Right Financial Policies A Must

Studying macroeconomic trends is of paramount importance and determines the future state of the economy.

Some of the key components that espouse the economic stability are growth rates, level of consumption, investments, trade balance, capital flows, employment and currency exchange rates. The world's economies have become extremely interdependent and open in terms of goods, services, technology, capital and information.

The macroeconomic financial policies play a vital role that can be categorized mainly into monetary policy and fiscal policy.

Monetary Policy: The functional objective is to ensure price stability by the RBI for the economy. The critical deciding factors include money supply, inflation, interest rates (M3) that indicates the level of stock of currency in the country. In addition, the RBI also announces the frameworks for the banks, financial sector and the institutions governed through it.

Instruments of the monetary policy includes bank rate of interest, cash reserve ratio, statutory liquidity ration, statutory, open market operations, margin requirements, deficit financing, credit control and issue of the new currency.

The fiscal policy epitomizes the revenue and expenditure of the government. The ultimate aim is to cure recessions and maintain the economic stability in the country. The instruments of fiscal policy include reduction of the government expenditure, increase in taxation, imposition of new taxes, wage control, public debt, rationing, maintaining surplus budget, and increase in savings.

Monetary policy differs from fiscal policy in many ways. Monetary policy brings about changes in the economy by changing the money supply and interest rate whereas fiscal policy is a much broad tool with the government. Monetary policy regulates the supply of the money, the entire cost and availability of the credit in the economy dealing with the borrowing and the interest rates. Further, monetary policy aims to maintain price stability, full employment and economic growth. Fiscal policy helps in overcoming recession and controls inflation. It is the deliberate changes in the government revenue and its expenditure that influences the level of national output and the prices.

The monetary policy also facilitates the adequate flow of credit to the more productive sector of the economy, bring stability to the national currency. The real sectors are being impacted through the long and the variable period including the financial markets though there can be short term implications.

On 4 October 2016 the new governor of Reserve Bank of India decided to ease the monetary policy by cutting the repo rate by quarter percent (6.50 % to 6.25%) lowest in last five years. The marginal standing facility rate (Bank Rate) has been reduced to 6.75% from 7% previously and the reverse repurchase rate to 5.75% from 6 per cent, cash reserve ratio (CRR) has been maintained at 4% and statutory liquidity ratio (SLR) at 20.75 % from 21%.

It is also expected to achieve an inflation target of 5% in Q4 2016 with projected growth gate of 7.8% in 2017. The hike in the public sector salaries with good monsoon is bound to boost the household spending. The private sector is benefiting from the favorable liquidity conditions. The implications of changes in the interest rate would be felt by home buyers, players investing in equity / fixed deposit and investors.

For home buyers the impact would not be felt at immediately. But in the long run if the rate continues to fall and the banks continue to pass the benefits the cumulative impact can be substantial. On an average 9.5 per cent interest on the home loans of Rs 45 lakh for 15 years, the burden can be reduced by over one lakh. For the safe players the debt funds benefit from the plummeting rates due to the relationship between the yields and prices of the securities.

Various Crises
The equity investors also benefit from the falling interest rates. Declining interest rate strengthen the economic activity of the company increasing the profits which in turn increases their stock prices. For the bank fixed-deposit investors the rate cut directly impacts the depositors and investors who are looking for the safe investment heaven. It is most likely that the interest rate would on FD would be reduced in the near future. For investors the rate sensitive stocks would be under the watch and brokerage firms have to redefine their strategy for the same.

If we analyze the USA economy, the convention monetary policy includes the policy rate tool and the supply of money. The unconventional side has components like zero interest rate policy, quantitative easing, credit easing, forward guidance, the negative interest rates and the liquidity support of the banks and nonbanks.

The lapses in the financial policy involving the macroeconomic variables can result in the financial crisis and economic instability.

Let us look at the some of the recent financial crisis in the developed and developing economies which have become painful and are somewhat cyclic in nature.

The most recent developed markets crises include US housing and sub-prime crisis in 2007-2009 which became global in nature with Fed reducing the interest rates few years before the crisis and markets being less regulated. Others include the sovereign debt crises and economic crisis in the Euro zone (2010-2013) involving countries like Greece, Ireland, Portugal, Spain, Italy, Cyprus and Slovenia.

Some of the recent emerging market crises include the China turmoil (2015), Turkey and Argentina Crisis (2011), Brazil (1999, 2014) East Asia (1997-98), and Mexico( 1994).

One of the major types of financial crisis is currency crisis that is when the currency goes into a free fall and the fixed exchange rate collapses.

The Euro zone crisis (2010-2013) can be categorized as one of them. Some of the other financial crises include sovereign debt crisis (Greece crisis 2011-2013), balance of payment crisis(euro crisis, 2011), banking crisis (Irish banking crisis, 2008-2011), household debt crisis (USA, 2007-2009). It is also interesting to know that few crises may involve all the above components for example Argentina crisis (2001).

The financial crises can be further differentiated into broad category: The liquidity crisis and solvency crisis.

Liquidity crisis: A liquidity crisis happens when a firm (or a country) has a temporary cash flow problem. Its assets are can be greater than its debts, but some assets are illiquid (it takes a long time to sell a house. The economic housing crisis (2007) can be categorized under this.

Insolvency: An agent seems to be insolvent when its debt in comparison to income is significantly higher and that in most states of the world it will not be able to pay back its debt and the interest on it(unsustainable debt). Eurozone crisis (2011) was one of the forms.

With the precarious nature of the world economy, the macros like growth rates, level of consumption, investments, trade balance, capital flows, employment and currency exchange rates are bound to be affected. It is the duty of the government to formulate and implement right set of financial policies with the purpose to stabilize the economy.