Indian Financial System project---

The Indian Financial System

Synopsis – Inflation And Its Effect On Our Economy

Table of Contents

Topic of Discussion

The Indian Financial System: An Overview

1. The Financial System : An Introduction2. Financial System: Functions and Implementation

3. Financial Tools And Instrumentations4. Components of Financial System-An Introduction

Core Project

1. Inflation : An Introduction2. Effects of Inflation3. Causes of Inflation

4. Inflation rate of India and other countries

INDIAN FINANCIAL SYSTEM

Financial System is an institutional framework existing in a country to enable financial transactions.  There are three main parts in Indian financial system. They are as follows:

Financial assets comprises of loans, deposits, bonds, equities, etc.

Financial institutions such as banks, mutual funds, insurance companies, etc. Financial markets include money market, capital market, forex market, etc.

Regulation is another aspect of the financial system. The regulatory authorities are RBI, SEBI, IRDA, and FMC.

The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector.  While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a deficit.   A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit.  A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy.  The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation. These are briefly discussed below;

FINANCIAL MARKETS

A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument.  Funds are available in this market for periods ranging from a single day up to a year.  This market is dominated mostly by government, banks and financial institutions.

Capital Market -  The capital market is designed to finance the long-term investments.  The transactions taking place in this market will be for periods over a year.

Forex Market - The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies.  Depending on the exchange rate that is applicable, the transfer of funds takes place in this market.  This is one of the most developed and integrated market across the globe.

Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

India has a financial system that is regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors. In a number of sectors Government plays the role of regulator.

Ministry of Finance, Government of India looks after financial sector in India. Finance Ministry every year presents annual budget on February 28 in the Parliament. The annual budget proposes changes in taxes, changes in government policy in almost all the sectors and budgetary and other allocations for all the Ministries of Government of India. The annual budget is passed by the Parliament after debate and takes the shape of law.

Reserve bank of India (RBI) established in 1935 is the Central bank. RBI is regulator for financial and banking system, formulates monetary policy and prescribes exchange control norms. The Banking Regulation Act, 1949 and the Reserve Bank of India Act, 1934 authorize the RBI to regulate the banking sector in India. India has commercial banks, co-operative banks and regional rural banks. The commercial banking sector comprises of public sector banks, private banks and foreign banks. The public sector banks comprise the ‘State Bank of India’ and its seven associate banks and nineteen other banks owned by the government and account for almost three fourth of the banking sector. The Government of India has majority shares in these public sector banks. 

India has a two-tier structure of financial institutions with thirteen all India financial institutions and forty-six institutions at the state level. All India financial institutions comprise term-lending institutions, specialized institutions and investment institutions, including in insurance. State level institutions comprise of State Financial Institutions and State Industrial Development Corporations providing project finance, equipment leasing, corporate loans, short-term loans and bill discounting facilities to corporate. Government holds majority shares in these financial institutions. 

Non-banking Financial Institutions provide loans and hire-purchase finance, mostly for retail assets and are regulated by RBI. 

Insurance sector in India has been traditionally dominated by state owned Life Insurance Corporation and General Insurance Corporation and its four subsidiaries. Government of India has now allowed FDI in insurance sector up to 26%. Since then, a number of new joint venture private companies have entered into life and general insurance sectors and their share in the insurance market in rising. Insurance Development and Regulatory Authority (IRDA) is the regulatory authority in the insurance sector under the Insurance Development and Regulatory Authority Act, 1999. RBI also regulates foreign exchange under the Foreign Exchange Management Act (FERA). India has liberalized its foreign exchange controls. Rupee is freely convertible on current account. Rupee is also almost fully convertible on capital account for non-residents. Profits earned, dividends and proceeds out of the sale of investments are fully repatriable for FDI. There are restrictions on capital account for resident Indians for incomes earned in India.

Securities and Exchange Board of India (SEBI) established under the Securities and Exchange aboard of India Act, 1992 is the regulatory authority for capital markets in India. India has 23 recognized stock exchanges that operate under government approved rules, bylaws and regulations. These exchanges constitute an organized market for securities issued by the central and state governments, public sector companies and public limited companies. The Stock Exchange, Mumbai and National Stock Exchange are the premier stock exchanges. Under the process of de-mutualization, these stock exchanges have been converted into companies now, in which brokers only hold minority share holding. In addition to the SEBI Act, the Securities Contracts (Regulation) Act, 1956 and the Companies Act, 1956 regulates the stock markets. 

