NISM RA study kit
Chapter 5 of 15

Economic analysis

Worth 5 marks of 100Book pages 90 to 104About 40 minutes

Before judging a company, check the weather: is the economy growing, and will the government and central bank help or hold it back?

Chapter mapSix parts. 5.3 is the longest. Tap to jump.
5.1 and 5.2Micro and macroSmall picture, big picture 5.3The big numbersGDP, savings, inflation, jobs, foreign money 5.3.6 to 5.3.9Policy and tradeFiscal, monetary, BoP, globalisation 5.4Why analysts careEconomy to industry 5.5Three kinds of trendSecular, cyclical, seasonal 5.6Where to find dataFour sources
5.1 and 5.2

Micro and macro

Economics studies how people make choices when resources are scarce. It assumes people are rational: they have clear goals and try their best to reach them. Choosing one thing usually means giving up another. That is a trade-off.

Two lenses on the same economy
5.1

Microeconomics: the small picture

  • Individuals and firms: what they buy and consume at current prices
  • Belief: prices and production are driven by consumer demand
  • Includes the "theory of the firm": how firms set inputs, outputs and prices to raise profit
  • Explains how prices are set and how goods are shared among people
5.2

Macroeconomics: the big picture

  • The whole economy: aggregate supply and demand
  • GDP, unemployment, price levels, inflation, savings, investment
  • Shaped by public policy: government (fiscal policy) and central bank (monetary policy)
  • Covers trade, balance of payments, exchange rates, links between economies
Micro is looking at one tree: how it grows, what it needs. Macro is looking at the whole forest: is it spreading or shrinking, and what is the weather doing to it?

John Maynard Keynes put great weight on macroeconomics. His book, "General Theory of Employment, Interest and Money", changed economic thinking.

The two major influencers of economic policy are the government and the central bank. Not stock exchanges, not SEBI.
5.3

The big numbers

Policy makers aim for three things: low unemployment, stable prices (low inflation) and steady growth. Even so, economies go through booms and busts, because no one controls every variable.

The book's exampleIn 2011, 2012 and 2013, the RBI raised interest rates to bring down high inflation. It did not work as hoped, because food prices stayed high.

5.3.1 National income

GDP versus GNPWhere it is produced, or who produces it
GDP

Gross Domestic Product

Market value of goods and services produced within the country's borders, whoever owns the producer.

GNP

Gross National Product

Market value of goods and services produced by the country's residents, wherever in the world they are.

GDP

Inside the borders

+ NFIA

Net factor income from abroad: income received by residents minus income paid to non-residents

= GNP

By the nation's people

Three ways to measure GDP

Three methods, similar answersSmall differences come from things like errors in statistics
Product method

Count what is made

Value of all final goods and services, sector by sector: agriculture, industry, services. Intermediate goods, used to make other goods, are left out.

Income method

Count what is earned

Wages and salaries of employees, fees of professionals, profits of entrepreneurs, returns and rent of investors. (The book borrows these four groups from author Robert Kiyosaki.)

Expenditure method

Count what is spent

Private consumption + government spending + gross capital formation + net exports. Spenders: individuals, companies, government.

A cake is baked, sold and eaten. You can measure its value by what the baker made (product), what the baker and helpers earned (income), or what the customers paid (spending). Done carefully, all three give about the same number.

Why national income matters

  • Welfare and growth. Per capita income = national income ÷ population. It is a better measure of the standard of living than national income, because if population grows faster than income, each person is worse off.
  • Who gets what. The income method shows how income is shared. The product method shows which sector contributes most. The book: services are 60% of India's GDP at factor cost.
  • Guide to policy. Savings, consumption and investment figures help policy makers act.

5.3.2 Savings and investments

How national saving adds up

Personal savings

Individuals

+ Corporate savings

Companies' undistributed profits

+ Public savings

Government. Rare: governments usually run deficits

= National saving

Personal + corporate together = private savings

Savings are not the same as investment. Savings become investment only when they flow into productive use through instruments like shares, bonds and government securities. Governments and central banks build efficient financial markets to help this happen. Higher savings, and more of them turned into investment, are good for the economy.

5.3.3 Inflation and interest rates

Inflation is a general rise in prices that erodes what money can buy. Rs 1,000 kept in a drawer is still Rs 1,000 a year later, but it buys less.

Demand-pull inflation

Demand is more than supply, so prices rise.

Cost-push inflation

Input costs rise, so prices rise.

Inflation is measured at the wholesale level by the WPI (Wholesale Price Index) and at the retail level by the CPI (Consumer Price Index). Both price a basket of commonly used goods.

Inflation and interest rates are linked. Higher inflation needs higher rates to persuade people to save. Higher rates then:

  • cut consumption (people save more),
  • cut investment (capital costs more),
  • hit real estate and autos hardest, because middle-class buyers borrow to buy them.

High inflation also shrinks people's spare income, cutting demand everywhere.

