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Introduction to Economic Factors

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Gopal Kavalireddi
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For any stock market participant, a basic understanding of the various economic factors affecting the business environment, and the impact of these factors on specific sectors and industries is essential. Macroeconomics and Microeconomics deal with the understanding of these factors in detail.

While macroeconomics is a top-down approach, dealing with large indicators like GDP, employment, inflation, interest rates etc., microeconomics is a bottom-up approach, with indicators more specific to a particular company like the business prospects, capex cycle, and decisions based on regulatory changes. These macro and microeconomic factors are basically statistics, which provide short and long term trends while indicating the possible direction of future performance.

 

Understanding General Concepts

The macro factors are the result of private consumption, private investment, government expenditure as well as exports. These 4 pillars can be considered as the growth engines of any economy. The performance of each of these pillars is critical for a sustainable economic growth.

 

Private Consumption

Relates to consumer spending is the key driver of economic growth. For most countries, consumption accounts for a large part of the nominal GDP and for India, it was at 61.5% as of Dec 2017. The lowest ever consumption indicated was at 52.5% in Mar 2011 and the highest was at 71.1% in Sep 1996 (source). Private consumption includes all purchases & payments made by consumers, such as food, housing rentals, electricity, clothing, health, leisure, education, communication, travel as well as hotels and restaurant services.

This high domestic consumption is due to the large demographics of India and is partly responsible for India being less susceptible to global recessionary trends during times of distress. Large demographics aid in maintaining the demand in the local markets without any need for exports.

As more and more people have sufficient disposable incomes to spend, private expenditure rises. But at the same time, this can also result in higher inflation. For eg: a change in the income levels or increase in tax exemptions leaving surplus income in the hands of the citizens, is normally used for buying automobiles or vacation or for other discretionary consumption. These consumption patterns increase the demand for goods and services, which increases the prices and results in higher inflation and, increasing inflation can result in an increase in interest rates to bring down the demand.

 

Private Investment

Relates to the investment made by various companies and individuals in establishing infrastructure and services for business operations. India is a very large country and the govt. along with the public sector companies cannot address the issues of employment generation, capital availability etc. and hence, has to enlist the support of private investment. The government’s job is to facilitate conditions that bring in private investments through regulatory changes, policy reforms and other mechanisms, which can support the ease of business and returns expectation of the investors.

Public Private Partnership (PPP), Build-Operate-Transfer (BOT), Build-Own-Operate-Transfer (BOOT), Hybrid Annuity Model (HAM) are some of the mechanisms introduced, while higher FDI in non-sensitive sectors, single window approvals and clearances, Insolvency & Bankruptcy Code (IBC) and Goods and Services Tax (GST) are some of the reforms undertaken to give impetus to private investment, particularly in manufacturing.

Private investments in India were around the 38% levels prior to the global financial crisis and since then, have come down to a low 10% in 2016 due to debt burdens, slowdown in private credit, NPA issues for the corporate and public sector banks, low capacity utilizations and excess capacities (Source).

 

Government Expenditure

Relates to the expenditure incurred by the govt. which is broadly classified either as capital expenditure and revenue expenditure. The expenditure incurred in creating or acquiring a capital asset or. improving the existing capacity of an asset to increase the productive life, is termed as capital expenditure. Expenditure incurred for normal functioning of the government departments and maintenance of services is termed as revenue expenditure, which is not used for the creation of any assets, but is essential to maintain the earning capacity of the available assets.

The revenue for the government is through various sources – direct and indirect taxes, dividend and interest incomes, divestment proceeds - are all deposited in the Consolidated Fund of India and used for expenditure with the approval of the parliament. The govt. undertakes many public programs specifically aimed at promoting sustained and equitable economic growth. Increase in government expenditure in the form of social schemes such as health, education (human capital formation) and infrastructure (physical capital formation) bolsters the level of growth by expanding the scope of economic activities.

At the same time, for higher spending on socio-economic needs, the govt. does borrow money through issuance of long term bonds. Incase, the borrowing is excessive, it affects the interest rate scenario, fiscal deficit and thereby, the sovereign credit rating. Therefore, the govt. should make optimal use of the collected revenues and judiciously balance the requirements of additional borrowing.

