Game of Compounding

In an earlier article we discussed about how to make your money work for you. And this is very much indispensable for an individual to forget it, and the fun in the game is due to a concept called as compounding. Albert Einstein has quoted it once, “Compounding interest is the greatest mathematical discovery of all time”. On every investment you generate a certain amount of money inform of returns, and this return can be regarded as the interest on the principle that you invested. And when this interest is added to the principle and the next interest is calculated on such new principle this process is called as compound interest, and the process keeps on going. Compounding works on two basic premises: re-investment of earnings and time.

And this is the most important feature in any of the investments. Compounding investment earnings can turn your small investments into a whopping sum after a period of time. The best way to take advantage of compounding is to start saving and investing wisely as early as possible. For this let’s play a golf game and try to understand the power of compounding.

The rules of the game are simple; there are 18 holes that you need to put. For the first hole that you put you will receive 10 paisa. And for each successful and subsequent put the stake will be doubled.

Lets see how this looks like on the graph.

And if you closely analyse the fun in the game starts from 12^th hole. But the sad thing is you cannot start directly from the 12^th hole. And if you join the game three holes after, i.e. 4^th hole is your 1^st hole then; you would end up with Rs. 1638.40 only.

‘Time is Money’ and not timing. Most of the people tend to ask this question, what the right time to invest is. I would generally suggest today and right now. The idea is simple: the earlier you start investing, the more likely it is that you would end up making more money. Now once you have decided to make the money work for you, next question that should arise where to take the advantage of this compounding. For this you need to wait a bit for my next article releasing soon.

Tame it Else Don't Blame it

In an earlier article we discussed about inflation and how it is calculated in India. With the inflation touching about 9.5%, the RBI has started taking corrective measures to tame such inflation, as even the fixed deposits with banks are also yielding negative returns. Recently, Mr. Duvvuri Subbarao, Governor RBI, raised the repo and reverse repo rate by 50 bps. So it becomes very important for us to understand various tools which a government can use to tame inflation.

Mainly, we have two important policies to control inflation, namely, Fiscal Policy & Monetary Policy. Both the policies affect the demand side of the economy, in the process of controlling inflation, i.e. they increase or decrease the demand of the people in the economy, does control the money supply. Here, in this article we will throw some light on the quantitative tools in the monetary policy.

MONETARY POLICY

It is the process by which the central bank of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. In India, the central bank for framing monetary policy is named as the Reserve Bank of India (RBI). The official goals usually include relatively stable prices and low unemployment. Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual (i.e. intends to increase inflation), and contractionary policy expands the money supply more slowly than usual or even shrinks it (i.e. intends to decrease inflation). For this RBI has following commonly used tools:

• Open Market Operations
• Cash Reverse Ratio
• Statutory Liquidity Ratio
• Bank Rate
• Repo & Reverse Repo Rates

OPEN MARKET OPERATIONS

Also known as OMO, is the buying and selling of government securities or bonds in the open market by RBI. It is the primary means of implementing monetary policy. The main aim of it is to control the short term interest rate and the supply of base money in an economy, and thus indirectly the total money supply. RBI does it like, if there is excess money supply, the RBI intervenes and sucks it by issuing bonds, and getting the money from market and if the liquidity starts to dry up in the markets, the RBI intervenes once again and infuses liquidity by buying back the bonds that are with the investors.

CASH REVERSE RATIO

Also known as CRR refers to this liquid cash that the commercial banks have to maintain with the RBI, as a certain percentage of their NDTL (Net Demand and Time liabilities/deposits), ensuring safety and liquidity of deposits. Say for example if the CRR is 10% then a bank with net demand and time deposits of Rs 10,000 will have to deposit Rs 1,000 with the RBI as liquid cash, and the banks are net left with Rs. 9,000 to be disbursed as loans. Now to control money supply in the markets, RBI tend to increase such CRR which in turn leaves banks with lesser amount of money for being disbursed as loan. In above example, the CRR is hiked to 15%, then banks will have to deposit Rs. 1,500 and does are left with Rs. 8,500. The opposite may happen to increase the liquidity in the markets. This has to be maintained on fortnightly basis by all the commercial banks. The current CRR as on August 1, 2011 is 6%.

