How Insurance Companies Make Money

So, with articles on basic insurance and Risk Management, it’s time we dig deep and learn how insurance company actually works, how they manage risks and most importantly, how insurance companies make money! And that too, when LIC is posting profits of more than Rs 25,000 Crores!

So, if I have to get straight to the point, the combination of charging profitable premiums, plus making money on invested reserves, is how an insurance company makes money. And to talk about LIC, it has invested huge in OIL companies, Banks and other like equities.

So, as in the previous articles, when the smart guy in the burnt house example charged everyone Rs 110 and one house did burn, he still made a profit of Rs. 1000/-. And this is what all of us think how profits are made by insurance. Well, it is one of the ways to make money, but not the only one. And yes they do invest in equities (Hold shares in different companies) which give handsome returns. And in India, where the concept of insurance is generally linked with savings cum insurance, where you do get your money back along with some predefined rate of interest if the insured is still alive, to put it blatantly, the concept of earning money through premiums does become obsolete and the idea of earning money gains traction.

So, technically speaking, insurance companies make money in two ways: Underwriting and Investments. 

Investments, we have a bit of an idea how it works. Now, what is this underwriting?  Underwriting is the process of evaluating the risk to be insured. This is done by the insurer (I am sure we all are sure about Insurer and the Insured here!) when determining how likely it is that the loss will occur, how much the loss could be and then using this information to determine how much you should pay to insure against the risk.

Just remember the smart guy in the basics of Insurance article, where he decided to charge Rs 110/ to insure the houses against fire. What he did was what we call as underwriting!

Let's simplify it a bit more. Imagine a life insurance company is going to issue RS.100,000 policies to 1000 people for a one year period. They collect a pot of premiums from those 1000 people. During that one year, some number of the 1000 insureds will die and collect the Rs. 100,000. The rest won't. Underwriting is choosing whom to sell the policies too and figuring out how much premium to charge.

There are different approaches to this. You could take all comers and charge them all the same amount. Of course, going into it you have to have a prediction of how many people are going to die so that you'll have enough to cover and still make a profit. Say you think 10 people will die. So you'll have to collect 10 x 100,000 = 1,000,000 to cover plus a little more for profit, administrative expense and a safety margin. Let's say you decide you need 1,250,000. You charge each of your 1000 insureds Rs.1250.

Of course you could also charge the 25 year old healthy male non-smoker less than the 75 year old obese overweight heart patient who smokes like a chimney because the first guy is far less likely to die during the year. After centuries, the life insurance industry is very sophisticated about predicting how many and when people will die. But the whole idea is that you collect enough from the large pool of insureds to pay the benefits of the small number that die during the year. That's the underwriting side of it!

Easy enough!

Now, for the other way, that is, through investment. Go back to our example. Say you collect Rs 1,250,000 in premiums on January 1 for that one year insurance policy. During that year you invest the Rs.1,250,000 and make a return -- for ease of calculation sake, say 10%. 10% of Rs 1,250,000 is Rs.125,000 -- Profit!

So, simply speaking, as insurance company's reserves are not held in a savings account. Rather, the insurance company invests those reserves. If the insurance company makes a positive return on those investments, then that money would be a profit. So, if the company makes a 10 percent return as described  earlier, they will make a clean profit of Rs. 125,000, after accounting for the payments they have to make , which actually does incorporates all the expenses they have.

Now, to understand the investment process a bit more, I would say, clearly, we would have to understand the time value of money. In the simplest of terms, it means that a 100 rupees right now will be worth less tomorrow than what it is today. Let’s understand it in a better way. You were able to buy one kg of tomatoes for Rs. 30. Today they are at Rs. 60 a kg! So, the value of that Rs. 30 has decreased by a half!! That’s what we mean by Time Value of money.  Or to say it in a different way, the present Rs. 30 is worth half of its value in the future, say after one years! 

Or, to understand the business of Insurance better, we can say that if I borrow Rs. 30 from you today and then returning the same Rs 30 to you after one year, you are actually losing money! By the tomato analogy, you actually got half of what you  should have got! So, the value of money of same amount of money today is more than what it will be after an year! And if you follow what I have been trying to say, a Rs 30 in future, here, is actually as good as Rs. 15 today!! Eureka!

