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INDIAN ECONOMYINDIAN ECONOMYINDIAN ECONOMYINDIAN ECONOMYINDIAN ECONOMY

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CONTENTS

Sl. No. TOPICS Pg. No.

1. Economics : An Introduction ............................................................. 5-8

2. State of the Indian Economy ............................................................ 9-13

3. National Income Concept and Accounting ..................................... 14-16

4. Planning ........................................................................................... 17-31

5. Public Finance in India .................................................................... 32-42

6. Banking System in India.................................................................. 43-55

7. Inflation ............................................................................................ 56-59

8. Fiscal Federalism In India ............................................................... 60-69

9. Money Market Instruments In India ............................................. 70-72

10. Indian Capital Market ...................................................................... 73-78

11. Services Sector In India's ................................................................ 79-82

12. Balance of Payments : Concept ...................................................... 83-86

13. Exchange Rate : Concept ................................................................. 87-90

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[4] Chronicle IAS Academy

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Chronicle IAS Academy [5]

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Definition of EconomicsThere are three representative definitions of

economics, which encompass major dimensionsof the subject. They are as follows:

• Adam Smith defined economics as the'Science of Wealth'. (Material Definition)

• Economics is a study of mankind in theordinary business of life; it examines thatpart of individual and social action whichis most closely connected with the attain-ment and with the use of material requi-sites of well being'. (Welfare Definition)

• Professor Robbins in his 'Nature and Sig-nificance of Economic Science (1932)' de-fined economics as 'the science which stud-ies human behaviour as a relationship be-tween ends and scarce means which havealternative uses.' (Behavioral Definition)

Macro and Micro EconomicsRanger Frisch used the terms macro and

micro economics first in 1953. The subject mat-ter of economics and its various concepts canbe classified either in 'microeconomics' or mac-roeconomics' for the sake of convenience ofstudy. Microeconomics is the study of unitswhereas macroeconomics is the study of ag-gregates. As its name implies, microeconomicsis concerned mainly with small segments of thetotal economy, i.e., behaviour and decision ofindividual consumer or producer or group ofconsumers and producers that form a marketunit. Microeconomics is about production orconsumption of an individual unit, demand andsupply of an individual unit, price and outputdetermination of an individual unit, etc. Onthe other hand Macroeconomics is the study of'whole' or 'aggregate' such as national income,aggregate saving, aggregate demand, aggregatesupply, etc.

Positive versus Normative economicsIn Economics, mainly there are two types of

approaches- positive and normative; the former

CHRONICLEIAS ACADEMYA CIVIL SERVICES CHRONICLE INITIATIVE

ECONOMICS : AN

INTRODUCTION

approach deals with "what is" and the latterwith "what should be". In positive economicswe describe, explain and understand the eco-nomic phenomena "as they are" while in nor-mative economics we study "what should be"and we conjecture, suggest and do value judg-ments to take certain stands on various issuesand judge the worth of economic policies andstances as good or bad, desirable or undesirable.So, normative approach is which deals with"what should be" or "if" and "then" conditions.

Fundamental Questions for an EconomyEconomics broadly deals with anything,

which has a price or monetary value. This mon-etary value arises out of two factors:

1. Unlimited wants and desires of the people.2. Limited/Scarce availability of resources.Since unlimited needs and wants of the

masses have to be satisfied out of the scarceand limited resources available, Economics triesto find out the most efficient allocation of thescarce resources so that the needs and desiresare satisfied to the best possible extent. Theanswers of three fundamental questions ofeconomics determine the allocation of scarceresources among its alternative uses. The threefundamental questions are as follows:

1. What to produce?2. How to produce?3. For whom to produce?The three fundamental questions of econom-

ics are resolved differently in different economicsystems. The more important economic systemsare Socialism, Capitalism and Mixed Economy.Under a Socialist regime, all the resources arecollectively owned. Under Socialism, the ques-tions, what, how and for whom to produceare decided by the central planners keeping inview various factors, such as the priorities ofthe economy and supply and demand condi-tions. They assign different quantity of resourcesto different products depending on expected


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demand and hence let the economy work in acentrally planned fashion. The socialisteconomy, therefore, do not allow the free playof market forces. Government intervention isthe hallmark of socialist economies.

On the other hand capitalism tries to an-swer all these fundamental questions throughmarket mechanism. It explains that the invis-ible hand of free market forces will determinethe above answers to questions. Prices of fac-tors of production and commodities togetherwith purchasing power of different consumergroups will determine what to produce, howto produce and for whom to produce. Thusmarket mechanism brings all the commoditiesand factor markets in equilibrium.

Mixed Economy involves ownership of fac-tor resources by private as well as public sec-tor. Whereas strategic and core sectors are gen-erally owned by public sector, non-strategic,capital and consumer goods are open to pri-vate sector to compete.

Main Features of Capitalism:• Laissez faire or free market.• Private property.• Capital owned by capitalists.• Production done by hired labour.• Market mechanism (invisible forces of mar-

ket) determines prices of commodities andfactors of production as well as distribu-tion of products and income.

• Modern day capitalism accepts limitedstate intervention.

Market EconomyThe term market economy is not identical to

capitalism where a corporation hires workersas a labour commodity to produce materialwealth and boost shareholders profits. A "mar-ket economy" is an economy in which indi-viduals make economic decisions according tothe principle of supply and demand. A marketeconomy is a realized social system based onthe division of labour in which the prices ofgoods and services are determined in a freeprice system set by supply and demand. This isoften contrasted with a planned economy, inwhich the central government determines theprice of goods and services using a fixed pricesystem. Market economies are contrasted withmixed economy where there the price system

is not entirely free but under some governmentcontrol that is not extensive enough to consti-tute a planned economy. In the real world,market economies are regulated by society.

Laissez-faireLaissez-faire is a French phrase literally mean-ing Let do ("allow to do"). From the Frenchdictum first used by the eighteenth centuryphysiocrats as an injunction against govern-ment interference with trade, it became usedas an economic ideology which advocates mini-mal state intervention in the economy. Manywriters suggest that laissez-faire capitalismnever existed. It is generally understood to bea doctrine that maintains that private initiativeand production are best allowed a minimal ofeconomic interventionism and taxation by thestate beyond what is necessary to maintain in-dividual liberty, peace, security, and propertyrights.

Crony capitalismCrony capitalism is a pejorative term describ-ing an allegedly capitalist economy in whichsuccess in business depends on close relation-ships between businessmen and governmentofficials. It may be exhibited by favoritism inthe distribution of legal permits, governmentgrants, special tax breaks, and so forth. Cronycapitalism is believed to arise when politicalcronyism spills over into the business world;self-serving friendships and family ties betweenbusinessmen and the government influence theeconomy and society to the extent that it cor-rupts public-serving economic and politicalideals.In its lightest form, crony capitalism con-sists of collusion among market players.

SocialismSocialism refers to a broad set of economic theo-ries of social organization advocating state orcollective ownership and administration of themeans of production and distribution of goods.Modern socialism originated in the late nine-teenth-century working class political move-ment. Karl Marx posited that socialism wouldbe achieved via class struggle and a proletar-ian revolution, it being the transitional stagebetween capitalism and communism.

Features of classical form of socialism• Productive resources owned by states.


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• No private property.• State intervention.• State employed workers.• Centrally planned economies.• Production and distribution decisions

taken by a central agency.• Administered prices.Socialism is not a discrete philosophy of fixed

doctrine and program; its branches advocate adegree of social interventionism and economicinterventionism, sometimes opposing each other- especially the reformists and the revolution-aries. Some advocate complete nationalizationof the means of production, distribution, andexchange; social democrats propose selectivenationalization of key national industries inmixed economies combined with tax-fundedwelfare programs; libertarian socialists advo-cate co-operative worker ownership of themeans of production; most Marxists (some in-spired by the Soviet economic model), advo-cate centrally-planned economies. By contrast,Social-Anarchists, Luxemburgists, the U.S. NewLeft and various forms of libertarian socialismfavor decentralized ownership via co-operativeworkers' councils and participatory planning.

Market socialismMarket socialism is a term used to denote

two different economic system(s) based in so-cialism which operate according to market prin-ciples. The first term relates to an economydirected and guided by socialist planners oneither alocal or state level. The earliest models of thisform of market socialism were developed byEnrico Barone (1908) and Oskar R. Lange(1936). Lange and Fred M. Taylor proposedthat central planning boards set prices through"trial and error," making adjustments as short-ages and surpluses occurred rather than rely-ing on a free price mechanism. If there wereshortages, prices would be raised; if there weresurpluses, prices would be lowered. Raising theprices would encourage businesses to increaseproduction, driven by their desire to increasetheir profits, and in doing so eliminate the short-age. Lowering the prices would encouragebusinesses to curtail production in order toprevent losses, which would eliminate the sur-plus. Therefore, it would be a simulation of themarket mechanism, which Lange thoughtwould be capable of effectively managing sup-ply and demand. There are a few examples of

market socialism in the contemporary world.Market mechanisms have been utilized in ahandful of socialist states, such as Yugoslaviaand even Cuba to a very limited extent. ThePeople's Republic of China is run by the Com-munist Party, but its economy involves consid-erable private enterprise and market forces inboth private and public sectors.

CommunismCommunism is a socioeconomic structure

that promotes the establishment of an egalitar-ian, classless, stateless society based on com-mon ownership of the means of production andproperty in general. It is usually considered tobe a branch of socialism, a broad group of so-cial and political ideologies, which draws onthe various political and intellectual movementswith origins in the work of theorists of theIndustrial Revolution and the French Revolu-tion, although socialist historians say they areolder. Communism attempts to offer an alter-native to the problems believed to be inherentwith capitalist economies and the legacy ofimperialism and nationalism. Communismstates that the only way to solve these prob-lems would be for the working class, or prole-tariat, to replace the wealthy bourgeoisie, whichis currently the ruling class, in order to estab-lish a peaceful, free society, without classes, orgovernment. The dominant forms of commu-nism, such as Leninism, Stalinism, Maoism andTrotskyism are based on Marxism, but non-Marxist versions of communism (such as Chris-tian communism and anarchist communism)also exist and are growing in importance sincethe fall of the Soviet Union Planned economyor Directed economy or Command economy.

Planned Economy: A planned economy ordirected economy is an economic system inwhich the state or government manages theeconomy. Its most extensive form is referred toas a command economy, centrally plannedeconomy, or command and control economy.In such economies, the state or governmentcontrols all major sectors of the economy andformulates all decisions about their use andabout the distribution of income, much like acommunist state. The planners decide whatshould be produced and direct enterprises toproduce those goods.

Unplanned Economy: Planned economies arein contrast to unplanned economies, such as amarket economy, where production, distribu-


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tion, pricing, and investment decisions are madeby the private owners of the factors of produc-tion based upon their own and their custom-ers' interests rather than upon furthering someoverarching macroeconomic plan.

Mixed EconomyA mixed economy is an economic system

that incorporates aspects of more than one eco-nomic system. This usually means an economythat contains both privately-owned and state-owned enterprises or that combines elementsof capitalism and socialism, or a mix of marketeconomy and planned economy characteristics.There is not one single definition for a mixedeconomy, but relevant aspects include: a de-gree of private economic freedom (includingprivately owned industry) intermingled withcentralized economic planning (which mayinclude intervention for environmentalism andsocial welfare, or state ownership of some ofthe means of production). The term "mixedeconomy" arose in the context of political de-

bate in the United Kingdom in the postwarperiod, although the set of policies later associ-ated with the term had been advocated fromat least the 1930s. Supporters of the mixedeconomy, including R.H. Tawney, AnthonyCrosland and Andrew Shonfield were mostlyassociated with the British Labour Party, al-though similar views were expressed by Con-servatives, including Harold Macmillan. Indiaand France are examples of mixed economies.With varying degrees all contemporary econo-mies are mixed economies because pure capi-talism or pure communism are a misnomer.

Features of a Mixed Economy• Elements of both socialism and capitalism.• Both public and private investment.• Freedom to buy, sell, and profit.• Economic planning by the state.• Significant regulations (e.g. wage or price

controls) combined with, including taxes,tariffs, and state-directed investment.

•••


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State of the Indian EconomyWith 1.2 billion people and the world’s

fourth largest economy, India’s recent growthand development has been one of the mostsignificant achievements. Over the six and halfdecades since independence, the country hasbrought about a landmark agriculturalrevolution that has transformed the nation fromchronic dependence on grain imports into aglobal agricultural powerhouse that is now anet exporter of food. Life expectancy has morethan doubled, literacy rates have quadrupled,health conditions have improved, and a size-able middle class has emerged. India is nowhome to globally- recognized companies inpharmaceuticals and steel and information andspace technologies, and a growing voice on theinternational stage that is more in keeping withits enormous size and potential. At the sametime, the country is in the midst of a massivewave of poverty and unemployment.

The foremost reason for slowing growthrate in India during the first half of 2012-13 isweakening industrial growth in the context oftight monetary policy followed by the ReserveBank of India (RBI) through most of 2011-12,and continued uncertainty in the global economy.

The other reasons are listed below:

1. The slowdown in growth in advancedeconomies and near recessionary conditionsprevailing in Europe resulted in decrementof exports along with poor inflows of foreigninvestments in the country.

2. As India is an energy deficient nation,thus, it is mainly dependent on import ofcrude oil. This is leading to higher currentaccount deficit.

3. Rainfall in the monsoon season of 2012-13has been below normal, particularly in thekey months of June and July. This affectedsowing and resulted in a lower growth rateof agriculture and allied sectors.

4. The Reserve Bank of India followed a tightmonetary policy to control inflation,although there has been some relaxationin the recent months in the StatutoryLiquidity Ratio (SLR) as well as CashReserve Requirement (CRR).

5. Poor implementation of infrastructureprojects failed to provide proper boost tothe economy . Further delay in passage ofprojects due to red-tapism has reducedthe investments in infrastructure.

6. The service sector declined due to areduction in the growth rate of ‘Trade,hotels, transport and communications’sector as these are demand driven sectorand high inflation is forcing people toinvest less in these sector.However India is expected to record 6.1

per cent gross domestic product (GDP) growthin the current fiscal. The growth is expected toincrease further to 6.7 per cent in 2014-15,according to the World Bank's latest IndiaDevelopment Update. While, the PrimeMinister's Economic Advisory Panel expects theeconomic growth rate to increase to 6.4 percent in 2013-14 from 5 per cent during 2012-13, on back of improvement in performance ofagriculture and manufacturing sectors.

PRESENT STATUS OF

INDIAN ECONOMY

Agriculture Sector

As per the National Accounts Statistics,theagriculture and allied sector registered a growthof 2.1 per cent during the first half of2012-13which is lower than the growth rate of 3.4 percent in the first half of 2011-12.

Further average annual growth of theagriculture and allied sector during the EleventhFive year Plan at 3.6 per cent fell short of the4 per cent growth target. Realized growth,however, has been much higher than the


STATE OF THE

INDIAN ECONOMY


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average annual growth of 2.5 and 2.4 per centachieved during the Ninth and Tenth Plans,respectively.

