September 2013 – Page 2

Sources of India’s Foreign Exchange Reserves

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at [email protected]

India has seen an unprecedented fall in the value of its currency against the widely used global currency US dollar in the last couple of months. Analysts, experts, finance ministry, RBI, all are blaming high current account deficit (CAD) for the rupee fall.

To save the value of rupee somewhat by squeezing its supply and increasing the supply of dollar, the Reserve Bank of India (RBI) sometimes sell dollars in the open market. This action of RBI reduces our forex reserves and thus becomes one of the factors for such a reduction.

On September 3rd, Mr. Ramamurthy asked me how the RBI or the Government has raised these reserves over all these years, despite we having a higher import figures against the export numbers, thus always resulting in current account deficit (CAD) and never a current account surplus.

Here is his comment.

Ramamurthy September 3, 2013 at 12:07 pm

Shiv

RBI or Govt is supposed to be having a Dollar reserve.I dont know the exact amount.

But I would like to know how RBI have accumulated this amount? I thought India never had a favourable CAD respect of Dollars.Imports were always in excess of exports.

Let us understand it, we spend dollars on our imports and get dollars for our exports. Actually, current account deficit (or total imports > total exports) is just a part of our overall foreign exchange standing. There are many other sources which affect our forex reserves either positively or negatively.

India’s foreign exchange reserves as on September 11, 1998 were at $29.048 billion, which on August 30th, 2013 stand at $275.49 billion, a jump of $246.442 billion or approximately 848% in 15 years’ time. RBI releases this figure every Friday, for the reserves held on the preceding Friday. If any of you wants to have the week-wise data of India’s historical forex reserves, you can visit this page of RBI to check it.

On July 27, 2013, the RBI released India’s Balance of Payments (BoP) data for financial year 2012-13. Here is the RBI’s Press Release regarding that. It lists the “Sources of Variation in Foreign Exchange Reserves” and I will try to explain these sources in a simple language to the best of my abilities.

I. Current Account Balance (= -$88.2 billion) – Current Account Balance is nothing else, but it is the other name of our Current Account Deficit or Current Account Surplus, as the case may be. If it is positive, then we call it a surplus and if it is negative, then we call it a deficit. It is calculated by adding our balance of trade, factor income (interest and dividends from international loans and investments) and net transfer payments.

Balance of trade (or trade balance) is the most significant component of our Current Account. It is calculated by deducting India’s total imports of goods and services from its total exports of goods and services. For FY 2012-13, our current account deficit (CAD) stood at negative $88.2 billion or 4.8% of India’s GDP.

II. Capital Account (net) (= $92 billion) – To finance a country’s current account deficit, it is very important for the government to encourage international capital flows into the country. All the foreign money which flows into India or Indian money which flows to some other countries, in the form of capital investments, gets counted under capital account. What are the sources of India’s capital account? Here we have it:

a. Foreign Investment (= $46.7 billion)

(i) Foreign Direct Investment (FDI) (= $19.8 billion) – FDI refers to an investment made by a foreign entity into India that involves establishing operations or acquiring tangible assets, including stakes in other businesses. Here, the investor seeks to control, manage or have significant influence over its Indian operations, either by establishing its own subsidiary or entering into a joint venture with an Indian entity.

(ii) Portfolio Investment (= $26.9 billion) – This refers to a passive investment by a foreign investor in Indian securities such as stocks, bonds or other financial assets, none of which entails control, active management or significant influence of the issuer by the investor.

Foreign Institutional Investments (FIIs) – Overseas institutional investors investing in Indian securities, either debt, equities or other financial assets listed here in India, comes under foreign institutional investments.