Now, to understand it better, let’s get back to our books. So, if you remember something called Compound interest, the equations for which looks something like:

The equation simply means that if you invest Rs. 80 at the rate of 25% per year, after plugging in the values , the value after one year would be:

FV= 80* (1.10)^1=100

So, 80 rupees right now becomes 100 after one year.Now, just juggle the equations a bit, we will have:

What this equation does is simply exchange the places for Present value and Future value. So, if in future, if we have 100 Rs, here, it’s present value would be Rs. 80 only!!

So, when insurance companies charges you premiums based on that Rs 80 and gives you back the pledged amount after , say, 10 years, they have effectively made money with this investment without moving a muscle! That’s the beauty of time value of money! And the power of compounding, which Einstein said was the eighth  wonder of the world!  Insurance companies, in effect, know they will be paying a lot less ten years or even two years down the line than what they charged premiums for and this is where the major parts of the profits are made.

I am sure you would have a good idea by now how Insurance companies make money. In the next article, I will talk a bit more about risk management and then follow it up with articles on different types of Insurance. Keep reading!

Risk Management and the Insurance link!

So, as promised, here’s an introduction to risk management!

As they say, life is full of risks - some are preventable or can at least be minimized, some are avoidable and some are completely unforeseeable. What's important to know about risk when thinking about insurance is the type of risk, the effect of that risk, the cost of the risk and what you can do to mitigate the risk?

Now, in simple terms, mitigating the risk means taking care of the risks. Or reducing it. So, when you play cricket and wear helmets and pads and all the accessories, you are mitigating your risk of getting injured! And taking that analogy, when you buy a motor insurance, you are insuring yourself against accidents and insuring your loss of vehicle. You are mitigating these risks.

Let's take the example of driving a bike.

                       

Type of risk: Injury, Complete Bike gone, having to fix your bike

The effect: Spending time in the hospital, having to rent a car and having to make EMI payments for the bike which no longer exists! 

The costs: Can range from small to very large. Think of just fixing the brakes to changing the whole Fuel tank, shockers, and wheels. All combined!

Mitigating risk: Not driving at all (risk avoidance), becoming a safe driver (you still have to contend with other drivers and especially those Truck Drivers on the NH 24), or transferring the risk to someone else (insurance).

So, as we have seen, Risk is a condition whereby there is a possibility of loss occurring. In insurance the subject matter insured is called the Risk( You having a bike crash or your house getting, in the previous  article!).

There are two main components in definition of risk:

i) Uncertainty: Uncertainty refers to a situation where an event may or may not happen.

For eg. a building may or may not have a fire accident.

ii) Undesired consequences: Undesired consequences refers to the negative results that may arise out of an event, such as a fire accident which may result in damage to a property as well as result in consequential loss of business due to stoppage of work.

Other two things that is important to note is that Risk is distinguished from peril and hazard. Peril is a cause of loss, eg. fire. Hazard is a condition that may create or increase the chance of a loss arising from a given peril.

So, risk is that you will get cancer; Peril is that your lungs will go haywire and smoking is the hazard! Simple enough!

Let's explore this concept of risk management (or mitigation) principles a little deeper and look at how you may apply them. The basic risk management tools indicate that risks that could bring financial losses and whose severity cannot be reduced should be transferred.

            

                                                         Risk Management!

So, the basic idea for Risk Management is that first of all, you have to identify the risks. Or what we call Asses the risks. So, when you realized that you might get into an accident or some other truck wala will run you over, you realized and identified the risk you are having.

That’s about Identification of the risk!

So, after identifying the risks, you will analyze what needs to be done to mitigate the risk! Will you be able to pay the amount involved if you get involved into accident, broke your bike or your bones or both! Say, everyone in your city is such a good driver that they have never been into an accident and the chances that you will get into an accident are so less or almost negligible that paying the premiums is actually a waste of money! Or if you live in a city like Delhi, where accidents are so common that you will not even think before signing that cheque for premiums!

So, what we did in the previous steps is what we call Analysis of Risk or Risk Assessment!