Growth has also been reasonably stabledespite large weather shocks during 2009(deficient south west monsoon), 2010-11(drought/deficient rainfall in some states), and2012-13 (delayed and deficient monsoon). Animportant reason for this dynamism was step-up in the gross capital formation (GCF) in thissector relative to GDP of this sector, which hasconsistently been improving from 16.1 per centin 2007-8 to 19.8 per cent in 2011-12 (atconstant 2004-5 prices)

Overall GCF in agriculture (including theallied sector) almost doubled in last 10 yearsand registered a compound average annualgrowth of 8.1 per cent. Rate of growth of GCFaccelerated to 9.7 per cent in the Eleventh Plan(2007-12) compared to a growth of 2.7 per centduring the Tenth Plan (2002-07). Averageannual growth of private investment at 12.5per cent during Eleventh Plan (first four years)was significantly higher as against nearlystagnant investment during the Tenth Plan.

But there has been a decline in overall areaunder foodgrains during 2011-12 (2nd AdvanceEstimates) as compared to 2010-11. The areacoverage under foodgrains during 2011-12stood at 1254.92 lakh ha compared to 1267.65lakh ha last year. The lower area underfoodgrains has been due to a shortfall in thearea under jowar in Maharashtra, Rajasthanand Gujarat; bajra in Maharashtra, Gujarat andHaryana; and in pulses in Maharashtra, UttarPradesh, Andhra Pradesh, and Rajasthan.However the area under coarse cereals andoilseeds has also come down as compared tothe previous year. The area coverage under riceduring 2011-12 is around 444.06 lakh ha which15.44 lakh is ha more than the previous year.The area coverage under sugarcane during thecurrent year has slightly improved to 50.81 lakhha, higher by about 1.96 lakh hectares ascompared to the previous year, and the areaunder cotton has increased significantly to121.78 lakh ha as compared to 112.35 lakh haduring 2010-11

The agriculture, including allied activities,accounted for only 14.1 per cent of the GDP atconstant (2004-5) prices in 2011-12, its role inthe country's economy as its share in totalemployment according to the 2001 census is

58.2 per cent. The declining share of theagriculture and allied sector in the country'sGDP is consistent with normal developmenttrajectory of any economy, but fast agriculturalgrowth remains vital for jobs, incomes, and thefood security. The growth target for agriculturein the Twelfth Five Year Plan remains at 4 percent, as in the Eleventh Five Year Plan.

Agricultural production in the country isgreatly influenced by policies such as pricing,procurement, storage, etc. The MinimumSupport Prices (MSPs) for major crops havebeen raised substantially by the Government in2012, in line with the objective of ensuringremunerative prices to farmers for their produceand with a view to encouraging higherinvestment and production in the sector. Thispolicy also resulted in higher procurement offoodgrains by Food Corporation of India (FCI)and the State agencies. The procured foodgrainsare being made available to the consumersunder the targeted public distribution system(TPDS) at central issue prices(CIPs) that aremuch less than the economic costs to theprocuring agencies.

Reasons for slow growth in agriculture sector:

1. Slowdown in agriculture growth.2. Weak Framework for Sustainable Water

Management and Irrigation.3. Stringent land regulations discourage rural

investments.4. Rural poor have little access to credit.5. Weak Natural Resources Management.6. Excessive use of chemical inputs are

decreasing rate of fertility of soil.7. Frequent floods and droughts.8. Irregular monsoon.

Industrial Sector

As per the IIP, industrial output growthrate during April-September 2012-13 was 0.1per cent as compared to 5.1 per cent in April-September 2011-12. The Mining sectorproduction has contracted in the last sixquarters. The contraction in the current yearwas largely because of decline in natural gasand crude petroleum output. Manufacturing,which is the dominant sector in industry, alsowitnessed deceleration in growth, as did theelectricity sector. There was, however, a sharppick-up in growth in October 2012 with


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manufacturing growth improving to 9.8 percent, the highest recorded since June, 2011.Growth, however, turned negative in Novemberand December, 2012 and was placed at (-) 0.8per cent and (-) 0.6 per cent, respectively. Grosscapital formation (GCF) in the industrial sectorcomprising mining, manufacturing, electricityand construction recorded negative during2008-09 and again in 2011-12.

The major cause of manufacturing sluggishnessare:

1. Drop of investment in new projects dueto the slower rate of growth indisbursement of bank credit. Furtheradverse business sentiment is also leadingto lower investment.

2. Decline in capital goods, natural gas, crudepetroleum, and fertilizers output.

3. Infrastructure bottlenecks has impinged onthe performance of the mining andelectricity sectors.

4. High inflation and high interest rateswhich has made borrowing costs higher.

5. The global economic slowdown.6. Supply-side bottlenecks such as inadequate

infrastructure, inadequacy of fuel supplylinkages and delays in project clearancesof large manufacturing and infrastructureprojectsHowever as per the survey by HSBC Indian

manufacturing and services sectors expandedmore than China in February 2013. The HSBCcomposite index for India for manufacturingand services stood at 54.8 in February 2013,whereas it was 51.4 for China.

The Government has been takingconfidence building measures for improving theindustrial climate and manufacturing in thecountry. Three important initiatives taken inthis regard are announcement of NationalManufacturing Policy (NMP), implementationof Delhi Mumbai Industrial Corridor (DMIC)Project and policy reforms to promote ForeignDirect Investment (FDI).

In addition, the Government has initiatedimplementation of the e-Biz Project, a MissionMode Project under the National e-GovernancePlan (NeGP) for promoting an online singlewindow at the national level for business users.The objectives of setting up of the e-Biz Portalare to provide a number of services to business

users, covering the entire life cycle on theiroperation. The project aims at enhancingIndia’s business competitiveness through aservice oriented, event-driven G2B interaction.

Service Sector

The share of services in India’s GDP atfactor cost (at current prices) increased from33.3 per cent in 1950-51 to 56.5 per cent in2012-13. With an 18.0 per cent share, trade,hotels, and restaurants as a group is the largestcontributor to GDP among the various servicessub-sectors, followed by financing, insurance,real estate, and business services with a 16.6per cent share. Both these services showedperceptible improvement in their shares overthe years. Community, social, and personalservices with a share of 14.0 per cent is in thirdplace. Construction, a borderline servicesinclusion, is at fourth place with an 8.2 percent share.

The HSBC Markit services PurchasingManagers' Index (PMI), which gauges businessactivity from a survey of over 400 companiesranging from banks to hospitals, stood at 50.7in April 2013

Indian service sector enjoyed foreign directinvestment (FDI) inflows amounting to US$4.75 billion during April-February 2012-13,according to the recent statistics released bythe Department of Industrial Policy andPromotion (DIPP).

As the Indian economy is gaining due togrowth in service sector, government has takenmany new initiatives to boost service industryin India.

The initiatives are as follows:

1. Liberalized the FDI policy for the servicessector. These include liberalising the policyon foreign investment for companiesoperating in the broadcasting sector, likeincreasing the foreign investment limitfrom 49 per cent to 74 per cent in teleports(setting up up-linking HUBs/teleports)and direct to home (DTH) and cablenetworks, and permitting foreigninvestment of up to 74 per cent in mobileTV. Foreign airlines have also beenpermitted to make investment up to 49per cent in scheduled and non-scheduledair transport services. FDI, up to 51 per


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cent, in multi-brand retail trading andamended the existing policy on FDI insingle-brand product retail trading.

2. The insurance sector could invest in thecapital markets and other than traditionalinsurance products, various market linkinsurance products were available to theend customer to choose from.

3. Rajiv Gandhi Equity Saving Scheme: toallow income tax deduction to retailinvestors on investing in equities.

4. Insurance companies has been empoweredto open branches in Tier II cities andbelow without prior approval of IRDA.

5. All towns of India with a population of10,000 or more will have an office of LICand an office of at least one public sectorgeneral insurance company.

6. An ambitious IT driven project tomodernise the postal network at a cost ofRs. 4,909 crore. Post offices to become partof the core banking solution and offer realtime banking services.

Price Indices and Inflation

The headline inflation measured in termsof Wholesale Price Index (WPI) in 2012-13(April-December) averaged 7.55 per cent ascompared to 9.44 per cent during thecorresponding period in 2011-12. Inflation hasbeen in the range of 7-8 per cent in the lasttwelve months. Overall WPI food inflationcomprising primary food articles andmanufactured food products, with a weight of24.31 per cent, averaged 9.08 per cent in 2012-13 (April-December) as compared to 7.91 percent during the corresponding period in 2011-12. In December 2012, food inflation was 10.39per cent as compared to 2.70 per cent duringDecember 2011.

The persistently elevated prices for animalproducts (eggs, meat and fish), the rise in theprices of cereals and vegetables, along with theincrease in international prices of fertilizers(non-urea) and the increase in administeredprices of diesel have contributed to inflation todiffering degrees over time.

The Consumer Price inflation for majorindices generally followed a similar trend. TheCPI-IW inflation in 2012-13 (April-December)averaged 10.0 per cent as compared to 8.82per cent in the same period last year. TheCentral Statistics Office (CSO) launched a new

series of Consumer Price indices from January2011. All India general inflation for CPI-NSaveraged 10.04 per cent in 2012-13 (April-December) and was placed at 10.56 per cent inDecember 2012. Inflation based on other groupspecific CPIs (CPI for Agricultural Labourers andCPI for Rural Labourers) also remained in doubledigit in December 2012. While part of the higherCPI inflation reflects the high weight of food inthe consumption basket (46 – 69 per cent), pricepressures have persisted in services and housing,which are included in the CPI basket.

The reasons behind persistent inflation are(a) higher international prices of crude, preciousmetals, edible oil etc. (b) change in dietarypattern leading to structural demand supplymismatch for protein rich items (c) revision inMSP prices for some of the essentialcommodities (d) revision in petroleum prices inSeptember 2012 among others. Inflation hasbeen a major cause of concern for both theGovernment and Reserve Bank of India whoare taking a number of measures to contain itas indicated.

1. RBI has reduced the policy repo rate underthe liquidity adjustment facility (LAF) by25 basis points from 7.5 per cent to 7.25per cent with immediate effect.

2. The reverse repo rate under the LAF,determined with a spread of 100 basispoints below the repo rate, standsadjusted to 6.25 per cent with immediateeffect.

3. The Bank Rate stands adjusted to 8.25 percent with immediate effect.

4. The cash reserve ratio (CRR) of scheduledbanks has been retained at 4.0 per cent oftheir net demand and time liabilities(NDTL).

Trade

India is the 19th largest merchandiseexporter and 12th largest importer in the worldwith shares of 1.7 per cent and 2.5 per cent inworld exports and imports respectively in 2011,as per the World Trade Organization (WTO).In commercial services, India is the 8th largestexporter and 7th largest importer in the worldwith shares of 3.3 per cent and 3.1 per cent inworld exports and imports respectively.

The rate of growth of India’s exports was40.5 per cent in 2010-11. It decelerated in 2011-12 to 21.3 per cent. During 2012-13 (April-


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December), exports were valued at US$ 214.1billion, registering a negative growth of 5.5 percent over the level of US$ 226.5 billion in 2011-12 (April-December). Value of imports duringthis period was US$ 361.3 billion, whichwas marginally lower by 0.7 per cent than thelevel of US$ 363.9 billion in the correspondingperiod of 2011-12. Rising crude oil prices,along with increase in gold and silver priceshave contributed significantly to the import bill.Of the total imports, Petrol oil and lubricantsimports accounted for US$ 124.5 billion(34.5 per cent of total import) in April-December 2012. This was 12.2 per centhigher than the level of US$ 111.0 billion in2011-12 (April-December). Non-Petrol oil andlubricants imports during 2012-13 (April-December) valued at US$ 236.7 billion, were6.4 per cent lower than the level of US$ 252.9billion in 2011-12 (April-December).Consequently, trade deficit for 2012-13 (April-December) increased to US$ 147.2 billion vis-a-vis US$ 137.3 billion in 2011-12 (April-December).

Thus the biggest risk to the economy stemsfrom the CAD which was historically thehighest and well above the sustainable level of2.5 per cent of GDP as estimated by the ReserveBank. The priority has therefore been to reduceCAD through improving trade balances. Effortshave been made to promote exports bydiversifying the export commodity basket andexport destinations.

Recent Measures taken by the government toboost exports

The Union Minister for Commerce,Industry and Textiles has recently announcedadditional incentives to boost exports. Theseincentives came in the backdrop of the AnnualSupplement of the Foreign Trade Policyannounced on June 5, 2012. According to thenew guidelines the 2% Interest SubventionScheme on rupee export credit which isavailable to certain specific sectors includinghandicrafts, carpets, handloom, readymadegarments, processed agriculture products, sportsgoods and toys, has been given an extensionup to March 31, 2014. At present, the Schemeis scheduled to end on 31st March 2013. Alongwith this, Small and Medium Enterprises(SMEs) for all sectors will now be able to availthe benefits of the Scheme.

The scheme has been extended to certainspecific sub-sectors of the engineering sector.

Government has also announced theintroduction of a “pilot scheme” of 2% InterestSubvention for Project Exports through EXIMBank for countries of SAARC region, Africaand Myanmar. The interest subvention wouldbe linked to the Buyer’s Credit Scheme whichwas introduced in the last financial year beingimplemented through EXIM Bank, ECGC andthe National Export Insurance Account. The“objective of the scheme is to boost India’sexports in these countries by providing longterm concessional credit through EXIM Bank,as co-financing in infrastructure sectors suchas drinking water, housing, irrigation, roadprojects, renewable energy, etc.

Apart from these, five new countries havebeen added under the Focus Market Schemewhile Eritrea has been added under the SpecialFocus Market Scheme. The five countries beingadded under FMS are New Zealand, CaymanIslands, Latvia, Lithuania and Bulgaria. UnderFMS Duty Credit of 3 per cent is given on theFoB value of exports. Sixty new products whichinclude Engineering, Rubber, Textiles, Drugs &Pharmaceuticals products among others, andthree countries (Taiwan, Thailand and CzechRepublic) have been incorporated under theMarket Linked Focus Product Scheme.

Banking Sector

Banks as financial intermediaries collectdeposits from savers and on-lend these toinvestors and others. The deposits of banks formthe basis of their lending operations. Aggregatedeposits of the banking sector increased froman average of Rs. 48,019.8 billion in 2010-11 toRs. 64,362.3 billion during Q3 of 2012-13.Year-on-year growth of aggregate deposits,however, moderated from an average of 17.9per cent in Q1 of 2011-12 to 12.87 in Q3 of2012-13.

Money supply (M3) growth was around14.0 per cent during Q1 of 2012-13 butdecelerated thereafter to 11.2 per cent by end-December as time deposit growth slowed down.There was some pick up in deposit mobilizationin Q4, taking deposit growth to 14.3 per centby end-March. Consequently, M3 growthreached 13.3 per cent by end-March 2013,slightly above the revised indicative trajectoryof 13.0 per cent.

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National income accounting is a branchof macroeconomics of which estimation ofnational income and related aggregates is a part.

Some definitions used in national incomeconcept:

a) What is Economic territory?Economic territory is the geographical

territory administered by a government withinwhich persons, goods and capital circulatefreely.

