like export earners, non residents on their becoming residents, those returning to the country with foreign exchange after a business trip or holiday and foreigners.
Different Types of Resident Foreign Currency Accounts:
Different types of accounts that can be opened in foreign currency are given below:
1. Resident Foreign Currency Accounts (RFC)
2. Exchange Earners Foreign Currency Account (EEFC)
3. Resident Foreign Currency (Domestic) Account
4. Resident Foreign Currency (External) Account
5. Resident Foreign National’s account
6. Diamond Dollar Account.
1. Resident Foreign Currency Accounts (RFC)
These accounts can be opened by a person of Indian nationality or Indian origin, who has returned to India for permanent settlement or persons inheriting assets abroad from persons who acquired such assets while being a non- resident.
The account can be opened in any foreign currency excluding the currency of Nepal or Bhutan.
Persons who have been residing outside India for a continuous period of more than one year (exclusive of short visits for personal reasons) who return to India for permanent settlement should change the status of their NRO/NRE Account from non-resident to resident and inform the bank of the change in status. Such persons should close NRE and FCNR (B) deposit accounts on maturity. The proceeds can be transferred either partly or completely to an RFC account.
Features of Resident Foreign Currency Accounts
· RFC account can be current, savings or fixed deposit account.
· The term of fixed deposits are ranging from 30 days to 6 months.
· Cheque facility is not available for RFC current accounts.
· Balance held in a RFC account is repatriable for a bona fide purpose, without the prior permission of RBI.
· A RFC account is free from all restrictions concerning utilization including any restrictions on investments outside India.
· Interest earned on the balance in this account is free of tax for 2 years from the date of return to India.
· The account can be operated jointly or individually.
· Nomination facility is available in RFC account. If the account holder dies and the nominee is abroad, the balance in the account can be repatriated to him/ her.
· Loans can be granted against the balances lying in the account subject to commercial judgment.
Deposits that can be credited to the RFC account are:
· Remittances from abroad representing funds in bank accounts outside India, income such as dividend, interest, profit, rent, etc. earned on eligible assets held abroad and from the sale proceeds of eligible assets.
· Pension and other monetary benefits received from abroad arising out of employment taken up outside India prior to return to India.
· Interest earned on RFC Accounts.
· Foreign currency notes/ traveler’s cheques brought by returning non-residents.
· Balances in non-resident external accounts and foreign currency non-resident accounts.
· Earnings of insurance claims/ maturity value or surrender value of insurance policies taken by the holder when he was a non-resident and settled in foreign currency. It can include policies issued by insurance companies in India. But they should be registered with IRDA to conduct insurance business.
Funds in an RFC account are free from all restrictions regarding utilization. The funds can even be used for making investments outside India.
2. Exchange Earners Foreign Currency Account (EEFC)
A person resident in India can open, hold and maintain EEFC accounts; the account will be maintained only in the form of non-interest bearing current account. Credit facilities such as fund-based or non-fund based, are not permitted against the security of balances held in the account.
The limits of credit facilities to the accounts are given below:
· 100% for Status Holder Exporter (as defined in EXIM Policy)
· 100% for Export Oriented Units, Units in Export Processing Zones (EPZs), Electronic Hardware Technology Park (EHTPs) and Software Technology Park (STP)
· 50% for persons resident in India
Individual professionals are allowed to keep up to 100 per cent of their foreign exchange earnings from consultancy and other services provided to persons or bodies outside India, in their Exchange earners’ foreign currency (EEFC) account. This is for the benefit and convenience of individual professionals, doctors, artists, architects, engineers, consultants, lawyers, chartered accountants, directors on boards of overseas companies, etc. Payments received in foreign exchange by a unit in domestic tariff area (DTA) for supply of goods to a unit in special economic zones (SEZ) out of its foreign exchange currency account may be credited to an EEFC account.
Exporters can avail trade related loans / advances to overseas importers out of their EEFC balances without any upper limit. They can also repay packing credit advances whether availed in rupee or in foreign currency from balances in their EEFC account or rupee resources to the extent exports have actually taken place. Purchase of foreign exchange from the market for refunding advance payments credited to accounts would be allowed only after utilizing the entire balance in the exporter’s EEFC accounts maintained at different banks.
With regard to units in Special Economic Zones (SEZ):
· All foreign exchange funds received by the unit in the SEZ must be credited to this account. This also includes foreign exchange purchased by units in Domestic Tariff Area (DTA) for making payment towards goods supplied by Units in SEZ.
· Foreign exchange purchased in India against rupees will not be credited to the account without the permission of the Reserve Bank
· The funds should represent bona fide transactions of the unit in the SEZ.