Next comes what we Risk Treatment, wherein we do risk planning.There are two ways that risks can be controlled. You can avoid the risk altogether, or you can choose to reduce your risk. So, based on the city you live, you will decide whether yo take the risk yourself or pass on the risk to some insurance companies. That is what we call Risk Financing! If you decide to transfer the risk, you can then transfer the risk to some insurance company. This is also where the concept of Risk Sharing comes in, where you pay the premiums and share the risk of a bike accident with fellow riders or share the risk if your house getting burnt!

For risks that involve a high severity of loss and a low frequency of loss, then risk transference (ie. insurance) is probably the most appropriate protection technique. Insurance is appropriate if the loss will cause you or your loved ones a significant financial loss or inconvenience. For risks that are of low loss severity but high loss frequency, the most suitable method is to keep the risk with yourself (say, you getting a cold!). In other words, some damages are so inexpensive that it's worth taking the risk of having to pay for them yourself, rather than forking extra money over to the insurance company each month. 

The last step is monitoring those risks, keeping a check on the finances so that cost of transferring the risk doesn't become greater than the risk itself!  And even if you have transferred the risk, it is better to avoid the realization of those risks than face them!

So, after an introduction to Risk Management, I will be taking up Risk Management from the point of view of Insurance Companies and how they actually make money!

An Introduction to Insurance

So, with all the talks about Uttarakhand disaster and LIC paying a record amount of money to the policy holders, insurance business has come into limelight like never before. And combine that with the talks of LIC holding stakes in some of the largest oil companies and others such companies, the whole business of insurance does become interesting!

So, what is Insurance?  Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium.  Now, what does that mean? Simply speaking,  insurance is risk management.

How?

Let me explain this through a very basic example. Say, you live in a village of 100 houses and it’s winter time. All of the families depend heavily on burning firewood to counter that. Now, as you might guess, fires will be a big concern  and somehow, you do calculate that there is one in a hundred chance of a house being burnt. Now, let’s say the price of reconstructing a house is Rs 10,000. So, a smart guy comes along and says that if everyone pays Rs. 110 rupees, he will pay the amount if any house burns! So, in effect, he gets RS 110*100=Rs 11000. Now, a house does get burnt and he does pay Rs. 10,000 to the family. So, in effect, the family whose house got burnt  got the amount he needed by just spending Rs 100 and the smart guy pockets Rs. 1000 as his profits. And all others who paid Rs 100 are actually happy seeing that an amount of Rs 100 secures his house, which would otherwise have cost them Rs 10,000!

       

The above story actually encompasses almost everything about insurance! Let’s see how!

The families were under pressure and if faced with the problem, here, their houses being burnt, would have suffered huge financial setbacks! So, they were under a risk! And what is a risk? Simply speaking, it is the probability of a loss occurring. And a smart guy saw that some people are under risk and sensed a business opportunity, wherein he could transfer their risks to himself and earn some money in the process! But then again, what if two houses caught fire. What if that number, in the highly unlikely case, goes to five? He will be broke! So, even he is under a risk that his calculations of the risk he is taking goes off chart (And this is where those FRM’s and Actuaries come into picture!)! Now, in pure business, even he can pass on those risks at some cost to some even smarter guy (In Technical terms, Insurers of the insurers).

And talking of technical terms, the families in the example are the insured and the smart guy is the insurer! And the amount of Rs 100 paid by every family is what we call a premium. An dthe amount of Rs.10,000 which will be given to the family whose house got burnt is what we call pledged amount or, sum assured! Simple enough, I believe!

Now, of course, there are various kinds of risks. Like a motor accident or a flood or your life or your shop getting looted or your house getting burnt! Fairly enough, there are various kinds of insurance. Broadly, it is divided into two parts: Life Insurance which insures life or in simple terms, promises a definite amount of money if someone (The insured dies) and Non-Life Insurance, such as theft insurance which promises to pay back the value of the goods stolen!

Insurance is appropriate when you want to protect against a significant monetary loss. Say, life insurance . If you are the primary breadwinner in your home, the loss of income that your family would experience as a result of our premature death is considered a significant loss and hardship that you should protect them against. It would be very difficult for your family to replace your income, so life insurance ensures that if you die, your income will be replaced by the insured amount. The same principle applies to many other forms of insurance. If the potential loss will have a detrimental effect on the person or entity, insurance makes sense. Now, you would not want to insure if you get a cold! That would not be worth the effort and the money involved!