Those parts of the political frontiers of acountry where the government of India, doesnot enjoy the above “freedom” are not to beincluded in economic territory of that country.One example is embassies. Government ofIndia does not enjoy the above freedom in theforeign embassies located within India. So,these are not treated as a part of economicterritory of India. They are treated as part ofthe economic territories of their respectivecountries.

For example the U.S. embassy in India isa part of economic territory of the U.S.A.Similarly, the Indian embassy in Washington isa part of economic territory of India.

Based on ‘freedom’ criterion, the scope ofeconomic territory is defined to cover:

• Political frontiers including territorialwaters and air space.

• Embassies, consulates, military bases, etclocated abroad, but excluding thoselocated within the political frontiers.

• Ships, aircrafts etc, operated bythe residents between two or morecountries.

• Fishing vessels, oil and natural gas rigs,etc operated by the residents in theinternational waters or other areas overwhich the country enjoys the exclusiverights or jurisdiction.


NATIONAL INCOME

CONCEPT AND

ACCOUNTING

b) What is the difference between citizenand resident?Citizenship is basically a legal concept

based on the place of birth of the person orsome legal provisions allowing a person tobecome a citizen. On the other handresidentship is basically an economic conceptbased on the basic economic activities performedby a person.

A resident, whether a person or aninstitution, is one whose centre of economicinterest lies in the economic territory of thecountry in which he lives. That is NRI are thecitizens of India but their economic interest liesin other countries ( a engineer working in USthus its economic interest in US) thus NRI areknown as Non Resident Indian.

c) What is the difference between Nationaland Domestic Product?National income and related aggregates

are basically measures of production activity.There are two categories of national incomeaggregates: domestic and national, or domesticproduct and national product.

Production activity of the production unitslocated within the economic territory isdomestic product irrespective of whethercarried out by the residents or non-residentsi.e. irrespective of whether performed by citizenof India or not.

National product includes productionactivities of residents irrespective of whetherperformed within the economic territory oroutside it (such as workers working in Gulfcountries).

National product is derived in the followingway:

National product = Domestic product +residents contribution to production outside theeconomic Territory - non-residents contributionto production inside the economic territory.


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In practical estimates the resident’scontribution outside the economic territory iscalled “factor income received from abroad”.The non-residents’ contribution inside theeconomic territory is called “factor income paidto residents”.

Therefore, National product = Domesticproduct + Factor income received from abroad- Factor income paid to abroad.

d) What is the difference between Grossand Net?Gross means total value of products

received from the buyer i.e. if I bought a laptopand pay 1000 rupees then it is gross and net iswhat is received by company after deductingthe depreciation cost, excise duty, taxes etc i.e.finally company may receive 600 rupees afterdeducting all this. Then it is known as Net.

e) What is the difference between marketprice and Factor cost?If, I buy a bike of 50000 rupees this is the

Gross amount (as discussed above) and whentaxes and depreciation are deducted it becomesNet.

Some companies even get subsidies fortheir products.

Thus Market price is 50000 rupees andFactor cost is market price – indirect taxes +Subsidies.

This is what is actually available toproduction units for distribution of incomeamong the owners of production house.

Thus National income is defines as the NetNational Product at Factor Cost.

Methods for estimation of National Income

The flow of production, income andexpenditure never stops. It is a circular flowwithout a beginning or an end. Productiongenerates income; income generates demand forgoods and services. And demand leads toexpenditure on the goods and servicesproduced, so that, the circle of production,income and expenditure always continues.Production aspects point to the flow of goodsand services in the economy or the process ofvalue adding. Income or distribution aspectspoints to the generation of income in terms ofthe wages, interest, rent and profit and,

expenditure or disposition aspect indicatesdisposal of income in terms of consumptionexpenditure or investment expenditure.

National income of a country is measured atthree different levels:

1. Output or Production Method: Thismethod is also called the value-addedmethod. This method approaches nationalincome from the output side. Under thismethod, the economy is divided intodifferent sectors such as agriculture,fishing, mining, construction,manufacturing, trade and commerce,transport, communication and otherservices. Then, the gross product is foundout by adding up the net values of all theproduction that has taken place in thesesectors during a given year.In order to arrive at the net value ofproduction of a given industry,intermediate goods purchased by theproducers of this industry are deductedfrom the gross value of production of thatindustry. The aggregate or net values ofproduction of all the industry and sectorsof the economy plus the net factor incomefrom abroad will give us the GNP. If wededuct depreciation from the GNP we getNNP at market price. NNP at market price– indirect taxes + subsidies will give usNNP at factor cost or National Income.The output method can be used where acensus of production for the year iscalculated. The advantage of this methodis that it reveals the contributions andrelative importance and of the differentsectors of the economy.

2. Income Method: This method approachesnational income from the distribution side.According to this method, nationalincome is obtained by summing up of theincomes of all individuals in the country.Thus, national income is calculated byadding up the rent of land, wages andsalaries of employees, interest on capital,profits of entrepreneurs and income of self-employed people.This method of estimating national incomehas the great advantage of indicating thedistribution of national income amongdifferent income groups such as landlords,capitalists, workers, etc.


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•••

3. Expenditure Method: This method arrivesat the national income by adding up allthe expenditure made on goods andservices during a year. Thus, the nationalincome is found by adding up thefollowing types of expenditure byhouseholds, private business enterprisesand the government: -

a) Expenditure on consumer goods andservices by individuals and householdsdenoted by C. This is called personalconsumption expenditure denoted by C.

b) Expenditure by private businessenterprises on capital goods and onmaking additions to inventories or stocksin a year. This is called gross domesticprivate investment denoted by I.

c) Government’s expenditure on goods andservices i.e. government purchases denotedby G.

d) Expenditure made by foreigners on goodsand services of the national economy overand above what this economy spends onthe output of the foreign countries i.e.exports – imports denoted by (X – M).Thus, GDP = C + I + G + (X – M).

Limitations of National Income Estimation inIndia

There are limitations in the estimation ofNational Income in India. These are:

a) The output of the non-monetized sector istotally excluded. A difficulty arises in

finding out the imputed value of theproduce of the non-monetized sector.

b) Non-availability of data about the incomeof small producers or householdenterprises.

c) Lack of differentiation in economicfunctions.

d) Absence of data on income distribution.e) The illegal income remains unreported.

Brief history of National income concept

In 1876, DadaBhai Naoroji was the firstperson to prepare estimates of national incomeand per capita income for the year 1867-68.DadaBhai Naoroji estimated national incomeat Rs 340 crore and per capita income of Rs 20.Professor V.K.R.V. Rao estimated NationalIncome for the year 1931-32 at Rs 1689 croreand per capita income at Rs 62. Ministry ofCommerce (Govt. of India) estimated nationalincome at Rs 6234 crore and per capita incomeat Rs 198 for the year 1945-46. PresentlyCentral Statistical Organization measures thenational income of the country.

According to UN “an under developedcountry is one in which per capita real incomeis low when compared to that of US, Canada,Australia and western Europe.

But a comprehensive measure ofdevelopment must take into account thepotential of an economy to use its human,natural and capital resources to raise the levelof living of its population.


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PLANNINGCHRONICLEIAS ACADEMYA CIVIL SERVICES CHRONICLE INITIATIVE

Overview of Indian planning

When India became independent in 1947,it was gripped by mass poverty, literacy,unemployment, low industrial development,etc. After the independence the leaders ofindependent India had to decide on the typeof economic system most suitable for our nationbased on the principles guided by the DirectivePrinciples i.e. a system which would promotethe welfare of all rather than a few.

The Directive Principles of the Constitutionlays down that: the State will direct its policytowards securing that a) all citizens, men andwomen equally have a right to an adequate meansof livelihood; b) the ownership and control of theresources of community are so distributed as bestto achieve common good; c) economic developmentshould not lead to concentration of wealth.

There were mainly two types of economicsystems: Capitalist and Socialist and amongthem, socialism has been chosen by JawaharlalNehru however not in toto. Nehru, and manyother leaders and thinkers of the newlyindependent India, sought an alternative to theextreme versions of capitalism and socialismi.e. a mixed economy where private and publicentities will collaborate together to achieve asuitable economic development. Thus Indiangovernment after being formally declaredrepublic in January 1950, embarked on astrategy of five year plans which spells somegeneral goals as well as specific objectives whichare to be achieved within a specified period oftime. (Planning means a systematic utilizationof the available resources at a progressive rateso as to secure an increase in output, nationaldividend, employment and social welfare ofpeople).

Economic planning refers to any directingor planning of economic activity by the state,in an attempt to achieve specific economic orsocial outcomes. Planning is an economicmechanism for resource allocation anddecision–making in contrast with the market

mechanism. Most economies are mixedeconomies, incorporating elements of marketmechanisms and planning for distributinginputs and outputs and India is one of them.

India adopted planning in the 1950s as avehicle of its development. Planning derives itsobjectives and social promises from the DirectivePrinciples of State Policy enshrined in theConstitution. The country has completed tenFive Year Plans and is currently engaged inimplementing the Eleventh Plan.

Each Plan registers gains–and someinadequacies. The succeeding Plan should takefull cognizance of all these changes, no lessthan their implications. The broad goals andobjectives of the State Plan are generally inconformity with the National Plan although thestrategies, thrust areas and programmes mayvary.

Issues in Development

The immediate goal for achievement wasto increase living standard, decrease in poverty,increase in agricultural and industrialproduction, employment, savings and capitalformation and improvements in infrastructure.Apart from the overall development, achievingsome social objectives was also given primeimportance as India followed Soviet model ofsocialist form of production. Among socialobjectives reducing income inequalities andreaching benefits of development to deprivedsections of population were considered of primeimportance.

Achievement of the fore mentioned goal wasnot an easy task as the state of infrastructurewas awry, low availability of capitals, unskilledand ill equipped labour force and lowproductivities in most of the sectors. Along withthese problems the other factors that hindereddevelopment were reaching of the benefits ofthe developments to the lowest strata of society,translating investment into production.Similarly, translation of the savings into


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productive investments, increasing savings tofinance capitals, financing of current andcapital consumption were some other problemsthat were encountered in the process ofdevelopment. The inadequate financialinfrastructure and absence of well developedfinancial market entailed the problem of suchfruitful conversion of whatever little savingswere available for finance.

Other structural backwardness relate tomajor obstacle to development of the economy.These structural backwardness pertainedmainly due to acute deficiency of capital, lowrate of capital accumulation due to low capacityto save and inadequacies in converting thedomestic savings into productive investmentdue to lack of infrastructure. Also, agriculturesector was marked with underemployedlabourers, reducing productivities anddiminishing returns due to fragmentation ofholdings.

Another problem faced by the formulatorswas the limited choices available in the form oftrade off between present and futureconsumption. Policy formulators faced with theproblem of financing current consumption atthe cost of foregoing capital formation withsmall availability of limited finance andbudgetary provisions to increase expenditure.The other major policy dilemma was bringingthe social justice by reducing the inequalities inincome, on the other hand allowing someinequalities to foster to create new class ofentrepreneurs in the society.

Technical Approach for Planning in India

The techniques that are applied in economicplanning can be broadly classified under overallregulation of economic activities through fiscaland monetary measures and the other isthrough sectoral policies to regulate theeconomic activities. The sectoral policies werebased on the objectives to have a balancedregional growth. The Indian planners followedexpansionist fiscal and monetary measures aswould have done by any of the developingcountries to increase the income and spending.

Demand and supply management becamea major concern with the growing economy asthe structure became more complicated. Lateron persistent inflationary pressures build uplimited the scope of monetary policies. Initially

it was assumed that in process this could getcorrected with the passage of time by itself givenunlimited supply of foreign exchange that canbe utilized to finance imports. The importswould also help in augmenting the domesticsupplies that would help in controlling demand.

Initially the fiscal policies that was soughtto be expansionist was sought through deficitfinancing, which later on could get controlledby controlling and curtailing governmentexpenditures. But later on large governmentdeficit became a major problem as most of therevenues from the taxes were utilized in deficitfinancing. It left little scope for social sectordevelopment finance.

Among different sectors agricultural outputand development were sought to be augmentedby developing suitable developmentalprogrammes and providing assistance to thefarmers to help bridge the credit gap.Subsequently, government also resorted toproviding subsidy to provide agriculturalassistance for inputs. Also industries likechemicals and fertilizers were also subsidizedfor many years and are still being done so todevelop agricultural. However in subsidizationof the industries and the sectors it became amajor hurdle in germinating inefficiencies anduncompetitiveness of these industries thatbecame a burden rather than of any help.

In absence of free market the pricemechanism fell into sole and whole purview ofthe government. Various price policies wereformulated that helped regulate the supply anddemand in different sectors. Thus industries andagriculture were subjected to various pricecontrol mechanism. Industrial pricing wereintroduced. In the sixties agricultural pricecommission was also established to control theagricultural prices of important food grains andcommodities. Apart from the price controlmechanism these sectors were also subjected tovarious qualitative and quantitative controls.

In agricultural sector pricing publicdistribution system and procurement policiesplayed an important role. Buildinginfrastructure like public distribution systemwould help the government in directlyinfluencing the market price. This would helpgovernment in controlling the agricultural pricesand checking inflationary pressures due toincreases in food prices. In case of inflationary


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pressures the government through increasingits market intervention can augment the marketsupply of commodities.

PLANNING HISTORY

The planning history can be discussed as aconstituent of two phases. First phaseconstituting of sustained growth phase for theyears from 1950–51 to 1964–65. Second phaseconstituting since 1964–65 till date has beentermed as slowing down phase. The growthphase constituted for the first three plans i.e.1st, 2nd, 3rd plan periods, country’s output orproduction, per–capita income, infrastructuraldevelopments in terms of establishinginstitutions and industrial as well as financialinfrastructure, all grew at phenomenal ratehowever rate was slower than projected in plan.However the growth rates trailed behind asper the projections in the plan documents. Indiscussing the plan history it is most importantto discuss the second plan as it marks theturning point for Indian economy as the growthtrajectory was based on the basis ofMahalanobis formulation.

The economic growth was expected to takeplace through modern industrialization, thusexpected to be replica of industrialization inadvanced countries. But in the Mahalanobisstrategy stress were placed on importsubstitution by developing the countriescapabilities in producing capital goods. It wason this line that during the second plan therewere substantial public sector investment ininfrastructure and industries that producedintermediate goods like steel, coal, power andheavy electrical machinery. The cottage andsmall scale industries expanded only to theextent that it provided large scale employmentto labour. Thus the phase recorded 8 to 10 percent growth in industrial output, 3–3.5 per centgrowth in agricultural output and 1.75%growth in per capita income.

During First Plan Year that is in 1951-56was a reflection of basically reconstructing thetattered economy and establishing infrastructureand institution to enable the country run on itsown. Initially the planners formulated policiesbased on supply side of the economy ignoringany deficiencies in aggregate demand. Also thepublic investment in the areas in sectors thathad large gestation lag, public utilities and

sectors that required heavy investment weretaken to be of prime importance. Thus in theinitial plan document investment in publicsector unit that were of importance to thecountry’s defence like arms and ammunitions,artilleries, infrastructure like power, roadtransport and railways were undertaken. Alsodeveloping heavy industries like electricalindustries, iron and steel, aluminium, etc. wereundertaken. Apart from this public investmentin agriculture sector were also undertaken toincrease the production as well as theproductivities.