Introduction Of The Topic:

INFLATION is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring central banks can adjust nominal interest rates (intended to mitigate recessions), and encouraging investment in non-monetary capital projects.

By inflation one generally means rise in prices. To be more correct inflation is persistent rise in the general price level rather than a once-for-all rise in it, while deflation is persistent falling price.These days economies of all countries whether underdeveloped, developing as well developed suffers from inflation. Inflation or persistent rising prices are major problem today in world. Because of many reasons, first, the rate of inflation these years are much high than experienced earlier periods. Second, Inflation in these years coexists with high rate of unemployment, which is a new phenomenon and made it difficult to control inflation.

A situation is described as inflationary when either the prices or the supply of money are rising, but in practice both will rise together. In the Keynesian sense True inflation begins when the elasticity of supply of output in response to increase in money supply has fallen to zero or when output is unresponsive to changes in money supply. If there is full employment then condition will of clearly inflationary, if there is increase in the Money Supply.

Inflation can take many form as:

Deflation: is the opposite of inflation when fall in prices occurs.

Disinflation: is process of bringing down prices moderately from their high level.

Stagflation: is state where there is stagnation as well as inflation both side by side as prevailed in India in 1974-75 and 1979-80.

Hyperinflation: If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead to the abandonment of the use of the country's currency, leading to the inefficiencies of barter.

Depending upon the reason of inflation, it can be divided in many types as-

(1.) Demand-Pull inflation : This represents a situation where there is increase in Aggregate Demand for resources either from the government or the entrepreneurs or the households. Result of this is that the pressure of Demand can’t be met by the Currently available Aggregate Supply which result in Aggregate Demand > Aggregate Supply which is bound to generate inflationary pressure in the economy.

(2.) Cost-Push inflation: This represents the condition where even though there is no increase in Aggregate Demand, prices may still rise. This may happen if the costs of especially wage cost rise.

(3.) Structural inflation : This type of inflation occurs because of change in structure of economies as happened in India from Agricultural Structure i.e. Green Revolution to Industrialization. Thus because of change in Economic Structure gives rise to increase in prices thus generate inflationary pressure.

Inflation is very unpopular happening in an economy. Opinion survey conducted in India, USA and many other countries reveal that inflation is the most important concern of the people as it badly affects their standard of living. So why it is called Inflation is enemy number one.

India is facing the problem of inflationary pressure because of the increase in Aggregate Demand while Aggregate Supply is respectively constant. The inflationary pressure faced by Indian Economy is due to Demand-Pull inflation i.e. Aggregate Demand > Aggregate Supply.

Thus to curb inflation need to fill the gap between Aggregate Demand and Aggregate Supply. For this either need to increase AS or decrease AD that can hamper economic development. Thus to increase AS is the best tool which can be used. To increase AS either need to increase production capacity of all current production unit of to build new production plants. But as quoted in an survey done by RBI that all the production plants are running at their full production capacity thus all resources all-full employed the other way is to built new plant but to do this will take at least 18months to 2years. Thus meanwhile need to decrease Money Supply, which is opted by RBI.

As in short run it’s not possible to meet the gap between AD and AS thus RBI is planning to decrease liquidity by reducing Money Supply from the market. For this it has been planned that by decreasing CRR, repo rate and reverse repo rate Liquidity from the market will be drained.

CRR : Cash Reserve Ratio is the percentage of deposit that a commercial bank need to keep with RBI by which RBI control liquidity in the market and create Money Supply.Currently CRR is 6.5% in the Indian Context.

Repo Rate: is the rate at which RBI lends money to other commercial Banks.

RBI planned that Liquidity from the market can be drained by decreasing money supply and to do so it is increasing CRR, repo rate, reverse repo rate and taking other measure like that. But interest is that whether hike to CRR and other factors will curb inflation and what are the other factors, which are influencing inflation.

Inflation Is Caused Due To Several Economic Factors:

When the government of a country print money in excess, prices increase to keep up with the increase in currency, leading to inflation.