ADRs/GDRs – Foreign investors can also invest in an Indian company through the purchase of American Depository Receipts (ADRs) or Global Depository Receipts (GDRs). ADRs or GDRs are essentially negotiable instruments, denominated in US dollar or any other currency, representing a publicly-traded issuer’s local currency equity shares.

b. External Commercial Borrowings (ECBs) (= $8.5 billion) – ECBs are money borrowed by Indian corporates from foreign sources in the form of commercial loans, credits, notes, bonds or preference shares. ECBs open another avenue of credit at lower international rates for Indian commercial borrowers.

c. Banking Capital including NRI Deposits (= $16.6 billion) – It includes foreign assets and liabilities of commercial banks, including NRI deposits, foreign currency holdings etc. and movement in balances of foreign central banks and international institutions like Asian Development Bank, International Bank for Reconstruction and Development, International Development Association etc.

d. Short-Term Trade Credit (= $21.7 billion) – It refers to either suppliers’ credit, extended by the overseas suppliers, or buyers’ credit, arranged by the importers themselves from a foreign bank or financial institution, for imports into India. Short-term credit has a maturity period of less than 3 years. If the maturity period is more than 3 years, then it comes under ECBs.

e. External Assistance (= $ 1 billion) – It refers to multilateral and bilateral loans given to India by foreign governments and loans given by India to foreign governments.

f. Other Items in Capital Account (= -$2.4 billion) – These are miscellaneous items of capital account, whose value is not of any major significance.

III. Valuation Change (= -$6.2 billion) – When the US dollar appreciates against other global currencies including Indian Rupee, it results in a “Valuation Loss” for India’s forex reserves and when the dollar depreciates, it results in a “Valuation Gain”.

As India has grown at a rapid pace in the past and is expected to maintain this growth chart in the coming couple of decades, foreign investors have been pouring money here to reap the benefits of this growth and that is how India has enjoyed a major uptick in its foreign exchange reserves. To maintain the value of rupee and thereby our forex reserves, India is required to become innovative, competitive and efficient. It is required to win foreign investors’ trust and thereby become a reliable partner in its future growth.

Fixed Maturity Plans aka FMPs – Favourable Factors & Checklist for the Investors

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at [email protected]

Of late, the market has been flooded with fixed maturity plans (FMPs). In fact, I have never seen such a huge number of FMPs getting launched in such a short span of time and that too with a variety of tenors going up to 5 years.

Mutual Fund houses, which have seen a big dip in their assets under management (AUMs) in the past couple of months due to huge outflow of money from their debt fund schemes, especially liquid funds, do not want this money to flow out of the mutual fund industry.

As the short-term interest rates have risen quite sharply during this period, these mutual fund companies are launching FMPs of shorter duration, like one month and three months and also of one year, in huge numbers with quite attractive indicative yields.

What is so attractive about these FMPs?

High Interest Rates: As mentioned above, fixed maturity plans are offering high indicative yields these days due to a sudden spike in interest rates, especially short-term interest rates. Though the market regulator SEBI has disallowed it to disclose the indicative yields of FMPs, some of the fund houses are privately quoting it to be in the range of 9.60% to 10.60% for 1 year period, which is quite attractive.

Ranged Indicative Yield: FMPs usually invest in certificates of deposits (CDs), commercial papers (CPs), NCDs and other securitized debt. As per SEBI regulations, an FMP cannot invest its money in instruments with maturity greater than the maturity of the FMP itself. Also, the mutual fund companies need to disclose it in the scheme’s offer document, in which all instruments it is going to invest the scheme’s corpus.

So, taking a cue from its planned investment in these instruments, the management team of an FMP is able to provide an indicative yield to be expected out of this scheme. The returns at the time of maturity are very close to this indicative yield, if the scheme does not suffer any credit default. So, unlike open ended mutual fund debt schemes like gilt funds, income funds or short-term funds etc., there is no uncertainty with regards to the holding period returns of these FMPs.

Fixed Maturity: As FMPs are closed-ended funds and get matured after some definite maturity period, their investors know well in advance when they are going to get their money back. Like bank fixed deposits, there is no uncertainty with regards to their holding periods.

Taxation Rules for FMPs – Before I proceed further with the positive points of FMPs, we first need to know the taxation rules applicable to FMPs.

Growth Option – FMPs, if held for more than one year, would fall under long-term capital gain tax and are taxed at 20% with indexation or 10% without indexation, whichever is less. If the holding duration is equal to or less than one year, then FMPs would attract short term capital gain tax and will be taxed at the slab rate of the investor.

Dividend Option – Dividends announced by the mutual fund houses for these FMPs are tax-free in the hands of the investors, but are subject to dividend distribution tax (DDT) of 28.325% i.e. 25% tax + 10% surcharge + 3% education cess.