Second plan for the growth of economy wasgiven the prime importance. During this planinvestments were increased to promoteindustrial development thus takingindustrialization as the impetus for growth.Industrialization based on Mahalanobis modelwas unveiled. Import substitution and enlargedpublic sector investment with focus onestablishing PSUs in the areas that requiredhuge investment were given importance.

Third Plan and Fourth Plan were resultantsof repercussion of first and second plans whenthe formulators realized that industrializationalone without giving adequate attention to othersector growth resulted in failure of 1st & 2ndPlan. Thus the need to develop agriculturesector and infrastructure was paid attention toin these plans. It was during these years thatGreen Revolution was undertaken to boostagricultural production with the help ofincrease in yield. Thus, taking the country backto growth strategies with overall developmenttaking place in almost all the sectors of theeconomy. It was during this time period thatthe government formulated suitable agriculturalprice policy and came up with publicdistribution system concept. These two policieshelped the government in getting the controlof the market where it enabled the governmenton playing a more proactive role in dealingwith situations of price rise and food security.Also it helped the government in addressingthe issues of poverty where it tried to providethe people living below poverty with food grainsthrough rationing.

During Fifth and Sixth five year plan a shiftin strategies were warranted as the populationgrowth rate became very high making all theplan formulation fail. Thus these two plans


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were based on assessment of the economicsituation. Though during these two plans theprime concern remained increasing GDPgrowth rate with focus on overall developmentalong with increasing the per capita income.In the back drop the population control becamemajor concern of the formulators. With growthin population above the natural rate some otherissues became pertinent like issues of growingunemployment, decrease in productivities,inefficient use of capital, issues of growingdemand for food and other items, increasingurbanization leading to migration, increasinglandless laborers, decrease in agriculturalproductivities even after experiencing initialspurt of green revolution due to lack ofinfrastructure and inputs, building up ofinflationary pressures and illiteracy. Thesefactors were supposed to form the basis ofseventh plan.

Increasing population and growingdemands led to increasing need to improve theagricultural production not only to make theeconomy self reliant but also to meet the otherimpending factors arising out of it likeenhanced need to achieve a food securitysystem. Though improving the existing pds andprocurement system played an important role,however increasing agricultural productivitiesby expanding green revolution to other cropslike rice and other cereals did form the originalbasis to achieve the goal. Apart from thisimproving agricultural infrastructure increasingirrigation and extension of credit assistance,these issues were also addressed.

Besides agriculture sectors manufacturingand other secondary sector industrial problemswere also scrutinized and addressed. Basicissues that were identified were lowproductivities in secondary sector, low capacityutilization of existing capital resources andincompetetiveness in terms of cost and scale ofoperations of some of the public sector unitscame up. Some other factors that contributedto these inefficiencies in running were excessiveprotection provided to these organizations. Thusthe seventh plan was targeted to address theseissues. There was shift in focus of planning forindustry away from getting in any newinvestment to existing optimum capacityutilization and productivity enhancement.

In the external sector appropriate exportpolicies were also postulated to improve the

countries balance of payment position.Shrinking external assistance was also one ofthe factors that compelled the policy makers tolook for export sectors as an alternative. Thusthe seventh plan postulates the integration ofexport policy with all policies and programmesthat affected productivity and costs.

Growing unemployment, lack of skilledlaborers, increasing illiteracy, increasingmigration of rural laborers to the urban areasas effect of urbanization led to developing newpolicies to increase employment and education.Thus the policies focused on universalisationof education, increasing educationalinfrastructure and skill formation. Also issuesrelated to unemployment were addressed.Apart from stress on cottage and small scale,other government programmes that assisted inaddressing the unemployment isssues in ruraland urban areas were also undertaken. Thusmany of the government programmes likeintegrated development programmes, trysemetc were launched that had inbuilt andintegrated component directed to increaseemployment. Some of the poverty alleviationprogrammes were also launched to address theissue of increasing poverty like Minimum NeedsProgrammes.

Eighth Plan and Liberalization in India

During seventh and eighth plan manyfactors emerged for non performance of theeconomy on the whole with industrial sectorregistering almost negligible growth and theGDP growth rates hovering around 3.5 percent. Thus addressing these major issues weregiven prime importance in Eighth plan. Thecollapse of Rupee Trade area and failure of theeconomic off take to targeted growth path ledto a series of reforms in many sectors. TheEighth plan is also popularly known as‘Liberalization’ of the economy. Theliberalization policies were unveiled by thenFinance Minister Dr Manmohan Singh in theyear 1991–92. This was accompanied withsubstantial opening of the economy.

The frame work for the eighth planencompassed four important macroeconomicaspect related to liberalization. These were thepolicy regime governing the trade, technologyand trans-border capital flows; industrialderegulation and administered price policy;financial sector reforms; and effective monetary


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and fiscal policies enactment to regulateaggregate demand in the economy. Thesepolicies are discussed briefly in the followingsections.

• Trade, technology and capital flows

Series of trade reforms were carried thatincluded lowering of customs duties on importand exports, reducing the negative list items,lowering of tariff rates applicable and enactingliberal trade policies. In liberal trade policiesincentives were announced to promote exportsand imports and capital inflows in EXIMpolicies. There were substantial reductions inthe import duties from 300 to 150, reducingtariffs on export to 110 per cent. Also partialconvertibility of rupees was introduced in orderto increase the incentives for exporters. Underthe system exporters or the foreign exchangeearned through the remitters could getconverted to rupees with 40 per cent at theofficial exchange rate and 60 per cent of it atmarket determined prices.

In order to integrate the economy withexternal world a series of capital flows policieswere also unveiled to increase the foreign directflow in the economy. The regulation that wasliberalized for FDI included technology transferthrough automatic route. The technologycollaboration and equity participation underautomatic route were also allowed up to 51per cent in almost 31 areas.

• Deregulation and Price Policies

Opening of the economy to external sectorformed one of the parts of liberalization; alongwith it privatization of industrial sector formedanother significant part. This was done mainlyby reducing the bureaucratic interference inindustrial operation by liberalizing entry andexit of the private firms, delicensing of many ofthe industrial units, reducing government stakein industrial sick units either through selling itsstake to other private players or closing downof the non performing units. However,disinvestments in large public sector units werestrongly opposed and were carried outcautiously in phased manner.

Policies on small sector units that were non–performing were to assist in technologicalupgradation and modernization. These unitswere not shut as these were labour intensiveand provided employment to millions.

Price policy reforms were also introducedto allow the private players to play dominantrole. Many of the products that were tradableand the sector in which competition due topresence of private players was subjected tomarket determined prices. Whereas for the unitsthat were non- tradable goods and services thegovernment followed long run marginal costpricing of the production.

• Financial Sector Reform

Another integral component of theliberalization policies were financial sectorreforms. Under credit lending and interestpolicies were reformed. Increasing role of thedevelopment financial institutions can bewitnessed in this period and was dulyrecognized by the government. Under thisregime the lending rates could not be fixed bythese DFIs. Also the interest rates charged couldnot be fixed on the basis of the marketconditions by these DFIs.

The banking sector was also subjected toseries of reforms. The interest rate structure forthe commercial banks was fixed upward.Lending credit limits were raised. Besides givingthe banks flexibility to charge credit and lendingrates, partial deregulation of term deposit ratesof the commercial banks were also carried.

Many other reform policies that suited thenew capital market structure where the privatesector companies could also raise funds fromthe market through equity participation werealso introduced. Apart from regulations thatcontrolled foreign exchange operations of themarket were also liberalized. India also adoptedfloating system of exchange rate during thistime. Many new forms of financial institutionslike merchant banking, mutual funds, leasingcompanies, venture capital companies andfactoring companies also came up. Howeverregulatory framework for many of theseinstitutions was developed later.

Credit policies related to lending were basedon prioritization. Thus the sectors that were inthe priorities for development by thegovernment were given easier access to credit.This helped in developing not only the laggingsectors but also the lagging regions. Extensionof banking system and culture throughextension services and regional rural banks to


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remote places of India were also carried. Earlierthe post offices were the only form that helpedin reaching the rural India. Thus it helped notonly in mass mobilization of capital from ruralsavings; at the same time it also helped theagricultural sector to avail the facilities ofpriority lending.

The reforms were also marked by substantialdilution of government stake ownership in thebanks and credit lending agencies. Thishappened mainly on account to the redefiningof capital adequacy norms for the banks. Thecommercial banks that operated internationallyhad to subsume to a capital adequacy ratio of8 per cent by March 1994 whereas domesticbank had to accede to a ratio of 4 per cent byMarch 1993. In case of the banks failing theseratio norms had to tap the capital market forraising funds in the form of loan and equityparticipation. This led to decrease of governmentownership stake in many of the commercialbanks.

• Monetary and Fiscal Policies

Monetary and fiscal policies were targetedto regulate and manage the aggregate demandin balance with the increasing aggregate supplyso that it would curtail building up of anyinflationary pressures. Prior to eighth plan thefiscal deficit had grown disastrously at 11 percent of the GDP. The eighth plan tried toachieve a 7 per cent deficit. This was donemainly by increasing the revenue base byreforming the tax structure prevalent in theeconomy. Also prudent governmentexpenditure management by pruning the excessexpenditure was sought. The governmentexpenditure had increased from 19 per cent ofGDP in seventies to 31 per cent of GDP in 1990-91. This was done by decreasing the non planexpenditure of the states, controllingconsumption expenditure and reducingsubsidization.

The consumption expenditure of thegovernment rose on account of two variablesdefence expenditure and increasedadministrative cost. Government tried to reduceboth these cost by reforming the bureaucraticstructures and deregulating the large publicsector units.

The subsidy element had increased theexpenditure of the government by 4 per cent in

the year 1990–91. This accounted mainly forthe fertilizer subsidy, food subsidy and interestrate subsidy. Also other subsidizationprogramme like rural subsidy for electrificationand others also accounted. Thus governmentpruned its expenditure by revising its policiesand withdrawing subsidy given to many ofthese units. Subsidy on account of Publicdistribution system also formed a major chunkthus government reduced its PDS operation andalso by reforming the procurement and pricepolicies followed by the government.

The government also tried to increase itsrevenue resources by substantially improvingthe tax structure. In it, apart from broadeningthe tax base the direct tax structure like incometax, corporate tax structures were also modified.Besides improving internal tax, external tariffstructures were improved by reducing theexternal tariff to 110 per cent to increaseexports. Lowering of custom duties and othernon tariff barriers helped in expanding theforeign trade that helped generate revenue inreturn. Indirect taxes like sales and excise taxeswere also subjected to reform regulations.MODVAT and value added taxes wereintroduced to reduce the tax distortions in theeconomy. The Chelliah Committeerecommendations for taxes and OfficialCommittee of the government were the twomain instrumental forces in introducing the taxreforms in the country. It was on theirsuggestion that government reformed thesystem that helped in increasing the revenuefrom tax.

Ninth Five Year Plan India ran through theperiod from 1997 to 2002 with the main aim ofattaining objectives like speedyindustrialization, human development, full-scaleemployment, poverty reduction, and self-reliance on domestic resources.

The main feature of the Ninth Five YearPlan India is that at its onset our nation crossedthe fifty years of independence and this calledfor a whole new set of development measures.There was a fresh need felt for increasing thesocial and economic developmental measures.The government felt that the full economicpotentiality of the country, yet to be explored,should be utilized for an overall growth in thenext five years. As a result in the Ninth FiveYear Plan India, the emphasis was on human


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development, increase in the growth rate andadoption of a full scale employment schemefor all. For such development one needs topromote the social sectors of the nation and togive utmost importance to the eradication ofpoverty.

The Ninth Five Year Plan of India looksthrough the past weaknesses in order to framethe new measures for the overall socio-economic development of the country.However, for a well-planned economy of anycountry, there should be a combinedparticipation of the governmental agenciesalong with the general population of thatnation. A combined effort of public, private,and all levels of government are essential forensuring the growth of India’s economy.

Objectives of Ninth Five Year Plan:

The main objectives of the Ninth Five Year Planwere:

• To prioritize agricultural sector andemphasize on the rural development.

• To generate adequate employmentopportunities and promote povertyreduction.

• To stabilize the prices in order to acceleratethe growth rate of the economy.

• To ensure food and nutritional security.

• To provide for the basic infrastructuralfacilities like education for all, safe drinkingwater, primary health care, transport,energy.

• To check the growing population increase.

• To encourage social issues like womenempowerment, conservation of certainbenefits for the Special Groups of thesociety.

• To create a liberal market for increase inprivate investments.

The Tenth Five Year Plan India (2002-2007)aims to transform the country into the fastestgrowing economy of the world and targetedan annual economic growth of 10%. This wasdecided after India registered a 7% GDP growthconsistently over the last decade.

This GDP growth of 7% is much higherthan the world’s average GDP growth rate.Thus, the Planning Commission of India sought

to stretch the limit and set targets which wouldpropel India to the super league of industriallydeveloped countries.

In a nutshell, the Tenth Five Year Plan

envisaged:

• More investor friendly flexible economicreforms.

• Creation of congenial investmentenvironment.

• Encourage private sector involvement

• Setting up state-of-the-art infrastructure.

• Capacity building in industry.

• Corporate transparency.

• Mobilizing and optimizing all financialresources.

• Implementation of friendly industrial policyinstruments.

Eleventh plan vision included overallimprovements of quality of life and welfare ofthe deprived section of the population. Thisincluded Scheduled Castes, Scheduled Tribes,other backward castes, minorities and women.Thus the eleventh plan termed suchdevelopmental growth as inclusive growth ofthe country. Also the plan visualised tointegrate the country with global economy,increasing employment opportunities at home,reducing poverty, spread of education and skilldevelopment. On numerical front a target of 9per cent GDP growth every year was targetedand 7.6 per cent annual growth rate of percapita income.

The focus in this plan shifted fromincreasing the income to improving thelivelihood conditions of the population. Untilnow the manufacturing sector growth andtertiary sector formed the core of planningstructure of the five year plan. However ineleventh plan though the manufacturing andtertiary sectors were given attention but thefocus shifted to improvement in social andhuman capital, including agriculturaldevelopment. The budgetary outlay onimproving educational infrastructure anduniversalisation of education increased frommeagre 8 per cent in tenth plan to almost 19per cent. Apart from this the agriculture,health and rural development expenditure alsotripled.


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Another prime importance given was oninfrastructure where the expenditure is likelyto go up to 9 per cent of GDP. The public sectorinvestments also focused on developing thesocial capital and addressing the equity issuesin society. Thus many of the governmentprogrammes that strengthened these objectiveswere given priorities. Also the existingprogrammes were redefined and many newprogrammes launched to meet the goal.

Schemes under national rural employmentguarantee act (NAREGA) that mainly helpedcreation of rural employment and rural assetswas extended to 330 districts more. Agriculturaldevelopment under the governmentprogrammes like Accelerated Irrigation Benefits,Bharat Nirman, Rashtriya Krishi Vikas Yojnaand National Rainfed Area Authority wereextended. National food security mission toaddress the food crisis in India and especiallyamong rural poor was launched. Governmentalso launched national rural health missionscheme to improve the country’s healthexpenditure.