Increase in production and labor costs, have a direct impact on the price of the final product, resulting in inflation.

When countries borrow money, they have to cope with the interest burden. This interest burden results in inflation.

High taxes on consumer products, can also lead to inflation. Demands pull inflation, wherein the economy demands more goods and services than what is

produced. Cost push inflation or supply shock inflation, wherein non availability of a commodity would

lead to increase in prices

The Problems Due To Inflation Would Be:

When the balance between supply and demand goes out of control, consumers could change their buying habits, forcing manufacturers to cut down production.

The mortgage crisis of 2007 in USA could best illustrate the ill effects of inflation. Housing prices increases substantially from 2002 onwards, resulting in a dramatic decrease in demand.

Inflation can create major problems in the economy. Price increase can worsen the poverty affecting low income household,

Inflation creates economic uncertainty and is a dampener to the investment climate slowing growth and finally it reduce savings and thereby consumption.

The producers would not be able to control the cost of raw material and labor and hence the price of the final product. This could result in less profit or in some extreme case no profit, forcing them out of business.

Manufacturers would not have an incentive to invest in new equipment and new technology. Uncertainty would force people to withdraw money from the bank and convert it into product

with long lasting value like gold, artifacts.

Measures To Control Inflation:

A variety of methods have been used in attempts to control inflation:-

1. Monetary policy:-

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.[1] The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being expansionary, or a contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and a contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy is contrasted with fiscal policy, which refers to: taxation, government spending, and associated borrowing

2. Consumer Price Index The Consumer Price Index or CPI is a measure of the prices of consumer goods and services bought at retailprices. This includes food, fuel, clothing and pharmaceuticals. The percentage change in CPI measures inflation. To compile the Consumer Price Index, a predetermined set of goods, forming a typical basket of goods bought by an average urban consumer, is selected. All the items are weighted according to the percentage ofincome that households spend per category. An average of thechange in the prices of these items is calculated on a monthly basis. Core CPI excludes food and energy prices, which are often volatile, and is an indicator of the headline inflation rate.

Uses of Consumer Price Index

Apart from measuring inflation, the index is useful in indicating the need to adjust:

wages to keep pace with a rise in the cost   of   living

pensions

regulated prices

tax brackets to avoid increases in the rate of taxes induced by inflation

3. GDP   deflator

GDP, gross   domestic   product , deflator is a method to menstruate the price change of all new domestic goods and services in the economic system. It gives the net value of all goods and services procured over a specific time.

Like consumer price index, GDP deflator doesn't rely upon a constant market basket. The basket is changeable, so new consumption patterns can be shown through this deflator according to the people's reaction to the changing market prices.

Interpretation:The GDP deflator can be depicted mathematically by this equation given below:

GDP deflator = ( Nominal GDP / Real GDP)*100.

Nominal GDP: In a nominal GDP, inflation is not taken into account or consideration. It is evaluated on the basis of the current market   price .

Real GDP: Real GDP is computed by taking the market price of some base year.By measuring t the nominal GDP of a base year price level 2 the real GDP is calculated. Real values are adjusted for different price level in a year.

By dividing the nominal GDP with GDP deflator, the real GDP is computed, and hence, deflates the nominal GDP. Actually, the difference between the deflator and a price   inde x , like the CPI, is not huge. GDP deflator almost gives the accurate measurement of changing prices in the overall economy.

Utility: The GDP deflator can be seen as a conversion factor that transfigure the Real GDP into Nominal GDP.

GDP deflator gives the construction of an implicit index of price level for one year.

It is used to calculate the rate of inflation or deflation.

4.Fixed exchange rates:-

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP.

It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to theMundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achievemacroeconomic stability.

3. Wage and price controls:- Measures taken by a government under its incomes policy to control wages in an attempt to check cost-push inflation and wage-push inflation. Collective governmental effort to control the incomes of labor and capital, usually by limiting increases in wages and prices. The term often refers to policies directed at the control of inflation, but it may also indicate efforts to alter the distribution of income among workers, industries, locations, or occupational groups.

4.Gold standard:-A monetary system in which both the value of a unit of the currency and the quantity of it in circulation are specified in terms of gold.If two currencies are both on the gold standard, then the exchange rate between them is approximately determined by their two prices in terms of gold.

