Economy - Licchavi Lyceum

INDIAN ECONOMY

Introduction to Economy

Economics is “the social science that studies the production, distribution, and consumption of goods and services.”

Economics has been divided in two branches:

Microeconomic
Macroeconomics

Microeconomics: It is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

Macroeconomics: Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability.

Types of Economy

Capitalist Economy
Communist Economy
Mixed Economy

Capitalist Economy: Capitalism is an economic system in which private actors own and control the factors of production. Key Features of Capitalist Economy is to make a profit.

The capitalistic form of economy has its origin in the famous work of Adam Smith—Wealth of Nations.

Precisely, the model is based on the principle of ‘laissez faire’ (non-interference by the government).

According to Smith, the ‘invisible hand’ of the ‘market forces’ (price mechanism) will bring a state of equilibrium to the economy and a general well-being to the countrymen.

Communist Economy: This is also called the State Economy. Socialism is a populist economic and political system based on public ownership (also known as collective or common ownership) of the means of production. The whole economy is owned by the government.

It was proposed by the German philosopher Karl Marx.

Mixed Economy : The system of economy where both public and private sectors coexist.

Keynesian Economy: According to this approach in normal situation the market force drives the economy but during recession, the state can stimulate economic growth.

The government can increase the investment in infrastructure when the demand is low. This will help to restore demand and ultimately revival of the economy.

Idea of National Income

GDP: Total market value of goods and services produces within the geographical boundary of the country within a given time period.

The GDP of a country is derived from the different sectors of the economy, namely the agricultural sector, the industrial sector and the service sector. The contribution made by each of these sectors makes up the structural composition of the economy.

Nominal GDP: If GDP is calculated considering market price of the current year, This GDP is called nominal GDP.

Real GDP: If the GDP is calculated considering the market price of base year, This GDP is called real GDP.

Deflator: The deflator is used to calculate real GDP by Nominal GDP. It neutralizes the effect of inflation.

In order to compare the economic performance of current year the real GDP is used.

While calculating the GDP only the final goods and services are taken into account and intermediate goods and services are not counted. This is done to avoid the double counting.

What is market price?

The price of a good calculated after adding taxes and duties.

What is factor cost?

The term factor refers to all the factors of production i.e. Land, Labor and Capital. The actual cost incurred in the production of an item is called the factor cost. For calculating the factor cost from market price we need to subtract taxes and add subsidies given by the government. (Cost of production till factory gate).

So, GDP at factor cost= GDP at market price – Taxes + Subsidies

What is the ‘Tax-To-GDP Ratio’?

The tax-to-GDP ratio is the ratio of tax collected compared to GDP. Some countries aim to increase the tax-to-GDP ratio by a certain percentage to address deficiencies in their budgets.

Transfer of Payment: The transfer of payment refers to the payments done by the government to the section of society for which no economic activity is produced in return. Examples are Scholarship, Pension.

Estimating GDP: There are three ways to calculate the GDP.

Expenditure Method: This method adds the consumption, Government Expenditure, Investments and Net export from the country.
Income approach: This method adds the income received by each factor of production like wages, rents etc.
Output Method: This method adds the total value of final goods and services produced in the country.

The calculated value of GDP should ideally be the same by all these methods. Practically they are different.

Note: If the depreciation of the capital goods is taken into account, then the value becomes net value.

Gross National Product GNP: The final value of goods and services produced by the nationals of a country. The production is counted irrespective of the geographical location.

GNP ≡ GDP + Net factor income from abroad

(Net factor income from abroad = Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy).

Net National Product (NNP): The value of GNP after subtracting the depreciation. (NNP=GNP- Depreciation). Net means after depreciation.

National Income (NI): National Income is the Net National Product at facto cost, (NNP – Taxes + Subsidy).

Problems in calculating National Income

The double counting of Products and Services Produced within a time frame.
Black Money
Non Monetization of Services like Household Workers
Non accounting of charitable works
Environmental costs are ignored.

Per Capita Income: The GDP divided by population. The per capita in India was estimated by Dadabhai Naoroji. This helps to ascertain a country’s development status. It is one of the three measures for calculating the Human Development Index of a country. Income per capita counts each man, woman and child, even newborn babies, as a member of the population.

Note: In pre-independent India, Dadabhai Naoroji was the first to discuss the concept of a Poverty Line. He used the menu for a prisoner and used appropriate prevailing prices to arrive at what may be called ‘jail cost of living’.

What is ‘Gross Value Added – GVA’: Gross value added is a productivity metric that measures the contribution to an economy, producer, sector or region. Gross value added provides a dollar value for the amount of goods and services that have been produced, less the cost of all inputs and raw materials that are directly attributable to that production.

# Note: In an open economy the GDP and GNP are different whereas in closed economy the GDP and GNP are same. In closed economy neither the export nor the import takes place.

Who calculates GDP?

The Central Statistical Office calculated GDP. CSO also calculates the GDP deflator.

Problems faced while calculation the National Income:

Black Money is not taken into account
The household services are not counted.
The Charitable work is not counted
The environmental costs are not accounted.

The GDP growth is measured in terms of gross value added. These measures by what percentage the GDP of current year is higher than the GDP of previous year.

The GDP of a country shows the level of development in the country. However this condition is not always fulfilled.

That part of our final output that comprises of capital goods constitutes gross investment of an economy.

Human Development Index

The Human Development Index (HDI) is a composite statistic of life expectancy, education, and per capita income indicators, which are used to rank countries into four tiers of human development. A country scores higher HDI when the lifespan is higher, the education level is higher, and the GDP per capita is higher. The HDI was developed by Indian Economist Amartya Sen and Pakistani economist Mahbub ul Haq.

The index is used to measure the human development level in the country with the help of following three indicators.

Life expectancy at birth
Literacy Rate
Purchasing Power parity

Genuine Progress Indicator

Genuine Progress indicator (GPI) is a metric that has been suggested to replace, or supplement, gross domestic product (GDP) as a measure of economic growth.

The genuine progress indicator is designed to take fuller account of the well-being of a nation, only a part of which pertains to the health of the nation’s economy, by incorporating environmental and social factors which are not measured by GDP.

Gross National Happiness

This is the tool to measure the level of development in a country. The tool has been evolved by Bhutan. Bhutan claims to be the happiest country in the world based on this indicator.

World Happiness Index

The main focus of this year’s report, in addition to its usual ranking of the levels and changes in happiness around the world, is on migration within and between countries.

The World Happiness Report is a measure of happiness published by the United Nations Sustainable Development Solutions Network.

Global Hunger Index

International Food Policy Research Institute (IFPRI) prepares it. The index is updated once a year.

Green GDP

The green GDP is calculated by subtracting the environmental cost from the GDP of the country.

Fiscal consolidation: The term fiscal consolidation means to strengthen the government financial health by managing fiscal deficit, managing disinvestment and deciding the priority area of expenditure, Tax reform etc.

The aim of fiscal consolidation is to minimize the wasteful expenditure and strengthen government financial health.

Tax expenditure: The government at times gives exemption of tax liability to companies. This results in lowering of tax collection. This is called Tax expenditure.

Tax expenditure is justified on the basis of work of these company to boost the further economic growth.

Tax Shelter: The investment done in particular sector gives tax exemption to tax payer. The mechanism to escape from tax payment is called tax shelter.

What is difference between Tax avoidance and tax evasion?

Tax avoidance is to adopt the legalize means to avoid the tax payment whereas Tax evasion is the illegal means to hide the income so as to escape from tax payment.

The bank of International Settlements: This is the international organization, which serves as the bank of central banks. The FSI was jointly created in 1998 by the BIS and the Basel Committee on Banking Supervision. HQ: Basel

Pigovian Tax: The tax imposed on the products that harm the surroundings like taking cigarette.

Octroi: The entry tax in case of inter-state transportation.

Tax Buyoncy: The tax buoyancy is the increase in tax collection as a result of rise in national income.

Tax elasticity: The percentage change in tax collection in response of change in tax rate.

Tobin Tax: The tax imposed on the international transaction. This is imposed to punish the very short term investments.

MAT: Normally the companies are liable for tax payment on the profit they earn. Some companies earn profits and even pay the dividends to the stake holders but they manage to show that the taxable income is zero. Hence they escape from tax payments. In order to curb such practice, the government has introduced the minimum alternate tax at a rate of 18 % on the profit.

The finance ministry had set up a committee led by justice A.P. Shah to study and clarify the issue. The committee recommended that MAT cannot be levied on foreign portfolio investors as well as foreign companies who have no permanent establishment in India.

Presumptive Tax: There are a number of business entities who do not maintain proper profit and loss account for their business. It becomes difficult to calculate the tax liability on such business establishments. The presumptive tax is imposed on the assumption that the tax liability on the company will not be less than the estimated value.

Laffer curve: Relation between tax collection and tax rate.

Base erosion and profit shifting (BEPS): It is a tax avoidance strategy used by multinational companies, wherein profits are shifted from jurisdictions that have high taxes to jurisdictions that have low (or no) taxes.

Double Taxation avoidance agreement: This is the agreement signed between two countries in order to avoid double taxation to a foreign country. Suppose a company is based in Mauritius invests in India and gains capital, then the company will not be liable to pay tax to India and will only pay capital gain tax to Mauritius.

Since there is no provision of capital gain tax in Mauritius, the company need not pay any tax. This was the reason why India received maximum FDI from Mauritius (42 % of the total FDI). The GAAR war introduced to curb such practices. The DTAA is applicable for all direct taxes e.g. Income Tax, Corporation tax, Capital Gain tax.

General anti-avoidance rule (GAAR): It is an anti-tax avoidance regulation of India. Originally proposed in the Direct taxes code 2010, the target is to check the transaction made specifically to avoid taxes (Tax evasion).

Uniqueness to Indian Economy

Today the service sector accounts for almost 54% of Indian GVA in India.
The Industry sector lags behind it with 25.92% contribution and the Agriculture sector is at the third place with 20.19% contribution.
Hence, it is sufficient to conclude that it is no more an agrarian economy.
The dependency of population on the primary sector for its employment still remains at over 56.8 per cent and it is a symptom of an agrarian economy.
The expansion of the industries was not sufficient to attract the labour force from the primary activities. India is still lagging on this
front.

Growth and Development

Economic Growth: An increase in the economic variables over a period of time is economic growth.

The most important aspect of growth is its quantifiability i.e. one can measure it in absolute terms

Economic Development: Economic development is quantitative as well as qualitative progress in an economy. It means, when we use the term growth we mean quantitative progress and when we use the term development we mean quantitative as well as qualitative progress.

Measuring Development

Human Development Index

The index is used to measure the human development level in the country with the help of following three indicators.

Life expectancy at birth
Literacy Rate
Purchasing Power parity

Genuine Progress Indicator

Genuine Progress indicator (GPI) is a metric that has been suggested to replace, or supplement, gross domestic product (GDP) as a measure of economic growth.

Gross National Happiness

This is the tool to measure the level of development in a country. The tool has been evolved by Bhutan. Bhutan claims to be the happiest country in the world based on this indicator.

World Happiness Index

The main focus of this year’s report, in addition to its usual ranking of the levels and changes in happiness around the world, is on migration within and between countries.

The World Happiness Report is a measure of happiness published by the United Nations Sustainable Development Solutions Network.

Global Hunger Index

International Food Policy Research Institute (IFPRI) prepares it. The index is updated once a year.

Economic Reforms

Economic reforms denote the process in which a government prescribes declining role for state and expanding role for the private sector in an economy.

Washington Consensus: It is the development strategy focusing on the minimum intervention of government and maximum role of market forces.

The Economy reform of 1991

New Industrial Policy, 1991: India was faced with a severe balance of payment crisis in June 1991 and there were several inter-connected events which were growing unfavorable for the Indian economy.

(i) Due to the Gulf War (1990–91), the higher oil prices were depleting India’s foreign reserves.

(ii) Sharp decline in the private remittances from the overseas Indian workers in the wake of the Gulf War, especially from the Gulf region.

(iii) Inflation peaking at nearly 17 per cent.