· Balances in EEFC accounts sold forward by the account holders shall remain assigned for delivery and such contracts shall not be cancelled.
Investments in overseas joint ventures can be funded out of balances in EEFC accounts. Cheque facilities are available in EEFC account. Exporters are allowed to grant trade related loans/ advances from their EEFC account to overseas exporter or importer clients without any ceiling. Where the amount of loan exceeds US$ 1,00,000, a guarantee of a bank of international status located outside India will be required to be provided by the overseas borrower in favor of the lender. These funds are not to be lent or made available to any person or entity in India. The balances will be credited to NRE/FCNR (B) Account, at the request of the account holders. – Claims settled in rupees by ECGC (Export Credit and Guarantee Corporation of India Ltd) should not be interpreted as export realization in foreign exchange and claim amount must not be credited to the EEFC account. Prior approval of the Reserve Bank (RBI) is not required for remittances made from EEFC accounts for consultancy services received.
3. Resident Foreign Currency (Domestic) Accounts (RFCD)
A person resident in India can open RFCD accounts out of foreign exchange acquired in the form of currency notes, bank notes and traveler’s cheques acquired in the following ways:
· While on a visit to any place outside India by way of payment for services not arising from any business or anything done in India.
· From any person not resident in India and who is on a visit to India, as gift or for services rendered or in settlement of any lawful obligation.
· By way of gift or honorarium while on a visit to any place outside India.
· The unspent amount of foreign exchange obtained from an authorized person for travel abroad.
· The proceeds of life insurance policy claims/maturity/surrender values settled in foreign currency from an insurance company in India permitted to undertake life insurance business.
· Being gifts received from close relatives.
These types of accounts are current accounts and will earn no interest. There are no maximum to the balance that may be held in these accounts. Balances in the RFCD accounts may be credited to NRE/FCNR (B) Account, at the request of the account holders consequent upon change in their residential status from resident to non-resident.
4. Resident Foreign Currency (External) Account (RFCE)
A firm or company incorporated in India can open, hold and maintain a foreign currency account outside India by making remittances from India for the purpose of regular business operations of a branch office or a representative there. Indian companies or individuals carrying out turnkey projects or civil construction contract may also be able to open foreign currency accounts abroad. A national of another country living in India and working for a foreign company on delegation in India or a citizen of India employed by a foreign company outside India on deputation in India may open, hold and maintain a foreign currency account (RFCE) with a bank outside India and receive the salary payable to him for services rendered in India, by credit to such account provided that:
· The amount to be credited to such account should not exceed 75 percent of the salary accrued to or received by such person from the foreign company
· The outstanding salary is paid in rupees in India
· Income tax paid on the entire salary in India.
The surplus funds held in this account must not be invested abroad without prior permission of the RBI and any funds rendered surplus should be send back to India.
Information / statements to be submitted:
· Account number, name of bank, place and country where the account is opened within 15 days from the date of opening the account
· Statement of operation on the account on half yearly basis
· Bank certificates confirming the amount repatriated periodically
Closure of foreign currency (RFCE) account with bank certificates evidencing transfer of balance to India immediately on completion of the relevant contract. A liberalized remittance scheme of US$ 25000 for resident individuals per calendar year for any purpose has been introduced. Resident individuals are permitted to open, maintain and hold foreign currency accounts with a bank outside India without the prior approval of the RBI for the purpose of making remittances under the scheme.
5. Resident Foreign Nationals account
Branches of foreign firms in India and foreign nationals resident in India (not permanently resident in India) are permitted to open such bank accounts. But care should be taken that the foreign currency is not given to residents. No rupee loans can be given under this account except personal loans, this may be up to Rs.5 lakhs.
Diplomatic personnel, Diplomatic missions and non-diplomatic staff of foreign embassies, who are nationals of the concerned foreign countries and holding official passport, can maintain foreign currency deposit accounts.
6. Diamond Dollar Account (DDA)
Diamond dollar accounts (DDA) can be opened by firms and companies dealing in purchase/sale of rough, cut or polished diamonds / diamond studded jewelry. They must have a track record of at least three years in import or export of diamonds and an average annual turnover of Rs. 5,00,00,000 or above during preceding three licensing years (from April to March)
Nevertheless not more than five Diamond Dollar Accounts can be opened with banks. Under the Diamond Dollar Account (DDA) Scheme, it would be in order for banks to liquidate PCFC granted to a DDA holder by dollar proceeds from sale of rough, cut and/ or polished diamonds by him to another DDA holder.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=16&aid=216&acat=&ahead=Resident%2520Foreign%2520Currency%2520Accounts
Different Types of Resident Foreign Currency Accounts:
Different types of accounts that can be opened in foreign currency are given below:
1. Resident Foreign Currency Accounts (RFC)
2. Exchange Earners Foreign Currency Account (EEFC)
3. Resident Foreign Currency (Domestic) Account
4. Resident Foreign Currency (External) Account
5. Resident Foreign National’s account
6. Diamond Dollar Account.
1. Resident Foreign Currency Accounts (RFC)
These accounts can be opened by a person of Indian nationality or Indian origin, who has returned to India for permanent settlement or persons inheriting assets abroad from persons who acquired such assets while being a non- resident.