STATUTORY LIQUIDITY RATIO

Also known as SLR refers to the amount of liquid assets, such as cash, gold or other approved securities, that a commercial bank must maintain as reserves with itself other than the cash with  RBI (in form of CRR). This also is calculated as a certain percentage of their NDTL (Net Demand and Time liabilities/deposits), Say for example if the CRR is 10% and SLR is 25%, then a bank with NDTL of Rs 10,000 will have to deposit Rs 1,000 with the RBI as liquid cash and keep Rs. 2,500 with itself in declared format and thus are net left with Rs. 6,500 to be disbursed as loans. Now similarly, to control money supply in the markets, RBI tends to increase such SLR which in turn leaves banks with lesser amount of money for being disbursed as loan. In above example, the CRR is 10% and SLR is hiked to 30%, then banks will have to deposit Rs 1,000 with the RBI as liquid cash and keep Rs. 3,000 with itself in declared format and thus are net left with Rs. 6,000 to be disbursed as loans.  The opposite may happen to increase the liquidity in the markets. This has to be maintained on fortnightly basis by all the commercial banks. The declared way to maintain SLR is in form of cash, gold and securities approved by RBI. The current SLR as on August 1, 2011 is 24%.

BANK RATE

The bank rate is that interest rate at which RBI lends money to commercial banks, to control the money supply and the banking sector in the country. When RBI reduces the bank rate, it increases the attractiveness for commercial banks to borrow, thus increasing the money supply. When RBI increases the bank rate, it decreases the attractiveness for commercial banks to borrow, consequently decreasing the money supply. A change in bank rates affects customers as it influences prime interest rates for personal loans. The bank rate as on August 1, 2011 is 6%.

REPO & REVERSE REPO RATES

Repo means repossession or a repurchase agreement that is the sale of securities together with an agreement by the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively representing interest, called as repo rate.

In monetary policy, repo is a collateralized lending by RBI to commercial banks which borrow money to meet short term needs, have to sell securities, usually bonds to RBI with an agreement to repurchase the same at a predetermined rate and date. In this way the lender of the cash is RBI, the securities sold by the borrower are the collateral against default risk, the borrower of cash is usually commercial banks. RBI charges some interest rate on the cash borrowed by banks. This rate is usually less than the interest rate on bonds as the borrowing is collateral. This interest rate is called 'repo rate’. The lender of securities is said to be doing repo whereas the lender of cash is said to be doing ‘reverse repo’.

A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints. Now the commercial banks with excess funds can park them with RBI in exchange of securities. The interest paid by RBI in this case is called reverse repo rate.

Repo Rate Example: say the repo rate is 10%, and commercial bank needs funds they can sell securities worth Rs. 10,000 (market value) to RBI, then RBI would pay Rs. 10,000 to the commercial banks and get the securities from them and after one year (assumed) the commercial bank would repurchase the sold securities from RBI by paying Rs. 11,000. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.

Reverse Repo Rate Example: Say, the reverse repo rate is 8%, and commercial banks wants to park their funds with RBI Rs. 10,000, then commercial bank would pay Rs. 10,000 with RBI and get the securities from them, and after one year (assumed), the commercial bank would resell the purchased securities from RBI by paying Rs. 10,800.

A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive, similarly, an increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system and vice versa. The repo rate as on August 1, 2011 is 8% & reverse repo rate is 7%.

CONCLUSION

Like every coin has two sides, similarly even inflation can have good and bad effects, i.e. why they also call inflation a double edged sword. Many economists suggest that they will use resources like the central bank to create and maintain certain levels of inflation as necessary for our economy. Practically they mean to say, a little bit of controlled inflation is a good thing but a very high and uncontrolled inflation is a bad thing. A little bit of inflation is like a tax on idle money. It prompts people to get their money out of the pocket or low interest accounts and put it to work on investments. And this investments works in the favour of the concept of capital formation in an economy and does in the growth and development of it.