(4) The gross fiscal deficit of the central government reaching 8.4 per cent of the GDP.

(v) By the month of June 1991, India’s foreign exchange had declined to just two weeks of import coverage.

The financial support India received from the IMF to fight out the BoP crisis of 1990–91 were having a tag of conditions to be fulfilled by India. These IMF conditions required the Indian economy to go for a structural re-adjustment.

As the nature and scope of economy were molded by the various industrial policies India did follow till date, any desired change in the economic structure had to be induced with the help of another industrial policy.

The new industrial policy, announced by the Government on July 23, 1991 had initiated a bigger process of economic reforms in the country, seriously motivated towards the structural readjustment naturally obliged to ‘fulfill’ IMF conditions. The major highlights of the policy are as follows:

De-reservation of the Industries: The industries which were reserved for the Central government by the IPR, 1956 were cut down to only eight. In coming years many other industries were also opened for private sector investment.

De-licensing of the Industries: The numbers of industries put under the compulsory provision of licensing were cut down to only 18.
Promotion to Foreign Investment: The FDI started in the year 1991 itself.

India agreed to the conditions of World Bank and IMF and announced the New Economic Policy (NEP).

The NEP consisted of wide ranging economic reforms. The thrust of the policies was towards creating a more competitive environment in the economy and removing the barriers to entry and growth of firms.

This set of policies can broadly be classified into two groups: the stabilization measures and the structural reform measures.

Stabilization measures are short term measures, intended to correct some of the weaknesses that have developed in the balance of payments and to bring inflation under control. In simple words, this means that there was a need to maintain sufficient foreign exchange reserves and keep the rising prices under control. On the other hand, structural reform policies are long-term measures, aimed at improving the efficiency of the economy and increasing its international competitiveness by removing the rigidities in various segments of the Indian economy. The government initiated a variety of policies which fall in three heads viz., liberalization, privatization and globalization.

The reform introduced some of the major reforms in the Fiscal Policy of India for correcting the fiscal imbalance. It is also called the LPG Reform.

Liberalization

The liberalization of the economy means to free it from direct or physical controls imposed by the government. This may be similar to deregulation.

Privatisation

Privatization describes the process by which property or business goes from being owned by the government to being privately owned. It generally helps governments save money and increase efficiency, where private companies can move goods quicker and more efficiently.

Globalisation is generally termed as ‘an increase in economic integration among nations’.

were: reduction in fertilizer subsidy, abolition of subsidy on sugar, disinvestment of a part of the government’s equity holdings in select public sector undertakings, and acceptance of major

Inflation

Inflation: The general rise in the price of commodities in the market. Inflation plays a key role in the economy.

It erodes the purchasing power of people and hurts the people living on the margin.
Low level of inflation is good for the health of economy as it benefits the investors.
The high inflation can increase the interest rates of Banks, this affects negatively the growth in infrastructure.

EFFECTS OF INFLATION

Favors Debtors: Inflation favors the debtors as the amount which the debtor actually pays is less due to inflation.
Decrease in value of currency: Purchasing power of money decreases if there is inflation in the market as inflation makes things costly.
Favors Domestic Farms: The inflation favors the domestic farms and makes the business profitable as the row materials cost are less and the final good cost fetches higher price.
Widening Current Account Deficit: As a result of it the domestic farms prefers to sell their product in the domestic market itself hence the export decreases. This leads to higher current account deficit.

Why moderate level of Inflation is good for the economy?

Rising inflation indicates rising aggregate demand and indicates comparatively lower supply and higher purchasing capacity among the consumers.
Usually, higher inflation suggests the producers to increase their production level as it is generally considered as an indication of higher demand in the economy.

Further, the investment in the economy is boosted by the inflation (in the short-run) because of two reasons:

Higher inflation indicates higher demand and suggests entrepreneurs to expand their production level, and
Higher the inflation, lower the cost of loan

Effect of Inflation on Exchange rate?

With every inflation the currency of the economy depreciates (loses its exchange value in front of a foreign currency) provided it follows the flexible currency regime.

Inflation Targeting: The aim is to set the inflation level to predefined value (Remember Urjit Patel recommendation to keep the inflation level to 4 %).

Note: The RBI has been using headline Consumer Price Index (Combined) as the benchmark for all monetary policy stance from April 2014 onwards.

What is ‘Headline Inflation’?

Headline inflation is the raw inflation figure as reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics.

The CPI calculates the cost to purchase a fixed basket of goods including Fuel and Food items, as a way of determining how much inflation is occurring in the broad economy.

Wholesale Price Index (WPI): It is prepared by Office of the Economic Adviser Department of Industrial Policy & Promotion, Ministry of Industry.

While the WPI-inflation is used at the macro level policy making, the CPI-inflation is used for micro level analyses.

Weight of components in WPI – Primary Articles (weight: 22.62%), Fuel & Power (weight: 13.15%) and Manufactured Products (weight: 64.23).
WPI food index measures the changes in prices of food items at the level of producers.

Consumer Price Index: A consumer price index (CPI) measures changes in the price level of market basket of consumer goods and services purchased by households.

It is published by CSO.

Liquidity Trap: A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. Thus interest rate will not decrease thus fail to make economic growth.

CPI-IW: Inflation based on the Consumer Price index for Industrial Workers (CPI-IW) is released by the Labour Bureau.

Consumer Price Index – Combined: (CPI-C) released by the Central Statistics Office (CSO).

Skewflation: This rise in price level of a small segment of commodity is called Skewflation.

Deflation: The general fall in price of goods in the economy. This is opposite to inflation.

Disinflation: The decrease in the level of inflation is disinflation.

Structural Inflation: The structural inflation is due to structural constrains of the system. There is lack of storage infrastructure of onions, leading to high price for onions in the lean season.

Inflation Tax: Inflation erodes the value of money and the people who hold currency suffer in this process. This looks as if inflation is working as a tax.

Inflation Spiral: The wage supports the price to go up and the higher price forces the wage to go up. This relation is known as the inflation spiral.

Reflation: When the economy is crossing a cycle of recession (low inflation, high unemployment, low demand, etc.) and government takes some economic policy decisions to revive the economy from recession, certain goods see sudden and temporary increase in their prices, such price rise is also known as reflation.

Stagflation: A situation in an economy when inflation and unemployment both are at higher levels, contrary to conventional belief.

Inflation Accounting: A term popular in the area of corporate profit accounting. Basically, due to inflation the profit of firms/companies gets overstated. When a firm calculates its profits after adjusting the effects of current level of inflation, this process is known as inflation accounting.

How inflation affects export?

The company in India will sell the product in India itself as he will get higher price due to inflation, Hence the export will decrease. The American company will have to pay more Dollars to buy the goods and services, Hence the export will reduce.

Inflation Premium: The bonus brought by inflation to the borrowers is known as the inflation premium. The interest banks charge on their lending is known as the nominal interest rate which might not be the real cost of borrowing paid by the borrower to the banks. To calculate the real cost a borrower is paying on its
loan, the nominal rate of interest is adjusted with the effect of inflation and thus the interest rate we get is known as the real interest rate. Real interest is always lower than the nominal interest if the inflation is taking place—the difference is the inflation premium.

Philip Curve: Relation between inflation and unemployment. Higher the inflation lower is the unemployment.

What causes inflation?

Demand Pull Inflation: If the demand of goods rises, it leads to inflation.
Cost Push inflation: Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of wages and raw materials. Cost-push inflation can occur when higher costs of production decrease the aggregate supply the supply of commodities reduces, the price goes up.
Structural Inflation: The structural inflation is due to structural constrains of the system. There is lack of storage infrastructure of onions, leading to high price for onions in the lean season. This is also known as the bottle neck inflation.
Bottleneck Inflation: This inflation takes place when the supply falls drastically and the demand remains at the same level. Such situations arise due to supply-side accidents, hazards or mismanagement which is also known as ‘structural inflation’. This could be put in the ‘demand-pull inflation’ category.
Core Inflation: Core inflation is the change in the costs of goods and services, but it does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are much more volatile.

Types of Inflation

Low Level or Creeping Inflation: If the inflation is under control and monthly figures are in the range of 0 to 3 percent.
Galloping Inflation: This is a “very high inflation” running in the range of double-digit or triple digit.
Hyperinflation: This form of inflation is ‘large and accelerating’ which might have the annual rates in million.

Deflationary Gap: If the supply is more than the demand it leads to slowdown in the demand. This is also known as the output gap or Deflationary Gap.

Inflationary Gap: The excess of total government spending above the national income (i.e. fiscal deficit) is known as the inflationary gap. This is intended to increase the production level which ultimately pushes the prices up due to extra-creation of money during the process.

Inflation Targeting: The measures taken by govt. and RBI to control the inflation level. Monetary and fiscal policy both plays to control the inflation level.

Skewflation: A condition where there is a price rise of one or a small group of commodities over a sustained period of time.

Business Cycle

The economists have pointed out that the business cycle is characterised by four phases or stages.

Depression
Recovery
Boom
Recession

Recession: The slowdown of the economy in which there is a decline in the GDP in two consecutive years.

Depression: The depression is higher degree of recession. An economic depression is a period of sustained, long-term downturn in economic activity in one or more economies. It is a more severe economic downturn than a recession, which is a slowdown in economic activity over the course of a normal business cycle.

Recovery: An economic recovery is when an economy is bouncing back from a recession and starting to expand again. Economies move in phases and, once they have contracted and fallen into a recession, they eventually enter a stage of recovery before starting the cycle again.

Boom: A boom refers to a period of increased commercial activity within either a business, market, industry, or economy as a whole.

Indian Agriculture

Agriculture remains the most important sector of the Indian economy whether it be the pre-independence or the post-independence period. This fact is emphatically proved by the large number of people who depend on it for their livelihood.

Cropping patterns in India

Ravi: Wheat (Starts in the winter season and ends in March.). Wheat requires cold climate to mature and finally warm climate in March April is required for ripening.

The major wheat producing states are Uttar Pradesh, Punjab, and Haryana.

Kharif: Rice (starts with the onset of monsoon). Rice has the largest sown area in the country. India continues to be the second largest producer of Rice after China. High rainfall and high temperature along with fertile soil is required for the production of rice. Normally low lying area of the river delta is suitable for the cultivation of rice. Major states producing rice are West Bengal, Andhra Pradesh, Bihar, Orissa, and Tamil Nadu.

Zaid: Pulse (between the two crops) is an example of Zaid. The cultivation of pulse improves the productivity of soil.

Gram is produced in UP and Punjab, Madhya Pradesh.

WTO and Agricultural Subsidy

AMS: The subsidies provided by the government to the agricultural sector is termed by the WTO as Aggregate Measure of Support (AMS).

Agreement on Agriculture

It aimed to remove trade barriers and to promote transparent market access and integration of global markets.
Agreement on agriculture stands on 3 pillars viz. Domestic Support, Market Access, and Export Subsidies.

Green Box: Subsidies which are no or least market distorting, Payments under environmental programs, and agricultural research and-development subsidies.

Blue Box: Blue box supports are subsidies that are tied to programmes that limit production. Hence it is an exception to the general rule related to agricultural support. The Blue box subsidies aim to limit production by imposing production quotas or requiring farmers to set aside part of their land.

Targets price are allowed to be fixed by government and if ‘market prices’ are lower, then farmer will be compensated with difference between target prices and market prices in cash. This cash shall not be invested by farmer in expansion of production.

Amber Box: Those subsidies which are trade distorting and need to be curbed. Amber box subsidies are those subsidies which distort the international trade by making products of a particular country cheaper in comparison to same product in another country. Examples of such subsidies include input subsidies such as electricity, seeds, fertilizers, irrigation, minimum support prices etc.

S&D Box: Other than the above-discussed highly controversial boxes of agricultural subsidies, the WTO provisions have defined yet another box i.e., the S & D Box.

The Social and Development Box (S & D Box) allows the developing countries for some subsidies to the agriculture sector under certain conditions. These conditions revolve around human development issues such as poverty, minimum social welfare, health support etc. especially for the segment of population living below the poverty line. Developing countries can forward such subsidies to the extent of less than 5 per cent of their total agricultural output.