Insurance works by pooling risk. What does this mean? It simply means that a large group of people who want to insure against a particular loss pay their premiums into what we will call the insurance bucket, or pool. Because the number of insured individuals is so large, insurance companies can use statistical analysis to project what their actual losses will be within the given class. They know that not all insured individuals will suffer losses at the same time or at all. This allows the insurance companies to operate profitably and at the same time pay for claims that may arise. For instance, most people have bike insurance but only a few actually get into an accident.

                      

                        Pooling Risks so that no one person has to pay the whole!

You pay for the probability of the loss and for the protection that you will be paid for losses in the event they occur!

So this was a general introduction to the business of Insurance. In the most basic sense, it is Risk Management! Though it is not easy and in fact, professionals are ther to manage risks for both the insured and the insurer! Let’s talk about Risk Management in the next article on the Insurance series!

Sovereign Bonds and Phorex Money!

So with all the newspapers and magazines going gaga over Sovereign bonds and the ability of India to raise capital through these (Some are saying to the tune of $8billion), the word has suddenly become the new hot and sexy word in the finance world.

So, what is a sovereign bond? And how will it help in stalling the fall of rupee and how  it will help the economy in general? Are there any risks involved? What are those risks? How will it be mitigated? Does Greece and Spain, with whom, the word Sovereign has so closely been mentioned all these months when they failed, have done something which India should be wary of?

These and other questions are cropping up and rightly so. These need to be addressed.   So, what is a sovereign bond? And what is sovereign?  Simply speaking, sovereign is government. Although the literal meaning does mean a ruler or king, for our purpose, govt. will suffice. And a bond is a paper issued by anybody which says that that the person (Or the organization) which issued the bond owes some amount of money, generally printed on the paper. Think of NSC papers or Kisan Vikas Patras! They are bonds! Simple no?

For that matter, say you want to open up a company and need money for that. You decide to raise money through public, but do not want to offer an IPO(Initial Public Offerings!). So, what you will do is you will announce to your friends that you want some money and you are willing to offer a fixed amount of interest on that. They give you the money. How would you assure them that they will receive the interest and the amount they lent you? Simple, you will offer them a legal paper which will state the amount borrowed, interest amount (maybe) and a promise to pay that back! So, in effect you have decided to issue bonds to raise money! Which is nothing but a promise made so that you can borrow money and would pay later! Or in economic terms, these papers called bonds are in effect a way to borrow money. Or what economists call as Debt Instruments! Easy Peasy!

Now, as you can guess, what will happen if your company fails? Or you run away with all the money without actually investing all that money anywhere? Or you die? Or you are notoriously known for not paying back and nobody is actually interested in lending you money?  Or the idea of your company is very shaky and even if you are a saint, the lenders doubt your company will do good enough to pay you back?

All these are risks associated when bonds are issued. Now, inflate the stakes, as we always do, and think of a country needing money and that too dollars? What will it do? It will try to issue bonds in dollars (which means bonds which are denominated in dollars and can be bought in dollars only and payable also, in dollars!), hoping to  strengthen its economy with all that money and then pay back with  all the more earned (And hopefully, strengthen own currency so that dollar cost can be lowered. Think of buying dollars at  60 a pieces, making money on that and in the process, bringing the dollar down to 50! So , a country will earn 10 Rs per dollar without moving a muscle! Awesome! )

So, now, let’s get a bit more involved. A sovereign bond is a debt security issued by a national government within a given country and denominated in a foreign currency. The foreign currency used will most likely be a hard currency, and may represent significantly more risk to the bondholder. The risk is, say if dollar weakens(In our case , Rupee Strengthens, so somebody who has bought the dollars by selling a rupee will actually lose out if, say interest earned is 10 Rs and dollar has weakened by more than that! Poor guy! ) And the debt so obtained is called sovereign debt! Again, elementary stuff!

A US bond looks something like the one given below:

        

Now, a few things to note are that the denomination that is printed on the bond is the amount that the person buying the bond will be getting at the maturity( i.e, after the time for which it was taken,has elapsed) . Then what is the profit that the bond holder will be getting? The funda here is that bonds are issued at what we call generally a discount . So, a 10% discount bond will mean that a bond of $ 1000 denomination will actually be available at $900, a 10% discount. These discounted bonds are also called as zero yield bond!

