Indian Economy, 5th edition (132 page)

Skimming price

A pricing method of charging high profits–adopted by a firm when consumers are not price- sensitive and demand is price-inelastic.

Social costs

The costs borne by the society at large resulting from the economic activities by the firms–pollution being a prominent example.

Solvency margin

The term made news in the 1970s concerning a life insurance company. The only requirement, till then, by a life insurance company was that the value of its assets should not be less than the value of its liabilities. The regulators in many conntries felt that the value of assets should exceed the value of liabilities by a certain margin. This margin which came to be known as
‘solvency margin’
became a useful device to force shareholder of a life insurance company either to keep in reserve a certain portion of the profit or to bring in additional capital if there is not sufficient profit to meet unforeseen contigencies. The European Union developed an empirical formula taking recourse to the past experience to determine the quantum of margin required. The IRDA has stipulated that the excess of assets (including capital) over liabilities should not be less than 150 per cent of the solvency margin arrived at by the EU formula.

On March 31, 2006, the total liability of LIC stood at Rs. 4,52,000 crore and its assets valued at Rs. 4,52,000 crore, having a comfortable margin that did not require capital infusion (though the IRDA has suggested to raise its capital by Rs. 7000 crore by 2009).

Sovereign risk

The risk of a government defaulting on its debt or a loan guaranteed by it (all international loans by the private companies are basically guaranteed by the government of an economy).

Spot price

The price quoted for anything in a transaction where the payment and delivery is to be done now.

Spread

A frequently used term of financial market which is the difference between two items, for example, the spread (i.e, the difference) an underwriter pays for an issue of bonds from a company and the price it charges from the public. Similarly, the returns on two different bonds if they are different; the difference is known as the spread.

Standard deviation

It is a statistical technique to measure how far a variable moves over time away from its mean (average) value.

States’ market borrowing

The state governments, for years, had few worries when it came to raising money from the market as it was done at the tutelage of the centre. However, with the onset of financial sector reforms, the contours of raising funds from the market both for the states and the Centre have changed. In the early days after the central bank had come into existence, Madras had objected to the Reserve Bank of India being given the mandate to manage public debt for states. State loans used to be underwritten then.

However, that practice was stopped in the 1950s. Since then, major reforms have taken place. Starting from the 1990s, increasingly states as well as the Centre have accessed funds at market-related rates. Now increasingly, the onus will be on the states to manage their borrowing programmes adroitly.

The borrowing requirements of states were decided earlier in consultation with the Planning Commission and the
f
inance
m
inistry. The Reserve Bank of India as the banker to states as well as the debt manager handles the floatations. For decades, the borrowings of states or state loans or
tap issues
as they are called used to be on the basis of pre-determined rates. In effect, all states were treated on the same footing when it came to borrowing. Now a part of market borrowings is through the auctions where the rate is determined based on market response with the rest being through the fixed coupon basis.

The Reserve Bank of India used to take into account the borrowing programme of the Central government, liquidity conditions, the cash flow needs of states, future repayment schedules while working out the borrowing programme for states.

A significant change was signalled when the Twelfth Finance Commission recommended the delinking of grants and loans in Plan assistance to states as part of reforms on the borrowing programme front. Earlier, there was a ratio of 70:30 between loans and grants for extending plan assistance to states.

What this meant was that states could access loans from the Central Government for their plan expenditure. These loans were for long tenures of over 20 years and a relatively higher interest spread.

The government has accepted the Finance Commission’s recommendations on doing away with such loans. This would mean greater recourse to the markets by states. Now like the Centre, states will have to decide their annual borrowing programme within the framework of their fiscal responsibility programmes. This is expected to help in fiscal discipline.

The Commission and the RBI want to impose some sort of discipline on states on their debt management. If more market borrowings by states governments are carried out through the auction route, it would mean that well-managed states would stand to gain. They would be in a position to obtain better rates as the market would factor in the fiscal strengths of a particular state when pricing is determined.

When states take a recourse to market borrowings through the auction route, there would be greater price discovery besides enhanced secondary market liquidity for such securities.

A state whose credit rating is strong will get a better rate while borrowing while a weaker state may have to settle for a higher rate. This is expected to lead to greater attention and focus fiscal responsibility and debt management by states especially as they cannot look to the Central Government for loans as in the past. The Reserve Bank of India, which is the debt manager for both the Centre and states, wants to progressively raise the share of market borrowings by states under the auction route so that the entire programme is covered through auctions.

Stealth tax

A popular name given to an obscure tax increase as for example stamp duty, property tax etc. Which get implemented months later by the time they usually fade out from the public memory.

Stochastic process

It is a process that shows random behaviour. As for example,
Brownian
motion which is often used to describe changes in share prices by the experts in an efficient market (random walk), is such a process.

Sub-Prime crisis

The word ‘sub-prime’ refers to borrowers who do not have sound track record of repayment of loans (
it means such borrowers are not ‘prime’ thus they could be called as ‘less than prime’ i.e. ‘sub-prime’). The
‘sub-prime crisis’ which has been echoing time and again recently has its origin in the United States housing market by take-2007–being considered as the major financial crisis of the new millenium.