The economic development for the eleventhplan was based on series of model of theeconomy. A broad framework whichrepresented an indicative planning wasprepared. Under this different growth targetsfor different sectors were fixed to achieve overall9 per cent annual growth rate for the GDP.There was an increase in investment and savingtarget though the increased planned forachievement was modest with ICOR remainingmore or less the same. However in quantitativeterms even the same amount of ICOR (capitaloutput ratio) amounted to a substantialamount. Agricultural growth target was fixedat 4 per cent, industry at 10-11 per cent andservices at 9-11 per cent.

Among the industrial growth core sectorgrowth formed the basis of the industrialgrowth model. This was likely to be achievedwith an increase in overall investment to 37-38per cent on average throughout the plan period.The major structural change in the investmentpattern was decrease in share of the publicinvestment in total investment. The privatesector investment now accounts for almost 77per cent in total investment in the economy.Competitive environment was sought to beincreased by policy enactment such that the

market mechanism to would play dominantrole in reaching equilibrium, also thegovernment role was reduced to minimum.This was furthered by reducing quantitativeand qualitative restrictions both for internalprivate investors and external investors to boosteconomic growth. Infrastructural developmenthowever was left for the public sectorinvestment as government increased itsinvestment in agriculture, irrigation and watermanagement. Thus public sector investmentwas targeted to increase from 4.1 per cent in2006–07 to 6.8 per cent in 2011–12.

The increased investment is projected to bemost likely to be funded by increasingequivalent increase in savings. Further stress isput on the increase in domestic savings.Whereas the main factors identified forincreasing the domestic savings was householdsavings and corporate savings, the public sectorsavings played lesser role in it. Though duringthe seventh plan the public sector savingsimproved as compared to previous plan onaccount of the impact of the Fifth PayCommission’s recommendations worked itselfout in the system, the implementation of theFiscal Responsibility and Budget Management(FRBM) Act, and the fiscal and revenue deficittargets for 2008–09 established thereby helpedintroduce an element of discipline, and thebuoyancy in tax revenues arising out of thehigh growth rate recorded in the Tenth Plancombined with improvements in taxadministration contributed to improved savings.

Apart from internal savings and investmentidentity policies to balance of payment fromexternal account were also unveiled. In theglobalised market where the financial systemwas complicated the role of external factorsare important. Thus a series of policies wereannounced to help the economy not onlyintegrate with globalized market but also availthe opportunities from it. The merchandisetrade was further liberalized by reducing thequantitative and qualitative restrictions. Alsomany new export promoting incentives wereannounced. To increase both foreign directinvestment that were long term andinstitutional investment that are short term thegovernment reformed its financial and capitalmarkets. For example apart from allowing 51percent FDI in most of the sectors appropriatespecial economic zone policies conducive for


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direct investment were also enacted during thisplan. Direct investment in many of the sectorsnow flow through automatic route.

APPROACH PAPER TO THETWELFTH PLAN (2012-2017)

Indian planning has travelled a longdistance since its inception in March 1950. Theplanning has been a mixed experience. On theone hand India has overcome the bottlenecksexisting in the form of low saving, lowinvestment, food scarcity, etc. On the other stillIndian economy ‘tryst with destiny’ is far fromtrue realization as socio-economic and humandevelopment indicators has been the biggestobstacle for the realization of an egalitariansociety.

So far eleven plans have been formulatedand implemented. The approach paper to the12th Plan has been approved by the Cabinet inSeptember. It would be prudent to analyse theperformance of the Eleventh Plan as given bythe Mid-Term Appraisal of the 11th Plan inbrief and then the issues that has been identifiedby the 12th Plan that need to be overcome.

Eleventh Plan Performance

GDP growth for the 11th Plan is likely tobe 8.2%, which is less than the target of 9%,but is a remarkable achievement given the worstdrought in 30 years and the global recession.There has also been progress on various aspectsof inclusiveness, though the progress has beenless than what was targeted. Agriculturalgrowth has improved from 2% in the TenthPlan to 3%, but this is below the 4% target.There has also been progress in povertyreduction and in the areas of health, educationand in upliftment of SC/STs. However, trendsreveal that we are likely to miss the MillenniumDevelopment Goals (MDGs) in several of thetargets, especially those relating to health.

Inflation has accelerated in the past twoyears and is now an area of concern. The globalenvironment is also highly uncertain, both interms of the strength of recovery in thedeveloped countries and also the volatility incommodity prices, especially oil. Internationalfinancial markets are yet to stabilize, and theextraordinary easing of global money supplyhas yet to play itself out.

Planning Commission has undertakenextensive consultations with a wide range oforganizations and individuals, which revealsthat citizen groups support the broad objectivesof existing government programmes, but theyhave little faith in the design of theseprogrammes and the manner of execution.There is a perception that governmentprogrammes, especially Centrally SponsoredSchemes, are not sensitive enough to localneeds. Also, Government works in silos withlittle effort to achieve convergence and co-ordination across Ministries and betweenCentre and States, even though most problemsrequire inter-Governmental and inter-Ministerial co-ordination.

Twelfth Plan Objectives

The basic objective for the Twelfth Plan mustbe faster, more inclusive and sustainablegrowth.

A key issue is what the Growth targetshould be. The target of 10% is being mentioned,but assessment of the 11th Plan and uncertainglobal environment indicates that even 9% willbe difficult to achieve. In the short to mediumrun, the main constraints relate to insufficientagricultural growth leading to inflation,growing skill shortages, and the unsettled globaleconomy. In the longer run, the environmentand natural resources, particularly energy andwater, pose serious challenges. Therefore 12THPlan has proposed a target range of GDPgrowth of 9 to 9.5%.

An inclusive growth strategy is essential toaddress some of the main growth constraintsoutlined above, and to make the target growthrate feasible. The following are the keyinstruments for making growth more inclusive:

• Better performance in agriculture (at least4% growth).

• Faster creation of jobs in manufacturingthrough spreading industrial growth morewidely.

• Both agricultural and manufacturinggrowth will depend upon the creation ofappropriate infrastructural facilities in awidely dispersed manner. Ruralconnectivity is particularly important in thisregard, especially in the backward areasand the north-east.


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• There must be a much stronger effort athealth, education and skill development

• Reforming the implementation of flagshipprogrammes to increase their effectivenessin achieving the objective of greaterinclusion.

• Special challenges focused by vulnerablegroups and backward regions. The needfor a special focus on backward regions hasparticularly become urgent.

Agriculture and Rural Development

Moving forward on the estimatedagriculture growth of 3-3.2% in the 11th Plan,12th Plan has aimed a target of 4% agriculturalgrowth. It is further estimated that cereals willgrow only at 1.5 to 2.0%. However, other food(horticulture, dairying, fisheries etc.) need togrow at more than 5%. This calls for a changein agricultural strategy as these are allperishable products, and therefore subject tomuch higher degree of market risk than food-grains, oil seeds or natural fibres. In the case ofthese products, which are all relatively highvalue, investments and institutionaldevelopment are more important than subsidiesor price support systems.

In order to achieve the agriculture growthof 4% 12th Plan has emphasized on raisingland productivity and water use efficiency.State specific strategies are emphasised. Dryareas need to focus on livestock. Mostimportantly, markets must be reformed. Animportant beginning has been made by grantingstatutory status to warehouse receipts.However, the real benefits from this measurecan accrue only when the appropriatewarehouse infrastructure and supportingbackward linkages have been created and anationwide trading platform has been put inplace. Consideration should be given toextending infrastructure status to a wider rangeof agricultural market facilities in the samemanner as for warehouses. States must modifythe Essential Commodities Act (ECA) and theAPMC Act (perhaps exclude horticulture andperishables entirely from the ambit of APMC),rebuild the extension system, increase theinvolvement of private sector in marketing, andalso facilitate leasing in/out of land by farmers.State agricultural universities and extensionnetworks are in a bad shape and needstrengthening.

MGNREGS has helped generateemployment and income in rural areas but itcan do much more to increase land productivity,particularly in rainfed areas. This calls forredesign of the programme in the Twelfth Plan.In addition, MGNREGA has transformed rurallabour relations, which is bound to affect theproduction decisions of farmers, both in termsof crops as well as technologies. TheAgricultural support systems must facilitate thistransition, which requires greater flexibility andresponsiveness. Forest economies and tribalsocieties need greater protection and promotion.Steps need to be taken to make PESA and FRAmore effective. This can be in conjunction withschemes for increasing resources directed to thebackward regions.

Water

Water is emerging as a major problem, bothfor drinking as well as for irrigation. Urbanand industrial demand for water is going uprapidly, without commensurate augmentationof supply. To address this critical problem,need is to put an integrated strategy in placeimmediately. The elements of this strategycould be:

• Re-estimate India’s water balance basin-wise. All aquifers must be mapped overthe next five years and aquifer managementplans put in place.

• AIBP must be restructured to incentivizeirrigation reform and efficiency of wateruse. Setting up Water Regulatory Authorityshould be made a precondition for AIBPapprovals. Some States are already doingthis.

• Watershed management must be givenhigher priority, with convergence ofprogrammes and better technical support.

• Separation of electrical feeders foragriculture with high-quality assured, evenif rationed, power supply can potentiallyreduce ground water use.

• Water recycling in urban areas and byindustries should be enforced to protectwater levels and water quality in bothsurface and ground water sources.

• The legal and policy framework needs tobe improved. In this direction 12th Planhas considered promulgating a newGroundwater Law reflecting the principles


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of Public Trust Doctrine, and a new WaterFramework Law along the lines of the onethat exists in the European Union.

• A National Water Commission may be putin place to monitor compliance withconditionalities imposed in clearance ofimportant projects.

• Since water is primarily a State subject, wewill need to evolve a political consensusalong the lines of what was done in thecase of power. Perhaps a special NationalDevelopment Council meeting could beconvened for this purpose.

Industry

Manufacturing performance is weak.Growth of manufacturing in the 11thPlan islikely to be only 8%. We need to raise this to11-12% per year in the 12th Plan to create thejobs for our growing labour force. This hasbecome a particularly urgent need since it isnow clear that agriculture will no longer absorbmore workers, and may indeed release some ofthe existing work-force. As per the 12th Planestimation, the manufacturing sector will haveto create around 3 to 4 million jobs over andabove the pace of job creation in the recentpast.

To achieve the desired growth inmanufacturing 12th Plan emphasizes oneffectively harnessing the abundance ofabundance of entrepreneurial talent in thecountry. The corporate sector has largely beenunfettered, and has demonstrated itsdynamism. There are, however, limits to whichit can grow. A large part of the additionalgrowth will have to come from the MSMEsector, which continues to face a plethora ofhurdles in realizing its true potential. TheTwelfth Plan will need to focus on this.

For accelerating manufacturing growth,therefore, we need a strategy to:

• Achieve greater domestic value additionand technological depth in Indian industryto cater to growing domestic demand andto improve our trade position.

• Attract investment, including FDI, incritical areas where manufacturing capacityshould modernised and developed.

• Improve the business environment andreduce the cost of doing business. This is

largely an agenda item for stategovernments. (Procedural wrangles andcorruption affect small business the most.)

• Land and infrastructure constraints mustbe addressed effectively. Again, this islargely in the domain of the State, but theCentre can incentivise.

• Promoting “clusters” is a very effective wayof helping manufacturing and promotingMSMEs. State Governments should beincentivized to support clusters

Education

Education has received less funds in theEleventh Plan than was envisaged. This is partlybecause the sector made a slow start, but alsobecause of resource constraints. The TwelfthPlan has to correct this.

Eleventh Plan focused on quantity in schoolexpansion. In this regard significant success hasbeen recorded with enrolment rates going uprapidly, especially in primary education.However, scholastic achievement tests showthat learning achievements of the students arewell below desired levels. Twelfth Plan mustfocus on quality. This includes teacher trainingand evaluation, and also measures to enforceaccountability.

There is need to rapidly build capacity insecondary schools to absorb the graduates fromexpanded primary enrolments. States mustfacilitate PPP in secondary education. Statesare keen to do this, and Planning Commissionis collaborating with them on this. The drop-out rates between primary and secondaryeducation continue to be extremely high, whichraises questions regarding the perceptions ofthe utility of secondary education among thepeople. This will need to be changed throughintroducing higher skill content at the secondaryschools level. Vocational education will needto be given greater emphasis and made moreattractive.

The gross enrolment ratio (GER) in highereducation must be targeted to increase fromnearly 18% today to say 25% by 2016-17 andperhaps 30% by 2020. Private universities andcolleges have played a major role in increasingenrolment in higher education in recent years,but there are concerns regarding both equityand quality. Measures will need to be taken to


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further promote private initiatives in highereducation while addressing the concerns thathave arisen. Skill Development needs a majorfocus at all levels. To ensure that the skillsdeveloped also lead to employability, theemphasis in the Approach Paper is onpromoting PPP.

Health

The quality of health services needs to beimproved through NRHM. Besides, the need isto focus on preventive aspects of health care,particularly drinking water, sanitation,nutrition, better maternal and child services andimmunisation.

Shortage of qualified medical personnel atall levels is a major hurdle in improving theoutreach of the healthcare system, especiallythe public health facilities. This needs to becorrected expeditiously. Efforts are alreadyunderway to increase the out-turn of doctors.This will have to be accelerated, and similarefforts have to be put in place for nurses andmedical technicians. However, such efforts willtake time to have sufficient impact. In themeanwhile, systems will need to be put in placefor more effective PPP models in primary healthcare.

Role of PPP in secondary and tertiary healthcare must be explored with greater vigour.Planning Commission needs to evolveappropriate concession models to facilitate this.Planning Commission is in touch with states tostudy their experiments, and best practices willneed to be propagated in the country.

Expenditure on health by the Centre andStates needs to be increased from 1.3 percentof GDP at present to 2.0 percent (and perhapseven 2.5 percent) by the end of 12th Plan.

Energy

GDP growth of 9% requires commercialenergy growth of 7%. The likely achievementin 11th Plan is 5.5%. Unless adequate growthin commercial energy availability is ensured theGDP growth target cannot be achieved.

The following policy issues have to beaddressed.

• The need to create 100,000 MW of newpower capacity in the Twelfth Plan. Theability to do so is seriously undermined by

persisting large losses in the discoms,estimated at Rs.70, 000 crore per year. Theselosses are being sustained only becausebanks continue to lend to what areeffectively bankrupt discoms. StateGovernments have to be incentivised toimplement distribution reforms whichreduce ATC losses. Some states aresucceeding but in general the progress istoo slow. Better performing states shouldbe rewarded.

• Forest and environment clearanceprocedures are hindering both coalavailability and hydro-power development.State governments with coal and hydroresources have been complaining stronglyabout the costs being borne by them.

• The implementation of past policy initiativesis incomplete. Prices of electricity are notsufficiently flexible and regulators are beingrestrained from allowing periodic priceincreases. Open access is still not a reality,and needs to be incentivized.