Indexation or Tax Benefits: ‘Indexation’ or ‘Double Indexation’ benefit is one thing which makes these FMPs score highly over bank fixed deposits. Double-Indexation benefit accrues to those FMPs which run over to 3rd financial year. If an FMP is bought at the lag end of 1st financial year and gets matured in the beginning of 3rd financial year, then it makes your capital gains virtually tax-free.

Let me explain it to you: Say, you invest in an FMP at the NAV of Rs. 1,000 on September 5, 2013 and it matures on April 5, 2015, earning for you a return of say 15% in one and a half years. Cost inflation index for 2013-14 is ‘939’. Let us assume it comes out to be ‘1014’ for 2014-15 at 8% inflation and ‘1085’ for 2015-16 at 7% inflation. Then, your indexed cost of acquisition for your FMP would be Rs. 1,000 * 1,085 / 939 = Rs. 1,155 and the long term capital loss would be Rs. 1,155 – Rs. 1,150 = Rs. 5. So, there is no need to pay any tax on the gain of Rs. 150.

Even single indexation benefit makes taxation of these FMPs quite favorable and quite close to getting tax-free, if your holding period is close to 1 year plus i.e. 370 days or 368 days or 371 days etc.

Taking the above case forward for single indexation benefit, let us take the maturity date to be September 10, 2014 and one year return to be 10%. Cost of acquisition comes out to be Rs. 1,000 * 1014 / 939 = Rs. 1,080 and the long term capital gain would be Rs. 1,100 – Rs. 1,080 = Rs. 20. On this investment, capital gain tax would be either Rs. 4 i.e. 20% of Rs. 20 or Rs. 10 i.e. 10% of Rs. 100, whichever is less. So, the tax is Rs. 4 and your effective return would be 9.60%.

Factors to keep in mind while investing or selecting a fixed maturity plan (FMP) – Though FMPs are launched by different fund houses and probably have similar maturity period, say 370 days, but their portfolio investments may differ quite a lot. Here are the pointers which you should keep in mind while going for an FMP:

Where your money is getting invested – It is very important to know to whom your money is getting lent. This is what the scheme’s fund management is doing on your behalf. As per the SEBI regulation, the scheme’s offer document must have the details about the type of securities it intends to invest into.

As the corporate profitability is on a decline amid economic gloom, FMPs have started avoiding the riskier sectors in which they foresee some probability of a credit default, like real estate, airlines, gems and jewellery etc.

Credit rating of the securities – You should also check the scheme’s offer document for the minimum credit rating of the securities the fund management intends to invest into. The investors should also note that the higher the credit ratings of their securities, the lower the returns would be for the FMPs.

FMPs of shorter duration, like 30 days, 90 days or up to 370 days, typically invest in CDs issued by some of the banks or CPs issued by some of the corporates. FMPs of longer duration, like 1875 days, 1820 days or 1095 days, typically invest in NCDs issued by some of the corporates. CDs are considered the safest among these instruments as many of these CDs get issued by PSU banks and normally carry higher credit ratings like ‘AAA’ or ‘AA+’ depending on the issuer banks. CPs and NCDs normally carry lower credit ratings of ‘AA’ or ‘AA-’.

Let us take a look at the “Intended Portfolio Allocation” of Birla Sun Life Fixed Term Plan – Series HV, an FMP of 368 days, opened on September 2nd and closes on September 5th.

Expense Ratio of the scheme – These days mutual fund houses are attracting distributors to promote their long-term FMPs by offering them high distribution commissions. These high commissions they do not pay from their own pockets. These are charged from the investors’ money only. So, you should select a scheme which has a reasonable expense ratio as per the tenor of the FMP.

FMPs are tradable but closed-ended schemes – As per SEBI regulation, FMPs now get listed on the stock exchanges and are tradable at their respective NAVs. But, as there is not enough number of interested buyers and FMPs are closed-ended schemes, FMPs normally trade at a discount to their fair values and this should be kept in mind while investing in FMPs. Investors should choose these FMPs as per their time horizon and then should stay invested till their maturity to realize their full potential.

Investor’s Tax Bracket – Investors with zero tax liability or who are in the 10% tax bracket do not gain much from the tax differential between FMPs and FDs and that is why it is better for them to invest in FDs or NCDs themselves as compared to FMPs. It is the investors in the 30% or 20% tax bracket who gain maximum by investing in FMPs.