The account can be opened in any foreign currency excluding the currency of Nepal or Bhutan.
Persons who have been residing outside India for a continuous period of more than one year (exclusive of short visits for personal reasons) who return to India for permanent settlement should change the status of their NRO/NRE Account from non-resident to resident and inform the bank of the change in status. Such persons should close NRE and FCNR (B) deposit accounts on maturity. The proceeds can be transferred either partly or completely to an RFC account.
Features of Resident Foreign Currency Accounts
· RFC account can be current, savings or fixed deposit account.
· The term of fixed deposits are ranging from 30 days to 6 months.
· Cheque facility is not available for RFC current accounts.
· Balance held in a RFC account is repatriable for a bona fide purpose, without the prior permission of RBI.
· A RFC account is free from all restrictions concerning utilization including any restrictions on investments outside India.
· Interest earned on the balance in this account is free of tax for 2 years from the date of return to India.
· The account can be operated jointly or individually.
· Nomination facility is available in RFC account. If the account holder dies and the nominee is abroad, the balance in the account can be repatriated to him/ her.
· Loans can be granted against the balances lying in the account subject to commercial judgment.
Deposits that can be credited to the RFC account are:
· Remittances from abroad representing funds in bank accounts outside India, income such as dividend, interest, profit, rent, etc. earned on eligible assets held abroad and from the sale proceeds of eligible assets.
· Pension and other monetary benefits received from abroad arising out of employment taken up outside India prior to return to India.
· Interest earned on RFC Accounts.
· Foreign currency notes/ traveler’s cheques brought by returning non-residents.
· Balances in non-resident external accounts and foreign currency non-resident accounts.
· Earnings of insurance claims/ maturity value or surrender value of insurance policies taken by the holder when he was a non-resident and settled in foreign currency. It can include policies issued by insurance companies in India. But they should be registered with IRDA to conduct insurance business.
Funds in an RFC account are free from all restrictions regarding utilization. The funds can even be used for making investments outside India.
2. Exchange Earners Foreign Currency Account (EEFC)
A person resident in India can open, hold and maintain EEFC accounts; the account will be maintained only in the form of non-interest bearing current account. Credit facilities such as fund-based or non-fund based, are not permitted against the security of balances held in the account.
The limits of credit facilities to the accounts are given below:
· 100% for Status Holder Exporter (as defined in EXIM Policy)
· 100% for Export Oriented Units, Units in Export Processing Zones (EPZs), Electronic Hardware Technology Park (EHTPs) and Software Technology Park (STP)
· 50% for persons resident in India
Individual professionals are allowed to keep up to 100 per cent of their foreign exchange earnings from consultancy and other services provided to persons or bodies outside India, in their Exchange earners’ foreign currency (EEFC) account. This is for the benefit and convenience of individual professionals, doctors, artists, architects, engineers, consultants, lawyers, chartered accountants, directors on boards of overseas companies, etc. Payments received in foreign exchange by a unit in domestic tariff area (DTA) for supply of goods to a unit in special economic zones (SEZ) out of its foreign exchange currency account may be credited to an EEFC account.
Exporters can avail trade related loans / advances to overseas importers out of their EEFC balances without any upper limit. They can also repay packing credit advances whether availed in rupee or in foreign currency from balances in their EEFC account or rupee resources to the extent exports have actually taken place. Purchase of foreign exchange from the market for refunding advance payments credited to accounts would be allowed only after utilizing the entire balance in the exporter’s EEFC accounts maintained at different banks.
With regard to units in Special Economic Zones (SEZ):
· All foreign exchange funds received by the unit in the SEZ must be credited to this account. This also includes foreign exchange purchased by units in Domestic Tariff Area (DTA) for making payment towards goods supplied by Units in SEZ.
· Foreign exchange purchased in India against rupees will not be credited to the account without the permission of the Reserve Bank
· The funds should represent bona fide transactions of the unit in the SEZ.
· Balances in EEFC accounts sold forward by the account holders shall remain assigned for delivery and such contracts shall not be cancelled.
