7.4 Analysing Economy through Indicators
ECONOMIC ANALYSIS BY USING INDICATORS
The level of taxation in a country has a direct effect on the economy. If tax rates are low, people have more disposable income. Also, they have an incentive to work harder and earn more. And an incentive to invest. This is good for the economy. It is interesting to note that in every economy there is a level between 35 to 55 per cent wherein tax collection will be the highest. While the tax rates may go up, collection will decline. This is why it has been argued that the rates in India must be lowered. In taxation, the theory of consumption plays an important role. One man’s expenditure is another man’s income. But all the income is disposed of? Every man keeps some part of income as saving. This will create reduction in income to some people.
If low-income people can save 10 per cent of their income, high-income people may save up to 50-75 per cent of their income. To avoid a huge blockage of money the government has to follow a progressive taxation system of high tax for higher income, say 10 per cent tax for people of Rs1 lakh income and 15 per cent for Rs2 lakh income, 25 per cent for Rs5 lakh income and so on. The government also encourages saving habits and attracts all the balance of unutilised money to some organised channels like bank deposits.
Balance Of Trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation’s imports and exports. A favourable balance of trade is known as a trade surplus when export is more than import while an unfavourable balance of trade is known as a trade deficit or, when the export is less than import - informally, a trade gap. In simple terms, balance of trade means the value of a country’s exports minus its imports.
The types of balance of trade are:
- The current account consists of the goods and services account, the primary income account and the secondary income account.
- The capital account is much smaller than the other two and consists primarily of debt forgiveness and assets from migrants coming to or leaving the country.
- The financial account consists of asset inflows and outflows, such as international purchases of stocks, bonds and real estate.
When exports and imports are in balance or equal, we have a balance of trade. But developing nations like India suffer from an unequal balance of trade. Advanced countries export technology goods like computers, satellites, radars, aircrafts, warships, engineering machineries and the cost of these goods is very high. Developing nations export agricultural goods, coffee, tea, textiles etc which have low money value when compared to technology goods. After 1990 India adopted a liberal economic policy and started producing various technology goods with the utilisation of high foreign investments and started moving towards becoming a major power.
Impact Of War
A war always shows a negative effect on the economy with a decrease in money value, profits etc. A war is always bad for any economy and it does not matter whether it is a superpower economy or a growing one. In the year 1999, during the Kargil border dispute, India lost money to the tune of thousands of crores. The post-war inflation is always high. Taxes go up to make up for government expenditure. The purchasing power of people is reduced and the aggregate demand declines so that company profits become low. Investors’ losses are therefore heavy.
Foreign Exchange Reserve
Greater the trade with foreign countries the better is the exchange of currency between various nations and this reflects on the country’s image. In 1991 a new economic policy was introduced in India. A lot of foreign investments were invited instead of high loans and increasing interest burdens. After the new policy came into effect, the country’s foreign currency reserves shot up to high levels and this brought about a massive turnaround in the economy. The Indian stock market improved and the number of companies listed in the BSE and NSE rose substantially.
Public And Foreign Debt
Public debt seems high in Indian companies compared to advanced countries. In India, the money market development is relatively poor and there is less liquidity for sale of debt instruments. Now the Indian government has introduced development finance institutions such as the ICICI, IDBI and IFCI etc. These are directly controlled by the Ministry of Finance. The above debt instruments are easily saleable with stock exchanges and also one can enjoy high security in investing in the bonds of such development finance institutions.
The stock market's working is highly dependent on budgeting. At the time of the Union Budget the stock market sees a bit of a swing because there are high expectations and if the budget is not up to these expectations it results into a steep fall in the stock market. For example, in July 2009, on the eve of the budget, stock prices slumped by nearly 2 per cent as investors were nervous about budgetary support.
The development of an economy is dependent on its infrastructure. Industry needs electricity to manufacture and roads to transport goods. Bad infrastructure leads to inefficiencies, poor productivity, wastage and delays. This is possibly the reason why the recent budgets lay so much emphasis, and offer so many benefits, to infrastructural industries such as power and transportation. Flyovers have been built, national highways are being widened and made better and improvements made in communications to reach out to the larger masses.
The government policy has a direct impact on the economy. A government that is perceived to be pro-industry will attract investment. The liberalisation policies of the Narsimha Rao government excited the developed world and foreign companies have, since then, shown keen interest to invest in India. The initiative of the former BJP government in improving the infrastructure grabbed the attention of foreign investors. The present government continues to focus on infrastructure as it has been realised that progress at a decent rate is not possible without infrastructure. Before the new norms in 1991 the government was keeping its doors closed for outsiders but the new reforms increased the holdings by up to 50 percent.
How is the WPI calculated?
