Home Loans: How to lower the EMI and lower the Term?

Whether to take home loans for a longer term or for shorter term?

We all know that, if we loan term is reduced EMI will go higher and if the loan term is increased the EMI will come down.

Advantages of having a shorter tenure:
1. We are debt-free very early. Being debt-free brings us a peace of mind, which won't be possible if you are in debts.
2. Less out go of cash due to interest. Longer the term, longer will be the total money you have paid.
For a 1 lakh loan for 10 years, the EMI is Rs 1,377.50 at 11% interest rate, where as for 20 years, the EMI is Rs 1,032.19. So the total cash out flow is Rs 1,65,300.00/ and Rs 2,47,725.60 respectively. This is the power of compounding. Here the Eight wonder of the world as quoted by Albert Einstein, is working against us.
3. Increased liability needs increased insurance cover, hence the insurance cost will also be high if the loan term is longer.
4. Increase in interest rate, can be handled much comfortably by extending the term. (i.e. 10+2 years is comfortable than 20+2 years.)

Advantages of having a longer tenure:
1. EMI is less. Hence, we can comfortably pay the EMI without any defaults and we may be eligible for higher loan amount.

Is it possible to get the advantages of both lower term and lower EMI?
Partially yes, Partially No. Yes, if you are disciplined, you can prepay the loan, a couple of years early, for the same EMI. No, you can't get higher loan from a HFC or a bank.

You have to take a house loan for Rs 15,00,000/ and at the interest rate of 11p.a. For simplicity, I am taking a fixed rate, and let us assume, it is pure fixed rate loan, as available in HDFC, ICICI etc. (Some HFC's and Banks have a maximum fixed term as 5 years or 2 years, etc.)

It is assumed that, you are eligible for any term of 10 years, 15 years or 20 years.
Analyze your financial abilities, responsibilities and liabilities and decide on the tenure. Let us say, you want to pay the loan in 15 years. So, the EMI is Rs 17,048.95/ That is, you can pay this amount Rs 17,049/ without any problems for 15 years. Also, you have came up with this figure after considering the tax deductions also. So, in our computation, we are going to ignore the tax savings advantage.

Now, apply for the home loan for 20 years, instead of 15 years. So, your EMI is Rs 15,482.83. Hence the reduction in EMI is Rs 1566.12/ Now, invest this amount in a diversified mutual fund. Since the time period is long, the risk accompanying this investment is negligible. Let us assume a conservative returns @15%.

A simple calculation will show us that, at the end of 15 years, the value of our investment will be 1,060,048.83/ But the outstanding balance with us will be Rs 712,102.13. Withdraw the investment and prepay the loan. Now, you will be left with Rs 3 lakhs additional cash. You should also consider the prepayment penalty. Usually 2% of the prepayment amount, that is around 14,000. Many banks have no prepayment penalty up to some specified amount. Example, IDBI has around 25% of outstanding balance, in every 6 months, citi bank has around 25% every year. So, Instead of closing the loan, all at once, you can make a systematic withdrawal and prepay the loan, thus, avoiding the prepayment penalty and also redeeming at a depressed market.

So, we will be left with approximately 20% of the loan value in our hand.

Currently we have kept the tenure and monthly liability (EMI + investments) at the same level, and generated an extra cash of 20%, at almost no risk.

What if the interest rate is not fixed through out the term, but part fixed i.e. only for 5 years?
Still, apply the same rule for the fixed tenure. At the end of 5th year, if the interest rate is higher, you can either use the savings the prepay the loan, thus reducing the EMI, increase the loan term, with the same EMI, and continue investing at higher rate, at the end of 15 years, you will most likely end up with a higher investments. But, do the home work properly, if the interest rate is too high i.e. greater than or equal to 15%, then it is better to increase the EMI, but if it is lesser than 15%, we can keep the EMI same as we can generate better returns.
You should also consider investing more amount in mutual funds, if required, to generate more value in order to prepay the loan at the exact tenure.

Interest rate at the 1 st year : 11%
Interest rate at the 6 th year : 13%
Interest rate at the 11th year : 14%
Interest rate at the 16st year : 14%

Strategy 1:
Always prepay the loan, before every hike.