 

Exports

Relates to the goods manufactured in India being sold in other countries. Traditionally, Indian exports consisted of textiles, electronic goods, gems and jewellery, leather, and agricultural products, which are mostly labour intensive sectors. But of late, petroleum oils, metals, automotive parts, and meats are taking the top positions. The Foreign Trade Policy (FTP) is working towards increase in exports with various countries through Duty credit scrip and tax incentives to sectors involved in manufacturing. The other issues affecting exporters are transaction costs, red tape in clearances, infrastructural development having state-of-the-art port, airport and superhighway facilities, which when addressed will augment domestic and external trade. After all, the trade deficit and current account deficit are impacted severely by lower exports.

All the engines of growth are affected by three important rates, bearing a huge influence on any economy - inflation rate, exchange rate & interest rate.

 

Inflation Rate

A rate defining the general change in prices of goods and services, calculated on a monthly basis, highlighting the purchasing power of the consumer. A moderate inflation rate is required as a very high inflation rate reduces the purchasing power and vice versa. Fiscal Policy adopted by a Govt. - revenue generation and public expenditure policy - is designed to stabilize the inflationary effects while achieving sustainable economic growth.

The inflation rate is very important from the aspect of the rate of return, as interest rate movement is dependent on inflation. A higher inflation necessitates the need for higher interest rates, to prevent excessive consumption and to reduce demand for products and services, while a lower inflation rate augurs well for higher consumption, demand for products & services, resulting in higher economic growth.

 

Exchange Rate

A rate defining the ratio of exchange of a country’s currency against another currency. Since the US Dollar is the widely used medium of currency exchange, the INR vs. USD is considered an important parameter influencing exporters and importers alike. A depreciated rupee is good for export sectors like Information Technology, Pharma etc. while an appreciating rupee is good for import sectors like fuel related products, high end machinery etc.

The Reserve Bank of India, which is the central bank in India, monitors the movement of rupee and intervenes from time to time to prevent rupee from a high appreciation or depreciation, through the use of forex reserves.

 

Interest Rate

A rate defining the cost of debt capital offered by the financial institutions to the consumers. Banks and financial institutions accept deposits from the customers, termed as the savings interest rate, and offer these funds (credit basis) to companies & customers at an annualized interest rate, termed as commercial interest rate, for either short term or long term usage, which is dependent upon various factors. There are many types of rates, starting with the Repo Rate, Reverse Repo Rate, Real Interest Rate etc.

The RBI is the regulating agency for appropriate policy decisions on inflation. Through its monetary policy the central bank makes the appropriate changes which affect the usage of funds, thereby moderating the inflation from time to time. High interest rates reduce consumption, decrease credit growth and affect the operations of all financial institutions, while low interest rates spur demand for housing and other capital intensive sectors, thereby giving impetus to growth.  

 

Fiscal Deficit

When the govt. revenues collected through taxes are not sufficient to meet the annual expenditure incurred, it gives rise to the Fiscal Deficit. This deficit has to be met through borrowing and for that purpose, the bonds and securities are issued which are purchased by market participants like financial institutions, mutual fund houses etc. and are either held to maturity or sold in the open market for getting interest payments. Fiscal prudence is essential for every Govt. as excessive borrowing reduces the sovereign credit rating and liquidity available for other borrowers – private companies & individuals.

An upward-trending fiscal deficit will lower economic growth, increase inflation, and disrupt the capital flows, while increasing the currency rate fluctuations, ultimately affecting the financial system at large. Hence, it is vital that the Govt. manages its deficit better, by improving the revenue collection constantly, while resorting to optimal spending of the available capital.

 

Bond Yields

To bridge the fiscal deficit, the Govt. issues bonds from time to time, which carry a fixed interest rate payable at the time of maturity. The returns accrued by the bond holders is termed as Bond Yield. Yield is calculated as the interest rate (termed as coupon rate) divided by the value of the bond. Some important points regarding price of bonds, interest rates, bond yields and maturity date.