Equity markets are extremely volatile and interest rates are ruling higher, these two things set a perfect pitch for FMPs to gain investors’ confidence. But, turbulent times can affect financial condition of corporates quite badly and force some of them to default on their credit payments. So, it is always advisable to the investors to keep their portfolios well diversified with investments in various asset classes and also sub-heads of those asset classes.

Weekend Links Sep 6 2013

Let’s start with a great post that Deepak Shenoy wrote titled 6 myths about the Food Security Bill. This is a very well written post that is easy to comprehend and I agree with all that he says here and hope that people don’t have the misconceptions he talks about.

Next, JagoInvestor talks about a good concept that they have named ‘Threshold Limit‘ and I think this idea is well worth your consideration.

Hemant has a great post about how much a financial planner should charge.

I was quite moved to see this slideshow titled “Documenting Elephants’ Compassion, and Their Slaughter” in the NYT.

Good advice about succeeding in the business world.

This is an interesting concept and I’m a bit embarrassed to admit that I overheard someone talking about it but otherwise I don’t think I would have ever heard of such a thing. An elderly lady was talking about the beauty and grace of graves and was saying how peaceful they can be. I had never thought of it like that, but I’d like to hear if someone else had. Here are Top 10 Fascinating Graves in Père Lachaise.

Finally, Economist on Atheism in India.

Enjoy your weekend!

Why the taxman may send you a demand notice?

This post is written by Krishna Srinivasan, who is a personal finance blogger writes for Plan Your Investment.

Have you ever received notice from income tax office?. If you have filed income tax returns with all the details about your income, deductions, etc. and these details are verified by income tax department on random basis. Income Tax department has all the transactions pertaining to your PAN card. Once you have filed income tax returns, they can verify if the details submitted are correct as per your PAN records. If the details are not matching and any discrepancy found, they will send you a notice with details about the discrepancy. There is no need to panic for getting the notice, it is normal for income tax officer to send notice for the clarifications. This article explores when income tax department would send you a notice.

Even if the notice is seeking the payment, there is no reason to panic. Find out why IT Department asking for the payment and under what section they have sent the notice. Because, the notice can be sent for many reasons and if the demand for the payment is not correct as per your data, you can appeal against the notice.

Section 143(1) – Letter of Intimation

The intimation under section 143(1) is sent by the IT Department in response for the tax return filed by the tax payer. The main reason for this notice is intimating the tax payer about the arithmetic mistake while filing the return or claiming excessive deduction or wrong exemption found while processing the return. By receiving the notice u/s 143(1), one can not conclude that it is a demand notice. As the name suggests, it is a intimation notice to the tax payer about the refund from IT Department or tax payable. This intimation has to be sent before completion of the assessment year.

If this intimation contains any liability of the tax payment, then assessee may consider this as the demand notice and make the payment. It is clearly notified by the IT department that this intimation is acknowledgement for the return filing and if there is any calculation error while computing the tax. However, if it provide any pending payment, assessee has to clear the payment or file the application u/s 154 for the rectification. Do not worry and never try to ignore this notice. It may lead to a fine.

If the net “NET AMOUNT REFUNDABLE” is less than Rs. 100 or “NET AMOUNT DEMAND” is less than Rs. 100, then assessee can ingnore this notice and he thereupon won’t receive the refund or no need to pay the pending due.

Section 143(3) & 147

Notice u/s 143(3) is issued only after the notice from the section 143(2). This section is popular for the income tax scrutiny for an assesse’s income. However, this notice is not sent to assesse immediately after filing the returns. If the evidence provided by an assesse u/s 143(2), then IT Department sends a notice seeking the further scrutiny.

If Assessing Officer (AO) finds any income is escaping from the returns, then they would send a notice u/s 147.