Loan amount                : 15,00,000.00
Tenure                     : 20 years
5 years fixed
Rate of Interest           : 11%
EMI                        : 15,482.83

After 5 years:
Outstanding Balance        : 13,62,209.01 
Remaining Loan Term        : 15 years
New Rate of Interest       : 13%
Amount that can be prepaid :  140,441.53  (From investment from reduced emi)
   
Outstanding Balance        : 12,21,767.48
New EMI                    : 15,458.32

After 10 years:
Oustanding Balance      : 1,035,311.82 
Remaining Loan Term     : 10 years
New Rate of Interest    : 14%
Amount that can be prepaid : 142,650.39 (From investment from reduced emi)
   
Outstanding Balance     : 892661.43
New EMI                 :  13,860.04
or
New Term for same EMI   : 8 (EMI = 15,506.87)

Choosing same EMI:
After 15 years:
Oustanding Balance      : 453,714.00 
Remaining Loan Term     : 3 years
New Rate of Interest    : 14%
Amount that can be prepaid : 138,296.34  (From investment from reduced emi)
    
Outstanding Balance     : 315417.66
New EMI                 : 10,780.23
or
New Term for same EMI   : 2 (EMI = 15,144.11)

At the end of 17th year : 
Amount from investment : 53,593.50 

Here inspite of the increased payments, we have ended up prepaying the loan by 2 years and saving a cash in hand of Rs 53,593/

In our case, the interest rate kept on increasing. But, if the interest rate came down, saw from 11% to 10% or even if it retained the same, we need not prepay the loan, instead we can continue paying a low EMI and investing more in mutual funds. In fact, if we have the option to lower the EMI and keep the loan term as the same, we can do that.

Strategy 2:
Always keep the EMI same, and increase the loan period. The bank may not cooperate well with you, but if you can convince the banker, you can apply this strategy. Although this strategy doesn't have much risk, iinfact lesser risk as we will won't take out the mutual fund investments withing 15 years at any case, and we also won't very the monthly investment. But, this may affect your peace of mind. If you follow it with full discipline, this will be a better strategy.

Loan amount             : 15,00,000.00
Tenure                  : 20 years
5 years fixed
Rate of Interest        : 11%
EMI                     : 15,482.83

After 5 years:
Outstanding Balance      : 13,62,209.01 
Remaining Loan Term     : 15 years
Amount available        : 140,441.53  (From investment from reduced emi)
New Rate of Interest    : 13%
New Term                : 24 years (INR 15,451.08)

After 10 years:
Outstanding Balance      : 1,304,001.31 
Remaining Loan Term     : 10 years (actually 19)
Amount available        : 439,235.45 (From investment from reduced emi)
New Rate of Interest    : 14%
New Term                : 24 years (INR 15,451.08)

After 15 years:
Outstanding Balance      : 1,262,307.77 
Remaining Loan Term
Amount Available        : 1,060,071.28 

After 16 years
Outstanding Balance      : 1,249,889.30 
Remaining Loan Term
Amount Available        : 1,250,014.20 

You can pay all at once. So, although the tenure as per the bank will be around
35years, you have paid the loan in just 16 years.
The problem with this technique is, at some point of time, your loan statement will say, you will be in debt for 35 years. So, the bank may not cooperate well with you.
Use this only if the expected % from the market is much higher than that of the interest rate.

Strategy 3:
You can also mix and match both these two techniques, in such a way that you can arrive at a best combination at any point of time.

Loan amount             : 15,00,000.00
Tenure                  : 20 years
5 years fixed
Rate of Interest        : 11%
EMI                     : 15,482.83

After 5 years:
Outstanding Balance      : 13,62,209.01 
Remaining Loan Term     : 15 years
New Rate of Interest    : 13%
Amount that can be prepaid :  140,441.53  (From investment from reduced emi)
   
Outstanding Balance     : 12,21,767.48
New EMI                 : 15,458.32

After 10 years:
Outstanding Balance      : 1,035,311.82 
Remaining Loan Term     : 10 years
New Rate of Interest    : 14%
Amount that can be prepaid : 142,650.39 (From investment from reduced emi)
   
Outstanding Balance     : 892661.43
New EMI                 :  13,860.04(Amount that can be saved: 3188.91)
or
New Term for same EMI   : 8 (EMI = 15,506.87)

Choosing same Term:
After 15 years:
Outstanding Balance      : 595,662.99 
Remaining Loan Term     : 3 years
New Rate of Interest    : 14.5%
Amount that can be prepaid :  285,986.84  (From investment from reduced emi)
    
Outstanding Balance     : 315417.66
New EMI                 : 10,856.98
or
New Term for same EMI   : 2 (EMI = 15,218.72)

After 17years:
Investment value        :  51,494.32 

You can prepay the loan in 17 years, and you will have a mutual fund investment value of 51,494.32

In all these techniques, I haven't considered the tax savings. If you included the amount of tax saved also, you will be able to handle the interest rate hikes, better, and also, you will be able to prepay the loan much faster, or even create greater wealth.