The other thing to talk and know about is related to the risk that we talked about. Remember you running away with the money?  In case of sovereign bonds, ratings are allocated to countries, as shown below: 

Countries with AAA ratings are those with least risk and hence will have to pay lower discount or lower interest rates since they are considered safe .In case of India, the figure above means we have to offer higher interest rates to attract investors, because of BBB- ratings. Generally, lower the ratings, the more riskier it is and hence higher rates. Compare that with the money lenders who lend at higher rates because no documentation is involved and the fact that the borrower could actually run with the money. If you have an idea about the Sub prime market, banks lends to those customers who have a bad credit history at higher rates to compensate for higher risks involved!

Now, in case of India,  latest data from the RBI shows forex reserves fell to a three-year low of $280.17 billion in the week ended July 5. A sovereign bond issue would infuse more dollars into the domestic financial system, the liquid dollar available will increase and have a bearing on the rupee. And hopefully, more dollars in the economy will strengthen rupee and also shore up economics into higher growth mode.

Risks are that India will come under sovereign pressure, though it will be a good thing if the pressure is taken positively and the money is used for manufacturing and real economic growth rather than funding some fancy Gandhi plans, which will only lead to increased risk of default! We have issued these bonds twice in past, once when we were broke in 1991 and another in 1998. We need to make sure we raise money by planning better rather than as a panic reaction, which is what even 2013 bond issues will be, if there is any!

Of course, there are countries which have defaulted on Sovereign bonds, such as Russia Rubel default in 1998 which sent the stock markets and bond market crashing and the current defaults by Greece and other EU countries, which are facing very high sovereign default risks (If in local currency, you can print money, but then hyperinflation lurks just around the corner and what to do if they are in dollars!) But then again, another article for that!

Hyperinflation and the Zimbabwe Story!

Every  time I go to buy something from the vegetable market, I get a shock. Heights was when I was told that tomatoes are for  Rs. 70 a kg! And not just vegetables! The ever growing inflation is omnipresent and more often than not, I am calculating whether I am getting a raise or my earnings are actually decreasing on real basis, that my purchasing power is decreasing!

Now, question is, what is purchasing power? Simply put, it is the amount of goods that I will be able to buy for a certain amount of money. I used to buy one Deo for Rs.95 while  I was in college, now I am able to buy the same for Rs. 175!! So while I was able to buy a Deo for Rs 95, now it is for Rs 175. Product is the same, but I have to now pay more or the value of my money has decreased! And in this example, by more than 80 percent!!

The phenomena explained above is called inflation. And believe it or not, some amount of inflation, that is, price rise is actually good for the economy. I have explained this in my article on inflation           

                                 

                                       Both the Extremes are bad!  
Here, in this article, I will be talking about the third balloon in the figure; When the inflation goes too high! We call an abnormally high inflation as Hyperinflation. How Abnormal? The inflation percentage was 7.6 billion percentage for two years. Yes, you heard it right! And we are crying over the poor 8.4 % that we are facing! Imagine the kid here, with all that cash!  And  what was he going to buy? A loaf of bread!

                                                     
                                                                                                 

                                                                                                    

So, what is hyperinflation? Hyperinflation is when a country experiences very high and usually accelerating rates of inflation. The general price level within an economy increases rapidly as the official currency quickly loses real value(Imagine buying that Deo for ten thousand bucks! Or even more!). Meanwhile, the real value of economic items generally stay the same with respect to one another (You are still getting the same deo! And alas, only one deo!), and remain relatively stable in terms of foreign currencies(Think of Rupee sliding!).

Unlike regular inflation, where the process of rising prices is not that much highlighted and is, generally taken not that badly by the masses, hyperinflation sees a rapid and continuing increase prices and in the supply of money, and the cost of goods.Hyperinflation is often associated with wars, their aftermath, sociopolitical upheavals, or other crises that make it difficult for the government to tax the population, as a sudden and sharp decrease in tax revenue coupled with a strong effort to maintain the status-quo can be a direct trigger of hyperinflation. Or simply, very poor governance and greed. Couple that with people trying to get rid of their currency  since they know it will lose even more value. This then becomes a vicious circle, forcing the central banks to print more money, thus further lowering the value of the currency and this goes on!