  • The price of the bond and the interest rates have an inverse relationship - when interest rates rise, the price of a bond will decline and vice versa.

  • Similarly, the price of the bond and its yield have an inverse relationship – when the price of the bonds decline, the bond yield will increase to remain competitive with the prevailing interest rates and vice versa.

  • When a bond reaches maturity, the bond holder will receive a payment equal to its face value.  If the bond is selling at a premium to its face value, then the holder will receive less than the purchase price and vice versa.  

The credit rating agencies provide the rating of bonds and the following are the applicable ratings.

 

Credit Risk

Moody's Rating     

Standard and Poor's Rating     

Fitch Ratings  

Investment Grade 

Highest Quality

Aaa

AAA

AAA

High Quality

Aa

AA

AA

Upper Medium

A

A

A

Medium

Baa

BBB

BBB

Not Investment Grade

Lower Medium

Ba

BB

BB

Lower Grade

B

B

B

Poor Grade

Caa

CCC

CCC

Speculative

Ca

CC

CC

No Payments / Bankruptcy    

C

D

C

In Default

C

D

D

 

Index of Industrial Production (IIP)

The Index of Industrial Production (IIP) is an India related index detailing the growth of various sectors in an economy such as mining, electricity and manufacturing. The IIP is a composite indicator measuring the short-term changes in the volume of production of a basket of industrial products during a given period with respect to itself, over a chosen base period.

It is compiled and published monthly by the Central Statistical Organisation (CSO) six weeks after the reference month ends. This index is an important assessment of the health of the industrials, measured by the factory output across core sectors during a given time period. The weightages of manufacturing, mining and electricity production in overall IIP are 77.63%, 14.37% and 7.99% respectively (source).

 

Union Budget

Presented before the end of each fiscal year (Apr to Mar) by the finance minister of India, the Union Budget is a comprehensive statement of accounts, providing an aggregate view of all the revenue sources and expenditures, incurred and planned by the govt., to enforce the policies necessary for supporting the growth of the economic activity.

The budget is important from the view point of resource allocation to the various ministries, for undertaking the necessary activities to support the growth while balancing the social structure requirements of the country. Allocation to sectors like agriculture, infrastructure, education, defence, health, social schemes, railways etc. have a major bearing on the business prospects of private and public sector companies, thereby influencing the stock market movement.

 

Policy Reforms

With a prevailing dynamic economic scenario influenced by global cues, the govt. on a continuous basis has introduced many regulatory changes, implementing policy based reforms thereby changing the business landscape. Over the last 3 decades, since the Indian economy opened up for private players – domestic and foreign, many companies have been setup, technology transfer undertaken, investments in various sectors allowed, which has resulted in the growth of listed companies.

It is very important to understand these changes as they can either have a positive or a negative effect on the business prospects of any particular company or sector. For e.g. A spectrum auction put a severe strain on the finances of the telecom companies, the GST introduction changed the fortunes of the organized sector, a financial inclusion program expanded the customer base for the banking, insurance and financial services sector, while an anti-dumping duty provided support for the tyre and steel manufacturing companies.

 

External Factors

The above-mentioned factors are also applicable from a larger perspective, as global macros and policy decisions influence the stock market to a great extent. The US Fed raising interest rates, a Greek deficit, a Yen carryover trade, USFDA regulations, a surgical strike, the yuan devaluation and many such events have had a significant impact on the movement of the Indian stock markets.

Also, black swan events like the global financial crisis of 2008, which started in the US, spread like a contagion to all countries of the world, with many financial sector based companies declaring bankruptcy. It took its toll on all stock markets and many investors lost considerable savings.

It is upto each investor and market participant, to read and understand, a little bit of the global and local economic news each day, to get a perspective of the macro and micro trends, which can help in the trading and investing process.

 

Next Chapter

Introduction to Fundamental Analysis

15 Lessons

Get an understanding of the broad classifications involved in fundamental analysis of stocks. Learn how to analyse industries, companies and financial statements.

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