NAMA: The Non-Agricultural Products Market Access (NAMA) is a part of the WTO provisions which deals with the idea of encouraging market reach to the non-agricultural goods of the member countries.

But the encouragement was objected /opposed by the developing countries specially pointing to the non-tariff barriers enforced by the developed countries.

World Trade Statistical Review: The World Trade Statistical Review provides a detailed analysis of the latest developments in world trade. It will be produced on an annual basis and replaces International Trade Statistics, the WTO’s former annual statistical publication.

SSM: WTO’s Special Safeguard Mechanism (SSM) is a protection measure allowed for developing countries to take contingency restrictions against agricultural imports that are causing injuries to domestic farmers. It is a tool that will allow developing countries to raise tariffs temporarily to deal with import surges or price falls. It has been included under the Nairobi Package negotiated under the WTO.

The “Nairobi Package” was adopted at the WTO’s Tenth Ministerial Conference, held in Nairobi, Kenya, from 15 to 19 December 2015. It contains a series of six Ministerial Decisions on agriculture, cotton and issues related to least-developed countries (LDCs).

What is peace clause in WTO?

It is an interim mechanism, as per which WTO members had agreed not to challenge developing nations at the WTO Dispute Settlement Mechanism if they breached the cap of the product-specific domestic support (which is 10% of the value of production). The ‘Peace Clause’ is available to developing nations, including India, till a permanent solution is found to public stock holding for food security purposes.

India and China have raised objections over developed countries, including the US, the EU and Canada that have been consistently providing trade-distorting subsidies to their farmers at levels much higher than the ceiling applicable to developing countries. In WTO parlance, these subsidies are called as Aggregate Measurement of Support (AMS) or Amber Box support.

TRIPS: The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) is an international legal agreement between all the member nations of the World Trade Organization (WTO). It sets down minimum standards for the regulation by national governments of many forms of intellectual property (IP) as applied to nationals of other WTO member nations.

‘TRIPS’ was negotiated at the end of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) in 1994 and is administered by the WTO.

TRIPS Plus: Going even further than TRIPS, the common examples of TRIPS plus provisions include extending the term of a patent longer than the twenty-year minimum, or introducing provisions that limit the use of compulsory licenses or that restrict generic competition.

Way Forward for WTO: In the present decade, there has been a rush among the nations to enact their separate bi-lateral and multi-lateral trade agreements outside the ambit of World Trade Organization (WTO).

The proposed Transatlantic Trade and Investment Partnership (TTIP), Trans-Pacific Partnership (TPP) and Regional Comprehensive Economic Partnership (RCEP) are major examples of this phenomenon.

USA, EU and Japan feel aggrieved by China’s distortive trade policies such as- subsidies for state-owned enterprises, undervalued Yuan, labour exploitation, stringent norms against foreign companies from entering domestic Chinese market, rampant piracy and counterfeiting of MNC products.

While WTO’s dispute settling mechanism allows aggrieved parties to file cases against member-states, but some of the cases and issues have remained unresolved for a long time, and their permanent resolution requires changes in the trade agreements.

With this resentment, USA openly criticized WTO in the latest summit, saying “It is impossible to negotiate new rules while many of the current rules were not being followed (against China). WTO gives special and differential treatment to fast-growing and wealthy developing countries (like India and China). WTO is losing its focus and becoming too litigation-oriented.”

WTO and India

India is a founder-member of both GATT and WTO.

MFN Status: Most-Favoured-Nation Status, treating other people equally Under the WTO agreements, countries cannot normally discriminate between their trading partners. Grant someone a special favour (such as a lower customs duty rate for one of their products) and you have to do the same for all other WTO members.

Industrial Policy Resolution, 1948

It was the first economic policy of the country also. The major highlights of Industrial Policy, 1948 Policy are:

India will be a mixed economy.
Some of the important industries were put under the Central List such as coal, power, railways, civil aviation, arms and ammunition, defence, etc.
Some other industries (usually of medium category) were put under a State List such as paper, medicines, textiles, cycles, rickshaws, two-wheelers, etc.
Rest of the industries (not covered by either the central or the State Lists) were left open for private sector investment—with many of them having the provision of compulsory licensing.
Review of the policy after 10 years.

Industrial Policy Resolution, 1956

The Government was encouraged by the impact of the industrial policy of 1948 and it was only after eight years that the new and more crystallized policies were announced for the Indian industries. The new industrial policy of 1956 had the following major provisions:

Reservation of Industries: There was a clear-cut classification of the industries (also known as the Reservation of industries) was affected with three schedules:

(i) Schedule A: This schedule had 17 industrial areas in which the centre was given complete monopoly

(ii) Schedule B: There were 12 industrial areas put under this schedule in which the State governments were supposed to take up the initiatives with a more expansive follow up by the private sector.

(iii) Schedule C: All industrial areas left out of Schedules A and B were put under this in which the private enterprises had the provisions to set up the industries.

Industrial Policy Statement, 1969

The aim was to solve the shortcomings of the licensing policy started by the Industrial Policy of 1956.

The Monopolistic and Restrictive Trade Practices (MRTP) Act was passed.
The Act intended to regulate the trading and commercial practices of the firms and checking monopoly and concentration of economic power.

Industrial Policy Statement, 1973

This policy coined the term “Core Industries”.
The industries which were of fundamental importance for the development of industries were put in this category such as iron and steel, cement, coal, crude oil, oil refining and electricity.

Shell Corporation

A shell corporation is a company which serves as a vehicle for business transactions without itself having any significant assets or operations. Sometimes, shell companies are used for tax evasion or tax avoidance, or to achieve a specific goal such as anonymity.

Such companies are generally only in papers and are mostly established in tax havens.
Shell companies are corporate entities that do not have any significant assets in their possession or any active business operations.

Indian Financial Market

The market of an economy where funds are transacted between the fund-surplus and fund-scarce individuals and groups is known as the financial market.

Treasury bill: The Bill issued by RBI on behalf of GOI. The intention is to borrow short term loan from the market.

They are used by the Central Government to fulfill its short-term liquidity requirement upto the period of 364 days.

Certificate of Deposit (CD): CDs are used by the banks and issued to the depositors for a specified period.

Commercial Paper (CP): Organised in 1990 it is used by the corporate houses of India (which should be a listed company with a working capital of not less than 5 crore).

Call Money: The money borrowed for a very short term is called call money.

Notice Money: The money lend for more than 2 days and less than 14 days.

Term Money: Money lend for more than 14 days.

Ways and Means Advances (WMA): WMAs are the temporary advances given by the RBI to Centre and States to tide over any mismatch in receipts and payments. RBI makes WMA to the state governments for a period of 90 Days.

If the state government takes WMA against the collateral Government securities, it is called Special WMA.
At times, when there is a temporary mismatch in the cash flow of the receipts and payments of the State Governments, RBI provides Ways and Means Advances.
The rate of interest is the same as the repo rate.

Hedge Fund: This is a type of mutual fund that promises to give higher returns. However the fund is criticized as it attracts high risk. SEBI does not regulate it.

Venture Capital: The capital provided to the startups to set up their business. It helps to start the business and enables them to contribute in the economy.

Teaser Money: An introductory rate (also known as a teaser rate) is an interest rate charged to a customer during the initial stages of a loan. The rate, which can be as low as 0%, is not permanent and after it expires a normal or higher than normal rate will apply.

Angel Investors: These are investors who eyes on higher return than possible through conventional tools.

Share and Debenture: Share represents part of ownership of a company whereas debenture acknowledges loan or debt to the company. Thus, a shareholder is a participant in the profits as well as losses of the company.

Dividend is paid on share, which is an appropriation of profits, but a debenture holder is paid interest over the lifetime of the debenture and principal amount at the end of life.

PARTICIPATORY NOTES (PNs): A Participatory Note (PN or P-Note) in the Indian context, in essence, is a derivative instrument issued in foreign jurisdictions, by a SEBI registered Foreign Institutional Investor (FII), against Indian securities – the Indian security instrument may be equity, debt, derivatives or may even be an index.

Foreign Portfolio Investment: A portfolio investment is a grouping of assets such as stocks, bonds, and cash equivalents. Portfolio investments are held directly by an investor or managed by financial professionals. In economics, foreign portfolio investment is the entry of funds into a country where foreigners deposit money in a country’s bank or make purchases in the country’s stock and bond markets, sometimes for speculation.

Portfolio investments typically involve transactions in securities that are highly liquid, i.e. they can be bought and sold very quickly. A portfolio investment is an investment made by an investor who is not involved in the management of a company. This is in contrast to direct investment, which allows an investor to exercise a certain degree of managerial control over a company. Equity investments where the owner holds less than 10% of a company’s shares are classified as portfolio investment.

NBFC: Non-Banking Financial Company. These companies are involved in loan and advances, Buying and selling of shares but does not involve in core banking operations like accepting deposits. Some NBFCs are regulated by RBI.

Financial Inclusion: The strategy to bring marginal section of the society in the main stream. This can be achieved by SHGs, Priority Sector Lending, Digital India, Promoting Small Sector Industries and Medium Sector Industries.

Open Market Operations (OMOs): OMOs are conducted by the RBI via the sale/purchase of government securities (G-Sec) to/from the market with the primary aim of modulating rupee liquidity conditions in the market.

Liquidity Adjustment Facility (LAF): This is the provision to meet the day to day cash mismatches of the bank. The money is supplied by RBI in this case.

Banking Sector in India

The bank acts as the intermediary between depositors and borrowers.

What is Bank?

A financial institution which accepts different forms of deposits and lends them to the prospective borrowers as well as allows the depositors to withdraw their money from the accounts by cheque is a bank.

So, What is Non Banking Financial Institution?

If the financial institution has all the same functions but does not allow depositors to issue cheque and withdraw their money from deposits then it is a non-bank institution.

The Narasimham Committee was established under former RBI Governor M. Narasimham in August 1991 to look into all aspects of the financial system in India. The report of this committee had comprehensive recommendations for financial sector reforms including the banking sector and capital markets.

In broad acceptance to this committee, the government announced few of reforms.

The key recommendations with respect to the banking sector were as follows:

Reduction in the Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR): The Narasimham Committee had recommended bringing down the statutory pre-emptions such as SLR and CRR. It recommended that SLR should be reduced to 25% over the period of time and CRR should be reduced to 10% over the period of time. When reduced these ratios, bank would have more funds in their hands to deploy them in remunerative loan assets.
Redefining the priority sector: The Narasimham Committee redefined the priority sector to include the marginal farmers, tiny sector, small business and transport sector, village and cottage industries etc. The committee also recommended that there should be a target of 10% of the aggregate credit fixed for the Priority Sector at least.
Deregulation: The committee recommended deregulation of the Interest Rates, so that banks can themselves set the interest rates for their customers.
It also recommended setting up tribunals for recovery of Loans, tackling doubtful debts, restructuring the banks and allowing entry of the new private Banks

Actions on recommendations of First Narasimham Committee

Many of the recommendations of the committee were acceded to by the government. The SLR, which was around 38.5% in 1991-1992, was brought down to some 28% in five years. The CRR was also brought down from 14% to 10% by 1997.

The RBI introduced the CRAR or Capital to Risk Weighted Asset ratio in 1992 for the soundness of the banking industry. RBI also included new prudential reforms for classification of assets and provisioning of the non-performing assets.

Some strong banks (such as SBI) were allowed to seek access to capital markets. The banks which were relatively weaker were recapitalized by the government via budgetary support. More private banks were allowed. More freedom was given to banks to open branches. The RBI’s supervision system was strengthened. Rapid computerization of the banks was adopted. RBI started helping the commercial banks to improve the quality of their performance.

NPA: If the payment has not been made for 90 days, it becomes NPA. The rises NPA puts the bank under financial pressure that may lead to bankruptcy. The stakeholders and customers also may lose the confidence in the banks.

In case of non-recovery of the NPA the bank may raise interest rates on some other products that makes the borrowing tougher and weakens the economy.

What are haircuts in the Indian banking system?