Investments in overseas joint ventures can be funded out of balances in EEFC accounts. Cheque facilities are available in EEFC account. Exporters are allowed to grant trade related loans/ advances from their EEFC account to overseas exporter or importer clients without any ceiling. Where the amount of loan exceeds US$ 1,00,000, a guarantee of a bank of international status located outside India will be required to be provided by the overseas borrower in favor of the lender. These funds are not to be lent or made available to any person or entity in India. The balances will be credited to NRE/FCNR (B) Account, at the request of the account holders. – Claims settled in rupees by ECGC (Export Credit and Guarantee Corporation of India Ltd) should not be interpreted as export realization in foreign exchange and claim amount must not be credited to the EEFC account. Prior approval of the Reserve Bank (RBI) is not required for remittances made from EEFC accounts for consultancy services received.
3. Resident Foreign Currency (Domestic) Accounts (RFCD)
A person resident in India can open RFCD accounts out of foreign exchange acquired in the form of currency notes, bank notes and traveler’s cheques acquired in the following ways:
· While on a visit to any place outside India by way of payment for services not arising from any business or anything done in India.
· From any person not resident in India and who is on a visit to India, as gift or for services rendered or in settlement of any lawful obligation.
· By way of gift or honorarium while on a visit to any place outside India.
· The unspent amount of foreign exchange obtained from an authorized person for travel abroad.
· The proceeds of life insurance policy claims/maturity/surrender values settled in foreign currency from an insurance company in India permitted to undertake life insurance business.
· Being gifts received from close relatives.
These types of accounts are current accounts and will earn no interest. There are no maximum to the balance that may be held in these accounts. Balances in the RFCD accounts may be credited to NRE/FCNR (B) Account, at the request of the account holders consequent upon change in their residential status from resident to non-resident.
4. Resident Foreign Currency (External) Account (RFCE)
A firm or company incorporated in India can open, hold and maintain a foreign currency account outside India by making remittances from India for the purpose of regular business operations of a branch office or a representative there. Indian companies or individuals carrying out turnkey projects or civil construction contract may also be able to open foreign currency accounts abroad. A national of another country living in India and working for a foreign company on delegation in India or a citizen of India employed by a foreign company outside India on deputation in India may open, hold and maintain a foreign currency account (RFCE) with a bank outside India and receive the salary payable to him for services rendered in India, by credit to such account provided that:
· The amount to be credited to such account should not exceed 75 percent of the salary accrued to or received by such person from the foreign company
· The outstanding salary is paid in rupees in India
· Income tax paid on the entire salary in India.
The surplus funds held in this account must not be invested abroad without prior permission of the RBI and any funds rendered surplus should be send back to India.
Information / statements to be submitted:
· Account number, name of bank, place and country where the account is opened within 15 days from the date of opening the account
· Statement of operation on the account on half yearly basis
· Bank certificates confirming the amount repatriated periodically
Closure of foreign currency (RFCE) account with bank certificates evidencing transfer of balance to India immediately on completion of the relevant contract. A liberalized remittance scheme of US$ 25000 for resident individuals per calendar year for any purpose has been introduced. Resident individuals are permitted to open, maintain and hold foreign currency accounts with a bank outside India without the prior approval of the RBI for the purpose of making remittances under the scheme.
5. Resident Foreign Nationals account
Branches of foreign firms in India and foreign nationals resident in India (not permanently resident in India) are permitted to open such bank accounts. But care should be taken that the foreign currency is not given to residents. No rupee loans can be given under this account except personal loans, this may be up to Rs.5 lakhs.
Diplomatic personnel, Diplomatic missions and non-diplomatic staff of foreign embassies, who are nationals of the concerned foreign countries and holding official passport, can maintain foreign currency deposit accounts.
6. Diamond Dollar Account (DDA)
Diamond dollar accounts (DDA) can be opened by firms and companies dealing in purchase/sale of rough, cut or polished diamonds / diamond studded jewelry. They must have a track record of at least three years in import or export of diamonds and an average annual turnover of Rs. 5,00,00,000 or above during preceding three licensing years (from April to March)
Nevertheless not more than five Diamond Dollar Accounts can be opened with banks. Under the Diamond Dollar Account (DDA) Scheme, it would be in order for banks to liquidate PCFC granted to a DDA holder by dollar proceeds from sale of rough, cut and/ or polished diamonds by him to another DDA holder.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=16&aid=216&acat=&ahead=Resident%2520Foreign%2520Currency%2520Accounts
Are we going to face problems of deflation?
Nowadays we keep on reading that global economies such as US and Europe will face severe problems of deflation due to recession. Fed fund rate in the US is between 0.00-0.25% or 25 bp (100 basis point = 1%). Inflation in these countries is close to 0. With the falling interest rates in India will we too face similar situation?