Points to consider while considering the tax benefits:
The more tax you save, better it is. As we are investing the same amount, whether it is principal repayment or as interest, the total out flow is the same. Hence higher savings in tax should be preferable. So, always restructure the EMI in such a way that you will get higher tax benefits.

In such a case, the strategy 2 will prove to be very efficient than others. Because, in this strategy, we pay interest of more than 1.5 lakhs for around 15 years, which by itself gives around Rs 50,000/ Investing this in mutual funds, will generate a return much higher that you will be able to prepay the loan within 13 years.

If the property you buy is to let out, then you will not have the 1.5 lakhs cap for interest payment, there by producing a better returns.

Conclusion:
Use equities for long term wealth creation. Use leveraging appropriately. Although this works well with home loans, you should not apply the same technique with personal loans as the interest rate is 16%, but our expected earnings in stocks is just 15%. Also, don't be greedy, don't expect 30% return from the market. Market always surprises you.

If you can invest much higher, you

7 secrets that add fun to budgeting

Moneycontrol.com lists the why budgeting is important and how to create a useful budget.

Why budgeting?

• Makes you control money, instead of money controlling you
• Makes you ‘enjoy’ money, not ‘worry’ about money
• Doesn’t mean ‘curbing’ your spending, but makes it more ‘purposeful’
• Protects you from getting into financial problems

How to create a useful budget?

1. Make it a family affair
2. Have targets
3. Surprise yourself
4. Dare to do more
5. Think beyond money
6. It is not a test of your mathematical skills
7. Don’t be too rigid

See full article - 7 secrets that add fun to budgeting

Busted: 10 insurance myths that can prove costly

Moneycontrol has an interesting article about the insurance myths prevailing in the minds of the investors.
The insurance myths that are listed in the article are,
1. Should I buy life insurance on my child’s name?
2. Should I buy unit linked policies as an investment?
3. Will I really get a policy for 30 years where I have to pay premium for only three years?
4. I have some old policies from Life Insurance Corporation. My new agent is asking me to surrender them. What should I do?
5. We are the biggest company in…!
6. Our parent companies' credit rating is higher than that of the Government of India; excellent, but er… where do you invest?
7. I have adequate life insurance but my broker is talking about critical illness insurance. Do I need it?
8. My group insurance is adequate
9. My credit card gives me some insurance
10. I am adequately insured, my CA told me

Learn more at Busted: 10 insurance myths that can prove costly.

Insurance Truths

Many people are not interested in Term Insurance. Value Research online, puts one of the reasons given by the investors.
According to him, it works like a betting game. Let's say you insure yourself for Rs 10 lakh at an annual premium of just Rs 2,000. What it means, according to our reader, is that you are willing to bet that you would die this year and so willingly cough up Rs 2,000. The insurance company bets that you will not die and is willing to pay your family Rs 10 lakh if you do. If you survive - which, we're sure, you would really love to - you lose the bet and the insurance company walks away with Rs 2,000. If you win the bet, you know what happens.

This bet goes on over a period of 10, 15 or 20 years, whatever the term of the policy. And so, he concluded, that it goes against his faith to lay a wager on his life. That forced him to arrive at the conclusion that a policy which gave him a return would be a good option because he could view it more as an investment.


Value Research Online explains why this view is wrong with some maths, in "Insurance Truths".

I have already explained why Term Plans + ELSS is a better in "Insurance: Term Plan"

Zero Risk Investing and Tax Planning

Zero risk investing and capital guaranteed funds are a few of the buzz words in investment arena.

One way to avoid risk completely is to avoid any equities, any long term bonds or any thing that is related to market. The investment instruments like Bank Fixed Deposits, Post office investments, etc are really zero risk. But, as we all know, the returns are also very low with zero risk investments. Let us look at how to get a higher returns without taking any risk.