Basically, last few years have seen a gradual softening of international interest rates, relatively easier liquidity conditions across the world motivating the investor (i.e., banks, financial institutions, etc.) to expand their presence in the sub-prime market, too. The risks inherent in sub-prime loans were sliced into different components and packed into a host of securities, referred to as asset-backed securities and
collaterised debt obligations
(CDOs). Credit rating agencies have assigned risk ranks (e.g., AAA, BBB, etc.) to them to facilitate their marketability. Because of the complex nature of these new products, intermediaries (such as hedge funds, pension funds, banks, etc.) who held them in their portfolio or through special purpose vehicle (SPVs), were not fully aware of the risks involved. When interest rates rose leading to defaults in the housing sector, the value of the underlying loans declined along with the price of these products. As a result institutions were saddled with illiquid and value-eroded instruments, leading to liquidity crunch. This crisis of the capital market subsequently spread to money market as well.

The policy response in the US and the Euro area has been to address the issue of enhancing liquidity as well as to restore the faith in the financial system. The sub-prime crisis has also impacted the emerging economies, depending on their exposure to the sub-prime and related assets.

India has remained relatively insulated from this crisis. The banks and financial institutions in India do not have marked exposure to the sub-prime and related assets in matured markets. Further, India’s gradual approach to the financial sector reforms process, with the building of appropriate safeguards to ensure stability, has played a positive role in keeping India immune from such shocks.

Subsidies

Are subsidies negative taxes? Are they converse of indirect taxes? What are subsidies and why are they important? These are some questions which always make rounds every time the Union Budgets are presented.
Subsidies include all grants on current account made by the government to depress the price of any good or service below its economic cost.
Often subsidies are grants made by public authorities to government enterprises in compensation of operating losses when these losses are clearly the consequences of the policy of the government to maintain prices at a level below costs of production. The regime of subsidies is, therefore, a
political economic policy
framework typical of welfare states (India is one). Various subsidy regimes are meant to ensure distributive justice. Subsidies are directed at various sections of society to assist them economically. In India, the main beneficiaries have been farmers, needy people and those using various forms of public services, social services and economic services
.
The first includes fiscal and administrative services like justice, jails and police, which are in the nature of pure public goods. The last two categories include a range of goods and services, which are not purely public and where the users identifiable and user charges can be levied. For example, roads and power. Governments make such goods and services available to users at costs lower than what was expended to produce and/or provide them because social benefits of doing so exceed the aggregate of private benefits to individual consumers. For instance, compulsory and free elementary education, a subsidy provided by the government, aids the social development and uplift of the poor and socially depressed classed by making such education easily accessible to them. Subsidies are financed either from tax or non-tax revenue, or result in a deficit.

Broadly speaking and purely at the level of the central government, there are three major types of subsidies–food subsidies (for farmers and the poor who avail the public distribution system), fertiliser subsidies (for farmers), and petroleum subsidies (for the poor and the middle class, on
k
erosene and LPG, which they directly consume; or diesel which fuels the transport industry that carries essential goods and thus has an impact on their prices). These are clearly visible in the government’s budget document. Apart from these, there are also
minor subsidies
such as on interest rates and subsidies hidden in the provision of social and economic services–mainly healthcare and education. In social services, the Centre’s participation is limited. Most of the social sector expenditure pertains either to the Union Territories that figure in the Union budget, or are in the nature of departmental transfers to state governments.

The regime of subsidies has been a contentious issue of higher order in India. The benefits from subsidies can be maximised only when they are transparent, well targeted, and suitably designed for effective implementation without any leakages. Various studies have shown how the proliferation of subsidies in India is an outcome of undue expansion of government activities in the provision of goods and services that are not pure public goods. Subsidies result from the government’s inability to recover its costs adequately in many of these activities. Critics have blamed this on the ill-considered use of subsidies by political parties for electoral ends and have been arguing for reduction of some subsidies and the phasing out of others. Those who support the continuing of subsidies, however, argue that the focus on reducing subsidies only comes about because of the government’s failure to raise tax revenues.

Subsidy bidding

It is competitive bidding for subsidies, where companies bid against one another to serve an area at the lowest price–the lure is the subsidy and other benefits. This system is a way of administrating subsidies without leaving any room for some competitors or technologies gaining an edge over others. But competitive bidding has anticompetitive effects, since it gives a special advantage to one company. Regulators should adopt a consumer choice system, under which any subsidy for each high cost customer it served. If the customer moved to a competing carrier, the subsidy would move, too.

Substitution effect

The replacement of one product for another resulting from a change in their relative prices.

Sunk costs

The costs in commercial activities that have been incurred and cannot be reversed. The cost on advertisement, research and development, etc. are examples of such costs. Sunk costs are a big deterrant to new entrants in the commercial world as after the venture has failed these costs cannot be recovered–there is no two-way process here.

Swap

The act of exchanging one by another. It could be of many economic items:

Currency Swap

The simultanous buying and selling of foreign currencies could be
spot
or
forward/future
currency swaps. This is used by MNCs to minimise the risk of losses arising from exchange rate changes.

Debt swap

Exchanging one debt by another for a fresh term of repayment schedule at the same or usually lower interest rates.

Interest Rate Swap