INTRO:-The Indian economy weathered the global crisis of 2008-09 quite well. But Indian economy has clearly seen a spurt of inflation. The effect of inflation on financial market is complex, but it generally leads to an increase.

As inflation increases, the price of the stock, like other prices of goods in the economy, will generally rise as well. Inflation can have various effects on a company's health. While some companies may be

uninjured or even benefit from inflation, others may be seriously harmed if customers can no longer afford their products. Even as much of the developed world is still quite some distance from its pre-crisis growth rate, several emerging market economies(EMEs) have made up the lost ground relatively quickly. 

Rising inflation make hard for the investors to estimate their future returns and also safe guard their investments. Risk is a Characteristic feature of most of commodity and capital markets.This paper attempts various options available to mitigate and manage this inflation risk through Derivatives. A derivative Security is a financial contract whose value is derived from the value of something else, such as a stock price, commodity price, an exchange rate, an interest rate or index of prices (inflation).Derivative securities provide them a valuable set of tools for managing this risk.

 Crashed Financial Markets:- Financial stock market in the world trembled due to Liquidity crisis. Indian stock market is stated as Sensitive Exchange which shortly known as SENSEX. It is volatile to such an extent that single and small good or adverse news can affect it well. Significant amount of foreign investment have been made in India through stock market. Various modes of investments in Indian companies are made through P-Notes, Global Depository Receipts, American Depository Receipt and direct investments. Needs of funds in domestic market and cheaper stocks of home companies lead foreign investors to make heavy sell in our market. Failure of Lehman brothers and other biggis were sufficient for domestic investors to perceive slowdown to the greater extent. The effect was that the market fall up-to 8000 app. from highest end i.e. 21000 points in January 2008. No doubt strong fundamentals and adequate influence of stable government and RBI have caught investment back to country. During the period RBI put ban on P-notes which also affected market on large extent. One of the arguments is also made by research people that ban on P-notes affected much because black money was routed through these P-notes. Heavy derivatives losses and permanent reduction in value of the investments on balance sheet of the companies have made them unattractive. Not only the value of current investments slashed down but it had badly affected primary markets. This had restricted new flow in market. Since January 2008 after issue of Reliance power no company was able to successfully excess primary market. Well reputed companies like Tata Motors was also compelled to finance it deal through bank finance. Recently in July 09, Adani power, a company of Adani group had initiated action to access primary market by IPO.               Threat of corporate defaults:-  In addition to above, Indian economy is fairly dependent on external funding which impaired due to liquidity crisis in rest of the world. Indian companies which completely depend on US and European economy had suffered and they have to learn a lesson not to depend only on outside economy, no matter even if they look lucrative. To strengthen their position in market companies have leveraged themselves and took advantage of boost during 2003-07. The economic downturn and financial crisis have threatened to corporate distress and raised question against their solvency especially in US. As per Global Financial Stability Report April 2009, emerging economies would face rollover needs of more than $1.8 trillion in 2009. External funding will be curtailed more sharply that even prospected in the baseline projections in the context of deteriorating economic prospects and intense global