Deflation is a “sustained” fall in the general price level of goods and service below zero percent inflation. It results in an increase in the real value of money — a negative inflation rate. It is just opposite of inflation, which is the general increase in the price level of goods and services. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation. Disinflation is a substantial drop in the rate of increase of the price level. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices.
Inflation destroys real value in money whereas Deflation creates real value in money.
Real Price ~ Nominal Price –Inflation
With the passage of time, the “real price” of any good or service is characterized by above equation. Hence, if it is positive inflation or normal inflation, real price decreases over a period of time. However, if inflation is negative i.e. deflation, real price increases with time. Alternatively, the term deflation was used by the classical economists to refer to a decrease in the money supply and credit.
Causes of deflation
1. Deflation is caused by the fall in aggregate level of demand i.e. there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral. (As we can currently see that buyers believe real estate prices will fall further, thus delaying their purchase decisions. This in turn has reduced the demand for the real estate properties which in turn has reduced the construction activities. Thus, general economic activities such as cement production etc are down.)
As demand and economic activity falls, investments fall as well because corporate do not want to invest in increasing capacity as there is no demand. This leads to further reduction in aggregate demand. This is the deflationary spiral i.e. a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand such as reducing interest rates or giving money to corporate or people at significantly lower rates.
2. In monetarist theory, deflation is related to a sustained reduction in the velocity of money (It is the average frequency with which a unit of money is spent in a specific period of time. Velocity affects the amount of economic activity associated with a given money supply) or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement. In the present scenario it appears to be one of the prime reasons for growing fears of deflation.
3. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.
4. Deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply.
Indian scenario – Last few years we saw massive boom in all the sectors. There were huge demands for real estate properties, IT services, Cements, Food products etc. Our economy was growing in excess of 9% and mood was upbeat. Everybody thought this growth will continue forever. Hence, corporate invested heavily in building capacity, developers invested billions of dollars in launching new projects etc. Suddenly the boom busted due to financial crisis. People lost jobs, interest rates went up through the roof and demand plunged. There was a huge mismatch between supply (more) and demand(less). This led to price correction - real estate saw over 40% drop in prices, commodities went down by over 70% and so on. Moreover, due to global financial crisis, there is acute shortage of liquidity in the market and hence less flow of money in the economy. People are holding back to their investments as well as consumption; thus, reducing velocity of money. Does it sound like symptoms of deflation?
Effects of deflation
1. Deflation leads to decrease in prices of good and services, increasing value of money. While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property.
2. Deflation raises real wages, which are both difficult and costly for management to lower. Moreover, falling prices and demand discourages corporations from investing. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment.
3. Deflation often follows a period of nearly zero interest rates. When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.
Why deflation is bad?
While shoppers see falling prices as a good sign, economists see it as a threat to the economy or nation. Deflation hurts the economy much more than inflation. In fact a small positive inflation is good for the economy because it suggests growing demand as well as healthy economy. However, in deflationary conditions consumers postpone expenditure, because they think prices will decrease further. This decreases demand in the economy which badly affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.
We will now take a look at the most infamous deflation in the history of modern world.
Deflation in Japan
Deflation in Japan started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended. There were several reasons for deflation in Japan which are explained below:
1. Bust of Asset price bubble: There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
2. Insolvent companies: During the boom time (1980s) Japanese banks lent aggressively to companies and individuals that invested in real estate. However, when real estate values dropped, people were not able to pay back these loans to banks. The banks tried to collect the collateral (land or properties), but this wouldn't pay off the loan because their prices had fallen significantly. Banks delayed their decision to foreclose these loans hoping asset prices would improve. These delays were also allowed by national banking regulators. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law were suggested by leading economists as methods to speed this process and thus end the deflation.
3. Insolvent banks: Japanese banks had a larger percentage of their loans as "non-performing" i.e. they were not receiving any interest payments on them, but have not yet written them off. With high non-performing loans or assets, they were unable to lend more money; thus, their earnings declined significantly and risk of insolvency increased many a fold.
4. Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products were decreasing with the rise of economy of scale in China. Domestic producers had to lower their prices in order to remain competitive. This decreasing in prices of domestic products over a period of time led to deflation.
5. Fear of insolvent banks: Japanese people were afraid that banks might collapse so they preferred to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in local bank accounts. Thus less money was available for lending and therefore economic growth. This meant that the savings rate depresses consumption, but did not appear in the economy in an efficient form to spur new investment.
Deflation alarms in the US?