Section 206C – Tax Collected at Source (TCS)

We are aware of the Tax Deducted at Source (TDS) from our salaries and interest income. In the same way, for the certain goods seller has to collect the tax at the time of receiving the money. This is known as Tax Collected at Source (TCS). The specified list of goods are:

Alcoholic Liquor for human consumption (1%)
Tendu Leaves (5%)
Timber obtained under a forest lease (2.5%)
Timber obtained under any other mode (2.5%)
Any other forest products other than Timber. TCS is applicable for the forest products, not the agriculture products. (2.5%)

Note that, TCS also includes many other categories, but I have listed above is only related to the section 201C. TCS has to be collected at the time money received from the buyer in the form of cash or cheque or draft. The TCS rate is ranging from 1% to 5% for various product categories.

Collected tax has to be deposited within one week from the last date of the collection month. The seller has to file a return for every quarter for the income he earned from these transactions. If the seller is failed to pay the collected tax on time, he shall be liable to pay the interest at 15% per annul from the date he collected money and till when he has paid the tax. He would receive a notice from the income tax office under the section 201C for demanding the payment of TCS.

Other Sections

There are few other sections for sending the notice.

Section 153A/153 – Related to search and seizure operations
Section 201(1) 201(1A) – Failure to deduct tax or deposit deducted tax
Section 210(3) – Tax officer believes that advance tax is payable.

Some good news at last

I read the new RBI governor’s speech twice today because quite frankly I wasn’t able to grasp all the things he had announced at the first read.

This is quite amazing because it covers an incredible amount of ground, and takes a very liberal, progressive and long term view of the economy – something that we haven’t seen for a while. The speech can be found on this link and Business Standard has a good summary of the announcements that can be found here.

My first idea was to write about some things that would impact a regular person directly like the CPI linked bonds he spoke about, but that is simply taking too narrow a view. In this particular case, the steps that don’t directly impact you or the steps that are longer term in nature like building individual credit histories (not a new idea) are likely to impact you a lot more than any purchase of CPI linked bonds.

What Dr. Raghuram Rajan showed today was how RBI can take several small steps to liberalize the economy, instead of fixating over the Repo rate or conducting strange operations to drain liquidity which have terrible unintended consequences.

The Rupee and the market both gained today and normally I hate ascribing any market moves to an event, the speech quite clearly did the trick today, and I myself am feeling a little positive after a very long period.

I realize that there is a lot of difference between a speech and executing these steps, but if you don’t have a plan to execute then you there is no hope of execution. In this case there is a plan and let’s all hope that the RBI stays on course.

As I was reading through the speech, I came across the part where Dr. Rajan said these were his plans for the “short term time table” for the RBI, and I thought to myself, wow if this is really short term, I can’t wait to see what long term is like.

Muthoot Finance NCDs Issue – September 2013

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at [email protected]

Muthoot Finance has also launched its issue of non-convertible debentures (NCDs) from September 2nd, with its plan to raise Rs. 300 crore, including the green-shoe option of Rs. 150 crore. The issue will remain open for two weeks and will get closed on September 16th. However, if required, the company may extend the closing date of the issue, depending on the response for the issue.

The company offers to double your money in 72 months (or 6 years) with an effective yield of 12.25% per annum. This is just one of the eleven options that the company is offering to the investors, with different maturities and different interest payments.

Interest rates have been left equal for all the categories of investors and there is no differentiation among institutional, non-institutional, HNIs and the retail investors categories. The bonds will be issued for a tenor of 400 days, 24 months, 36 months, 60 months and 72 months, with monthly interest, annual interest and cumulative interest options.

I don’t know why the company is giving so many options and making it too complicated for the investors to take a decision, but it does not give me any confidence to know that the bonds, which are offering to double the money in 72 months, are actually ‘unsecured’ in nature.

Categories of Investors & Basis of Allotment – The investors have been classified in the following three categories and as always, each category will have certain percentage fixed for the allotment:

Category I – Institutional Investors – 15% of the issue is reserved

Category II – Non-Institutional Investors, corporates & HNIs – 35% of the issue is reserved

Category III – Retail Individual Investors including HUFs – 50% of the issue is reserved

NCDs will be allotted on a “first-come-first-served” basis.

Ratings & Nature of NCDs – There are two rating agencies involved in this issue – CRISIL and ICRA and both have assigned ‘AA-/Negative’ rating to this issue. Except the XIth option, all other options are ‘secured’ in nature.

Listing, Demat & TDS – These NCDs are proposed to be listed only on the Bombay Stock Exchange (BSE). Investors have the option to apply these NCDs in physical form as well as demat form for the first six options out of total eleven. NCDs applied under option VII, VIII, IX, X and XI will be allotted compulsorily in the demat form.