Let us define risk as 'the chance of losing the capital'. This is how most investors define risk, although in theory, the risk is defined by the standard deviation, or the chance of getting returns (positive or negative) above or below the expected returns.

Equities are the best way for higher returns (but, with higher risk), and the fixed return investments are the best way for zero risk (but, with low returns). We can use a combination for these two, to get a higher returns at zero risk. Let us look at various techniques of zero risk investing and also for zero risk tax planning.

Post Office Monthly Income Plan + SIP in Equity Fund
This article related to the zero risk investing -
How to invest in stocks WITHOUT any risk

Invest Rs 6 lakhs in the Post Office Monthly Income Scheme (POMIS). POMIS gives interest at the rate of 8% p.a., which means per year you would receive Rs 48,000. Since its a monthly income scheme, the interest per month works out to Rs 4,000. Now, this is fully taxable. Assuming you are in the 30% tax bracket, the net balance after tax left with you would be Rs. 2,800.

Now, enter into an SIP with this amount of Rs 2,800. POMIS is a six-year scheme. So basically, you would invest Rs 2,800 per month for six years. At the end of six years, you would receive the market value of your mutual fund investment and also the capital amount of Rs 6 lakhs invested in POMIS. Consequently, while you have kept your capital intact, you still have taken on equity with all its associated risk.

To see how this strategy can actually work out, we ran some numbers. Say, you started your POMIS account in September 2000. The monthly interest was invested in Franklin Templeton Prima Fund on an SIP basis.

By adopting this simple structure, at the end of six years, the investor would have received around Rs 9.45 lakh (Rs 945,000) just on account of the mutual fund investment. Add to it the capital amount of Rs 6 lakh of POMIS and the total investment would net a cool Rs 15 lakh (Rs 1.5 million). And this is after tax and without an iota of risk.


This is a nice and powerful technique. This assures capital guarantee. In the equity part, it also eliminates the timing risk by using SIP. But, there are a few drawbacks in this technique.

1. The amount invested in SIP is very less, because of the heavy tax on the income generated from POMIS.
2. The equity exposure is very less, as a major portion of the investment lies in low return investment, for most of the time period, there by reducing the returns.
3. It is difficult to extend the same technique for other time intervals, like 3 years, 5 years or 8 years, etc.

Fixed Deposits + Equity Fund
In this technique, we will invest in Fixed Term Deposits like Bank Deposits or Bonds like National Savings Scheme(NSC), or Kisan Vikas Patra(KVP), etc. Here, we will invest only the portion of the fund that is just sufficient to generate the total investment amount. That is, if the interest rate is 8% with a maturity period of 6 years, we will invest only Rs 3,80,000/ in this guaranteed, zero risk plan. The remaining amount can be invested in the equity funds. At the end of 6 years, the term deposit will mature with a amount of Rs 6,03,012.24/.

If we had invested the remaining amount (Rs 2,20,000/) in the same fund as in the previous example, the returns would have been Rs 27,57,804.73/ This is many times higher than the previous technique. This is because we have a higher equity exposure for a longer period of time. Here we didn't consider the tax. As the interest in most of the fixed maturity schemes are taxed at the same rate as that of the income tax rate, we shall assume the tax rate of 30% as in the previous example.
The interest generated is 223012.24, so, 30% tax = 66903.67, leaving a maturity value of Rs 536108.56/.

So, the investor should invest Rs 4,30,000/ in the Term Deposit. This will mature with Rs 6,82,355.95/. After tax, the net return will be Rs 6,06,649.165/. In the equity part, invest Rs 1,70,000/. This will return Rs 15,34,528.38/. This is far higher than the previous technique.

This techniques relies on two facts that helps achieve higher returns over the previous technique.
1. The returns in equity is directly proportion to the time period of the investment.
2. The tax paid today is higher than the equal value of the tax paid after 6 years.

A small variation can be done to this technique to avoid the timing risk. Instead of investing the entire amount at once, we can invest them as 6 months or 1 year SIP. Or, we can invest them in Liquid Funds and make a 6 months or 1 year STP to the equity fund. In this way, the timing risk can be eliminated. Also, the 1 year SIP is in many cases, more than sufficient to reduce the timing risk. But, since we have already made a capital guarantee, this risk can be ignored.