A haircut is the difference between the loan amount and the actual value of the asset used as collateral. It reflects the lender’s perception of the risk of fall in the value of assets. But in the context of loan recoveries, it is the difference between the actual dues from a borrower and the amount he settles with the bank.

Why banks were nationalized?

The main aim was the financial inclusion of public at large.

Mission Indradhanush: In 2015, under the Indradhanush plan, the government had announced capital infusion of ₹70,000 crore in public sector banks for four years, starting from 2015-16. In the first two financial years, ₹25,000 crore had been earmarked per year with ₹10,000 crore to be disbursed in each of the remaining two years.

However, credit rating agencies had pointed out that the sum was insufficient as banks needed to meet Basel-III norms as well as make provisions for rising bad loans.

Twin Balance Sheet Problem (TBS) deals with two balance sheet problems, One with Indian companies and the other with Indian Banks.

Thus, TBS is two two-fold problems for Indian economy which deals with:

Overleveraged companies– Debt accumulation on companies is very high and thus they are unable to pay interest payments on loans. Note: 40% of corporate debt is owed by companies who are not earning enough to pay back their interest payments. In technical terms, this means that they have an interest coverage ratio less than 1.
Bad-loan-encumbered-banks – Non Performing Assets (NPA) of the banks is 9% for the total banking system of India. It is as high as 12.1% for Public Sector Banks. As companies fail to pay back principal or interest, banks are also in trouble.

Bretton woods conference (1944): The conference was held after Second World War. Two financial institutions emerged at the conference. One was the World Bank and the other was IMF.

While the motive of world bank (International Bank of Reconstruction and Development) was to reconstruct the infrastructure after world war. The purpose of IMF was to maintain the world economic stability.

IMF: Situated in Washington USA. Each member nation after joining the IMF gets a quota depending on its economic size. The country is then required to contribute the determined amount of money to IMF. The money contributed is in widely accepted currency or SDR (One quarter) and country own currency (3/4th). IMF facilitates the quota for each member to refinance the nation. IMF reviews the quota after 5 years. IMF lends only to the member nations.

The objective of the IMF is to promote economic cooperation and stabilize the exchange rate (Global Financial stability Report is published by IMF) and ultimately to help the members in payment crisis (IMF acts as the lender of last resort and helps the member countries facing BOP crisis). IMF also monitors the fiscal health of member nations and publishes the ‘Fiscal Monitor Report’ twice a year.

Unlike other development banks, IMF does not finance specific infrastructure projects.

IMF provides low interest loan to member country in case of disaster. The low interest rate is also applicable in case of financially weaker member countries.

‘World Economic Outlook’: IMF published the report ‘World Economic Outlook’ containing the world economic development.

India is the founding nation of IMF. IMF has helped India in the time of BOP crisis. India has become the creditor for the IMF.

This year IMF has approved loan for Pakistan under Extended Fund Facility (EFF). EFF is provided to countries facing balance of payment crisis due to structural constrains in the economy. Review of the financial plan is done before providing the assistance.

Financial Stability Report: The International Monetary Fund publishes it.

Special Drawing Right: SDR is an international asset reserve that can be exchanged with the international currency. It is not the currency as such.

This is issued by IMF.
The value of SDR is set on the basis of basket of currency namely Dollar, Renminbi, Yen, Euro, and Sterling.
At international level it has been demanded to replace USD by SDR as the global currency.
The SDR is neither a currency nor a claim on the IMF.
Currencies included in the SDR basket have to meet two criteria: the export criterion and the freely usable criterion.
A currency meets the export criterion if its issuer is an IMF member or a monetary union that includes IMF members, and is also one of the top five world exporters.
For a currency to be determined “freely usable” by the IMF, it has to be widely used to make payments for international transactions and widely traded in the principal exchange markets.
SDRs cannot be held by private entities or individuals.

The SDR basket now consists of the following five currencies: U.S. dollar 41.73%, Euro 30.93%, Renminbi (Chinese Yuan) 10.92%, Japanese Yen (8.33%), British Pound (8.09%).

Reserve Bank of India

Functions of RBI:

Issue of Notes.
Banker to the banks
Banker to the govt.
Controller of credit.
Financial adviser to the government
RBI acts as the custodian of foreign currency

The Payment banks are also required to take the prior approval from RBI for their financial products.
It is mandatory for the banks to open 25 % of the branches in unbanked rural areas.

Quantitative Easing: At times even if the interest rate is close to zero but the economy is not reviving, then the central bank of the country used nonconventional method and purchases securities from the financial institutions. This method is called quantitative easing. This leads to flow of money in the economy and results in investment.

Monetary Policy of RBI: The monetary policy controls the flow of credit in the economy.

Marginal Standing Facility: The special window of the RBI through which commercial banks can borrow at a rate 1 % higher than the repo rate.

This is a penal rate.
This is used when other options of borrowings are exhausted.
MSF is a very short term borrowing scheme for scheduled commercial banks.
Banks may borrow funds through MSF during severe cash shortage or acute shortage of liquidity.

Long-Term Repo Operations (LTROs): The LTRO is a tool under which the central bank provides one-year to three-year money to banks at the prevailing repo rate, accepting government securities as the collateral.

Liquidity Adjustment Facility: This is the provision to meet the day to day cash mismatches of the bank. The money is supplied by RBI in this case.

MCLR: The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI.

It is an internal benchmark or reference rate for the bank.
MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank.

Cash Reserve Ratio: The share of banks deposit that the commercial banks need to deposit to RBI.

This reserve attracts no interest.
This is 4 %.

Repo Rate: The rate at which the commercial banks borrow (for short term) the loan from RBI.

This is around 6%.
In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

Reverse Repo Rate: The rate at which RBI takes the loan from commercial banks.

Bank Rate: The rate at which RBI gives comparatively long term loan to the banks. If bank rate reduces banks will rush to RBI for loans hence more liquidity will be available in the market and inflation will rise.

SLR: Statutory liquidity ratio (SLR) is the Indian government term for the reserve requirement that the commercial banks in India are required to maintain in the form of cash, gold reserves, RBI approved securities before providing credit to the customers. This is in the range of 25 to 40 per cent.

Base Rate: It is the interest rate below which Scheduled Commercial Banks (SCBs) will lend no loans to its customers – its means it is like Prime Lending Rate (PLR).

SARFESI Act: The purpose of the act was to recover the loan from willful defaulters.

The aim was to reduce the increasing NPA on the banks.
The act authorized the financial institution to take over the asset of the defaulters or take over the control of management.
As per the recent revision, the District Magistrate is the authority to coordinate with the banks in the process of recovery.

Asset Reconstruction Companies: The ARCs buys the bad loan form the banks.

They recover it from the defaulters.
They are expert in recovery.
The Narsimha committee recommended this provision.

Basel Norms: Since the banks are intermediate financial institutions. They accept the deposit from public, borrows from market and lend it to the borrowers. There are risks that the loan will not be paid back by the borrowers. This poses a risk to the banks.

hence, in order to minimize the risks of non-payment of the loans the Basel norms has been made.

The Basel norms direct the banks to keep aside 8 % of the total risk loans aside.
This is required for absorbing shocks.
India has accepted the Basel norms.
Basel norms are not legally binding.

AT1 bonds: These bonds have no maturity date. Technically they can continue to pay the coupon forever.

The issuing bank has the option to call back the bonds or repay the principal after a specified period of time.
The attraction for investors is higher yield than secured bonds issued by the same entity.
But this comes with a two-fold risk: First, the issuing bank has the discretion to skip coupon payment.
Second, the bonds can get written down in certain circumstances. In some cases, there could be a clause to convert into equity as well. Given these characteristics, AT1 bonds are also referred to as quasi-equity.

Money

Money is a commodity accepted by general consent as a medium of economic exchange.

High Power Money

It indicates the total liability of RBI and includes cash flowing in the economy. It has following components:

Cash with Public,
Cash within the vault of commercial banks,
Cash with the government of India
It is the total liability of RBI.

M0: M0 is material currency (cash itself). all notes, coins, specie and bearer certificates convertible on demand (which includes, by definition, depositor reserves of banks which must be kept in physical cash).

M1: It includes M0 (i.e. Cash) plus the balance of all demand deposit accounts which can be instantly converted into cash.

Mathematically, M1 = M0 + Demand Deposits with the Banks

M2: It is M1 plus all other depositor accounts that can be readily (within 30 days) converted to physical cash of equal value (known as “near-cash”).

Mathematically, M2 = M1 + Demand Deposits with the Post Office

M3: It is M2 plus all other investment instruments that can be converted into cash, but which may have significant restrictions on a timely conversion.

Mathematically, M3 = M1 + Time Deposits with the Banks

M4: It is M3 plus total deposits with the Post Office

Mathematically, M4 = M3 + Total Deposits with the Post office (Both Time and Demand)

Liquidity of Money: As we move from M1 to M4 the liquidity (inertia, stability, spendability) of the money goes on decreasing and in the opposite direction, the liquidity increases.

M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.

Narrow Money: In banking terminology, M1 and M2 are called narrow money as it is highly liquid and banks cannot run their lending programmes with this money.

Broad Money: The money component M3 is called broad money in the banking terminology. With this money (which lies with banks for a known period) banks run their lending programmes.

Time deposits: The fixed deposits have a fixed period to maturity and are referred to as time deposits.

Demand Deposit: A deposit of money that can be withdrawn without prior notice.

Reserve Money (RM): The gross amount of the following six segments of money at any point of time is known as the Reserve Money (RM) for the economy or the government.

RBI’s net credit to the Government
RBI’s net credit to the Banks
RBI’s net credit to the commercial banks
Net forex reserve with the RBI
Government’s currency liabilities to the Public;
Net non-monetary liabilities of the RBI

Fiat money: Fiat money is also called legal tenders as they cannot be refused by any citizen of the country for settlement of any transaction.

The term fiat derives from the Latin word, meaning “let it be done.”

Every currency notes bears on its face a promise from the Governor of RBI.
They do not have intrinsic value like Gold or Silver Coins.

Fiat money is backed by a country’s government instead of a physical commodity or financial instrument. This means most coin and paper currencies that are used throughout the world are fiat money. This includes the U.S. dollar, the British pound, the Indian rupee, and the euro.

They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction.

Note: Cheque drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.

Currency Deposit Ratio (CDR): The currency deposit ratio is the ratio of money held by the public in currency to that they hold in bank deposits.

Security Market In India

The segment of a financial market of an economy from long-term capital is raised via instruments such as shares, securities, bonds, debentures, mutual funds is known as the security market of that economy.

NSE: The National Stock Exchange of India Ltd. (NSE) was set up in 1992 and became operationalized in 1994. It has a 50 share index (Nifty Fifty).

External Sector of India

Exchange Rate: There are basically three types of exchange rate systems globally. These are:

flexible or floating exchange rate system,
fixed exchange rate system and
managed floating (intermediate exchange rate system).

A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies.

By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.

India is having managed floating exchange rate system. In this hybrid exchange rate system, the exchange rate is basically determined in the foreign exchange market through the operation of market forces. Market forces mean the selling and buying activities by various individuals and institutions.

So far, the managed floating exchange rate system is similar to the flexible exchange rate system. But during extreme fluctuations, the central bank under a managed floating exchange rate system (like the RBI) intervenes in the foreign exchange market. Objective of this intervention is to minimize the fluctuation in the exchange rate of rupee.

FIXED CURRENCY REGIME

A method of regulating exchange rates of world currencies brought by the IMF, in this system exchange rate of a particular currency was fixed by the IMF keeping the currency in front of a basket of important world currencies (they were UK£, US $, Japanese ¥, German Mark DM and the French Franc). Different economies were supposed to maintain that particular exchange rate in future.

Exchange rates of currencies were modified by the IMF from time to time.

FLOATING CURRENCY REGIME

A method of regulating exchange rates of world currencies based on the market mechanism (i.e., demand and supply).

In the floating exchange rate system, a domestic currency is left free to float against a number of foreign currencies in its foreign exchange market and determine its own value. Such exchange rates, are also called as market driven or based exchange rates, which are regulated by the factors such as the demand and supply of the domestic and the foreign currencies in the concerned economy.

