Ifp 36 Environment of a Financial Planner

7/30/2019 Ifp 36 Environment of a Financial Planner

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270 Financial Planning Handbook PDP

Chapter 36



271Financial Planning HandbookPDP

Environment of a Financial Planner

The work of the financial planner is impacted by changes taking place in the economy. Factors that

impact inflation, interest rates, and stock prices are important for the financial planner to understand.

The planner should be able to anticipate the changes in the economy and make his recommendations

accordingly.

Let us try to understand the inter-relationships amongst the various factors that affect the Indian economy.

Structure of the Indian Economy

The biggest impact on the Indian economy is through the policies of the Government. The government

controls the economy through:

Monetary Policy

Fiscal Policy

Monetary and Credit Policy

The Monetary policy is concerned with the supply of money in the economy and costs of borrowing it.

The broad aim of the policy is to control the growth of the money supply so as to avoid an excessive rate

of inflation. The monetary policy is implemented through the Reserve Bank of India (RBI), which is an

independent body. The objectives of the policy are:

Stability of employment and prices

Economic growth

Balance in international payments

This is achieved through manipulation of:

Supply of money

Level and structure of interest rates

Other conditions affecting the availability of credit

The RBI also acts as the regulatory authority of the country’s monetary policy and is the sole provider and

printer of notes and coins in circulation. The central bank can best function in these capacities by remaining

independent from the government’s fiscal policy and therefore uninfluenced by the political concerns of any

regime. The central bank should also be completely divested of any commercial banking interests.

Role of the Central Bank in an Economy

A central bank can be said to have two main key functions:

Macroeconomic, when regulating inflation and price stability

Microeconomic, when functioning as a lender of last resort




Macroeconomic Influences

As the bank is responsible for price stability, it must regulate the level of inflation by controlling money

supply by means of monetary policy. The central bank performs open market transactions that either

inject the market with liquidity or absorb extra funds, directly affecting the level of inflation.

When the bank needs to increase the amount of money in circulation and decrease the interest rate(cost) for borrowing, it buys government bonds, bills, or other government-issued notes. This buying can,

however, also lead to higher inflation.

When the bank needs to absorb money to reduce inflation, it will sell government bonds on the open

market, which increases the interest rate and discourages borrowing. Open market operations are the

key means by which a central bank controls inflation, money supply, and price stability.

Microeconomic Influences

The RBI can also influence short term interest rates by setting the interest rate at which it lends to the

other commercial banks in the country.

The rate at which commercial banks and other lending facilities can borrow short-term funds from thecentral bank is called the PLR (Prime Lending Rate) or the discount rate (which is set by the central bank

and provides a base rate for other interest rates).

The RBI can quickly squeeze or expand the supply of money by increasing or decreasing the reserve

requirements of commercial banks. Currently, commercial banks are required to maintain two types of

deposit reserves:

CRR: Cash Reserve Ratio. Banks are required to keep a certain percentage of their demand liabilities

in the form of cash with the RBI.

SLR: Statutory Liquid Ratio. Banks are required to keep a certain percentage of their liabilities in

specified liquid securities.

Fiscal Policy

Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and

influence a nation’s economy. It is the sister strategy to monetary policy. These two policies are used in

various combinations in an effort to direct a country’s economic goals. Economic growth is largely

influenced by the fiscal policy. The Gross Domestic Product or the GDP is used by economists as a

measure of economic growth. GDP is calculated as:

GDP = C + I + G + (X – M)

Where,

C: Consumption of goods and services by households

I: Investments in capital goods by the private sector

G: Government expenditure

X: Export receipts

M: Import expenditure

An increase in GDP generally means that standards of living would rise, unemployment would reduce

and profits of corporations would rise. Thus, the impact of rise and fall of GDP can be seen in the

unemployment rates, inflation, consumer spending growth, aggregate demand and supply of goods etc.




The government directly influences GDP by increasing or decreasing its expenditure. It can also exert

influence indirectly by setting policies that encourage exports or imports or by creating tax laws that

encourage consumption or capital investments.

The Business Cycle

Economies have a tendency to move in recurring cycles. A boom in the economy is invariably followedby a depression, which is again followed by a boom.

In order to determine the current state of the economy, we first need to take a good look at the business

cycle as a whole. Generally, the business cycle is made up of four different periods of activity extended

over several years. These phases can differ substantially in duration, but are all closely intertwined in the

overall economy.