• At present, petroleum, gas and coal pricesall three are out of line with world pricesand world energy prices are unlikely tosoften. Domestic prices need to be betteraligned to give the right signals to bothconsumers and investors. The need is toadopt a time-bound programme to achievethis alignment over three years.

• Coal production will be a major constraintpartly due to weak performance of CoalIndia and partly environmental constraints.Because coal production cannot beincreased sufficiently, we must plan nowfor coal imports to rise from 80 milliontonnes to 250 million tonnes by the end ofthe 12th Plan. This will requirecorresponding expansion of rail and portcapacity.

• Coal India must become a coal supplier andnot just a mining company. It should planto import coal and carry out price poolingand blending to meet the needs of the users.

• In the petroleum and natural gas sector,need is to further expansion of new NELPblocks and a clear policy for exploration ofshale gas, integrated development of oil andgas blocks. Bidding in various oilexploration rounds in the past has not


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attracted oil majors. Term of PSCs shouldperhaps be clear to attract investment. Thisis an area where foreign participation inexploration also brings in up-to-datetechnology.

• Nuclear power programme must continue,with necessary safety review. Active effortsneed to be made to allay the apprehensionsof people regarding the safety of nuclearpower plants.

• Solar mission is seriously underfunded andrequires more support. It is also not clearwhether the current bidding process issufficiently competitive and providesappropriate incentives for improvingefficiency. Wind power too requires greatersupport, especially for off-shore locationswhich have not been sufficiently explored.

• Demand side management of energy is asimportant as action on the supply side.Realistic pricing will help. However, wealso need more pro-active standard settingfor appliances, vehicles and buildings.

Transport

GDP growth at 9% or more will need to besupported by much faster expansion intransport infrastructure than we have seen inthe past. The requirements of energy efficiencyalso require a shift from road to rail in freight.

The following are some of the importantissues that arise:

• The Dedicated Freight Corridor project is amajor capacity enhancing investment forthe Railways. It must be put on a monitoringsystem such that both corridors arecompleted before the end of the TwelfthPlan. For this purpose, milestone must beclearly fixed, and responsibility assigned.

• The Railways have to undertake anambitious programme of modernisation andtechnical upgradation which increases theirfreight carrying capacity. Unless this is donethey will not be capable of facilitating theshift from road to rail transport which iscrucial for energy efficiency. This can onlybe achieved if (a) the Railways desist fromdiverting resources to gauge conversion anduneconomic passenger lines and (b)Railways financing is improved to be ableto support medium term expansion.

• Improved Railway financing requiresrationalisation of freight: passenger fares inthe Railways. If this is not done, theRailways will simply not achieve financialviability.

• The Railways must move speedily toimplement the PPP projects that arepending in diesel and electric locomotives.

• Rail and road linkages to ports must havetop priority.

• The NHAI programme needs to be put ona track where monitorable milestonestargets are set for the 12th Plan withmaximum emphasis on viable BOT projectsto reduce the demand for Governmentresources.

• The port expansion programme has beenseriously delayed. PPP in ports should beexploited. Much more needs to be done todeepen ports.

Plan Size and Resources

In this regard, as in the past, a WorkingGroup has been set up under the Chairmanshipof the Chief Economic Adviser. The size willdepend upon:

• the buoyancy in revenues

• the tolerable level of the fiscal deficit

• the extent to which we can control non-Plan expenditure including subsidies.

A tentative picture available at presentsuggests that the Centre’s GBS could increasefrom 4.9% of GDP in 2011-12 to 6.2% of GDPin 2016-17. Most of this increase will be in thelast two years of the Plan since in the first threeyears the fiscal deficit will have to becompressed from 4.6% in 2011-12 (the baseyear) to 4.1%, 3.5% and finally 3.0% in2014-15.

A key assumption affecting the resourceprojection is that non-Plan expenditure growthcan be contained below GDP growth. Theabsence of a Pay Commission in this periodwill help. However, critical to this projection isthe assumption that subsidies will grow by only5% per year. It may be difficult to contain foodsubsidy within that limit, depending on theoutcome of the Food Security Act. However,strong action will be needed in containingfertiliser subsidy and petroleum subsidies.


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Allocation Priorities in the 12th Plan

The increase in the GBS as a percentage ofGDP between 2011-12 and 2017-18 is thereforeonly 1.3 percentage point. However, the needis to provide a significant increase for health,education, and infrastructure as a percentageof GDP.

Health and Education received only about60% of the planned allocation in the 11th Planas against an over-all realization of 87%. Thiswas partly on account of major new schemesbeing launched during the Plan and partly dueto limitations in the absorptive capacity in thesesectors. The preparatory work done duringthe 11th Plan has led to significant improvementin absorptive capacities, and these sectors bothrequire and are ready for significant increasesin allocations. It is estimated that the GBSallocated to these two sectors, including skilldevelopment initiatives, will need to beincreased by at least 1.2 percentage point ofGDP.

Infrastructure investments have seensignificant improvement during the 11th Plan,but the pace of infrastructure developmentneeds further acceleration if the glaringinfrastructure gaps are to be bridged within areasonable time-frame. Although PPPs havebeen successful in a number of infrastructuresectors, and efforts will need to be continuedin further encouraging private sectorinvolvement, it is felt that public investment ininfrastructure, particularly irrigation, watersheddevelopment and urban infrastructure, willneed an additional 0.7 percentage points ofGDP increase over the next five years.

These sectors will therefore need an increaseof 1.9 percentage points of GDP as GBS duringthe 12th Plan. The GBS for the other sectors asa percentage of GDP must therefore go down.The allocation of these sectors will increase inabsolute terms, but more slowly than real GDP.This reprioritisation must be accepted.

The above situation emphasises theimportance of resorting to PPP as much aspossible. This is particularly important in thesocial sectors, where only tentative beginningshave been made. Several states have initiatedinteresting models of PPP in social servicedelivery. These experiments need to beevaluated and best practices up-scaled to thenational level.

The innovations made at the state level ina range of sectors make a compelling reasonfor reconsideration of the Centrally SponsoredSchemes (CSS). The States have consistentlyargued that the CSS are structured too rigidlyto permit innovations and to meet localspecificities. There is merit in this argument.It is, therefore, proposed to reduce the numberof CSS to only a few major schemes which areof a national character and dictated by therights and entitlements of citizens. For all therest, it is proposed to create flexi-funds in theconcerned Ministries which can be used tosupport state-level innovations and/or up-scaling of successful experiments. The successof the Rashtriya Krishi Vikas Yojana (RKVY),which is in effect a flexi-fund scheme, ascompared to the other CSS lends furthercredibility to this approach.

A compelling argument has also been maderegarding the lack of ownership of the CSS bythe States, and its consequent effect in terms ofpoor implementation. It has been proposedtherefore that the model used in the newAPDRP should be extended to all other CSS aswell. In this model, central funds are initiallyprovided as loans to the state governments,which are subsequently converted to grants onachievement of pre-specified outcome or outputtargets.

Governance and Empowerment

Citizen feedback reveals generalunhappiness with governance and publicservice delivery. Four important dimensionshave been pointed out: (i) programmes andschemes are often designed without adequateunderstanding of the desires and limitations ofthe beneficiaries, especially the mostdisadvantaged; (ii) systems for informing thepeople of their rights and entitlements are verypoor and often exclusionary; (iii) the servicedelivery personnel, apart from issues ofcorruption, are inadequately informed of theirduties and responsibilities and take little pridein their work; and (iv) complaint redressalsystems are not independent of the deliverymechanism resulting in non-responsivebehavior.

People should be active agents of changeand this can be achieved only if flagshipprogrammes provide human and financialresources for social mobilization, capacity


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building and an information strategy. Theinvolvement of civil society organizations(CSOs) in programme design through wideconsultations should become a norm.Delivery and policy functions, the latterincluding concurrent evaluation, need to beseparated in Government Ministries in orderto introduce objectivity in programme designand redesign. Consideration needs to be givento setting up professionally managed deliveryorganizations with clear mandates andaccountability.

Information dissemination methodologiesneed to be entirely recast. The poorest andmost disadvantaged need to be targetedspecifically. It is also felt that women and theyouth are the most effective agents of change,and advantage should be taken of organizationswhich work closely with them to spread relevantprogramme information through formal andinformal channels.

Total Quality Management needs to beintroduced at all levels in service deliveryorganisations. Training of service deliverypersonnel and periodic review of performanceare essential.

Complaint recording and redressal systemshave to be created at an arm’s length from thedelivery system, and these should beempowered to enforce and monitor compliance.Advantage can be taken of IT systems toincrease transparency and responsiveness.

Government departments engaged inrelated areas tend to work in silos. The need isfor much better mechanism for converging theactivity of these departments. In many areasthere is need for effective mechanisms forresolution of inter-Ministerial and inter-departmental differences. This is particularlytrue in the field where the Collector ispotentially the only possible focus ofconvergence but is actually far toooverburdened.

•••


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PUBLIC FINANCE

It is that branch of economics that studies aboutgovernment finances. Government financeshave two main components-(1) Public Revenueand (2) Public Expenditure.

PUBLIC REVENUEPublic revenue refers to revenue of the gov-

ernment from tax and non-tax sources. Thereare two broad sources of public revenue- Taxand non-tax sources. Taxes are compulsory lev-ies, which every citizen is legally obliged to payto the government. Taxes are broadly categorisedas direct and indirect taxes. The non-tax sourcesof public revenue are mobilised from a variety ofsources. The non-tax sources include, among oth-ers, the surplus and profit generated in the com-mercial undertakings of the government, the sav-ings and profits of the Public sector undertakings,market borrowings, interest, repayment of prin-cipal by the debtors, the disinvestment proceedsof Public sector undertakings, signoirage, etc.

Tax BaseTax base refers to the base on which a tax

is levied. Some taxes are levied on income (in-come tax, corporate tax, profit tax, presump-tive tax, etc.) whereas some other taxes are lev-ied on commodity production and sale (exciseduty and sales tax). Taxes are also levied oncross border transactions or movements of com-modities (customs duty).

Direct and Indirect TaxesAll taxes have been broadly categorized as

direct and indirect taxes.

Direct Taxes: In the colloquial sense, a di-rect tax is one paid directly to the governmentby the persons (juristic or natural) on whom itis imposed (often accompanied by a tax returnfiled by the taxpayer). Examples include someincome taxes, some corporate taxes, PropertyTax, Wealth Tax, Expenditure Tax andtransfertaxes such as estate (inheritance) tax and gift tax.


Indirect Taxes : An indirect tax or "col-lected" tax is one (such as excise duty, customsduty, sales tax or value added tax or VAT)which is collected by intermediaries who turnover the proceeds to the government and filethe related tax return. Some examples of indi-rect taxes are-Excise Duty, Customs Duty, SalesTax, etc.

Impact and Incidence of TaxesThe impact of a tax refers to the first point

of levy of a tax whereas the incidence of a taxrefers to the final resting point of a tax. Now,the taxes in which the impact and incidence lieat the same point are not shiftable, hence, theyare direct taxes. On the other hand taxes inwhich impact of taxes is at one point and theincidence is on another point, they are shift-able, hence, they are indirect taxes.

Canons of a Good TaxAdam Smith has prescribed four canons of agood tax. They are:

(i) Canon of Equality: According to this canon,taxes should be in proportion to the abil-ity of tax payers of different economicclasses.

(ii) Canon of Certainty: A good tax must becertain and not arbitray in terms of timeand mode and manner of payment, therate of taxes to be paid, etc.

(iii) Canon of Convenience: The mode and tim-ing of tax payment should be convenientto the tax payer.

(iv) Canon of Economy: The cost of collectionof taxes should be minimum. Some morecanons of a good tax were added later bypublic finance experts. The importantamong them are:

(v) Canon of Productivity: It is called thecanon of fiscal adequacy as well. Accord-ing to this canon, a tax must be able togarner sufficient public revenue for thetreasury so that the government can avoiddeficit financing.

PUBLIC FINANCE

IN INDIA


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(vi) Canon of Buoyancy: The tax revenueshould have an inherent tendency to in-crease along with the increase in nationalincome, even if the rates and coverageare not revised.

(vii) Canon of Flexibility: The taxes should beflexible enough so that tax authorities canrevise the tax rate or its coverage or bothas per need of the hour.

(viii) Canon of Simplicity: The taxes should besimple to understand and administer.

(ix) Canon of Diversity: A tax system shouldpermit diversity and variety of taxes ratherthan relying on a few taxes.

Constitutional Provisions to Levy and CollectTaxes

The central and state governments needfunds to meet various socio-economic obliga-tions. The constitution has clearly mentionedabout the powers of centre and the states withregard to levy and collection of taxes. Amongthe taxes levied and collected by the centralgovernment the most important are the centralexcise duty and customs duties, apart fromincome and corporation taxes. But the centre isrequired to share the proceeds of excise andincome taxes with the states. The state govern-ments have the sole authority to levy taxes onland and agriculture. There is provision of somelocal taxes such as property taxes, octroi, pro-fession tax, etc. that local bodies can levy.

Till 1st April 2005, every state had its ownsales tax syatem, wherein they levied and col-lected it with their own machinery. From 1stApril onwards, 21 states have shifted to a sys-tem of unified VAT.

The Union taxes as laid down in List-I ofthe Seventh Schedule of the Constitution areas follows:

1. Taxes on income and other than agricul-tural income;

2. Corporation tax;3. Customs duties;4. Excise duties except on alcoholic liquors

and narcotics not contained in medical ortoilet preparations;

5. Estate and succession duties other thanon agricultural land;

6. Taxes on capital, value of assets, exceptagricultural land, of individuals and com-panies;

7. Rates of stamp duties on financial documents;8. Taxes other than stamp duties on trans-

actions in stock exchanges and future markets;9. Taxes on sale and purchase of newspa-

pers and on advertisements therein;10. Taxes on railway freight and fares;11. Terminal taxes on goods or passengers car-

ried by railways, sea or air and12. Taxes on the sale and purchase of goods

in the case of interstate trade.

The taxes under State List as given in theList- II of the Seventh Schedule of Indian Con-stitution are as follows:

1. Land revenue;2. Taxes on the sale and purchase of goods,

except newspapers;3. Taxes on agricultural income;4. Taxes on land and buildings;5. Succession and estate duties on agricul-

tural land;6. Excise on alcohol liquor and narcotics;7. Taxes on the entry of goods into a local area;8. Taxes on mineral rights, subject to any

limitation imposed by parliament;9. Taxes on the consumption and sale of elec-

tricity;10. Taxes on vehicles, animals and boats;11. Stamp duties except those on financial

documents;12. Taxes on goods and passengers carried by

board or inland waterways;13. Taxes on luxuries including entertain-

ments, betting and gambling;14. Tolls;15. Taxes on professions, trades, callings and

employment;16. Capitation taxes, and17. Taxes on advertisements other than those

contained in newspapers.

The Concurrent List of Taxes Include:1. Taxes on Motor vehicles2. Stamp duties on non-judicial stamps

Duties levied by the Union and collected andappropriated by States:

1. Stamp Duties


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2. Excise duties on medical preparations con-taining alcohol or narcotics

Taxes levied and collected by the Union andfully appropriated by the States:

In this case although taxes are levied andcollected by the Union government, the entireproceeds are assigned to states in proportiondetermined by the Parliament.