deleveraging. This would also affect small and medium enterprises as those large borrowers who were dependent on foreign borrowing would turn to banks for their financial needs. It became double-sided sword for SMEs as they were huge cut in demand for their products and they were even unable to maintain their liquidity. It is to remind that growth of the SMEs is most important for overall growth and development of economy. Rapid deterioration in exchange rate would further make situation worst by making balance sheet burdened with heavy repayment liabilities. If we talk about revenue, many large corporate have sold their receivables to banks and factors with or without recourse.  Hence they would not able to earn premium on those buyers who are sound and pay in time and they would even spend more interest for liberal recovery of debts.  Current account and Balance of Payment:-  All countries in the world with current account deficits and strong credit cycles are finding it difficult to bring cost of capital down in the current environment. India is no different. Increased government expenditure and packages declared had also lead to lower collection of revenue to create enough liquidity in the market. These leaded to more current account deficit and also destroyed our path-way to curb current account deficit expected by 2010. New measures do not change our view on the growth outlook. Indeed, we remain concerned about the banking sector and financial sector. The BOP- Balance of Payment deficit – at a time when domestic credit demand is very high – is resulting in a vicious loop of reduced access to liquidity, slowing growth, and increased risk-aversion in the financial system.  Sectoral Effects:- In total the recession have turned down the growth process and have set the minds of economists and others for finding out the real solution to sustain the economic growth and stability of the market which is desired for the smooth running of the economy. Complete business/ industry is in dolled rum situation and this situation persist for a longer duration will create the small business to vanish as they have lower stability and to run smoothly require continuous flow of liquidity which is derived from the market. Effect on various sector of Indian Economy can be summed up as it has mostly affected companies depending on foreign business i.e. ITies, BPOs, EOUs, and SMEs etc. and those which were dependent on primary products including infrastructural material as their raw material.   “The US slowdown will immensely hit the mid-sized IT companies and also the big players to some extent. On the higher end, you have scenarios where people are cutting back on contracts. They are reducing the fees per manpower in their contracts. But at the same time they are using IT as a tool to reduce their overall costs. Perhaps, it is balanced out. There are people who have gone up to that stage and used IT to reduce their costs because IT is the best way to be used as an eminent tool for cutting down monetary burden.” The problems of US slowdown have not only impacted the IT sector on all edges, it has   made the Indian manufacturing and energy sector worrisome too. The challenges that Indian industry is encountering with is a universal problem of rising energy and fuel cost. It is always followed that as the energy prices go up there is a probability of recession. The second factor that we see today is the

global developments in India. The textile, garment and handicraft industry are worse affected. Together, they are going to lose four million jobs by April 2009. According to the Federation of Indian Export Organization survey there has also been a decline in the tourist inflow lately. IT industries, financial sectors, real estate owners, car industry, investment banking and other industries as well are confronting heavy loss due to the fall down of global economy. Federation of Indian chambers of Commerce and Industry (FICCI) found that faced with the global recession, inventories industries like garment, gems, textiles, chemicals and jewellery had cut production by 10 per cent to 50 per cent.

In this context Ajay Shankar, Secretary, Ministry of Industry and Commerce opined that, “We take pride in saying that Indian economy is insulated to some extent from the global environment, which is really not true, because we can very clearly see the impact of that for the past few months where there is definite indication of economic slowdown in the country. The slowdown is taking place as the result of rise in the costs of the materials all over the world, surging commodity prices, the impact of surging food grain prices. We have been fortunate in case of the food inflation which has been very high and in seeing that we are able to insulate our consumers from the kind of food inflation which the rest of the world has experienced until now. Therefore, the government tried to use all the means of espousal to reduce inflation as far as the items of consumption of the common man is concerned. On the flip side this is a global shock for the high commodity and fuel prices. Moreover, our feeling is that worst is probably behind us and in the coming months things will definitely work well. Heavy Expenditure on Infrastructure by various developing countries like China, India, and Malaysia etc had created Inflationary condition related to infrastructural material. This has not only weakened Industrial expansion but also severely effected property market. In fact, the input prices have risen up mainly because of the steel prices that have surged up. The reason behind the sky-scrapping input costs is not only because of rising steel prices, but also due to hike in prices of aluminum and copper. Steel prices have gone up by 40 to 50 percent and aluminum has gone up by 50 percent accurately, says Dr. S.N. Dash, Secretary, Ministry of Heavy Industries & Public Enterprises. Investment bankers have gone overboard by giving loans to people, which were more than their repaying capacity. This crisis could be worse than what has been imagined, as the banks have not come out with the truth. It’s better to go slow on growth and keep inflation under control rather than bearing inflation with 10 percent GDP (gross domestic product).” “India’s progress is remarkable, but it is disheartening to see that it has been done at the cost of neglecting more than 80 percent of the common people of India who do not share the success story. 

Inflation is a state in the economy of a country, when there is a price rise of goods as well as services. Inflation is not only caused by an increase in money supply but also is caused by the expectation of inflation. With the increase in inflation every sector of the economy is affected. There is a serious effect in interest rates, exchange rates, investment and last but not the least Stock market. Prices of stock are determined by the net earnings of the company. It depends on how much profit the company is likely to make in the near future. Effect of inflation on the stock market is also evident from the fact that it increases the rates of interest. If the inflation rate is high interest rate is also high. In this

scenario the creditors will have the tendency to compensate for rise in the interest rate. This compels the debtors to avail loan at a higher rate of interest.This affects funds from being invested in the stock markets. With the high input cost and also lesser market the company’s profit is also bound to be reduced resulting fall of company stock prices.