Growth (Expansion/ Recovery)

This is the phase of a business cycle when the economy moves from a trough to a peak. It is a period

when business activity surges and gross domestic product expands until it reaches a peak. Employment,

production, and income all undergo a period of growth, and, overall, the economic climate is good.An expansion is one of two basic business cycle phases. The other is contraction. The transition from

expansion to contraction is termed a “peak” and the changeover from contraction to expansion is a trough.

Expansions last on average about three to four years but have been known to last anywhere from 12

months to more than 10 years.

This phase can also be termed as an “economic recovery”.

Peak

Peak is the highest point between the end of an economic expansion and the start of a contraction in a

business cycle. The peak of the cycle refers to the last month before several key economic indicators,

such as employment and new housing starts, begin to fall. It is at this point that real GDP spending in aneconomy is at its highest level (implying that there is very little waste occurring).

At its peak, the economy is running at full steam. Employment is at or near maximum levels and income

levels are increasing. In this period, prices tend to increase due to inflation; however, most businesses

and investors are having an enjoyable and prosperous time.

Recession (Contraction)

Contraction is a period of general economic decline. Contractions sometimes lead to a recession.

After experiencing a great deal of growth and success, income and employment begin to decline. As our

wages and the prices of goods in the economy are inflexible to change, they will most likely remain near

the same level as that found in the peak period unless the recession is prolonged. The result of thesefactors is negative growth in the economy.

Recession marks a significant decline in activity spread across the economy, lasting longer than a few

months. It is visible in industrial production, employment, real income and wholesale-retail trade. The

technical indicator of a recession is two consecutive quarters of negative economic growth as measured

by a country’s gross domestic product (GDP).

Interest rates usually fall in recessionary times to stimulate the economy by offering cheap rates at

which to borrow money. Recession is a normal (albeit unpleasant) part of the business cycle.




Trough

Trough is a stage of the economy’s business cycle that marks the end of a period of declining business

activity and the transition to expansion. This is the section of the business cycle when output and employment

bottom out and remain in waiting for the next phase of the cycle to begin.

In general, the business cycle is said to go through expansion, then the peak, followed by contraction, and

then it finally bottoms out with the trough.

Implications for Financial Planners

The share markets have a close co-relation with the stage of the economy. When the economy is in

the growth phase, share prices are rising. Share prices generally follow the economy with a small

lag. They reach their peak soon after the economy reaches it. As the economy enters the contraction

phase, the share prices crash. The financial planner can take advantage of this knowledge to guide

his client as to when to buy/sell shares.

Interest rates are also high when the economy is at its peak. Therefore, that is a good time to lock

into fixed rate debt instruments.

The levels of imports and exports impact the exchange rate, which in turn impacts the profits of

companies having international operations. A financial planner can choose good investments for his

clients if he has understanding of these relationships.

Financial Institutions (RBI, SEBI, AMFI etc.)

For realization of full potential, economies need institutions that impartially enforce property rights, low

transaction costs and transparency. The primary role of a financial institution is to serve as an intermediary

between lenders and borrowers. Financial institutions in the organized sector function under the overall

surveillance of the RBI.

Reserve Bank of India (RBI)

RBI, the central banking authority, is the backbone of the Indian financial system. It was established in1935 and became a government-owned institution from 1949 under the Reserve Bank Act of 1948. RBI

performs the following key functions:

Formulating and implementing monetary and credit policies

Functions as the Banker’s bank

Manages liquidity reserves of credit institutions and supervises their operations

Plays an important role in maintaining the exchange value of rupee

Controls payments & receipts for international trade and regulates other foreign exchange transactions

Apart from the above, RBI also performs the below mentioned functions which are aimed at developing

the Indian financial system:

Seeks to integrate the unorganized financial sector with the organized financial sector

Encourages the extension of the commercial banking system in the rural areas

Influences the allocation of credit

Supports innovation in cooperative banks

Promotes the development of new institutions, for example set up Unit Trust of India (UTI), Industrial

Development Bank of India (IDBI) & National Bank for Agricultural and Rural Development (NABARD)




Securities and Exchanges Board of India (SEBI)

SEBI was formed as per the guidelines laid down in the Securities and Exchange Board Act of 1992. This

act necessitated the establishment of a board to protect the interests of the investors in securities and to

promote the development and regulation of securities market. SEBI’s head office is in Mumbai and it

consists of the following members:

Chairman

Two members from the Government of India (Ministries of Law & Finance)

One member from the RBI

Two other members

The board has following key functions:

Regulating business in stock exchanges and any other securities market

Registering and regulating the working of all the intermediaries involved in the securities market

(stock-brokers, sub-brokers, share transfer agents, bankers and registrars to an issue, trustees of

trust deeds, merchant bankers, under-writers, portfolio managers, investment advisors)

Registering and regulating the working of depositories, custodians of securities, FIIs, credit rating

agencies

Registering and regulating the working of venture capital funds and collective investment schemes

(mutual funds)

Promoting and regulating Self-Regulatory Organisation (SROs)

Prohibiting fraudulent and unfair trade practices relating to securities market

Promoting investors’ education and training intermediaries

Prohibiting insider trading

Regulating substantial acquisition of shares and takeover of companies

Calling information for, undertaking inspection, conducting inquiries and audits of stock exchanges,

mutual funds, intermediaries and self-regulatory organizations

Levying fees and other charges for carrying out its work

Association of Mutual Funds of India (AMFI)

As the name suggests AMFI is the apex body of all the registered Asset Management Companies

(AMCs) in India. It was incorporated on August 22, 1995. All the companies which have launched a

mutual fund in Indian markets so far are its member. AMFI is dedicated to developing the Indian Mutual

Fund Industry on professional and ethical lines. The key objectives of AMFI are:

To define and maintain high professional and ethical standards in all areas of operation of mutual

fund industry. To recommend and promote best business practices and code of conduct to be followed by members

and others engaged in the activities of mutual fund and asset management, including agencies

connected or involved in the field of capital markets and financial services.

To interact with the SEBI and to the represent to SEBI on all matters concerning the mutual fund

industry.

To represent the Government, RBI and other bodies on all matters relating to the Mutual Fund

Industry.




To develop a cadre of well trained Agent distributors and to implement a programme of training and

certification for all intermediaries and others engaged in the industry.

To undertake nation wide investor awareness programme so as to promote proper understanding of

the concept and working of mutual funds.

To disseminate information on Mutual Fund Industry and to undertake studies and research directly

and/or in association with other bodies.

Commercial Banks

Commercial banks are the most common, well-known institutions in the financial system. State Bank of

India (SBI) is the largest commercial bank in India. It was set up in 1955 when the Imperial Bank was

nationalized and merged with some banks of the princely states. In 1969, at one go, 14 other large

privately-owned commercial banks were nationalized. Thereafter, some more banks have been nationalized

over the years, making the space virtually dominated by the public sector. Of late, a lot of private banks

(both Indian and multinational) have come into existence and gained importance.

Commercial banks accept deposits from the public for short periods and deploy the funds by way of

loans and advances, overdraft facilities and purchase/ discount of bills to industry and trade to meet theirworking capital requirements. Secondly, commercial banks are the primary vehicles through which credit

and monetary policies are transmitted to the economy (common man). The nature of lending and investing

by commercial banks is multi-functional. They deal in a wide variety of assets and accommodate different

types of borrowers.

Developmental Financial Institutions

These institutions have been set-up to primarily cater to the long-term financing needs of the industrial

sector. An elaborate structure of financial institutions consisting of three all-India term-lending institutions

(Industrial Development Bank of India, Industrial Financial Corporation of India and Industrial Credit and

Investment Corporation of India), State Financial Corporations and State Industrial and Development

Corporations has come into being.

Due to the importance given to the small scale sector, the government established the Small Industries

Development Bank of India (SIDBI) in July 1989. It is a subsidiary of IDBI and functions as the chief

refinancing agency for the small scale sector.

These institutions have been very responsive to the growing and varied long-term requirements of industry.

They have provided the bulk of long-term industrial capital needs, particularly for new projects through

direct/ indirect/ assistance financing. They help in identifying investment opportunities, encourage

competent new entrepreneurs, lay emphasis on development of backward regions, and support

modernization efforts.

Non-Banking Financial Companies (NBFCs)

NBFCs engage in a variety of fund-based as well as non-fund based activities. The principal fund-based

activities are leasing, hire purchase, and bill discounting; the main non-fund based activities are issue

management, corporate advisory services, loan syndication, and forex advisory services.

While their functions and the services they render are different, the common feature is acceptance of

deposits from the public, borrowing from banks and in the case of companies organized as public limited

companies, accessing the capital market.

Apart from the ones discussed above, other financial institutions include investment institutions like the

insurance companies, mutual funds and organizations like NABARD & post-office savings bank (POSB) etc.




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Ifp 36 Environment of a Financial Planner

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