How currency exchange rates are fixed?

Nominal Effective Exchange Rate (NEER) is the weighted average of bilateral nominal exchange rates of the rupee in terms of foreign currencies. It is simple and direct for example: – one US Dollar as per NEER will be say 66 rupees, Whereas Real Effective Exchange Rate (REER) is the weighted average of nominal exchange rates, adjusted for inflation.

The indices of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) are used as indicators of external competitiveness by RBI.

This is the bilateral nominal exchange rate – bilateral in the sense that they are exchange rates for one currency against another and they are nominal because they quote the exchange rate in money terms, i.e. so many rupees per dollar or per pound.

However, if one wants to plan a trip to London, she needs to know how expensive British goods are relative to goods at home. The measure that captures this is the real exchange rate – the ratio of foreign to domestic prices, measured in the same currency.

Purchasing power parity: If the real exchange rate is equal to one, currencies are at purchasing power parity. This means that goods cost the same in two countries when measured in the same currency. For instance, if a pen costs $4 in the US and the nominal exchange rate is Rs 50 per US dollar, then with a real exchange rate of 1, it should cost Rs 200 (ePf = 50 × 4) in India.

If the real exchange rises above one, this means that goods abroad have become more expensive than goods at home. The real exchange rate is often taken as a measure of a country’s international competitiveness.

In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply.

Factors affecting exchange rate:

Demand and Supply: In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply.
Speculation: Exchange rates in the market depend not only on the demand and supply of exports and imports, and investment in assets, but also on foreign exchange speculation where foreign exchange is demanded for the possible gains from appreciation of the currency.

Interest Rates and the Exchange Rate: In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries. There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates.

If we assume that government bonds in country ‘A’ pay 8 per cent rate of interest whereas equally safe bonds in country B yield 10 per cent, the interest rate differential is 2 per cent.

Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency. Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments.

Income and the Exchange Rate: When income increases, consumer spending increases. Spending on imported goods is also likely to increase, when imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency.

If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward. On balance, the domestic currency may or may not depreciate. What happens will depend on whether exports are growing faster than imports.

In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency depreciating because its imports grow faster than its exports. Its demand curve for foreign currency shifts faster than its supply curve.

Dirty floating: Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate. Official reserve transactions are, therefore, not equal to zero.

Clean floating: The exchange rate is market-determined without any central bank intervention. Clean floats can only exist where there is no government interference, as would be the case in a purely capitalistic economy. Clean floats are a result of Laissez-Faire or free market economics.

Gold standard: From around 1870 to 1914, the prevailing system was the gold standard which was fixed exchange rate system in which each participant country committed itself to convert freely its currency into gold at a fixed price.

What is import Cover?

Import cover is the number of months of imports that could be supported by a country’s international reserves.

The balance of payments (BOP) is a statement of all transactions made between entities in one country and the rest of the world over a defined period, such as a quarter or a year.

Further, the balance of payment may be deficit of surplus depending on the net transaction.

India faced balance of payment crisis in the year 1991. The forex reserve was depleted and India was facing the default situation on payment of short term loan.

The crisis was managed by devaluating Indian rupee, hence attracting more foreign investment. Indian companies were allowed to accept foreign funds.

Indian foreign trade expanded due to reduction in trade barrier.

Balance of payments is the overall record of all economic transactions of a country with the rest of the world. The balance of trade is included in the balance of payments.

Note: Balance of Trade accounts the visible items only whereas Balance of Payments accounts the exchange of both visible and invisibles.

The Reserve Bank of India (RBI) has been compiling and publishing Balance of Payments (BoP) data for India since 1948.

Current Account

The current account includes transactions in goods, services, investment income and current transfers (remittances, gifts, grants etc.).

Capital account

It includes transactions in financial instruments (FDI, FPI etc.) and central bank reserves.

Balance of Payment and invisibles: The trade in invisible means the trade in service, Transfer and income. Visible means the trade in goods.

Service means dealing in transportation, Telecommunication etc. Example: Income of Infosys from USA.
Transfer means the salary received and sent to India by the Indian workers working abroad. Income of labors based in UAE. This is also called remittance.
Income refers to the income received by Indian company based in some other countries. Income from Adani Plant in Africa.

Convertibility of Rupee: The freedom of converting a domestic currency to a foreign currency is called convertibility of rupees.

Capital Account Convertibly: The convertibility of investment and borrowing from abroad. Example: How much FDI is allowed, how much Indian company can borrow from abroad.

India has restricted capital account convertibility. Indian currency is however fully convertible i.e. Current account convertibility is allowed.

Allowing the capital account convertibility the FDI will become much easier; it may lead to appreciation and depreciation of the domestic currency. This may result in current account deficit.

Capital Account convertibility means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It refers to the removal of restraints on international flows on a country’s capital account, enabling full currency convertibility and opening of the financial system.

Current Account Convertibility: The ease of convertibility of a domestic currency to a foreign currency. Current account convertibility includes the payment towards import of commodities, Remittance etc.

What is full convertibility?

Full convertibility means freedom to convert domestic currency with other currency in both capital and current account with least restriction. The restriction is always there in sectors like Defence and Security; hence no currency is fully convertible.

Hard currency: It is safe-haven currency or strong currency is any globally traded currency that serves as a reliable and stable store of value.

Factors contributing to a currency’s hard status might include the long-term stability of its purchasing power, the associated country’s political and fiscal condition and outlook, and the policy posture of the issuing central bank.

Conversely, a soft currency indicates a currency which is expected to fluctuate erratically or depreciate against other currencies. Such softness is typically the result of political or fiscal instability within the associated country.

Benefits of convertibility:

More FDI inflows in India leading to increase in GDP and new employment opportunity.
Indian companies are able to borrow from abroad.

Depository Receipt: The bond issued by the domestic country in the international market to attract foreign investment.

SOFT CURRENCY: A term used in the foreign exchange market which denotes the currency that is easily available in any economy in its forex market. For example, rupee is a soft currency in the Indian forex market. It is basically the opposite term for the hard currency.

HOT CURRENCY: A term of the forex market and is a temporary name for any hard currency. Due to certain reasons, if a hard currency is exiting an economy at a fast pace for the time, the hard currency is known to be hot.

As in the case of the SE Asian crisis, the US dollar had become hot.

HEATED CURRENCY: A term used in forex market, to denote the domestic currency, which is under enough pressure (heat) of depreciation due to a hard currency’s high tendency of exiting the economy (since it has become hot)

It is also known as currency under heat or under hammering.

CHEAP CURRENCY: A term first used by the economist J. M. Keynes (1930s). If a government starts re-purchasing its bonds before their maturities (at full-maturity prices) the money which flows into the economy is known as the cheap currency, also called cheap money.

In banking industry, it means a period of comparatively lower/softer interest rates regime.

DEAR CURRENCY: This term was popularized by the other economists in early 1930s to show the opposite of the cheap currency. When a government issues bonds, the money which flows from the public to the government or the money in the economy in general is called dear currency, also called as dear money.

In the banking industry, it means a period of comparatively higher/costlier interest rates regime.

TRADE BALANCE

The monetary difference of the total export and import of an economy in one financial year is called trade balance.

DEPRECIATION
In foreign exchange market, it is a situation when domestic currency loses its value in front of a foreign currency if it is market-driven. It means
depreciation in a currency can only take place if the economy follows the floating exchange rate system.

DEVALUATION

In the foreign exchange market when exchange rate of a domestic currency is cut down by its government against any foreign currency, it is called devaluation. It means official depreciation is devaluation.

REVALUATION

A term used in foreign exchange market which means a government increasing the exchange rate of its currency against any foreign currency. It is official appreciation.

APPRECIATION

In foreign exchange market, if a free floating domestic currency increases its value against the value of a foreign currency, it is appreciation. In domestic economy, if a fixed asset has seen increase in its value it is also known as appreciation. Appreciation rates for different assets are not fixed by any government as they depend upon many factors which are unseen.

CURRENT ACCOUNT

It refers to the account maintained by every government of the world in
which every kind of current transactions is shown.

CAPITAL ACCOUNT

Every government of the world maintains a capital account which shows the capital kind of transactions of the economy with the outside economies.

Every transaction in foreign currency (inflow or outflow) considered as capital is shown in this account—external lending or borrowing, private remittance’s inflow or outflow, issuing of external bonds, etc. There is no deficit or surplus in this account like the current account.

BALANCE OF PAYMENT (BoP)

The outcome of the total transactions of an economy with the outside world in one year is known as the balance of payment (BoP) of the economy.

Basically, it is the net outcome of the current and capital accounts of an economy.

CONVERTIBILITY

An economy might allow its currency full or partial convertibility in the current and the capital accounts. If domestic currency is allowed to convert into foreign currency for all current account purposes, it is a case of full current account convertibility.

Similarly, in cases of capital outflow, if domestic currency is allowed to convert into foreign currency, it is a case of full capital account convertibility.

Convertibility in India

Current account is today fully convertible, it means that the full
amount of the foreign exchange required by someone for current purposes will be made available to him at official exchange rate. India was obliged to do so as per Article VIII of the IMF.

India is still a country of partial convertibility (40:60) in the capital account. The move is in line with the recommendations of the S.S. Tarapore Committee (1997).

NEER: The Nominal Effective Exchange Rate (NEER) of the rupee is a weighted average of exchange rates before the currencies of India’s major trading partners.

REER: When the weight of inflation is adjusted with the NEER, we get the Real Effective Exchange Rate (REER) of the rupee.

IMF CONDITIONS ON INDIA

The BoP crisis of early 1990s made India borrow from the IMF which came on some conditions. The medium term loan to India was given for the restructuring of the economy on the following conditions

Devaluation of rupee by 22 per cent (done in two consecutive fortnights—rupee fell from ‘21 to ‘27 against every US Dollar).
Drastic custom cut to a peak duty of 30 per cent from the erstwhile level of 130 per cent for all goods.
Excise duty to be increased by 20 per cent to neutralise the loss of revenue due to custom cut.
Government expenditure to be cut by 10 per cent per annum (the burden of salaries, pensions, subsidies, etc.).

India has not only fulfilled these conditions but it has also moved ahead.

HARD CURRENCY: It is the international currency in which the highest faith is shown and is needed by every economy. Some of the best hard currencies of the world today are the US dollar, the Euro(€), Japanese Yen (¥) and the UK Sterling Pound (£).

SOFT CURRENCY: A term used in the foreign exchange market which denotes the currency that is easily available in any economy in its forex market. For example, rupee is a soft currency in the Indian forex market. It is basically the opposite term for the hard currency.

HOT CURRENCY: A term of the forex market and is a temporary name for any hard currency. Due to certain reasons, if a hard currency is exiting an economy at a fast pace for the time, the hard currency is known to be hot. As in the case of the SE Asian crisis, the US dollar had become hot.

HEATED CURRENCY: A term used in forex market to denote the domestic currency which is under enough pressure (heat) of depreciation due to a hard currency’s high tendency of exiting the economy (since it has become hot). It is also known as currency under heat or under hammering.

CHEAP CURRENCY: A term first used by the economist J. M. Keynes (1930s). If a government starts re-purchasing its bonds before their maturities (at full-maturity prices) the money which flows into the economy is known as the cheap currency, also called cheap money.

In banking industry, it means a period of comparatively lower/softer interest rates regime.

DEAR CURRENCY: This term was popularized by the other economists in early 1930s to show the opposite of the cheap currency. When a government issues bonds, the money which flows from the public to the government or the money in the economy in general is called dear currency.

SPECIAL ECONOMIC ZONE: SEZ, or Special Economic Zone, is essentially an industrial cluster meant largely for exports. An SEZ is governed by a special set of rules aimed at attracting direct investment for export-oriented production.

SEZs, earlier known as Export Processing Zones or Free Trade Zones, are duty free enclaves which are treated as foreign territory only for trade operations, duties, tariffs and typically marked by the best infrastructure and least red tape.

INDIA’S FOREX RESERVES: Forex reserves are foreign assets of a country held in a liquid form by a country’s central bank as insurance against financial shocks. India’s forex reserves were $ 604 billion as on April 8, 2022.