During inflation, this economic growth is unsustainable and the stock markets face an inevitable crash since the Economy managers will have to tighten the rope sooner or later. The rising prices fuelled by inflation rob the investors since there is no corresponding increase in value. This has a corresponding implication too.The company's financials get over-stated as a result of inflation, since the revenue and earnings also rise in the same rate as the inflation and this in combination with additional value which is generated by the company. When there is a decline in the inflation, the previously inflated earnings and revenues likewise gets deflated. When a lot of money is chasing after goods that are fewer in supply, it happens to be a classic case of inflationThen the option is to make money more expensive to borrow. The excess capital gets removed and the cycle of price increase is slowed down. Inflation also impacts the future expectations of returns from assets. In this situation it is quite necessary that investors have to protect their income being affected by adopting suitable strategy. Below highlights some of the strategies that can be adopted to hedge against inflation.

Strategies to protect inflation risk in India

Investors can prepare for unexpected inflation by adopting one of the two strategies. They are-

a) Hedging the immediate effect

b) Earning a total return that outpaces inflation over time.

As an investor, a substantial portion of the portfolio ought to be in fixed income securities. Since the inflation erodes the purchasing power, fixed securities are the best option to counterfoil the market volatility. Even the retirees are advised to keep some amount of their assets as a stock investment. The interest rate sensitive stocks should be handled with utmost caution during the inflationary period.

It is important to make a distinction between properly anticipated inflation and unanticipated inflation. From strategic point of view, investors may wish to consider an allocation of assets that preserve purchasing power during inflationary periods.

Investors should carefully review their financial circumstances and investment goals before making changes in their portfolio to guard against inflation risk.

Investors should take a total return approach rather than assets based on correlation with CPI (Consumer Price Index).

By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve purchasing power of their cash.

Hedging techniques

The following Hedging techniques are suggested to overcome the inflation risk in Indian financial markets:-

Leading Inflation Hedges:-These are assets that tend to perform in advance of inflation becoming visible in the broader economy.

A typically diversified asset portfolio tends to have a greater proportion of leading hedges since most funds are excessively reliant on the equity risk premium to achieve their long term stock returns..Contemporaneous hedges:-These include Inflation linked bonds or inflation swaps. Inflation linked bonds are insulated against the raise of inflation by explicitly imbedding floating rate of inflation into the interest coupon that they pay or by adjusting the capital value of the bonds to reflect the prevailing inflation rate.

Inflation Swap provides investors with price movements in underlying inflation rate. It works as the exchange of stream of inflation indexed payments/coupon for a stream of nominal interest payments. These type of hedges are generally over the counter trade products. Countries like Australia, USA, UK, France and Sweden use such products.

 Lagging inflation Hedges:-

These are in assets that offer returns following bouts of inflation. For example as inflation drifts higher, the central banks seek to curb demand by pushing up short term interest rate. This product was very successful in Australia. Reserve Bank of Australia has been able to maintain average inflation rate of 2.9%over the last 10 years with a corresponding Reserve Bank of Australia cash rate of 5.4%.

As a result the investors are to locking in real rates of return by owning cash. With addition of margin for active management and with elevated cash rates, absolute return fixed interest looks a vital strategy for achieving real rates of return and a good inflation hedge.

Commodity Hedges:-With the increasing inflation trend the prices of commodities are also bound to go up in the future time. Hence investing in Commodity Options and Futures are quite advantageous in the inflationary times. Commodity futures as well as investments in gold, oil are also good and effective inflation hedges because their returns are positively correlated with inflation

Note:-

In many developed financial markets the existence of inflation linked financial securities provides market based measures of inflation expectation as a measure of hedge against inflation risk.Some EME(Emerging Market Economies) like Chile, Israel have been able to develop an inflation linked government bond market. The government can develop a break even rate with the following components built in it (i)Expected inflation during the remaining maturity period of the bonds;

(ii)inflation risk premium and (iii) liquidity premium. 