With the fed fund rate at a historic low (0.00-0.25%), there is a growing fear of deflation in the US. Many economists believe that USA could face short term period of deflation. With the bust of housing bubble, acute shortage of credit and falling consumption, USA has more or less similar conditions that were prevalent in Japan in early 1990s. However, I believe there are some basic yet crucial differences.
Firstly, Japanese companies were far more dependent on commercial banks for financing than are today's U.S. multinationals, which have stockpiles of internal capital as well as broader access to capital markets. Moreover, US Treasuries are still considered as the safest investments in the world. This keeps the flow of money into the US economy.
Secondly, Bank of Japan’s exceptionally poor monetary policymaking was a big reason for the country's protracted problem. The central bank's failure to lower interest rates in the early 1990s ultimately drove the economy into a deflationary death spiral. They were just too slow and conservative to react to the situation. However, US Fed has been quite aggressive and proactive in taking sound monetary decisions and ensuring that they do not repeat those mistakes. In 1992, for example, amid negligible inflation and a comatose economy, the Bank of Japan's key interest rate was still nearly 4%. In contrast, after the tech bubble burst in the USA, the Fed quickly slashed its benchmark rate to 1 %. Also, the current fed rate is between 0.00-0.25%.
Thirdly, though both USA and Japan faced housing trouble and mortgage crisis, Japan's central bank was too slow to act. The country's banks hid their bad loans beneath opaque corporate structures rather than absorb the losses. But rather than write off the loans, Japanese banks extended additional credit to borrowers, allowing them to at least make minimal interest payments. Those made banks look healthier than they were, at the cost of impairing the flow of credit to new businesses. However, American banks have been forthcoming in absorbing the losses on their books and writing off loans. This has given fed a clear picture of true losses and subprime crisis in the economy.
Having said that I believe the US economy may bleed for some time and enter a period of deflation. However, that period would be short lived and not as prolonged as that of Japanese economy in 1990s. As per an estimate, avoiding a long period of deflation and recession might cost the US a staggering $3 Trillion.
Will India face deflation?
Let’s examine Indian economy vis-à-vis Japanese economy of 1990s. In the last five years BSE exchange went up from 5,000 to 21,000, an increase of 400% while real estate prices in Indian witnessed an increase of over 300%. This is phenomenal increase in prices and asset prices looked highly inflated. After the global financial crisis, Indian stock exchange plunged by over 60% and real estate values dropped by almost 30-40% in less than six months. Some welcomed this fall while majority believed Indian global dream is finally over. The mayhem still continues with stock prices and real estate prices further going down.
Compare this with that of Japan - In the five years before its 1989 peak, the Nikkei (Japanese stock exchange) stock average rose 275%. Property prices became so inflated that the tiny spit of land surrounding the Imperial Palace in central Tokyo was briefly worth more than the entire state of California. At the time, Japan's seemingly unstoppable rise inflamed fears among Americans that the United States had slipped into permanent economic inferiority. When the bubble finally busted in late 1989, stock and property prices nose-dived in tandem. In less than three years, the Nikkei stock average fell 63% from its peak of 38,916. It didn't hit bottom until April 2003 and a total decline of 80%. Do these two stories sound similar? Yeah they do!
Inflation figures for the last week was 3.92% which is far less than the peak rate of 12% less than six months back. Are we going into a period of negative inflation or deflation? We are currently in a state of disinflation which is a decreasing value of inflation as the inflation rate is still positive. However, this may lead to a situation where downward price movement continues and we enter a period of deflation. I believe this is highly unlikely because we are a growing economy with very young population. Moreover, we are not an export oriented economy and hence do not depend too much on external demand. Our economy is mostly driven by domestic demand and consumption, which is somewhat insulated from other countries and global events. We still have lot of room to maneuver our policies to regenerate demand and spending. Yet, with the growing globalization we too run a risk of deflation if our monetary and fiscal policies are not handled well.
How deflation can be avoided?
To counter deflation we have to revitalize our growth story, reignite demand and create confidence among people. Compare to the inflation rate, 3.92%, lending rates in India are still close to 10%, which is quite high. Unless lending rates do not come down people won’t buy properties, automobiles or other consumer goods. Moreover, corporate won’t be able to borrow money to launch new innovative projects, spend on infrastructure or build capacity. Thus, to create demand and investments, government as well as RBI has to bring down this lending rate by implementing ways to reduce cost of borrowing funds.