1. Succession and estate duties;2. Terminal taxes on goods and passengers;3. Taxes on railway freight and fares;4. Taxes on transaction in stock exchanges

and future markets;5. Taxes on the sale and purchase of news-

papers and advertisements therein.6. Proceeds of additional excise duties on

mill-made textiles, sugar and tobacco.These taxes were levied in 1957 by theUnion in lieu of states' sales taxes on thesecommodities, are wholly distributedamong the states in a manner that en-sures their past income from the sameintact.

Taxes levied and collected by the Union andProceeds partially shared with States:

1. Income Tax2. Union excise duties

Some other notable points:• The union government has exclusive

power to impose taxes, which are not spe-cifically mentioned in the State or Con-current List.

• The property of the Union is exemptedfrom state taxation and the property andincome of the states are exempt fromUnion taxes.

• The Parliament may pass legislation fortaxation by the Union of any trading orbusiness activities of a state, which are notpart of the ordinary functions of the Gov-ernment.

• States may delegate part of their taxationpowers to the central government. The pro-vision has been applied in the case of ag-ricultural land, which has been includedin the purview of Estate duties in manystates.

• Parliament has exclusive powers to tax

sales or purchases of goods in the courseof the inter-state trade.

• In view of increased role of state govern-ments and limited sources of revenue, theConstitution of India has provided for thedevolution of resources from the Centerto the States.

• For devolution of certain central taxes' pro-ceeds to the states, the Article 280 of In-dian Constitution provides for the settingup of a Finance Commission by the Presi-dent every five years or earlier.

NEW TAXES IN INDIA

The Fringe Benefit TaxThe Budget 2005-06 has imposed what it calls

a 'fringe benefit' tax on certain expenses incurredby corporates. These expenses are deemed to bein the nature of fringe benefits extended to em-ployees. The specified expenses when incurredon employees are 'deemed' to be 'fringe benefits,'and hence, attract a tax even though the em-ployee may not derive any benefit from it. Thebudget 2005-06 contains the definition of 'fringebenefits' as "any privilege, service, facility oramenity, directly or indirectly, provided by anemployer to his employees (including formeremployee or employees) by reason of their em-ployment; or any reimbursement, directly or in-directly, made by the employer to his employeesfor any purpose; any free or concessional ticketprovided by the employer for private journeys ofthe employees and their family members; andany contribution by the employer to an approvedsuperannuation fund. Some of the most com-mon fringe benefits include car, computer ser-vices, hotel and tour expenses, etc. which gener-ally becomes a fringe benefit when it is owned orleased by an employer and made available forthe private use of an employee. This tax wasscrapped in the budget 2009-10.

Banking Cash Transaction TaxThe budget 2005-06 has introduced a tax on

cash withdrawal from banks, calledBanking Cash Transaction Tax or Banking CashWithdrawal Tax. The new banking cash trans-action tax, introduced for the first time in theIndian Budget was meant to keep a tax trail onblackmoney.The savings accounts were totallyexempted from 0.1 per cent tax on cash with-drawal from banks following criticismfrom trade, industry and political parties.The tax


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was applicable for withdrawals of Rs 25,000 andabove on a single day from current and othernon-savings accounts in the banks forindividuals and Hindu Undivided Families.For business accounts, the 0.1 per cent tax wasapplicable for any withdrawal beyond Rs 1 lakhon a single day. The central board of direct taxesthrough a notification in this regard (June 1, 1996, made it clear that if the total withdrawal ex-ceeds Rs 25,000 by individuals or Rs 1 lakh bybusinesses on a single day even through multitransactions, the tax would be effective. Origi-nally proposed to levy transaction tax of Rs 10,000and above, Finance Minister P. Chidambaramlater scaled up the limit to Rs 25,000 after itevoked wide-spread criticism from industry andpolitical parties. The budget 2008-09 announcedthat Banking Cash Transaction Tax (BCTT)would be withdrawn with effect from April 1,2009.

Minimum Alternate Tax (MAT)

In almost all the economies of the world,income tax laws provide a number of conces-sions in their income tax laws. A profit mak-ing clever company may conduct its businessa n daccounting affairs in such a manner that thecumulative effect of all such concessions isto reduce its income declared in the tax returnsto zero. The Minimum Alternate Tax is adevice to keep a zero tax company within thetax net.

In the 1996-97 budgets, an effort was madeto tackle the phenomenon of zero tax compa-nies, which despite having substantial bookprofits paid zero tax. The government broughtthe zero tax companies under the tax net. Thus,where the total income of a company afteravailing all eligible deductions was less than 30per cent of the book profit, the total income ofsuch companies was deemed to be 30 per centof the book profit and they were charged aminimum tax which works out to be 12 percent of the book profit. Some sectors such aspower, infrastructure and exports were exemptfrom the MAT.

Value-Added Tax (VAT) and GSTVAT (Value Added Tax) was introduced to

avoid cascading of taxes (tax being levied upona price that includes one or more elements oftax) as a product passes through different

stages of production/value addition. The tax isbased on the difference between the value ofthe output and the value of the inputs used toproduce it. The aim is to tax a firm only for thevalue added by it to the inputs it is using formanufacturing its output and not the entireinput cost. VAT brings in transparency to com-modity taxation: right now, only the final taxpaid by the consumer is apparent to her, whilewith value added tax generalised to a goodsand services tax (GST) that subsumes both cen-tral and state level taxation, the entire elementof tax borne by a good (or a service) would berepresented by the GST paid on it. A GST of20% might seem high, but it would be abouthalf the actual incidence of tax in most goodsat present.

CENVATCentral value Added Tax is the rechristenedMODVAT. The Government introducedCENVAT in lieu of central excise taxes in 2000-01 budget and it plans to extend the CENVATto the customs duties in due course. Initiallythe CENVAT was introduced as an experimenton a limited basis, but later it was extended toall sectors of the economy.

State VAT

State level VAT became operational from April1, 2005 to replace sales tax that varied overstates. Now we have a harmonized system ofstate VAT. Here are some the main features ofstate VAT.

• Introduction of VAT would help avoid cas-cading nature of sales tax.

• Present multiple rates and taxes can con-verge into a few rates and a single VAT.

• Transparency in the system of tax admin-istration through simple self-assessmentsand departmental audit.

• Rationalisation of taxes to result in lowertax burden and higher tax revenues.

• To avoid tax competition, the design ofState VAT needs to be harmonized evenas the distinctive needs of individual Statesare recognized.

• State VAT to have two basic rates of 4 percent and 12.5 per cent and to cover 550commodities. About 270 commodities willbe under 4 per cent rate.

• 46 items, comprising of natural and unproc-


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essed products in unorganized sector, itemslegally barred from taxation and items hav-ing social implications, are exempt fromVAT.

• Gold and silver ornaments subject to a spe-cial VAT rate of 1 per cent and other com-modities to attract a general VAT rate of12.5 per cent.

Finance Bill

The proposals of government for levy of newtaxes, modification of the existing tax structureor continuance of the existing tax structure be-yond the period approved by Parliament aresubmitted to Parliament through this bill. It isthe key document as far as taxes are concerned.

BudgetBudget (from originating from french word

'bougette') generally refers to a list of all plannedexpenses and revenues of government. An an-nual proposal that outlines anticipated Federalrevenue and designates program expenditures forthe upcoming fiscal year. Thus budget is a state-ment of the State's program plan, the resourcesnecessary to support that plan, a description ofhow and for what purposes the resources are tobe used, and a projection of the effects of theprograms on people and the environment. TheUnion Budget is the annual report of India as acountry. It contains the government of India'srevenue and expenditure for the end of a par-ticular fiscal year, which runs from April 1 toMarch 31. The Union Budget is the most exten-sive account of the government's finances, inwhich revenues from all sources and expenses ofall activities undertaken are aggregated.

Fiscal YearA fiscal year (or financial year, or sometimes

budget year) is a period used for calculatingannual ("yearly") financial statements in busi-nesses and other organizations. In many juris-dictions, regulatory laws regarding accountingand taxation require such reports once pertwelve months, but do not require that theperiod reported on constitutes a calendar year(i.e., January through December). Fiscal yearsvary between businesses and countries. In NewZealand, India, Hong Kong, the government'sfinancial year runs from April 1 to March31.The U.S. government's fiscal year begins onOctober 1 of the previous calendar year and

ends on September 30 of the year with whichit is numbered. The Australian government'sfiscal year begins on July 1 and concludes onJune 30 of the following year.The UnitedKingdom's fiscal year runs from April 6 to April5. Japan's income tax year runs from January1 to December 31, but corporate tax is chargedby their own one year period.

Performance and Programme Budgeting SystemProgramme Budgeting: The formulation of

the budget proposals should be directly relatedto the extent to which they can be imple-mented. The implementation of a budget involvesmaking programmes, setting agencies that willimplement it and the modus operandi for thesame.

Performance Based Budgeting (PBB): Testshave been devised for comparing actual withthe expected results and thereby assessing theefficiency of the project in terms of its perfor-mance. This aspect of budgeting is referred toas the performance budgeting. Performancebudget, as stated by the Hoover Commission(USA), is based upon activities, functions andprojects of the government.

Performance and Programme Budgeting Sys-tem (PPBS): A budget, which includes both theaspects of budgeting viz. programme budgeting andperformance budgeting may be termed Performanceand Programme Budgeting System (PPBS).

The PPBS is an outcome of efforts aimed atimproving the formulation and execution ofexpenditure policy of the government at theexecutors (not legislative) level. It incorporatesrules of managerial efficiency and flexibility inboth formulation and execution of expenditurepolicy of the government.

Revenue and Capital BudgetsA budget has two accounts, namely, (1) rev-

enue account and (2) capital account. Revenueaccount includes all receipts and expenditure,which are of recurring nature and which donot pertain to sale and purchase of assets. Thecapital account includes the heads which per-tain to receipts and expenditures of long termnature and sale and purchase of assets. Theformer is often called revenue budget whereasthe latter is called capital budget.

Revenue BudgetRevenue accounts cover those items, which


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are of recurring nature. Current expenses areequivalent to consumption. Revenue Budget con-sists of the revenue receipts - both tax - revenueand non - tax revenue and revenue expenditure.The tax revenue includes revenue form direct andindirect taxes. The non-tax revenue receipts in-clude revenue from currency, Coinage and mint,interest receipts, dividends, profits, revenue fromgeneral services (such as police, jails, supplies anddisposal, and public works), revenue from socialand community services (such as education,health, housing, broadcasting and so on) andrevenue from other services (such as agricultureand allied services, industry and mines, trans-port and communications).

Capital Budget (or Capital Account)Capital Budget or Capital Account of the

budget covers those items, which are in thenature of acquiring and disposing of capitalassets. Capital budget includes capital receiptsand capital disbursements. Capital account re-ceipts include market loans, borrowings fromReserve Bank of India and others through thesale of treasury bills and loans from foreigngovernments and others to the central govern-ment. Capital disbursements would include ex-penditure on acquisition of various physicalassets like land, buildings, machinery and equip-ment, investments in shares and debenturesand loans to state governments and other bod-ies. The capital budget also incorporates thetransactions in the Public Account.

The division between revenue and capitalaccount for state budgets is similar to that ofthe government of India. In India, till mid 1980s,in addition to the division of the budget intoRevenue and Capital Accounts, the Plan Bud-get was also prepared.

The Plan Budget was a document, whichshowed the budgetary provisions for importantprojects, programs and schemes included in thecentral plan. It gave the details of the budget-ary support for the Central Plan by sectors ofdevelopment, including the central plan assis-tance for States and Union Territories. Thebreak-up of the proposed outlays between Gen-eral Services, Social and Community Servicesand Economic Services was shown togetherwith various physical targets wherever possible.

Plan and Non-Plan Budget: Currently, inpursuance of the recommendations of the Au-ditor and Comptroller General of India, the

previous practice of dividing budget into rev-enue account, capital account and plan budgetstands modified. Now the budget is first splitup into plan and non-plan parts and withineach part, there is a further division betweenRevenue and capital accounts.

In the new classification, the expendituresare categorized as plan expenditure and non-plan expenditures.

Plan expenditure covers only that portion ofthe total expenditure, which is directed tofinance the schemes specifically initiated underthe given plan or which are the spillover of theprevious plan (s). The non-plan expenditureincludes such expenditures, which are done onthe maintenance of completed projects andother running expenditure of government.

Zero Based Budgeting (ZBB)Zero based budgeting is an extension of corpo-rate principles to the arena of public budget-ing. The main objective behind zero based bud-geting is to achieve efficiency in the budgetaryprocess by minimising wasteful expenditureand maximising the outcomes. In a wider sense,the ZBB is a means to convert a programmebuget into an essentially performance budget.

In the sphere of public budgeting, ZBB wasfirst tried by Mr. Jimmy Carter, Governor ofGeorgia in 1973. Gradually zero based budget-ing was given a trial in other states of the USA.

In zero based budgeting each item of expen-diture going to various segments of an indus-trial/manufacturing activity would have to bejustified against its actual performance (vis-à-vis target) and achievement. If a segment/sec-tion is not able to justify its own existence, itwould be closed down. And if its existence isjustified, the optimum levels of its operationsand the corresponding budgetary provisionshave also to be defended. ZBB refers to budget-ing process where every section (item of ex-penditure) has to justify its worth against theexpenditure it claims. In other words justifica-tion as to why money should be spent on aparticular head has to be proved by thespender. Every time, this exercise has to startab initio. An effective adoption of ZBB needs alot of understanding and detailed working outof different levels. The main hurdles, apart fromlack of data are firstly that ZBB may provemore expensive for it needs elaborate study and


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secondly no department would like to recom-mend its own closure.

PUBLIC EXPENDITUREPublic expenditure refers to government

expenditure. Public expenditure has beenincreasing all over the world due to increasedinvolvement of governments in developmentand welfare activities. It is classified asfollows:

Plan ExpenditureThis is essentially the Budget support to the

central plan and the central assistance to stateplans like all Budget heads, this is also splitinto revenue and capital components.

Non-plan ExpenditureThis is largely the revenue expenditure of

the government. The biggest items of expendi-ture are interest payments, subsidies, salaries,defence and pension. The capital componentof the non-plan expenditure is relatively smallwith the largest allocation going to defence. Itis important to note that the entire defence ex-penditure is non-plan expenditure.

Deficit FinancingDeficit financing means an excess of public

expenditure over public revenue. This excessmay be met by sale of public assets, borrow-ings from the domestic market, borrowings fromabroad, or drawing down of cash balances ofGOI or the issue (print) of fresh money by theCentral Bank.

Fiscal DeficitWhen the government's non-borrowed

receipts (revenue receipts plus loan repaymentsreceived by the government plus miscellaneouscapital receipts, primarily disinvestmentproceeds) fall short of its entire expenditure, ithas to borrow money from the public to meetthe shortfall. The excess of total expenditureover total nonborrowed receipts is called thefiscal deficit.