Inflation linked bonds are one of the best ways adopted by several countries in the world to overcome the inflation risk. Inflation linked bonds are regarded as risk free asset of choice for a long term pool like a Superannuation fund.The relevance of an inflation linked security  or inflation derivatives is high in a country like India where the inflation enjoys its own crests and troughs displaying a high volatility. It rose from 5.51% in Jan 2008 to 9.47% in dec 2010

INDIA INFLATION RATE

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2011 9.30                      2010 16.22 14.86 14.86 13.33 13.91 13.73 11.25 9.88 9.82 9.70 8.33 9.472009 10.45 9.63 8.03 8.70 8.63 9.29 11.89 11.72 11.64 11.49 13.51 14.972008 5.51 5.47 7.87 7.81 7.75 7.69 8.33 9.02 9.77 10.45 10.45 9.70* The table above displays the monthly average.

Inflation in India touches 10.16% recently and this inflations spreads its hand on manufactured goods also(As per recent press release.) Situation is worrying the government.  Government announced that RBI will take corrective measures to control the inflation.  The inflation is increasing steadily at a higher rate.  It seems to be the government is not seeing the situation in subtle and always ask RBI to take action. Also Food inflation jumped to a scorching 18.32% in the week ended December 25, 2010. This was against an already menacing 14% inflation clocked in the previous week. The main culprits were soaring prices of onions and other vegetables. Experts expect the RBI to tighten monetary policy to check further escalation in commodity costs, in its quarterly review on January 25, 2011.

Emerging economies like India, China are not directly affected by factors which were responsible for crisis in developed economies. No doubt the cascading effect of said crisis have made situation worst. East Asians like Japan have been hit hard due to collapse in demand for manufactured products. India would also see severe drop in export earnings on same footings but it would be able to maintain 1.5 to 2% growth in 2009 which would further rise to 4% due to its domestic demand. In India, crisis can be caught from short supply of agricultural products due to adverse climate condition in 2007-08 which was multiplied by rise in population and their use as input in industrial production. This had factors initiated inflationary phase at higher rate in the economy

Inflation Targeting the World

EURO AREA INFLATION RATE

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2011 2.30 2.40                    2010 1.00 0.90 1.40 1.50 1.60 1.40 1.70 1.60 1.80 1.90 1.90 2.202009 1.10 1.20 0.60 0.60 0.00 -0.10 -0.70 -0.20 -0.30 -0.10 0.50 0.902008 3.20 3.30 3.60 3.30 3.70 4.00 4.00 3.80 3.60 3.20 2.10 1.60* The table above displays the monthly average.

Euro area annual inflation was 2.4% in February 2011, up from 2.3% in January. A year earlier the rate was 0.8%. Monthly inflation

was 0.4% in February 2011. EU annual inflation was 2.8% in February 2011, unchanged compared with January. A year earlier the rate

was 1.5%. Monthly inflation was 0.4% in February 2011.

In February 2011, the lowest annual rates were observed in Ireland (0.9%), Sweden (1.2%) and France (1.8%), and the highest in

Romania (7.6%), Estonia (5.5%) and Bulgaria (4.6%). Compared with January 2011, annual inflation rose in fifteen Member States,

remained stable in three and fell in eight. The lowest 12-month averages4 up to February 2011 were registered in Ireland (-1.1%),

Latvia (0.0%) and the Netherlands (1.2%), and the highest in Romania (6.5%), Greece (5.0%) and Hungary (4.4%).

The main components with the highest annual rates in February 2011 were transport (5.7%), housing (4.9%) and alcohol & tobacco

(3.5%), while the lowest annual rates were observed for clothing (-2.6%), communications (-0.4%) and recreation & culture (0.0%).

Concerning the detailed sub-indices, fuels for transport (+0.62 percentage points), heating oil (+0.23), electricity (+0.11) and gas

(+0.10) had the largest upward impacts on the headline rate, while garments (-0.25) and telecommunications (-0.09) had the biggest

downward impacts.