Hence, only monetary policy won’t be sufficient to tackle this menace; fiscal policy too has to play a significant role here. Government has to be more aggressive in implementing reforms and speeding up infrastructure spending. Let us hope better sense will prevail among our political class.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=113&aid=248&acat=&ahead=Are%2520we%2520going%2520to%2520face%2520problems%2520of%2520deflation%3f
Deflation is a “sustained” fall in the general price level of goods and service below zero percent inflation. It results in an increase in the real value of money — a negative inflation rate. It is just opposite of inflation, which is the general increase in the price level of goods and services. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation. Disinflation is a substantial drop in the rate of increase of the price level. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices.
Inflation destroys real value in money whereas Deflation creates real value in money.
Real Price ~ Nominal Price –Inflation
With the passage of time, the “real price” of any good or service is characterized by above equation. Hence, if it is positive inflation or normal inflation, real price decreases over a period of time. However, if inflation is negative i.e. deflation, real price increases with time. Alternatively, the term deflation was used by the classical economists to refer to a decrease in the money supply and credit.
Causes of deflation
1. Deflation is caused by the fall in aggregate level of demand i.e. there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral. (As we can currently see that buyers believe real estate prices will fall further, thus delaying their purchase decisions. This in turn has reduced the demand for the real estate properties which in turn has reduced the construction activities. Thus, general economic activities such as cement production etc are down.)
As demand and economic activity falls, investments fall as well because corporate do not want to invest in increasing capacity as there is no demand. This leads to further reduction in aggregate demand. This is the deflationary spiral i.e. a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand such as reducing interest rates or giving money to corporate or people at significantly lower rates.
2. In monetarist theory, deflation is related to a sustained reduction in the velocity of money (It is the average frequency with which a unit of money is spent in a specific period of time. Velocity affects the amount of economic activity associated with a given money supply) or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement. In the present scenario it appears to be one of the prime reasons for growing fears of deflation.
3. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.
4. Deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply.
Indian scenario – Last few years we saw massive boom in all the sectors. There were huge demands for real estate properties, IT services, Cements, Food products etc. Our economy was growing in excess of 9% and mood was upbeat. Everybody thought this growth will continue forever. Hence, corporate invested heavily in building capacity, developers invested billions of dollars in launching new projects etc. Suddenly the boom busted due to financial crisis. People lost jobs, interest rates went up through the roof and demand plunged. There was a huge mismatch between supply (more) and demand(less). This led to price correction - real estate saw over 40% drop in prices, commodities went down by over 70% and so on. Moreover, due to global financial crisis, there is acute shortage of liquidity in the market and hence less flow of money in the economy. People are holding back to their investments as well as consumption; thus, reducing velocity of money. Does it sound like symptoms of deflation?
Effects of deflation
1. Deflation leads to decrease in prices of good and services, increasing value of money. While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property.
2. Deflation raises real wages, which are both difficult and costly for management to lower. Moreover, falling prices and demand discourages corporations from investing. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment.
3. Deflation often follows a period of nearly zero interest rates. When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.
Why deflation is bad?
While shoppers see falling prices as a good sign, economists see it as a threat to the economy or nation. Deflation hurts the economy much more than inflation. In fact a small positive inflation is good for the economy because it suggests growing demand as well as healthy economy. However, in deflationary conditions consumers postpone expenditure, because they think prices will decrease further. This decreases demand in the economy which badly affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.
We will now take a look at the most infamous deflation in the history of modern world.
Deflation in Japan
Deflation in Japan started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended. There were several reasons for deflation in Japan which are explained below:
1. Bust of Asset price bubble: There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
2. Insolvent companies: During the boom time (1980s) Japanese banks lent aggressively to companies and individuals that invested in real estate. However, when real estate values dropped, people were not able to pay back these loans to banks. The banks tried to collect the collateral (land or properties), but this wouldn't pay off the loan because their prices had fallen significantly. Banks delayed their decision to foreclose these loans hoping asset prices would improve. These delays were also allowed by national banking regulators. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law were suggested by leading economists as methods to speed this process and thus end the deflation.
3. Insolvent banks: Japanese banks had a larger percentage of their loans as "non-performing" i.e. they were not receiving any interest payments on them, but have not yet written them off. With high non-performing loans or assets, they were unable to lend more money; thus, their earnings declined significantly and risk of insolvency increased many a fold.
4. Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products were decreasing with the rise of economy of scale in China. Domestic producers had to lower their prices in order to remain competitive. This decreasing in prices of domestic products over a period of time led to deflation.
5. Fear of insolvent banks: Japanese people were afraid that banks might collapse so they preferred to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in local bank accounts. Thus less money was available for lending and therefore economic growth. This meant that the savings rate depresses consumption, but did not appear in the economy in an efficient form to spur new investment.
Deflation alarms in the US?