5.3.4 Unemployment rate

The share of people who are able and willing to work but have no job. It rises in a slowdown and falls in an expansion. More jobs mean more income, more spending and more growth.

5.3.5 Foreign money: FDI and FPI

Two ways foreign money comes in
Active

FDI: Foreign Direct Investment

Investors take part in decisions and run the business. Long term and stable.

Brings: jobs, new technology, new managerial skills, new products and services.

Passive

FPI: Foreign Portfolio Investment

Buys shares or bonds in the market. No part in management. There are limits on how much FPIs can hold in Indian companies.

Called "hot money": it can leave at any time, which can create systemic risk.

FDI is a family that buys a house and moves in. FPI is a guest in a hotel room: welcome, but able to check out tonight.
5.3.6

Fiscal policy

Fiscal policy is the government's decisions on its income (mainly taxes) and spending (education, health, police, defence, interest, welfare). Changing either one moves demand, supply, savings and investment.

Fiscal deficit = the budgeted excess of government spending over revenue in a year, usually stated as a % of GDP. It is bridged by market borrowings, both short and long term. A large deficit means heavy government borrowing, which pushes up interest rates and makes it harder for companies to borrow.

How the government funds spending

  • Recurring revenue: direct and indirect taxes, interest on its loans, dividends from public sector companies
  • Capital transactions: borrowing in rupees and foreign currency, and selling assets (disinvestment in PSUs)

Current account

Recurring receipts from abroad (exports, interest, dividends) minus payments (imports and so on). Surplus if receipts are larger, deficit if payments are larger. A high current account deficit (CAD) weakens the currency, makes imports dearer and raises the cost of foreign borrowing. A weaker currency helps exports, and strong FDI and FPI inflows can offset the CAD.

Three fiscal stances
Neutral

Balanced

Income and spending are in balance. No big changes needed.

Expansionary

Spend more, tax less

Used in recessions or a slow economy. Leaves more money with people and firms. Results in a fiscal deficit.

Contractionary

Spend less, tax more

Used when inflation or debt has overheated the economy. Cools it down. Results in a fiscal surplus.

5.3.7 Monetary policy

Run by the central bank. It manages money supply, inflation and interest rates to support growth while keeping prices stable. Like fiscal policy, it is either expansionary (more money, lower rates, to push the economy up) or contractionary (less money or slower growth of money, higher rates, to cool it).

The central bank's tools
ToolWhat it is
Repo rateRate at which the central bank lends to financial institutions for a very short term, against approved securities (it buys them with a promise to resell)
Reverse repo rateRate at which the central bank borrows money against securities
Bank rateRate at which the central bank lends to commercial banks without collateral, for medium to long term or emergency needs
CRRCash Reserve Ratio: minimum % of deposits banks must keep as cash with the central bank
SLRStatutory Liquidity Ratio: minimum % of deposits banks must keep in cash equivalents such as gold and government securities
Repo = central bank lends. Reverse repo = central bank borrows. Bank rate = lending without collateral. CRR is held as cash with the central bank; SLR is held in gold and government securities.
No sure-shot formulaThe same policy can have different results in different economies. A fix for one problem can create another: stimulating a stagnant economy with more money, more spending or lower taxes risks raising inflation. Cooling an overheated one with higher taxes or lower spending risks a slow economy and high unemployment.

5.3.8 International trade and the balance of payments

The balance of payments (BoP) records all of a country's transactions with the rest of the world.

Balance of payments: old and new layoutThe book describes both
Old structure

Two accounts

  • Current account: imports and exports of goods and services. Imports above exports = deficit.
  • Capital account: capital flows like FDI, FII, loans and grants.

Ideally the two offset each other. They seldom do.

IMF BPM6 (in use now)

Three accounts

  • Current account: almost unchanged.
  • Capital account: non-produced, non-financial assets (patents, rights, land, natural resources) and capital grants and transfers.
  • Financial account: FDI, portfolio flows, derivatives, long-term debt flows, and reserve assets.

Current + capital + financial + errors and omissions = change in reserves.

A country with a continuing current account deficit needs capital inflows to pay for it, or it uses up its foreign currency reserves. Either way, market confidence can fall and the currency may weaken sooner.

5.3.9 Globalisation

The freedom of people and firms to make anything anywhere and sell anywhere, with people and capital flowing to where they earn the best return. No country is forced into it; each decides for itself.

Positives

  • Resources flow to where they produce and earn best
  • Developing countries link with the developed world: learning, products, technology
  • Global competition drives innovation and keeps prices in check
  • More choice of art, films, music, food, clothing

Negatives

  • Survival of the fittest: jobs move to the most competitive countries
  • Problems spread: the 2008 US credit crisis hit the whole world
  • Developed countries gain first and negotiate hard; developing ones need strong political will
  • Old traditions may erode. ESG shows cultural issues can become business issues
5.4

Why analysts care

How much a business grows depends partly on its management and partly on the world outside. Economic analysis reads that outside world.