The main components with the highest monthly rates were recreation & culture (0.9%), food, housing, transport and hotels &

restaurants (all 0.5%), while the lowest were clothing (-0.5%), alcohol & tobacco (0.0%), health and education (both 0.1%). In

particular, package holidays (+0.06 percentage points), accommodation services and heating oil (+0.03 each) had the largest upward

impacts, while garments (-0.03), restaurants & cafés and footwear (-0.02 each) had the biggest downward impacts.

CANADA INFLATION RATE

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2011 2.30 2.20                    2010 1.90 1.60 1.40 1.80 1.40 1.00 1.80 1.70 1.90 2.40 2.00 2.402009 1.10 1.40 1.20 0.40 0.10 -0.30 -0.90 -0.80 -0.90 0.10 1.00 1.302008 2.20 1.80 1.40 1.70 2.20 3.10 3.40 3.50 3.40 2.60 2.00 1.20* The table above displays the monthly average

Canada's inflation rate rose 2.2% in the 12 months to February, following the 2.3% increase posted in January.  Energy prices rose

10.6% during the 12 months to February, after posting a 9.0% increase the previous month. Gasoline prices continued to increase in

February, rising 15.7%, after recording a 13.0% increase in the 12 months to January.

Excluding gasoline, the Consumer Price Index (CPI) rose 1.6% in the 12 months to February, compared with a 1.8% increase in January and also Shelter costs rose 2.2%. The largest increase occurred in the transportation component, where prices rose 5.1% in the 12 months to February, after a 4.8% increase in January.

The Bank of Canada's core index advanced 0.9% in the 12 months to February, following a 1.4% rise in January. The seasonally adjusted monthly core index fell 0.1% in February, following a 0.1% increase the previous month.

CHINA INFLATION RATE

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2011 4.90 4.90                    2010 1.50 2.70 2.40 2.80 3.10 2.90 3.30 3.50 3.60 4.40 5.10 4.602009 1.00 -1.60 -1.20 -1.50 -1.40 -1.70 -1.80 -1.20 -0.80 -0.50 0.60 1.902008 7.10 8.70 8.30 8.50 7.70 7.10 6.30 4.90 4.60 4.00 2.40 1.20* The table above displays the monthly average.

China said inflation remained high in February, fueling further doubt about the government's ability to tackle what officials have called

their main economic priority this year. The consumer-price index in the world's second-largest economy rose 4.9% in February from

the same month last year, the National Bureau of Statistics said on March 11. Food prices alone rose 11 percent in February.

China's February economic data are distorted by the timing of its Lunar New Year holiday, which fell earlier in the month this year than

in 2010. The holiday, China's biggest of the year, alters spending patterns, especially for food, limiting the ability of economists to

extrapolate longer-term trends. China's producer price index, a measure of pipeline inflation pressures, rose 7.2% from a year earlier, up

from January's 6.6% rise and higher than expectations for a 7% rise.

INDIA vs CHINA

Making an in depth study and analysis of India vs. China economy seems to be a very hard task. Both India and China rank among the front runners of global economy and are among the world's most diverse nations. Both the countries were among the most ancient civilizations and their economies are influenced by a number of social, political, economic and other factors. However, if we try to properly understand the various economic and market trends and features of the two countries, we can make a comparison between Indian and Chinese economy. 

Going by the basic facts, the economy of China is more developed than that of India. While India is the 11th largest economy in terms of the exchange rates, China occupies the second position surpassing Japan. Compared to the estimated $1.3123 trillion GDP of India, China has an average GDP of around $4909.28 billion. In case of per capital GDP, India lags far behind China with just $1124 compared to $7,518 of the latter. To make a basic comparison of India and China Economy, we need to have an idea of the economic facts of the countries.

Facts India China

GDP around $1.3123 trillion around 4909.28 billion

GDP growth 8.90% 9.60%

Per capital GDP $1124 $7,518

Inflation 7.48 % 5.1%

Labor Force 467 million 813.5 million

Unemployment 9.4 % 4.20 %

Fiscal Deficit 5.5% 21.5%

Foreign Direct Investment $12.40 $9.7 billion

Gold Reserves 15% 11%

Foreign Exchange Reserves $2.41 billion $2.65 trillion

World Prosperity Index 88Th Position 58th Position

If we make the analysis of the India vs. China economy, we can see that there are a number of factors that has made China a better economy than India. And that can be the reason why inflation rate in India is higher as compared to china.