Advantages:
1. Higher returns.
2. Can be easily extended to various time periods. Now there are many banks that give a 8% return for a very short term of just 1 year in term deposit. For example, ICICI Bank gives 8% p.a. for a period of 395 days, Kotak Mahindra Bank gives an interest rate at 8% p.a. for just 290 days, HDFC bank gives an interest rate of 8% for 380 days and 8.25% for 745 days (2 years + 15 days)

Limitations:
1: The timing risk. But this can be reduced or ignored. As the time period is longer.

Zero Risk Tax Planning - NSC/Tax Saving Fixed Deposit + ELSS
The previous technique can be used in the same way for tax planning, by only changing the investment instruments.
Zero Risk investment:
National Savings Scheme for 6 years. (8% p.a)
Tax Saving Fixed Deposits for 5 years. (7-5-8% p.a.)
Infrastructure Bonds for 3 years. (4-5%p.a)(not recommended)

High Return investment:
Equity Linked Savings Scheme (ELSS)
Choose any of the good funds like HDFC Tax Saver, HDFC Long Term Advantage, Magnum Tax gain, or Prudential ICICI Tax Plan or Sundaram Tax Saver.

---

But, validating any such schemes, you must read this article from value research online about Zero Risk Investing.
[i]Assets like bank FDs and cash mutual funds are always zero risk, short-term income funds are zero risk after six months, and a good stock portfolio like a well-chosen set of diversified equity funds are close to zero risk after maybe seven years.[/i]

That is, the equity fund itself carries a very low risk after six years, hence it is not needed to allocate a high amount in the fixed deposits, instead we can invest as low as 10-20% in fixed deposits and remaining in diversified equity funds. Only thing is there is no word 'guarantee' in this way, but this is proved many times in the history, and so we can expect the same in the future. The returns may vary, but the chance of losing capital is very less in long term.

--
Happy Investing at Zero Risk.

ITC worth buying

ITC Limited, is one of India's foremost private sector companies with a market capitalization of more than US $ 10 billion and a turnover of US $ 3.5 billion. Rated among the World's Best Big Companies by Forbes magazine, ITC ranks third in pre-tax profit among India's private sector corporations.

List of Products and Brands

ITC has a diversified presence in

• Cigarettes: Wills, Insignia, India Kings, Gold Flake, Navy Cut, Scissors, Capstan, Berkeley, Bristol and Flake


• Hotels: ITC-Welcomgroup Hotel Chola


• Paperboards & Specialty Papers:Classmate, ITC Bhadrachalam Paperboards Limited


• Packaging: BILT Industrial Packaging Co. Ltd


• Agricultural Industry: Agri-Business, Leaf Tobacco, Gold Ribbon, Blue Ribbon, Aqua Kings, Aqua Bay, Aqua Feast and Peninsular


• Packaged Foods & Confectionery: Kitchens of India, Aashirvaad, Sunfeast, Mint-O, Candyman


• Branded Apparel: Wills Lifestyle, John Players, Essenza Di Wills


• Greeting Card: Expressions


• Information Technology: ITC Infotech India Limited


• Safety Matches: iKno, Mangal Deep, VaxLit, Delite and Aim

Cigarettes:
Although the ITC has diversified products, the primary business is cigarettes. ITC holds the most famous brands of cigarettes in all prices attracting (or spoiling) the people with all economic statuses.

The business on cigarettes will never or rarely come down. Currently, there is no chance for the government to ban Tobacco and cigarettes. Also, the smokers very rarely quit. More than the people who quit, many more are getting addicted to cigarettes.

So, in terms of revenue ITC is very safe or risk-free with its business in cigarettes.
As more people are leaving out beedis, gutka and chewing tobacco, the consumers of cigarettes seams to increase drastically.

Also, whenever the government increases tax on cigarettes and other tobacco products, the cigarette companies can easily increase the price and increasing the profit margin along with the tax.

Paperboards & Specialty Papers
Other than the Cigratte business, the paper boards are the next major component of ITC's business. ITC is a market leader in Paperboards also.

FMCG
ITC has entered the FMCG business and attracted a good business with its two famous products - Aashirvaad packaged food products, Sunfeast biscuits. ITC's entry into the FMCG business will add a good source of income for the company.