One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours!

Huh, talk of starving Billionaires!

                  

                  

                              

So, without much ado, let’s see what exactly causes hyperinflation?  If we go by definitions, it occurs when there is a continuing and accelerating rapid increase in the amount of money that is not supported by a corresponding growth in the output of goods and services.

The price increases that result from the rapid money creation creates a vicious circle, requiring ever growing amounts of new money creation to fund government activities.

The above situation is actually called Supply Shock!

Now, think of you winning a huge lottery by some chance. Now, when you go to the local vegetable market, you will not bargain and pay the guy that Rs 70 for that one kilo for the tomatoes! Repeat this a few times  and the vegetable vendor  will raise the prices, sensing an opportunity to gain more profits. So, eventually this guy will have more money, so he will pay more the guy selling, say, milks and the whole chain will be getting more money like this!  Slowly, the whole area near you will have more money to spend, but same things to buy. And they will be willing to pay more now!

Just up the stakes and think of more money floating around the economy without actually more goods being produced. As such, more money will be available to buy the same things and this will lead to rise in prices. Such rapidly increasing prices cause widespread unwillingness of the local population to hold the local currency as it rapidly loses its buying power. Instead they quickly spend any money they receive, which increases the velocity of money flow; this in turn causes further acceleration in prices!

Usually, the excessive money supply growth results from the government being either unable or unwilling to fully finance the government budget through taxation or borrowing, and instead it finances the government budget deficit through the printing of money (Like I said earlier, poor governance!).

So in general, an unlimited and nonsensical printing of money combined with no real GDP output provides the impetus needed for hyperinflation!

So, how do we tackle this? There are very limited things a country can do after things have gone back. China had to switch currencies when it was plagued with Hyperinflation and the  overall impact of inflation was 1 Renminbi = 15,000,000,000,000,000,000 pre-1948 yuan!!  Recently, Zimbabwe had to abandon the local currency!

In fact, at independence in 1980, the Zimbabwe dollar (ZWD) was worth about USD 1.25. Afterwards, however, rampant inflation and the collapse of the economy severely devalued the currency. Inflation was steady before Robert Mugabe in 1998 began a program of land reforms that primarily focused on taking land from white farmers and redistributing those properties and assets to black farmers, which disrupted food production and caused revenues from export of food to plummet. Result was that to pay its expenditures their Reserve Bank printed more and more notes with higher face values.

Just for the sake of figures, Hyperinflation began early in the 21st-century, reaching 624% in 2004. It fell back to low triple digits before surging to a new high of 1,730% in 2006. The Reserve Bank of Zimbabwe revalued on 1 August 2006 at a ratio of 1 000 ZWD to each second dollar (ZWN), but year-to-year inflation rose by June 2007 to 11,000% (versus an earlier estimate of 9,000%). Larger denominations were progressively issued , with denominations reaching trillion dollars and then everything collapsed, with that trillion dollars good enough just buy one piece of bread!

So, after all this, the best thing I learnt is that the dreams I used to have during my childhood: A rupee printing machine is actually not a great idea at all!

The Poor Rupee!

So, our beloved rupee is on an ever sliding mode, notwithstanding the increase  of MSL rate by RBI today. And mark my words; this is nothing but a spray you put if you strain yourself playing a football match. If a bone is broken, it will remain broken; spray will only help alleviate the pain. And that too temporarily. The whole economy needs to push itself into a recovery mode and it has to start with us refusing to buy those imported Chinese Ganesha Idols or for that matter, Barbie dolls. We can as well start building up factories to copy China and in the process , well, beat them in their own game!             

                          

                         Chinese Toys:These need to be Stopped!

So, how does a currency is valued against some other currency, especially, Dollars? This question used to intrigue me a lot while I was in college (I am an B. Tech, so no course on this :( ). There are hordes of literature available on the issue and if anything else, they have helped me in getting confused even more! To cut it short, almost all trades between two different countries is done in a common currency, which is more often than not, the omnipresent dollar. Now, when a country starts importing more than exporting, the outflow of the dollar is more than the inflow and this simply means you have to start paying for your reserves or exchange  your currency for dollars. Now, who will buy your currency, since the buyer will not be able to use it for trading! So, this pushes down the value of the currency and if the poor country keeps on importing more, it will have to keep bleeding more and the  worth of its assets will keep sliding down ,significantly!
                