Again, the interest earned will be taxable as per the tax slab of the investor and TDS will be applicable if the interest amount exceeds Rs. 5,000. But, NCDs taken in the demat form will not attract any TDS on the interest income.

Minimum Investment – As with SREI Infra NCDs issue, this issue as well requires an investor to put in a minimum investment of Rs. 10,000 i.e. at least 10 bonds of face value Rs. 1,000. I don’t know why these private companies want it to be Rs. 10,000, when PSUs, like REC etc., are keeping their minimum investment requirement at Rs. 5,000.

With the gold prices rising, then falling and then artificially pushed up higher again due to higher import duty and falling value of the Indian currency, I think it is very difficult to analyse the future of gold prices and the growth pattern of the gold finance companies like Muthoot Finance, Manappuram Finance etc.

Though the interest rates are somewhat attractive, I would stay away from such NCD offerings for my personal investments and put my money either in tax-free bonds or tax efficient debt mutual funds including fixed maturity plans (FMPs).

Link to Download the Application Forms

RBI’s Monetary Policy – Tools & Expected Outcomes

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at [email protected]

We keep reading all these days RBI has done this to save rupee from falling further against the dollar or RBI has done that to contain inflation from rising further. Many of us must be wondering all the time what the heck these policy measures are and how do they actually affect our common day-to-day life.

What is RBI’s Monetary Policy? What exactly is the role of RBI in managing money supply in the country? What are RBI’s different tools through which it controls the money supply and other related factors. Through this post, I will try to throw some light on RBI’s monetary policy tools and impact of those tools on the factors which they are targeted on.

Open Market Operations (OMOs) involve sale and purchase of Government securities (G-Secs) by the RBI to adjust the liquidity conditions in the system. RBI conducts such selling operations to suck liquidity whenever it feels there is excess liquidity in the system. Similarly, when the liquidity conditions are tight, RBI goes for such buying operations in the open market, thereby releasing liquidity into the system.

Liquidity Adjustment Facility (LAF) is a policy tool which allows banks to borrow money from the RBI through repurchase agreements, popularly called repo transactions. As the name itself suggests, LAF has been provided to aid the banks in adjusting their day-to-day liquidity mismatches. LAF consists of repo and reverse repo operations. Repo transactions inject liquidity into the system, while reverse repo transactions result in absorption of excess liquidity.

Repo Rate is the rate at which commercial banks borrow money from the RBI for a short period of time. Banks sell their securities or financial assets to the RBI with an agreement to repurchase them at a predetermined price at some future date.

Expected Outcome: A high Repo Rate deters the banks to raise funds from the RBI, forces banks to keep their own lending and deposit rates high and thereby, keeps money supply in check. This is what RBI tried to do on July 16th, which caused panic among the market participants and banks/corporates scrambled to shore up their cash holdings.

Higher interest rates normally curtail investments, as a result of which the overall consumption and aggregate demand start falling. Lower demand results in lower resource utilization. When resource utilization is low, prices and wages usually rise at a more modest rate. On the other hand, RBI purposefully reduces Repo Rate as and when it wants to encourage banks to borrow money for further lending to spur investments.

Reverse Repo Rate is the rate at which banks deposit their excess money with the RBI for a short period of time. RBI lowers the Reverse Repo Rate whenever it wants banks not to deposit incremental cash with it, thereby raise liquidity in the banking system for further lending and to raise overall investment levels and hence the aggregate demand. It also makes banks to offer lower rate of interest on the deposits made by the general public. But, at the same time, it allows banks to lend at a lower rate. Reverse Repo Rate remains fixed these days at 100 basis points (or 1%) below the Repo Rate.

Cash Reserve Ratio (CRR) is the percentage of a bank’s total deposits, which the bank is required to maintain with the RBI. Banks are mandated to deposit this amount with the RBI on a fortnightly basis. CRR is a tool used by the RBI to control the liquidity in the system.

Expected Outcome: So, when there is excess money floating around in the system, RBI will raise the CRR to suck out the excess money. On the other hand, if there is a credit crunch, RBI cuts the CRR to release money into the system. Normally, CRR cut increases liquidity in the system to a marginal extent only.