With the fed fund rate at a historic low (0.00-0.25%), there is a growing fear of deflation in the US. Many economists believe that USA could face short term period of deflation. With the bust of housing bubble, acute shortage of credit and falling consumption, USA has more or less similar conditions that were prevalent in Japan in early 1990s. However, I believe there are some basic yet crucial differences.
Firstly, Japanese companies were far more dependent on commercial banks for financing than are today's U.S. multinationals, which have stockpiles of internal capital as well as broader access to capital markets. Moreover, US Treasuries are still considered as the safest investments in the world. This keeps the flow of money into the US economy.
Secondly, Bank of Japan’s exceptionally poor monetary policymaking was a big reason for the country's protracted problem. The central bank's failure to lower interest rates in the early 1990s ultimately drove the economy into a deflationary death spiral. They were just too slow and conservative to react to the situation. However, US Fed has been quite aggressive and proactive in taking sound monetary decisions and ensuring that they do not repeat those mistakes. In 1992, for example, amid negligible inflation and a comatose economy, the Bank of Japan's key interest rate was still nearly 4%. In contrast, after the tech bubble burst in the USA, the Fed quickly slashed its benchmark rate to 1 %. Also, the current fed rate is between 0.00-0.25%.
Thirdly, though both USA and Japan faced housing trouble and mortgage crisis, Japan's central bank was too slow to act. The country's banks hid their bad loans beneath opaque corporate structures rather than absorb the losses. But rather than write off the loans, Japanese banks extended additional credit to borrowers, allowing them to at least make minimal interest payments. Those made banks look healthier than they were, at the cost of impairing the flow of credit to new businesses. However, American banks have been forthcoming in absorbing the losses on their books and writing off loans. This has given fed a clear picture of true losses and subprime crisis in the economy.
Having said that I believe the US economy may bleed for some time and enter a period of deflation. However, that period would be short lived and not as prolonged as that of Japanese economy in 1990s. As per an estimate, avoiding a long period of deflation and recession might cost the US a staggering $3 Trillion.
Will India face deflation?
Let’s examine Indian economy vis-à-vis Japanese economy of 1990s. In the last five years BSE exchange went up from 5,000 to 21,000, an increase of 400% while real estate prices in Indian witnessed an increase of over 300%. This is phenomenal increase in prices and asset prices looked highly inflated. After the global financial crisis, Indian stock exchange plunged by over 60% and real estate values dropped by almost 30-40% in less than six months. Some welcomed this fall while majority believed Indian global dream is finally over. The mayhem still continues with stock prices and real estate prices further going down.
Compare this with that of Japan - In the five years before its 1989 peak, the Nikkei (Japanese stock exchange) stock average rose 275%. Property prices became so inflated that the tiny spit of land surrounding the Imperial Palace in central Tokyo was briefly worth more than the entire state of California. At the time, Japan's seemingly unstoppable rise inflamed fears among Americans that the United States had slipped into permanent economic inferiority. When the bubble finally busted in late 1989, stock and property prices nose-dived in tandem. In less than three years, the Nikkei stock average fell 63% from its peak of 38,916. It didn't hit bottom until April 2003 and a total decline of 80%. Do these two stories sound similar? Yeah they do!
Inflation figures for the last week was 3.92% which is far less than the peak rate of 12% less than six months back. Are we going into a period of negative inflation or deflation? We are currently in a state of disinflation which is a decreasing value of inflation as the inflation rate is still positive. However, this may lead to a situation where downward price movement continues and we enter a period of deflation. I believe this is highly unlikely because we are a growing economy with very young population. Moreover, we are not an export oriented economy and hence do not depend too much on external demand. Our economy is mostly driven by domestic demand and consumption, which is somewhat insulated from other countries and global events. We still have lot of room to maneuver our policies to regenerate demand and spending. Yet, with the growing globalization we too run a risk of deflation if our monetary and fiscal policies are not handled well.
How deflation can be avoided?
To counter deflation we have to revitalize our growth story, reignite demand and create confidence among people. Compare to the inflation rate, 3.92%, lending rates in India are still close to 10%, which is quite high. Unless lending rates do not come down people won’t buy properties, automobiles or other consumer goods. Moreover, corporate won’t be able to borrow money to launch new innovative projects, spend on infrastructure or build capacity. Thus, to create demand and investments, government as well as RBI has to bring down this lending rate by implementing ways to reduce cost of borrowing funds.
Hence, only monetary policy won’t be sufficient to tackle this menace; fiscal policy too has to play a significant role here. Government has to be more aggressive in implementing reforms and speeding up infrastructure spending. Let us hope better sense will prevail among our political class.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=113&aid=248&acat=&ahead=Are%2520we%2520going%2520to%2520face%2520problems%2520of%2520deflation%3f
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