In this method, a set of 435 commodities and their price changes are used for the calculation. The selected commodities are supposed to represent various strata of the economy and are believed to provide a comprehensive WPI value for the economy. WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, let’s assume the base year to be 1993. The data of wholesale prices of all the 435 commodities in the base year and the time for which the WPI is to be calculated is gathered. Let’s calculate WPI for the year 2008 for a particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1993 = Rs5.75 and in 2008 = Rs6.10. The WPI of wheat for the year 2008 is (Price of wheat in 2008 – Price of wheat in 1993) / Price of wheat in 1993 x 100 i.e. (6.10 – 5.75) / 5.75 x 100 = 6.09. Since WPI for the base year is assumed as 100, WPI for 2008 will become 100 + 6.09 = 106.09.
In this way individual WPI values for the remaining 434 commodities are calculated and then the weighted average of individual WPI figures are found out to arrive at the overall Wholesale Price Index. Commodities are given weightage depending upon their influence in the economy.
There is a direct relation between the stock market and inflation rate because as the inflation grows there is a negative effect on the economy of the country. As the inflation rises it leads to a rise in interest rate also which means less consumer spending. This leads to less in terms of investments. So inflation plays a big role to look at while investing in the economy.
Interest rate plays a vital role in terms of understanding a economy. If the interest rate is low it stimulates the investment in the economy. Low interest rate leads to high number of investments because the return on investments will be high. Whereas if the interest rate is high, it will show a reverse picture because it leads to high cost of production and less spending. When there is a increase in interest rate it leads to a decline in bond price which in turn leads to a fall in the stock price. When interest rates rise, the investors’ required rate of return on shares rise as well, causing the prices of securities to fall. Rising interest rates also make bond yields look more attractive in relation to share dividend yields.
When the economy grows at a faster rate, it requires more investments when domestic sources like banks and other investors cannot serve the rising demand. At this juncture the government encourages foreign investment which can be in two forms i.e. foreign direct investment (FDI) and foreign institutional investment (FII). FDI is allowed for all business ventures whereas FII is limited to investment in financial instruments and markets. When foreign investment is high it indicates healthy prospects in terms of the economic development of a country.
Impact Of Monsoon Monsoon plays a vital role in the economy. There is a direct relation of monsoon to the stock market. When there is good monsoon in the country the Sensex also sets a new high and vice versa. The impact of the monsoon is more pronounced on agro industries, fertilisers, pesticides, seeds and edible oil. Subsequently, the demand for other manufacturers’ goods also goes up.
Now let us discuss the key indicators that help an investor to analyse the true health status of an economy for taking investment decisions. There are many different tools which help us to understand the economy of the country. The tools used for economic analysis are as follows:
- Gross domestic product
- Monetary policy and liquidity
- Interest rates
- Fiscal policy
- Impact of the monsoon
- Impact of war
- Foreign exchange reserves
- Public debt and foreign debt
- Government policies
- Balance of trade
Gross Domestic Product
Gross Domestic Product (GDP) is a measure of economic activity. This is the total amount of goods and services produced in a country in a year. It is calculated by adding the final values of all goods and services produced in a year. GDP has several components. Some of the major components are as follows:
- Consumption Spending: Represents the production of those domestic goods and services which are consumed by the public.
- Investment Spending: Represents using capital for future productive purposes.
- Government Expenditure: Consists of spending by the central, state and local governments on goods and services such as infrastructure, research, roads, defence, schools and police and fire departments.
This does not include the amount spent in the form of relief or compensation, since they do not represent production of goods and services.
Monetary Policy And Liquidity
A good monetary policy and liquidity is essential for the economy since excess liquidity can be harmful. Excess liquidity leads to inflation, higher interest rates and costly sources of capital and slow growth. Money supply can be measured through M1, M2 and M3. M1 is the amount of money in circulation, demand deposits and traveller’s cheques. M2 is M1+small time and savings deposits. M3 measures the money supply that includes M2+large time deposits, repos at commercial banks and institutional money market accounts. A steep rise in BSE index is accompanied by a corresponding rise in M1 and M3.
Inflation has numerous effects on a country’s economy. It is of significance in relation to the stock market too. Before going into the effects of inflation on a country’s economy let us be clear with the meaning of inflation. The term inflation means the rate at which prices of goods and service increase in an economy. When there is a rise of inflation the purchasing power of the individual decreases. The price indices widely used for this are Consumer Price Index (adopted by countries such as USA, UK, Japan and China) and Wholesale Price Index (adopted by countries such as India). Thus inflation rate, generally, is derived from CPI or WPI. A constant inflationary situation will be foreseen as a positive influence on the investors and hence market prices are likely to go up under such circumstances.