GOLD IMPORTS – Evergreen Concern: India is one of the largest importers of gold in the world. Gold is the second major import item of India after POL. The rise in imports of gold is one of the factors contributing to India’s high trade deficit and CAD in 2011-12, forming 30 per cent of its trade deficit.

Ultimately, the best way to reduce gold imports in a sustainable way will be to offer the public financial investment opportunities that generate attractive
returns. This means bringing down inflation as well as expanding the range of investments investors have easy access to.

International Economic Organization & India

Bretton woods conference (1944): The conference was held after Second World War. Two financial institutions emerged at the conference. One was the World Bank and the other was IMF.

Unlike other development banks, IMF does not finance specific infrastructure projects.

IMF provides low interest loan to member country in case of disaster. The low interest rate is also applicable in case of financially weaker member countries.

‘World Economic Outlook’: IMF published the report ‘World Economic Outlook’ containing the world economic development.

India is the founding nation of IMF. IMF has helped India in the time of BOP crisis. India has become the creditor for the IMF.

Financial Stability Report: The International Monetary Fund publishes it.

Special Drawing Right: SDR is an international asset reserve that can be exchanged with the international currency. It is not the currency as such. This is issued by IMF. The value of SDR is set on the basis of basket of currency namely Dollar, Renminbi, Yen, Euro, and Sterling. At international level it has been demanded to replace USD by SDR as the global currency.

The SDR basket now consists of the following five currencies: U.S. dollar 41.73%, Euro 30.93%, Renminbi (Chinese Yuan) 10.92%, Japanese Yen (8.33%), British Pound (8.09%).

India’s Quota & Ranking: India’s quota (together with its 3 constituency countries) is 2.75 per cent and it is the 8th (from 11th) largest quota holding country.

Note: Cuba and North Korea are not the part of IMF.

WORLD BANK: The World Bank is an international financial institution that provides loans and grants to the governments of low- and middle-income countries for the purpose of pursuing capital projects.

IBRD: The International Bank for Reconstruction and Development is the oldest of the World Bank institutions which started functioning (1945) in the area of reconstruction of the war-ravaged regions (World War II).

IDA: The International Development Agency (IDA) which is also known as the soft window of the WB was set up in 1960 with the basic aim of developing infrastructural support among the member nations, long-term lending for the development of economic services.

IFC: The International Finance Corporation (IFC) was set up in 1956 which is also known as the private arm of the WB. It lends money to the private sector companies of its member nations. The interest rate charged is commercial but comparatively low.

MIGA: The Multilateral Investment Guarantee Agency (MIGA), set up in 1988 encourages foreign investment in developing economies by offering insurance (guarantees) to foreign private investors against loss caused by non-commercial (i.e. political) risks, such as currency transfer, expropriation, war and civil disturbance.

ICSID: The International Centre for Settlement of Investment Disputes (ICSID), set up in 1966 is an investment dispute settlement body whose decisions are binding on the parties.

ADB: Asian Development Bank is a regional development bank established in 1966 which is headquartered at Manila, Philippines. It promotes social and economic development in Asia.

The members in ADB are both within Asia and outside Asia.
India is a member of ADB.
The ADB was modelled closely on the World Bank, and has a similar weighted voting system where votes are distributed in proportion with members’ capital subscriptions.
The president has a term of office lasting five years, and may be re-elected. Traditionally, and because Japan is one of the largest shareholders of the bank, the president has always been Japanese.

Asian Development Outlook 2019: Published by Asian Development Bank, Growth in developing Asia is projected to soften to 5.7% in 2019 and 5.6% in 2020.

Voting rights in ADB: It is modelled closely on the World Bank, and has a similar weighted voting system where votes are distributed in proportion with members’ capital subscriptions.

Japan > United States > China > India >Australia

AIIB: The Asian Infrastructure Bank is a development bank for crediting the infrastructure projects. China is the biggest stake holder of the bank.

India is also the partner.
Major economies that are not members include Japan and the United States.
The capital of the bank is $100 billion, equivalent to 2⁄3 of the capital of the Asian Development Bank and about half that of the World Bank.
Headquarters: Beijing, China.

OECD: The roots of the Organisation for Economic Co-operation and Development (OECD), Paris, go back to the rubble of Europe after World War II. Determined to avoid the mistakes of their predecessors in the wake of World War I, European leaders realised that the best way to ensure lasting peace was to
encourage co-operation and reconstruction, rather than punish the defeated.

The Organisation for European Economic Cooperation (OEEC) was established in 1947 to run the US-financed Marshall Plan for reconstruction of a continent ravaged by war.

India, China, and Russia are not the members of OECD. USA is its member.

Tax Structure in India

Goods and Services Tax (GST)

Goods and Services Tax (GST) refers to the single unified tax created by amalgamating a large number of Central and State taxes applicable in India.

The 101st constitution Amendment Act of September 2016 made in this regard, inserted a definition of GST in Article 366 of the constitution.
It follows a multi-stage collection mechanism.
In this, tax is collected at every stage and the credit of tax paid at the previous stage is available as a set off at the next stage of transaction.
It is a destination based tax as the goods/services will be taxed at the place where they are consumed and not at the origin.
CGST and SGST would be levied at rates to be mutually agreed upon by the Centre and the States.
Credit of CGST paid on inputs may be used only for paying CGST on the output and the credit of SGST paid on inputs may be used only for paying SGST. In other words, the two streams of input tax credit cannot be mixed except in specified circumstances of inter-State sales.
The Centre would levy and collect the Integrated Goods and Services Tax (IGST) on all inter-State supply of goods and services.

What is input tax credit?

Input tax credit is the credit that a manufacturer has received for having paid input taxes towards the inputs that have been used in the manufacture of goods and products.

What is Tax Expenditure?

Tax expenditures are government revenue losses from tax exclusions, exemptions, deductions, credits, deferrals, and preferential tax rates.

Public Finance in India (L:18)

BUDGET: An annual financial statement of income and expenditure is generally used for a government, but it could be of a firm, company, corporation etc.

The Constitution of India has a provision (Art. 112) for such a document called Annual Financial Statement to be presented in the Parliament before the coummencement of every new fiscal year— popular as the Union Budget.

Data in the Budget

The Union Budget has three sets of data for every concerned sector or sub-sector of the economy.

Actual data of the preceding year (here preceding year means one year before the year in which the Budget is being presented.
Provisional data of the current year
Budgetary estimates for the following year (here following year means one year after the year in which the Budget is being presented.

What is Fiscal Policy?

The mechanism of earning and spending by the government to affect the national economy is called fiscal policy.

Fiscal Deficit: The difference between the total earning and total expenditure of the government. Besides tax proceeds the loan recovery, Money received from disinvestment are also included in the calculation of fiscal deficit.

How to reduce the fiscal deficit?

Reduce the government spending on unproductive activities.
Reduce the expenditure on welfare scheme.
Reduce the subsidy. Subsidies are a major component of government spending, and its reduction will cut down fiscal deficit.
Enhance tax collection.

Disinvestment: It refers to selling the share of PSU to private body. The proceeds received are normally applied to refinance PSUs, Manage Financial Deficit and fund the welfare projects like MGNREGA.

Public Debt: Public Debt in India includes only Internal and External Debt incurred by the Central Government. Internal Debt includes liabilities incurred by resident units in the Indian economy to other resident units, while External Debt includes liabilities incurred by residents to non-residents. The Public Account Liabilities is a type of liability.

The total Union Government Liabilities constitutes the following three categories:

Internal Debt
External Debt
Public Account Liabilities

Deficit financing: Deficit financing can be done by external aids, grants, borrowings and printing money. All these means will lead to extra supply of money in the economy, which will have the risk of inducing inflation. Deficit financed by borrowings will result into increase in public debt. That is why it is healthy for an economy to keep a low fiscal deficit.

Deficit Financing

The technique of deficit financing may be used to promote economic development.
Economic development largely depends on capital formation.
The basic source of capital formation is savings.
But, LDCs are characterized by low saving-income ratio.

Means of Deficit Financing

External Aids are the best money as a means to fulfill a government’s deficit requirements even if it is coming with soft interest.
External Borrowings are the next best way to manage fiscal deficit with the condition that the external loans are comparatively cheaper and long-term.
Internal Borrowings comes as the third preferred route of fiscal deficit management. But going for it in a huge way hampers the investment prospects of the public and the corporate sector. It has the same impact on the expenditure pattern in the economy. Ultimately, economy heads for a double negative impact—lower investment (leading to lower production, lower GDPs and lower per capita income, etc.) and lower demands (by the general public as well as by the corporate world) in the economy—the economy moves either for stagnation or for a slowdown.
Printing Currency is the last resort for the government in managing its deficit. But it has the biggest handicap that with it the government cannot go for the expenditures which are to be made in the foreign currency.
(a) It increases inflation proportionally. (India regularly went for it since early 1970s and usually had to bear double digit inflations.)
(b) It brings in regular pressure and obligation on the government for upward revision in wages and salaries of government employees—ultimately increasing the government expenditures necessitating further printing of currency and further inflation—a vicious cycle into which economies entangle themselves.

What is Monetized Deficit?

The amount of money that RBI prints to give it to the government, this is the last option in front of government. Monetized deficit is only a part of fiscal deficit.

FRBM Act, 2003

Reforms and Budget Management Act (FRBMA) was enacted to provide the support of a strong institutional/statutory mechanism designed for the purpose of medium-term management of the fiscal deficit.

The aim was to take measures to reduce fiscal and revenue deficit so as to eliminate revenue deficit by March 31, 2008 (which was revised by the UPA Government to March 31, 2009) and thereafter build up adequate revenue surplus.

FISCAL CONSOLIDATION IN INDIA

It means reducing the fiscal deficit and gradually shifting towards the revenue surplus situation.

Possible steps to fiscal consolidation

Reducing expenditure like cutting down the burden of salaries, pension , cutting down the subsidies, Reduce the Interest burden etc.
Increasing revenue receipts by Tax reforms, disinvestment of PSU, using surplus forex reserve for external lending.

Revenue Receipt: The revenue received by the government which is not to be paid in future like proceeds from direct tax and indirect tax.

Repayment of interest of loan by the states to the center comes under revenue receipt.
Repayment of principle part is Capital receipt.
Revenue receipt does not affect the liability in future.

Revenue Expenditure: That part of the spending of the government for which there is no capital creation. However, in case of India although the programme MGNREGA comes under the revenue expenditure but some capital asset like dams and wells are created.

The grant given by the central government to the state government for creation of assets comes under revenue expenditure even if some capital asset is created.

Revenue Deficit: The difference between the revenue receipt and revenue expenditure by the government.

The revenue deficit is not good for the economy in general as it shows more spending than the income. This difference is funded by borrowing from the market.
If FRBM act is implemented, then there will be revenue surplus in place of revenue deficit.

Effective Revenue Deficit: Conventionally, ‘revenue deficit’ is the difference between revenue receipts and revenue expenditures.

Here, revenue expenditures include all the grants which the Union Government gives to the state governments and the UTs – some of which create assets (though these assets are not owned by the GoI but the concerned state governments and the UTs).
According to the Finance Ministry (Union Budget 2011-12), such revenue expenditures contribute to the growth in the economy band therefore, should not be treated as unproductive in nature like other items in the revenue expenditures.

And on this logic, a new methodology was introduced to capture the ‘effective revenue deficit’, which is the Revenue Deficit ‘excluding’ those revenue expenditures of the GoI which were done in the form of GoCA (grants for creation of capital assets).

Capital Receipt: The receipts by the government which either makes liability to the government or decreases the assets of the government.

Examples are loan raised by the government from RBI, Commercial banks in the country, PF Deposits, Proceeds received by the disinvestment on PSU and the proceeds received as the recovery of loan by the state government.
The external commercial borrowing is also the capital receipt.
ECB can also be raised by the private sector companies.

Capital Expenditure: The expenditure that creates physical or financial assets like road, investment in share.

Gross Investment: The part of our final output that comprises of capital goods constitutes gross investment of an economy.