Statutory Liquidity ratio (SLR) is the proportion of deposits that banks are required to maintain in cash or gold or government approved securities.

Expected Outcome: Similar to CRR, a reduction in SLR also increases some money supply in the financial system. After keeping the required amount for CRR & SLR, the banks are free to use the remaining deposits for their lending purposes.

Marginal Standing Facility (MSF) is a facility provided only to the scheduled commercial banks under which they can borrow funds from the RBI for their overnight liquidity requirements. Banks can do this borrowing only against their SLR holdings, up to 2% of their net demand and time liabilities (NDTL). MSF rate is the rate at which banks can do this borrowing.

Expected Outcome: A hike in the MSF rate can raise banks’ cost of borrowing for their overnight liquidity requirements under the MSF window. At the same time, a cut in the percentage of NDTL, up to which the banks can borrow funds from the RBI, can squeeze liquidity for these banks. So, these two simultaneous steps mean a double trouble for the banks.

Till July 16th, MSF rate was fixed at 1% above the Repo Rate i.e. at 8.25% (7.25%+1%). At present it has been hiked to 3% above the Repo Rate i.e. 10.25%. Also, the RBI has cut the borrowing limit under MSF on two occasions in July, once from 2% to 1% and then from 1% to 0.5%, in order to squeeze liquidity from the markets and curb speculative trades in the currency market.

Impact on Your Investments

Equity Investments like Stocks, Equity Mutual Funds – A cut in the interest rates by RBI is always cheered by the stock markets and equity investors as this step reduces interest expense burden of the companies listed on various stock exchanges and thereby increases their profitability.

Financial Sector including Banks, Housing Finance Companies (HFCs) & NBFCs: Again, a cut in the interest rates boosts the business growth, profitability and net interest margins (NIMs) of the financial sector companies. Banks, HFCs, auto loan companies etc. get benefitted as it increases loan demand from its borrowers and also increases their margins.

Auto Sector, Real Estate Sector & Consumer Durable Sector Companies: Companies, which are in the businesses of auto or auto ancillary, real estate and consumer durables, get benefitted with a fall in interest rates as it reduces the borrowers’ overall cost of taking a loan and thus increases the demand for these companies’ products used by their customers.

Market-linked Fixed Income investments like Gilt Funds, Income Funds, Tax-Free Bonds or NCDs – There is an inverse relationship between interest rates and bond prices. When interest rates go up, bond prices fall and when interest rates fall, bond prices rise. RBI’s policy measures influence movement of bond yields, both government as well as corporate. Your market-linked investments like debt mutual funds, NCDs and tax-free bonds also get affected due to these measures. The value (or market price) of these investments goes up with a cut in the policy rates and vice-versa. The higher the quantum of rate cut and the more unexpected it is, the more will be the jump in the value of your investments.

Investments in gilt funds, which in turn invest in government securities (G-Secs) primarily, and investments in income funds, which invest in corporate bonds primarily, could give higher returns to the investors as the interest rates decline and their prices go up. Your direct investments in tax-free bonds or corporate NCDs also appreciate in value due to a cut in the RBI’s policy rates and a subsequent fall in their yield to maturity (YTM). This results in a gain in your overall bond portfolio.

Fixed Income Investments like Bank FDs, Company FDs or Post Office Schemes – A reduction in RBI’s policy rates does not affect your existing investments in FDs or Post Office schemes at all because these investments are not market linked and the interest rates, you are eligible to get, do not change. But, at the same time, it signals a likely fall in the interest rates on these FDs in the times to come.

Indian Currency (Rupee) – All those measures, which the RBI takes to absorb liquidity in the system, result in reduced supply of rupee in the markets as compared to the other global currencies. This reduced supply of rupee should ideally result in higher value (or appreciation) of Indian currency against other global currencies.

So, if the present situation is tough, if it is making the interest rates go higher, share prices and NAVs of your investments in mutual funds go down, then it should be taken as part of a cycle which keeps on changing with moving times. With a change in the decision-making authority at the RBI, people are again expecting something dramatic to happen for their bleeding portfolio values. Lets see what Mr. Raghuram Rajan has in store for us during his tenure as the Governor of RBI.