With all these valuable business ahead, ITC looks very attractive as a long-term investment.

Technical Analysis
The ITC stock is currently quoting at Rs 184.95/ as on Oct 23, 2006. It has a strong resistance at 193/ and a strong support at 185/. Once the resistance is broken, it has its next resistance level only at Rs 212/. Till then, ITC will have a very free upward movement. At the negative side, there are two important support levels one at 165 and another at Rs 150.

When to Buy?
As the stock price is almost at the support level, we can enter new positions now, for about 30% of the planned investment amount. As we are expecting the Q2 results on Oct 30, the results will directly influence the stock price. As ITC is looking for business expansion, the expenses might have increased a little, if this is the case, the stock price may go down out of panic, because of few short term traders and for booking profits. But, if the profits has really increased, the stock price will increase. So, instead of timing the market, we can invest another 30% after the results, thereby averaging the cost. The remaining 40% can be done whenever a dip occurs or as 10-15% every month.

Another important fact we should remember is, as the Q2 results will be announced for most of the stocks within next month and if the results where not fruitful overall even if it is for other industries, other sector, the market sentiment may affect ITC also. So, have some cash ready to invest during dips (if at all something happens) or buy even if it keeps increasing.

India's Growth Rate

India's growth rate for the fiscal year 2005-2006 is 8%. Our economy is booming with an explosive growth rate. India is described as the next super power, America-China-India will together rule the world in the future. We Indians are extremely happy about the massive growth rate and proud of it. But there are some questions.

The Rupee-Dollar exchange rate and the inflation rate doesnt justify the growth rate of the nation.

The dollar value went down from around Rs 43 per dollar in 2005 to Rs 45 per dollar in Mar 2006. That is rupee value went down by around 4.5%. This itself shows, if we can retain the same income as last year, we can show a growth rate of 4.5% without any real growth. That is if our value was the same $100, in rupees in would ne Rs4,300/ in 2005 and Rs4,500/ in 2006.

The inflation rate is also too high. Inflation rate is the one that really affects the people. Because inflation rate is calculated based on the essential commodities, where as the growth rate is calculated based on the overall income of the country that is contributed by big companies. The inflation rate crossed 5pts and the inflation rate is estimated to be around 5.5% in Mar 2007.

The current system may make the countries like US where the population is less to develope. But with countries like India were the core of the population is in villages with around 25 million below poverty line, the inflation rate should be kept in check along with the development.

Rupee Value and Petrol Price

Although it is an old article, i thought of adding this in my blog. This article was published in The New Indian Express.


Petrol at Rs 30 a litre? Possible, but...

S. Gurumurthy

Both Marxists and the BJP perhaps feel shy to find themselves together on the petrol price hike.

But little do both realise that the economics of petrol prices needs deeper reflection and is not simply a subject of slogans and agitations.

There is a process link between crude and petrol, yes. But there is a missing link between the cost of crude and the price of petrol.

What is that missing link?

We pay for crude supplies from outside in dollars. But we sell petrol and diesel refined out of the dollar-based crude for rupees. Thus there is an intermediary between the prices of dollar-based crude and rupee-based petrol and that is the exchange rate between the dollar and rupee.

So petrol prices in rupees not only depend on the price of crude in dollars but also the price of dollars in rupees.

How this missing link between the crude and petrol prices works?

The global crude price today is over 70 dollars per barrel. With the dollar rated at Rs 46, the cost of one barrel of crude is Rs 2,842. Imagine the price of one dollar is not Rs 46 but just half of it - Rs 23. Then the price of one barrel of crude becomes half in rupee terms, namely Rs 1,421, even though in dollar terms it is the same, that is, 70 dollars.

So if the rupee appreciates in value we need to pay less rupees for dollars. Consequently, the crude will cost less in rupee terms. What is the issue now?

Currently the dollar price in rupee terms highly undervalues the rupee whose real value is more. This compels us to pay more rupees for dollars. This makes the imported items, including the crude rated in dollars, costly in terms of rupees.

How did the rupee get undervalued in the market? It is the Government of India which has exerted pressure to have the rupee undervalued. Surprised?

It is not a well-kept secret that in the post-reform period, whenever the rupee rose against the dollar, the Government intervened to support the dollar against the rupee and kept the rupee in the market at lower than its real value.