Primary Deficit: The difference between the fiscal deficit and the interest payments. This is equal to the fiscal deficit minus interest payments.

Fiscal Stimulus: The act of government to resume and accelerate the economic activity in the slowdown condition like ‘public spending’ or ‘exemption from tax’ is called fiscal stimulus. It is an attempt to stimulate the economy. The prime motive is to move the economy and not to meet the demand.

Fiscal Drag: The situation where the inflation pushes the income into higher tax bracket but there is no increase in the purchasing power.

Note: The biggest share of tax in India is Corporation tax and Income tax is at second place.

ZERO-BASE BUDGETING

Zero-base budgeting is the allocation of resources to agencies based on periodic re-evaluation by those agencies of the need for all the programmes.

CHARGED EXPENDITURE

It is the public expenditure which is beyond the voting power of the Parliament and is directly withdrawn from the Consolidated Fund of India.

The emoluments of the President, Speaker and Deputy Speaker of the Lok Sabha, Chairman and Deputy Chairman of the Rajya Sabha, Judges of the Supreme Court and the High Courts, etc. in India, are examples.

CUT MOTION

In democratic political systems, there is a provision of Cut Motion in the House/Parliament.

Token Cut is a cut of 100 by the House from the total demand made by the government.
Economy Cut is a cut of specific amount from the total demands made by the government.
Disapproval of Policy Cut is cutting just Rs. 1 from the total government demands made in the budget. It is a symbolic cut.
Guillotine is the most severe form of the cut motion in which demands by the budget are directly put to vote without any discussion or scrutiny. This is the most radical form as it might culminate in the fall of the government—a kind of no confidence motion. Floor-crossing is an imminent danger in this. However, it has never happened in the Indian fiscal arena.

Reserve Bank of India

Functions of RBI:

Issue of Notes.
Banker to the banks
Banker to the govt.
Controller of credit.
Financial adviser to the government
RBI acts as the custodian of foreign currency

The Payment banks are also required to take the prior approval from RBI for their financial products.
It is mandatory for the banks to open 25 % of the branches in unbanked rural areas.

Monetary Policy of RBI: The monetary policy controls the flow of credit in the economy.

Marginal Standing Facility: The special window of the RBI through which commercial banks can borrow at a rate 1 % higher than the repo rate.

This is a penal rate.
This is used when other options of borrowings are exhausted.
MSF is a very short term borrowing scheme for scheduled commercial banks.
Banks may borrow funds through MSF during severe cash shortage or acute shortage of liquidity.

Liquidity Adjustment Facility: This is the provision to meet the day to day cash mismatches of the bank. The money is supplied by RBI in this case.

MCLR: The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI.

It is an internal benchmark or reference rate for the bank.
MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank.

Cash Reserve Ratio: The share of banks deposit that the commercial banks need to deposit to RBI.

This reserve attracts no interest.
This is 4 %.

Repo Rate: The rate at which the commercial banks borrow (for short term) the loan from RBI.

This is around 6%.
In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

Reverse Repo Rate: The rate at which RBI takes the loan from commercial banks.

Base Rate: It is the interest rate below which Scheduled Commercial Banks (SCBs) will lend no loans to its customers – its means it is like Prime Lending Rate (PLR).

SARFESI Act: The purpose of the act was to recover the loan from willful defaulters.

The aim was to reduce the increasing NPA on the banks.
The act authorized the financial institution to take over the asset of the defaulters or take over the control of management.
As per the recent revision, the District Magistrate is the authority to coordinate with the banks in the process of recovery.

Asset Reconstruction Companies: The ARCs buys the bad loan form the banks.

They recover it from the defaulters.
They are expert in recovery.
The Narsimha committee recommended this provision.

hence, in order to minimize the risks of non-payment of the loans the Basel norms has been made.

The Basel norms direct the banks to keep aside 8 % of the total risk loans aside.
This is required for absorbing shocks.
India has accepted the Basel norms.
Basel norms are not legally binding.

AT1 bonds: These bonds have no maturity date. Technically they can continue to pay the coupon forever.

The issuing bank has the option to call back the bonds or repay the principal after a specified period of time.
The attraction for investors is higher yield than secured bonds issued by the same entity.
But this comes with a two-fold risk: First, the issuing bank has the discretion to skip coupon payment.
Second, the bonds can get written down in certain circumstances. In some cases, there could be a clause to convert into equity as well. Given these characteristics, AT1 bonds are also referred to as quasi-equity.

History of Planning in India

The Congress Plan

It was on the initiative of the INC president Subhash C. Bose that the National Planning Committee (NPC) was set up in October 1938 under the chairmanship of J.L. Nehru to work out concrete programmes for development encompassing all major areas of the economy.

The Visvesvaraya Plan

The credit of proposing the first blueprint of Indian planning is given to the popular civil engineer and the ex-Dewan of Mysore state M. Visvesvaraya—in his book The Planned Economy of India, published in 1934.

His ideas of state planning were an exercise in democratic capitalism (similar to the USA) with emphasis on industrialization—a shift of labour from the agrarian set up to the industries targeting to double national income in one decade. Though there was no follow up by the British Government on this plan, it aroused an urge for national planning among the educated citizens of the country.

The Gandhian Plan

Espousing the spirit of the Gandhian economic thinking, Sriman Narayan Agarwal formulated this plan in 1944 (Year when Bombay plan was introduced). This plan laid more emphasis on agriculture. Even if he referred to industrialization it was to the level of promoting cottage and village-level industries, unlike the NPC and the Bombay Plan which supported a leading role for the heavy and large industries. The plan articulated a ‘decentralized economic structure’ for India with ‘self-contained villages’.

It needs to be noted here that the Gandhian did not agree with the views of the NPC or the Bombay Plan, particularly on issues like centralised planning, dominant role for state in the economy and the emphasis on industrialization being the major ones.

The People’s Plan

In 1945, yet another plan was formulated by the radical humanist leader M.N. Roy, chairman of the Post-War Reconstruction Committee of Indian Trade Union. The plan was based on Marxist socialism and advocated the need of providing the people with the ‘basic necessities of life’.

Agricultural and industrial sectors, both were equally highlighted by the plan. Many economists have attributed the socialist leanings in Indian planning to this plan. The common minimum programmes of the United Front Government of the mid-nineties (20th century) and that of the United Progressive Alliance of 2004 may also be thought to have been inspired from the same plan. ‘Economic reforms with the human face’, the slogan with which the economic reforms started early 1990s has also the resonance of the People’s Plan.

Nehru Mahalanobis Model

According to the plan, to achieve a rapid long-term rate of growth it would be essential to devote a major part of the investment outlay to building of basic heavy industries.

The Indian economy at the time of independence was mainly dependent on agriculture. There was little industrial growth. The country was dependent on import for necessary goods.

The emphasis of the model was on the infrastructure development of the country. The purpose was to establish the basic industries and heavy industries. The development of heavy industries will render further growth of the nation by producing required machines.

The Sarvodaya Plan

After the reports of the NPC were published and the Government was set to go for the five-year Plans, a lone blueprint for the planned development of India was formulated by the famous socialist leader Jaiprakash Narayan—the Sarvodaya Plan published in January 1950.

The plan drew its major inspirations from the Gandhian techniques of constructive works by the community and trusteeship as well as the Sarvodaya concept of Acharya Vinoba Bave, the eminent Gandhian constructive worker.

Major ideas of the plan were highly similar to the Gandhian Plan like emphasis on agriculture, agribased small and cottage industries, self-reliance and almost no dependence on foreign capital and technology, land reforms, self-dependent villages and decentralized participatory form of planning and economic progress, to name the major ones.

Five Year Plans in India

First Plan: The period for this plan was 1951–56. As the economy was facing the problem of large-scale food grains import (1951) and the pressure of price rise, the plan accorded the highest priority to agriculture including irrigation and power projects. About 44.6 per cent of the plan outlay went in favour of the public sector undertakings (PSUs).

The idea of Five Year Plan in India was borrowed from the USSR’s constitution.

Second Plan: The plan period was 1956–61. The strategy of growth laid emphasis on rapid industrialization with a focus on heavy industries and capital goods. The plan was developed by Professor Mahalanobis.

Third Plan: The Plan period was 1961–65. The Plan specifically incorporated the development of agriculture as one of the objectives of planning in India besides for first time considering the aim of balanced, regional development.

Due to heavy drain and diversion of funds, this plan utterly failed to meet its targets.

Three Annual Plans: The period of the three consecutive Annual Plans was 1966–69. Though the Fourth Plan was ready for its implementation in 1966, the weak financial situation as well as the low morale after the defeat by China, the Government decided to go for an Annual Plan for 1966–69.

Due to the same reasons the Government went for another two such plans in the forthcoming years. The broader objectives of these Annual Plans were inside the design of the Fourth Plan which would have been implemented for the period 1966–71 had the financial conditions not worsened by then.

Some economists as well as the opposition in the Parliament called this period as a discontinuity in the planning process, as the Plans were supposed to be for a period of five years. They named it a period of “Plan Holiday”, i.e. the planning was on a holiday.

Fourth Plan: The Plan period was 1969–74. The Plan was based on the Gadgil strategy with special focus to the ideas of growth with stability and progress towards self-reliance.

Fifth Plan: The Plan (1974–79) has its focus on poverty alleviation and self-reliance. The popular rhetoric of poverty alleviation was sensationalized by the Government.

The planning process got more politicised. The havocs of hyper-inflation led the Government to hand over a new function to the Reserve Bank of India to stabilize the inflation (the function which the RBI carries forward even today). A judicious price wage policy was started to check the menace of inflation on the wage-earners.

The Janata Government did cut-short the Fifth Plan one year ahead of its terminal. A fresh Plan, the Sixth Plan for the period 1978–83 was launched by the new Government which called it the ‘Rolling Plan’.

In 1980, there was again a change of government at the centre with the return of the Congress which abandoned the Sixth Plan of the Janata Government in the year 1980 itself.

The new Government launched a fresh new Sixth Plan for the period 1980–85.

Sixth Plan: This Plan (1980–85) was launched with the slogan of ‘Garibi Hatao’ (alleviate poverty).

Seventh Plan: The basic tenets of planning i.e. growth, modernization, self-reliance and social justice remained as the guiding principles.

Two Annual Plans: The Eighth Plan (whose term would have been 1990–95) could not take off due to the ‘fast-changing political situation at the Centre’.

Note: In India’s developmental plan exercise we have two types of schemes viz; central sector and centrally sponsored scheme. The nomenclature is derived from the pattern of funding and the modality for implementation.

Under Central sector schemes, it is 100% funded by the Union government and implemented by the Central Government machinery. Central sector schemes are mainly formulated on subjects from the Union List.

Under Centrally Sponsored Scheme (CSS) a certain percentage of the funding is borne by the States in the ratio of 50:50, 70:30, 75:25 or 90:10 and the implementation is by the State Governments. Centrally Sponsored Schemes are formulated in subjects from the State List to encourage States to priorities in areas that require more attention.

Funds are routed either through consolidated fund of States and or are transferred directly to State/ District Level Autonomous Bodies/Implementing Agencies.

Monetary Policy Committee

The Monetary Policy Committee of India is responsible for fixing the benchmark interest rate in India. The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.

The committee comprises six members – three officials of the Reserve Bank of India and three external members nominated by the Government of India. They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”. The Governor of Reserve Bank of India is the chairperson ex officio of the committee.

Hence, indirectly the government will have the say in setting the key rates

Decisions are taken by majority with the Governor having the casting vote in case of a tie. The current mandate of the committee is to maintain 4% annual inflation until March 31, 2021 with an upper tolerance of 6% and a lower tolerance of 2%.

The committee was created in 2016 to bring transparency and accountability in fixing India’s Monetary Policy. The monetary policy are published after every meeting with each member explaining his opinions.

The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months.

The formation of the committee has been done on the basis of recommendation of report of Urjit Patel. Keeping inflation of 4% (in the tolerance band of 2 % to 6 %) is the main aim of the committee. The CPI will be taken into account while calculating inflation. The key term used is inflation targeting.