                              

                               

This is what is happening with our poor rupee. Our  manufacturing is dying, we are producing less and less goods to satisfy our needs let alone exporting it to other countries. And this is simply pushing up our import bill. Actually, if you do read news, this is exactly what we call as current account deficit or CAD. Fiscal deficit is something different and I do plan to take it up sometime later on. 

And until and unless we buckle up and start  manufacturing goods of our own instead of relying on imported stuff(Heck, even the chair I am sitting on is made in China! We can certainly make them here, in our very own India!), we will continue to become even more reliant on dollars and our rupee will continue to slide even further, with 70 a mark not being far !

So, with this in mind, let’s see how the recent measures, be it open market operations or forcing  the banks to borrow less rupee so that they can buy even less dollar(Which banks do to take advantage to currency price differences to make money, buying and selling in different markets and then making money! And if you happen to be a fan of Elementary , a series on Sherlock Holmes, this is what Irene was actually trying to do, hoping to make billions in the process1). So, the RBI has increased the Marginal Standing Facility (rate at which banks borrow from the RBI using their statutory liquidity ratio securities as collateral) rate. So far, banks (bearish on the rupee, that is they do not have much hope on Rupee. A view we share!) Borrowed from call money markets and bought dollars in the forward markets expecting the dollar to rise. Since, borrowing short term money will now be costlier, banks will most likely cut their forward positions and reduce speculative trading. This will reduce pressure on the rupee. I know this does involve a few terms. I will be clearing them up in some time and later articles. 

In addition, RBI has capped the amount banks can borrow from overnight markets and will also conduct open market operation, where they will sale bonds. How does selling bonds help? Selling bonds at a good rate will entice buyers to buy them, in the process, liquidity will be sucked from the economy and people will have less money to buy dollars! The higher yields will attract Foreign Institutional Investors (FIIs)to invest more money in the Indian Bond market and this will provide more dollars.

All good till now, but is this really a great idea?

There are many reasons I believe the idea sucks. The major one being we are trying to do what shouldn’t be done. The liquidity crunch will lower the growth of our already ailing economy and will not help the manufacturing industry since the cost of borrowing money will increase and hence , the overall growth will be hurt. Badly. Even Infra sector will take a hit since loans will become costlier, coz banks will have them at higher costs! Simple enough!

The stock market plunge, especially the banking stocks plunging on the fears of rise in bank rates and CRR rates will only worsen the situation.

Even the benefits of FIIs is highly overrated since they do not contribute effectively to the economy. Most of them, if not all are interested in making money and will take their investments out if they fear any negative environment on economy and the coming elections will not help at all in this. What we need is more FDI, since it is here that real progress happens, infrastructure gets built up and people get employment. Making goods and , in effect, money in the process!

For real recovery, like in the case of broken bones, we need to think ahead of pain killers. Incentives to set up factories, SMEs Loans, better business environments, more emphasis in job creation rather than job taking in colleges and less politics while setting up a company will certainly help. So will creating avenues for entrepreneurs who wish to do more than just build apps for mobiles. Think of making mobile handsets! We need to have plans for these rather than announcing subsidies and taxing heavily the same product (Petrol and Diesel. That oil companies lose money on these is the largest misconception Indians are having!) and distributing food at giveaway price, which will come, eventually from the tax payers money and fill ministers and babus coffers.  We need to invest more in states like Odisha and Jharkhand and reap the benefits of mineral wealth we are having there rather than providing windfall gains to foreign conglomerates. And we need to manufacture BMWs rather than importing them. We need to open up our economy more and actually help those willing to do something rather than creating roadblocks for them! We need to bring money from those Swiss banks and build factories with that. We need to stop harping upon gold!     

                   

             
The list goes on, I am sure you must have an idea by now.

Remember, rupee was at 5 a dollar before we started making our democracy a mockery of the very word and handing the wheels of the country to a fake family! We need to take those wheels back!