But why should the Government do it? And how to determine the real value of the rupee and prove that the Indian currency is undervalued in the market? A slightly complex subject, but can be simplified for the uninitiated.

Experts would counsel that 'in the long run', that is over a period, the value of a currency would be equal to its purchasing power, regardless of the short-term fluctuations in its prices in the market. The real determinant of the exchange value between two currencies, they say, is the relative purchasing power of both, known as Purchasing Power Parity (PPP).

Between 1955 and 1985 the real value of the Indian rupee and its exchange rate with the dollar were similar. In 1982 the real value of the rupee on PPP terms was Rs 15 to a dollar and the exchange rate was less, Rs 9.3 to a dollar.

But between 1985 and 1992, the situation reversed; the real value of the rupee became lower than its actual exchange value. This led to a 20 per cent corrective depreciation of the rupee in 1991.

However, from 1993, the policy was to leave the rupee largely market-determined for trade and current transactions and except for capital account. This is where the present story starts. Particularly from 1994 when investments by Foreign Institutional Investors were allowed, the rupee began appreciating in real terms. But the Finance Ministry and the RBI began intervening repeatedly to keep the rupee priced in the market at below its real value.

Obsessed with the export-driven growth model of East Asian economies, the fashion then, the Government had opted for this strategy. As a crisis management formula for a while it was okay. But, on durable basis, this is unsuitable to an economy like ours which largely works on domestic activity. More, with the unprecedented dollar cost of fuel it is devastating the domestic economy now.

That the rupee has been deliberately kept undervalued in the market is self-evident.

First, take the rise in foreign exchange reserves and fall in rupee value. In principle if the foreign exchange reserve ' that is foreign currency assets ' rises, then the value of the rupee too will rise. Indian foreign currency assets have increased from 26 billion dollars in 1993 to 160 billion dollars today - an increase of 615 per cent.

Surprisingly, thanks to the RBI interventions during this period to help the dollar and suppress the rupee in the market, the rupee did not rise at all!

On the contrary, it has fallen from Rs 31 per dollar to Rs 46 per dollar now, that is, by 50 per cent!

Next, take the Purchasing Power Parity between the rupee and the dollar. The actual GDP for 2005 measured in market determined rupee-dollar rates is 746 billion dollars against which GDP in purchasing power terms is 3699 billion dollars, that is, five times the market exchange-rated GDP. It means that the buying power of rupee is five times its actual exchange rate. Consequently the price of the rupee in the market is one-fifth of its real value.

Theoretically then, the real exchange value of the rupee for the dollar should be Rs 9 to a dollar against Rs 46 to a dollar in the market today.

Thus both in terms of rise of foreign assets and purchasing power of the rupee, its value should be higher than in 1993, but it is actually less! If the dollar-rupee exchange value today were the same as in 1993, when the Indian economy was not faring as well, the cost of the imported crude will be half of what it is in rupees today. This would halve the petrol prices.

Then it is possible to sell petrol at Rs 30 per litre. But this will happen only if the policy makers get over their obsession of the 1990s for export-led growth.

Imagine the energy prices are halved today. What would be the competitive advantage of India? Is there any need to promote exports then?

Exports will rise automatically once such cost advantage is built in. We are undervaluing the rupee to promote exports, and damage the domestic economy with artificially high energy cost which in turn hurts our export competitiveness.

Ridiculous is the word. This has to be reversed.

Today a strong rupee will make a stronger economy as some one put it. The reversal process can be calibrated over a period so that it does not cause shock.

Will the Government and the RBI rethink? Will the Opposition, the BJP and the CPM, think rather than strike?



Mr. S. Gurumurthy says, the rupee value is five times undervalued, ie 1 Dollar = 9 Rupees as against 1 Dollar = 46 Rupees.

The reason why RBI and Indian Government in undervaluing is mainly to attract more foreign investments and to improve exports. After Manmohan Singh opened up FI in 1991, it's slowly becoming a happening story now with around 160 bn$ ForEx reserve. all these will not be possible without a "attractive" rupee valuation! Even the MNCs, we are working, will go away once rupee appreciates and they will have no reason to invest in India.

India has developed economically. But, to improve furthur, the rupee value should appreciate itself, in order to improve the domestic industries, there by improving the production, which inturn improves the Indian economy.