What each number tells the analyst

GDP growth

Is the overall economy growing?

Fiscal and monetary policy

Do policies support growth?

Rates, inflation, spending, deficit

Where will policy go next?

The industry

How will this path affect the industry being studied?

If the economy is shrinking, the inflation rate shows whether the central bank has room to cut rates, and the fiscal deficit shows whether the government has room to spend more.

5.5

Three kinds of trend

Three cycles inside "cyclical"

1. The economic cycle. The length of each phase is unpredictable. Knowing the phase helps an analyst form a medium-term view of an industry's volumes and prices.

The four phases of the economic cycle
1

Expansion or boom

Higher income, low rates, strong confidence. Production and jobs rise. Firms expand capacity, consumers buy long-term assets. Borrowing rises, so rates rise. Inflation is high at the peak.

2

Slowdown

High prices and rates discourage buying. Central banks tighten. Consumption still grows, but more slowly. New capacity sits under-used.

3

Recession

Expansion plans cut, layoffs. Unemployment up, income and spending down. People save instead of borrowing, so rates fall. Inflation falls.

4

Recovery

Low inflation lets the central bank loosen policy. Money is easier, prices lower, buying resumes. Leads back to expansion.

2. The commodity cycle. Hard commodity prices rise and fall, usually following the economic cycle, though sometimes on their own. High prices lead suppliers to add capacity. Too much capacity pushes prices down. High-cost suppliers shut down. Supply falls and prices rise again.

Everyone plants tomatoes after a year of high tomato prices. Next year there are too many tomatoes, prices crash, and many farmers switch crops. The year after, tomatoes are scarce and dear again.

3. The inventory cycle. Short cycles within a commodity cycle, caused by buyers and producers adjusting their stocks. Buyers with big stocks pause orders, so supplier stocks pile up and prices fall. When demand picks up slightly, buyers with thin stocks rush to buy, so prices rise.

The book's exampleIn April 2020, a huge crude oil inventory in Oklahoma pushed futures to around USD 20 a barrel, and briefly below zero. As inventory eased, futures traded around USD 40 by June 2020. The inventory cycle helps forecast near-term demand and prices.

Handling seasonality

Economists use seasonally adjusted growth rates. A simpler tool is year-over-year (YoY) growth: compare a quarter with the same quarter last year, not with the previous quarter, so the season is the same on both sides.

Comparing a harvest quarter with the quarter just before it would show a big jump that is only the season. That is why YoY comparison is used when a business is seasonal.
5.6

Where to find data

Government websites

Regulators' websites

SEBI, RBI, Ministry of Finance

Published economic research reports

The Economic Survey

Two sentences in the book are hard to read as printed: one mentions a "high fiscal deficit" where the context is trade, and one says aggregate demand is "sometimes referred as GNP". The quiz does not test these.

All exam traps in this chapter

  1. Micro: individuals and firms, "theory of the firm". Macro: the whole economy.
  2. Two major policy influencers: government (fiscal) and central bank (monetary).
  3. Keynes wrote "General Theory of Employment, Interest and Money".
  4. GDP: produced within borders. GNP: produced by residents anywhere. GNP = GDP + NFIA.
  5. Three GDP methods: product, income, expenditure. Product method counts final goods only.
  6. Per capita income, not national income, is the better measure of living standards.
  7. Services are 60% of India's GDP at factor cost (as per the book).
  8. National saving = personal + corporate + public. Private = personal + corporate. Savings are not investment.
  9. Demand-pull: demand exceeds supply. Cost-push: input costs rise. WPI is wholesale, CPI is retail.
  10. Higher rates hurt real estate and autos most.
  11. Unemployment rises in a slowdown, falls in an expansion.
  12. FDI: active, long term, stable. FPI: passive, "hot money".
  13. Fiscal deficit is stated as % of GDP and bridged by market borrowings. A large deficit pushes rates up.
  14. Expansionary fiscal policy leads to a deficit; contractionary to a surplus.
  15. Repo: central bank lends. Reverse repo: it borrows. Bank rate: no collateral. CRR: cash with central bank. SLR: gold and G-secs.
  16. A high current account deficit weakens the currency.
  17. Under BPM6, FDI and portfolio flows sit in the financial account, not the capital account.
  18. Secular: 7 to 10 years. Cyclical: 2 to 6 years. Seasonal: yearly.
  19. Boom: rates and inflation rise. Recession: rates and inflation fall.
  20. Seasonal businesses are compared year over year.
  21. Sources: government sites, regulators (SEBI, RBI, MOF), research reports, Economic Survey.

For the group discussion

  1. Which phase of the economic cycle do you think India is in right now? What data would you check?
  2. Why might raising interest rates fail to control inflation, as in 2011 to 2013?
  3. Is FPI "hot money" good or bad for Indian markets? Give one reason each way.
  4. Name one secular trend you have seen in your own life. Which industry lost value because of it?
  5. A company sells air conditioners. How would you compare its June quarter sales fairly?