Reserve Bank of India Act, 1934 (RBI Act) has been amended by the Finance Act, 2016, to provide for a statutory framework for a Monetary Policy Committee for maintaining price stability, while keeping in mind the objective of growth.

Price Stabilization Fund

Price Stabilization Fund (PSF) refers to any fund constituted for containing extreme volatility in prices of selected commodities.

It was created in 2015 for perishable agricultural and horticultural commodities, but initially limited to support potato and onion prices only.

The Government of India, in 2015, approved the creation of a Price Stabilization Fund (PSF) with a corpus of Rs.500 crores as a Central Sector Scheme, to support market interventions for price control of perishable agri-horticultural commodities during 2014-15 to 2016-17.

Initially the fund was proposed to be used for market interventions for onion and potato only and pulses were added subsequently.

Nonperishable products include cereals, pulses, edible oil, sugar, salt and tea.

PSF mechanism is apart from the Minimum Support Price (MSP) based initiatives already existing in the country for certain agricultural goods.

Market Intervention Scheme

Market Stabilization scheme (MSS) is a monetary policy intervention by the RBI to withdraw excess liquidity (or money supply) by selling government securities in the economy. It was introduced in April 2004.

MSS was initially launched to withdraw the excess liquidity in the system that was generated as a result of the RBI’s purchase of foreign currencies in the foreign exchange market.

It aids in liquidity absorption in case of significant capital inflows in the
economy.

MSS securities are included under the country’s ‘internal Central Government
debt’.

Financial Stability and Development Council

The Financial Stability and Development Council (FSDC) was constituted in December, 2010. The Council is chaired by the Union Finance Minister and its members are Governor, Reserve Bank of India; Finance Secretary and/or Secretary, Department of Economic Affairs; Secretary, Department of Financial Services; Chief Economic Adviser, Ministry of Finance; Chairman, Securities and Exchange Board of India; Chairman, Insurance Regulatory and Development Authority and Chairman, Pension Fund Regulatory and Development Authority.

What it does?

The Council deals, inter-alia, with issues relating to financial stability, financial sector development, inter–regulatory coordination, financial literacy, financial inclusion and macro prudential supervision of the economy including the functioning of large financial conglomerates. No funds are separately allocated to the Council for undertaking its activities.

Financial Data Management Centre (FDMC) Initially, FDMC was to be a non-statutory body to collect data from financial sector regulators, standardize and analyse them on issues relating to financial stability for onward decisions by the Financial Stability and Development Council (FSDC).

It was also to provide regular access to the data. However, the Department of Legal Affairs turned down the initial Cabinet proposal saying that a non-statutory FMDC would find it difficult to acquire data from the regulators, majority of which were statutory. Hence it will be set as statutory body.

The Reserve Bank of India (RBI) would soon no longer be the sole collector and custodian of financial data as the Law Ministry has approved a revised Cabinet proposal on the creation of the Financial Data Management Centre (FDMC) that would subsequently collect raw data directly.

The Financial Sector Legislative Reforms Commission (FSLRC) has, inter-alia, recommended the creation of a statutory Financial Data Management Centre (FDMC), a repository of all financial regulatory data, which would “serve to assist the Financial Stability and Development Council (FSDC) in conducting research on systemic risk and system-wide trends, and facilitate a discussion about policy alternatives between the members of the FSDC”.

Chit Funds

Chit funds are essentially saving institutions. They are of various forms and lack any standardized form. Chit funds have regular members who make periodical subscriptions to the fund.

Chit funds are included in the definition of Non- Banking Financial Companies by RBI under the subhead miscellaneous non-banking company (MNBC).

Chit fund business currently is regulated under the Central Act of Chit Funds Act, 1982 and the Rules framed under this Act by the various State Governments for this purpose.

Index of Industrial Production

The Index of Industrial Production (IIP): It is an index for India which shows growth of various sectors in an economy such as mining, electricity and manufacturing. The all India IIP is a composite indicator that measures the short-term changes in the volume of production of a basket of industrial products during a given period with respect to that in a chosen base period.

It is compiled and published monthly by the Central Statistical Organization (CSO) six weeks after the reference month ends.

GST Council

What is GST council?

The GST council is composed of the finance minister of India as the chairman, Union minister of state (Finance) and finance ministers of all the states and UTs. This is a constitutional body. The council will decide the rates of centre and state GST.

The GST bill has the provision that the parliament by lay may compensate the loss of revenue occurred to the states as a result of the implementation of this act.

Goods and Services Tax (GST) Council is a constitutional body established
under Article 279A for making recommendations to the Union and State Government on issues related to Goods and Service Tax. The (One Hundred and First Constitution Amendment) Act, 2016 introduced GST Council.

It is a joint forum of Centre and states and chaired by the Union Finance
Minister. The Quorum of the council is fixed at half of its membership i.e. 50% of the total membership of the council
Voting: Every decision of the council is to be taken by a majority of not less than
three-fourths of the weighted votes of the members present and voting at the meeting (and not half of the total strength).

The voting share of each state in the Council does not depend upon its
population. The vote share of each state is the same and combined votes of all states shall have the weightage of two-thirds of the total votes cast. The vote of the Central Government shall have one-third of the total votes cast.

Lorenz curve

In economics, the Lorenz curve is a graphical representation of the distribution of income or of wealth. It was developed by Max O. Lorenz in 1905 for representing inequality of the wealth distribution.

The curve is a graph showing the proportion of overall income or wealth assumed by the bottom x% of the people, although this is not rigorously true for a finite population. It is often used to represent income distribution, where it shows for the bottom x% of households, what percentage (y %) of the total income they have. The percentage of households is plotted on the x-axis, the percentage of income on the y-axis. It can also be used to show distribution of assets.

Gini coefficient

The Gini coefficient is the ratio of the area between the line of perfect equality and the observed Lorenz curve to the area between the line of perfect equality and the line of perfect inequality. The higher the coefficient, the more unequal the distribution is. In the diagram on the right, this is given by the ratio A/ (A+B), where A, B are the areas of regions as marked in the diagram.

The Gini Coefficient measures the degree of income equality in a population. The Gini Coefficient can vary from 0 (perfect equality) to 1 (perfect inequality). A Gini Coefficient of zero means that everyone has the same income, while a Coefficient of 1 represents a single individual receiving all the income.

Green Revolution

The ‘Green Revolution’ was introduced in India, in the late 1960s. The aim was to enhance the productivity of food grains like Wheat and Rice.

They made use of:

High Yielding Variety seeds,
Improved irrigation infrastructure,
Pesticides
Modern technologies

Where it occurred?

It occurred mainly in Punjab, Haryana, and Western UP.

Negative Effects: Although the yield increased in these areas but the land started degrading due to overuse of chemical fertilizers, Overuse of ground water reduced the ground water level.

Note: Pulses remain neglected. UP, Maharashtra and MP are the major producer states of pulse in India.

Why the use of chemical fertilizers is discouraged.

The chemical fertilizers when dissolved in the water gives required nutrients to plants. However soil may not retain the chemical for longer time and it may reach the ground water and contaminate it.
Chemical fertilizers can also kill Bacteria and others organisms which is essential for plants. This ultimately reduces the fertility of the soil and fertilizers required by the soil increases.

Monsoon in India

The western and central India gets rainfall through the south west monsoon. The Eastern India like Bihar, Bengal, North east states gets rainfall due to North East Monsoon.

South west monsoon accounts for around 90 percent rainfall in India. The south west monsoon has two streams, One the Arabian Sea stream and the other Bay of Bengal stream.

The two currents meet at Meghalaya and causes copious rain over there.

The south west monsoon retreats in the early October month and causes rain in the eastern coastal region of the country like Tamil and Andhra.

Priority Sector Lending

It refers to those sectors of the economy which may not get timely and adequate credit in the absence of this special dispensation. Priority Sector Lending is an important role given by the Reserve Bank of India (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections.

This is essentially meant for an all-round development of the economy as opposed to focusing only on the financial sector.

Advance Pricing Agreement

This is an agreement between the tax payer and the tax authority to avoid the issue of transfer pricing. Both the parties agree to the scheme of pricing in advance. It encourages the ease of doing business.

Transfer Pricing

The transfer pricing is the method adopted by MNCs to minimise their tax liability. Suppose the company X has branches in India and in other country. The company will show lower price of sold goods in India as the corporation tax in India is higher. The same company will show higher price in other country as the corporation tax in other country is lower.

Bretton woods conference (1944)

The conference was held after Second World War.
Two financial institutions emerged at the conference. One was the World Bank and the other was IMF.
While the motive of world bank (International Bank of Reconstruction and Development) was to reconstruct the infrastructure after world war. The purpose of IMF was to maintain the world economic stability.

IMF

It is situated in Washington USA.
Each member nation after joining the IMF gets a quota depending on its economic size.
The country is then required to contribute the determined amount of money to IMF.
The money contributed is in widely accepted currency or SDR (One quarter) and country own currency (3/4th).
IMF facilitates the quota for each member to refinance the nation.
IMF reviews the quota after 5 years.
IMF lends only to the member nations.

Objective of IMF

The objective of the IMF is to promote economic cooperation and stabilize the exchange rate.
Global Financial stability Report is published by IMF.
To help the members in payment crisis (IMF acts as the lender of last resort and helps the member countries facing BOP crisis).
IMF also monitors the fiscal health of member nations and publishes the ‘Fiscal Monitor Report’ twice a year.

Note: Unlike other development banks, IMF does not finance specific infrastructure projects.

IMF provides low interest loan to member country in case of disaster.
The low interest rate is also applicable in case of financially weaker member countries.
‘World Economic Outlook’: IMF published the report ‘World Economic Outlook’ containing the world economic development.
India is the founding nation of IMF.
IMF has helped India in the time of BOP crisis.
India has become the creditor for the IMF.

Financial Stability Report: The International Monetary Fund publishes it.

Special Drawing Right: SDR is an international asset reserve that can be exchanged with the international currency.

It is not the currency as such.
This is issued by IMF.
The value of SDR is set on the basis of basket of currency namely Dollar, Renminbi, Yen, Euro, and Sterling.
At international level it has been demanded to replace USD by SDR as the global currency.

The SDR basket now consists of the following five currencies: U.S. dollar 41.73%, Euro 30.93%, Renminbi (Chinese Yuan) 10.92%, Japanese Yen (8.33%), British Pound (8.09%).

World Bank

It is situated in Washington.
The World Bank provides loan to the poorer countries.
‘World Development Report’ is published by World Bank. The aim is to fight poverty and support to poorer countries.
The profit of World Bank is used to fight poverty.

Note: A country needs to be the member of IMF in order to become the member of World Bank. The president of the World Bank is an American.

The World Bank not only supports the member countries but also support the nonmember poorer countries.

There are two terms one is ‘world bank’ and the other is the ‘world Bank Group’, While World Bank refers to two institutions.

International Bank of Reconstruction and Development (IBRD): The target is relatively developed countries. It was formed to finance the reconstruction after Second World War.
International Development Association (IDA): its target is poorer countries.

The ‘World Bank Group’ contains in addition to above organization, other organizations like

International Finance Corporation: Intended to protect the private sector investment in member countries.
Multilateral Investment Guarantee Agency: The purpose is to promote FDI.
International Centre for Settlement of Investment Dispute: Arbitration of investment dispute.

Note: World Bank has financed for Water Highway project in India. The project is expected to challenge the conservation efforts of Gangetic Dolphins in the river.

Reports published by the World Bank

Global Financial Development Report
Energy Saving Ranking
World Development Report

Washington Consensus

This is a set of neoliberal economic prescriptions made by the International Monetary Fund, the World Bank, and the U.S. Treasury to developing countries that faced economic crises.
It recommended structural reforms that increased the role of market forces in exchange for immediate financial help.

Forex Reserve

What is Forex Reserve?

Foreign currency : Highest proportion in case of India
Gold: Second highest
SDR: Special Drawing Rights at IMF, It is at third position.
Reserve Tranche Position: This is the part of country’s quota at IMF that the country can access any time.

Balance of Payment