Primary DeficitThe revenue expenditure includes interest

payments on government's earlier borrowings.The primary deficit is the fiscal deficit less in-terest payments. A shrinking primary deficit

would indicate progress towards fiscal health.We had already discussed revenue deficit ear-lier. The Budget document also mentions thedeficit as a percentage of the GDP. This is tofacilitate comparison and also get a properperspective. In absolute terms, the fiscal deficitmay be large, but if it is small compared to thesize of the economy then it is not such a badthing. Prudent fiscal management requires thatgovernment does not borrow to consume, inthe normal course. That brings us to the FRBMAct.

Various Kinds of Deficits1. Budget Deficit = Deficit on Revenue

Account plus Deficit on Capital Account.2. Revenue Deficit = Deficit on Revenue

AccountThat is Revenue Expenditure - Revenue

Receipt. (Rev. Exp.> Rev. Rec.)

This deficit is an indicator of government'simprudent consumption.

3. Fiscal Deficit = Budget Deficit + Otherliabilities = Budget Deficit plus borrowingsfrom internal market other than 91-dayad-hoc treasury bills + External borrow-ing = Budget Deficit + Borrowing throughtreasury bills (other than 91-day) + Bor-rowing from Small Savings + Borrowingfrom provident fund + other borrowingsincluding external.

4. Monetised Deficit = Net increase in bor-rowing from RBI in a fiscal year.

5. Primary Deficit = Fiscal Deficit - Interestpayment.

Since 91 day ad-hoc treasury bills are notissued since 1997, the concept of budget deficithas been stopped to be used to gauge the fiscalhealth of the country. Monetised deficit is alsonot calculated now because the FRBM Act hasprohibited government borrowings from theRBI for budgetary purposes. Instead there is aprovision for ways and means advance throughwhich governments at state or central levelsmay borrow for their temporary revenue short-falls for duration of 15-90 days.

Fiscal PolicyFiscal policy refers to the policy related to

revenue and expenditure of the government witha view to correcting the situations of excessdemand or deficient demand in the economy.The instruments of fiscal policy are:


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(a) Fiscal Instruments Related toGovernment Expenditure: Thegovernment of a country incurs varioustypes of expenditure such as expenditureon public works (construction of roads,dams, bridges etc), education and publicwelfare, defence, maintenance of law andorder, various types of subsidies, andtransfer payments to the public.Government corrects the situations ofexcess demand or deficient demand in theeconomy by varying any or all types ofexpenditure.

(b) Fiscal Instruments Related to Financingof Government Expenditure: Taxation,public debt and deficit financing are thethree fiscal instruments related tofinancing of government expenditure.Government can correct the situations ofexcess demand or deficient demand in theeconomy by using above mentionedinstruments.

(c) Fiscal Policy and Deficient Demand

Following fiscal measures to correct thesituation of deficient demand:

(1) Decrease in Taxes: Government decreasestaxes, which leaves the households withmore purchasing power and the firmswith more cash reserves. Direct taxes likeincome tax, corporation tax etc arereduced. As a result both households aswell as investors will be encouraged tospend more. Consequently, demand willincrease.

(2) Increase in Public Expenditure: Tostimulate the demand the governmentincreases expenditure over public health,education, subsidies and transferpayments, and public works. Publicexpenditure causes the level of income toincrease in economy. Higher level ofincome causes high level of demand.

(3) Increase Deficit financing: Deficitfinancing (by way of printing more notesfor additional expenditure) is increasedduring times of deficient demand so thatthe overall level of purchasing power isenhanced in the economy.

(4) Public Borrowing: Public borrowing isreduced so that people are left withgreater disposable income.

(d) Fiscal Policy and Excess Demand

Excess demand generates inflationarypressures in the system. Following fiscal measuresare taken to correct the inflationary situation.

(i) Increase in taxes: Tax rates are increasedprogressively to mop up additionalpurchasing power within the economy.

(ii) Decrease in Government Expenditure:Government expenditure is reduced so asto cause the demand to decline.

(iii) Reduce Deficit Financing: Deficit financingis greatly restricted. The printing of morenotes would only increase the rate ofinflation.

(iv) Public Borrowing: The situation demandsless purchasing power with the people.So, the government takes resort toincreased public borrowing.

Main Objectives of Fiscal Policy in India

The fiscal policy is designed to achievecertain objectives as follows:-

1. Development by effective Mobilizationof Resources

The principal objective of fiscal policy is toensure rapid economic growth and development.This objective of economic growth anddevelopment can be achieved by Mobilization ofFinancial Resources.

The central and the state governments inIndia have used fiscal policy to mobilize resources.

The financial resources can be mobilized by:

a) Taxation: Through effective fiscal policies,the government aims to mobilize resourcesby way of direct taxes as well as indirecttaxes because most important source ofresource mobilization in India is taxation.

b) Public Savings: The resources can be mobilizedthrough public savings by reducinggovernment expenditure and increasingsurpluses of public sector enterprises.

c) Private Savings: Through effective fiscalmeasures such as tax benefits, thegovernment can raise resources fromprivate sector and households. Resourcescan be mobilized through governmentborrowings by ways of treasury bills, issueof government bonds, etc., loans fromdomestic and foreign parties and by deficitfinancing.


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2. Efficient allocation of FinancialResourcesThe central and state governments have

tried to make efficient allocation of financialresources. These resources are allocated forDevelopment Activities which includesexpenditure on railways, infrastructure, etc,whereas Non-development Activities includesexpenditure on defence, interest payments,subsidies, etc.

But generally the fiscal policy shouldensure that the resources are allocated forgeneration of goods and services which aresocially desirable. Therefore, India's fiscalpolicy is designed in such a manner so as toencourage production of desirable goods anddiscourage those goods which are sociallyundesirable.

3. Reduction in inequalities of Income andWealthFiscal policy aims at achieving equity or

social justice by reducing income inequalitiesamong different sections of the society. Thedirect taxes such as income tax are chargedmore on the rich people as compared to lowerincome groups. Indirect taxes are also more inthe case of semi-luxury and luxury items, whichare mostly consumed by the upper middle classand the upper class. The government invests asignificant proportion of its tax revenue in theimplementation of Poverty AlleviationProgrammes to improve the conditions of poorpeople in society.

4. Price Stability and Control of InflationOne of the main objectives of fiscal policy

is to control inflation and stabilize price.Therefore, the government always aims tocontrol the inflation by reducing fiscal deficits,introducing tax savings schemes, Productive useof financial resources, etc.

5. Employment GenerationThe government is making every possible

effort to increase employment in the countrythrough effective fiscal measure.

6. Balanced Regional DevelopmentAnother main objective of the fiscal policy

is to bring about a balanced regional develop-ment. There are various incentives from thegovernment for setting up projects in backwardareas such as Cash subsidy, Concess-ion intaxes and duties in the form of tax holidays,Finance at concessional interest rates, etc.

7. Reducing the Deficit in the Balance ofPaymentFiscal policy attempts to encourage more

exports by way of fiscal measures likeExemption of income tax on export earnings,Exemption of central excise duties and customs,Exemption of sales tax and octroi, etc.

The foreign exchange earned by way ofexports and saved by way of import substituteshelps to solve balance of payments problem. Inthis way adverse balance of payment can becorrected either by imposing duties on importsor by giving subsidies to export.

8. Development of InfrastructureGovernment has placed emphasis on the

infrastructure development for the purpose ofachieving economic growth. The fiscal policymeasures such as taxation generates revenueto the government. A part of the government'srevenue is invested in the infrastructuredevelopment. Due to this, all sectors of theeconomy get a boost.

Fiscal Responsibility and Budget Management(FRBM) Act

Enacted in 2003, the Fiscal Responsibility andBudget Management Act requires the elimina-tion of revenue deficit by 2008-09. This meansthat from 2008-09, the government will have tomeet all its revenue expenditure from its revenuereceipts. Any borrowing would then only be tomeet capital expenditure - repayment of loans,lending and fresh investment. The Act also man-dates a 3% limit on the fiscal deficit after 2008-09. This is a reasonable limit that allows signifi-cant leverage to the government to build ca-pacities in the economy without compromisingfiscal stability. It is important to note that sincethe entire Budget is at current market prices thedeficits are also calculated with reference to GDPat current market prices. The main features ofthe bill are as follows:

The Fiscal Responsibility and Budget Man-agement (FRBM) Bill was introduced in De-cember 2000 and enacted in August 2003. Therules are effective from July 5, 2004 and thegovernment has implemented the FRBM Act.Following are the main features of the FRBMAct:

• The Act stipulates the elimination of rev-enue deficit by March 31, 2008.

• According to the Act, the revenue deficitis to be reduced by a minimum of 0.5% ofGDP per annum and the fiscal deficit by


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0.3%. The rolling targets of FRBM pro-vide for a reduction in the revenue deficitto 1.5% in 2005-06 and to 1.1% in 2006-07 and eventually to zero in 2008.

• The FRBM Act also caps the level of guar-antees and prohibits government to bor-row from the RBI after April 1, 2006.

• The Act requires that on a quarterly basis,the Government would have to place be-fore both the Houses of Parliament an as-sessment of trends of receipts and expendi-ture. The Government also has to annuallypresent the macro-economic frameworkstatement, medium term fiscal policy state-ment and fiscal policy strategy statement.The three statements would provide themacro economic background and assess-ment relating to the achievement of FRBMgoals.

• The medium term fiscal policy statementwill contain a three-year rolling target forkey fiscal parameters that underpin theGovernment's fiscal correction trajectory.

• Through the FRBM discipline, the Govern-ment is also committed to undertake anintra-year assessment of the achievementof its budgetary targets.

TAX REFORMS

Recommendation of the Chelliah CommitteeThe tax reform committee under the chair-

manship of Raja J. Chelliah (1991) has recom-mended far reaching changes in the tax sys-tem. The main objectives of tax reform were (i)to remove loopholes from the system that leadto evasion (ii) to simplify and rationalize thetax structure, (iii) to make the tax structureefficient and transparent from the point of viewof revenue collection. In brief the proposals ofthe tax reform committee are related with sim-plification, rationalization and efficiency in thetax structure.

In respect of particular taxes the ChelliahCommittee has, inter-alia, recommended thefollowing:

Direct TaxesIncome Tax: (i) Lower rates of taxation with

a narrower spread between the entry rate andmaximum marginal rate, and a minimum oftax incentives, (ii) The system of subjecting theincome of both partnership firms as well as the

partners to taxation amounted to double taxa-tion and this should be avoided.

Corporation Tax: Corporation tax rate fordomestic companies being high should be low-ered to 40 per cent and the surcharge shouldbe abolished. Tax rates for foreign companiesshould also be lowered and the differentialbetween the tax rates on domestic and foreigncompanies should be around 7.5 percentagepoints and in no case to exceed 10 percentagepoints.

Capital Gains Tax: The present tax treat-ment of long-term capital gains is not correctbecause the deductions allowed in computingtaxable gain is not related to the period of timefor which the assets have been held. It doesnot take into account the inflation that mayhave occurred over-time. So the committee hasrecommended a system of indexation to ward-off the inflationary effect on capital gains.

The Committee also suggested that for levy-ing wealth tax a distinction is to be madebetween productive and non-productive assets.Thus by exempting productive assets such asshares, securities, bonds, bank deposits, etc.from wealth tax, the government can encour-age investment in them.

Indirect Taxes:

Customs Duties : Reduction in the generallevel of tariffs, a reduction in the dispersion ofthe tariff rates and a rationalization of the sys-tem with abolition of numerous end-use ex-emptions and concessions.

Excise Duties: The committee has recom-mended the switching over to ad-valorem ratesfrom specific rates. In case a specific rate hasto be retained; the same should be revised ev-ery year taking into account the price inflation.

For the sake of efficiency, the committeerecommended a general reduction is exemp-tions, tax rates and tax slabs. It also empha-sized broad basing of the tax system. (Such asintroduction of presumptive tax, taxes on ser-vices, etc.)

The government has accepted almost all therecommendations of Chelliah Committee. Allthe budgets after 1991 have tried to accommo-date these recommendations. The tax reformshave led to simplification, rationalization and


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broad basing of the tax system. All this has re-sulted into increase in tax revenue and decreasein tax evasion and avoidance. The tax systemhas become more growth oriented after imple-menting Chelliah Committee recommendations.

Kelkar Committee on Tax ReformsIn its report presented to the Finance Min-

ister, Mr P. Chidambaram, the Taskforce onImplementation of the Fiscal Responsibility andBudget Management (FRBM) Act, headed byMr Vijay Kelkar, has contended that slashingGovernment spending "would be contractionaryfor the macro-economy," whereas "raisingtax revenues is likely to be less contractionary."It has recommended that fiscal consolidationshould be "revenue-led" rather than basedon reduction in expenditures. The report hasalso argued that the Government shouldenhance capital expenditures "in order tocounter-balance the contractionary effectsof fiscal consolidation." Following are themain recommendations of the KelkarCommittee:

• A new Income Tax package comprisingtwo rate-structure and removal of exemp-tions except for housing loans, women,and senior citizens.

• Only three rate custom duty structurereaching ASEAN levels.

• New proposal with states on goods andservice tax.

• Reduction in corporate tax to 30 per centfor domestic cos.

• Reduction in general depreciation ratefrom 25 to 15 per cent

• Existing tax incentives for corporate unitsto be "grand fathered" for existing units,but removed for new units. The reportfavoured revenue mobilisation throughlow and few tax rates, alongside widen-ing of the tax base and shifting the inci-dence of taxation upon consumption.

There will be only two marginal rates: 20 percent for income levels of Rs 1 lakh to Rs 4 lakh

and 30 per cent for incomes above Rs 4 lakh. Themarginal rate would be nil on income levels upto Rs 1 lakh. At the same time, the standarddeduction available to salaried tax payers will bedone away with and all tax exemptions are togo, barring those relating to housing loans andschemes for senior citizens and women.

For corporates, the Taskforce has similarlymooted a reduction in the tax rate from 35.875per cent to 30 per cent for domestic companies,along with a lowering of the general deprecia-tion rate from 25 per cent to 15 per cent. Allexisting tax incentives will be 'grandfathered,' i.e.,new units will not be entitled for such benefits.

A radical suggestion made by the Taskforceis to have Goods and Services Tax, which willbe a single country-wide value added tax (VAT)covering virtually all goods and services. Fur-ther, there will be no demarcation betweengoods and services on which the powers oftaxation rest only with the Centre or the States.

Instead, the Taskforce has envisaged a 'grandbargain,' whereby States will have the powerto tax all services concurrently with the Cen-tre, and "both Central and State Governmentwould exercise concurrent but independent ju-risdiction over common or almost common taxbases extending over all goods and services,and in both cases, going up to the final con-sumer."

Within this framework, the report has pro-posed a three-slab ad valorem tax rate struc-ture - a floor rate of 10 per cent (6 per centlevied by the Centre and 4 per cent levied byStates), a standard rate of 20 per cent (12 percent plus 8 per cent) and a peak rate of 34 percent (20 per cent plus 14 per cent).

As per this, the total tax burden on mostgoods would work out to 20 per cent, which"compared favourably with the standard VATrates seen in OECD countries." Further, theCentre's standard rate would work out to 12per cent, which is below the existing Cenvatrate of 16 per cent. The Taskforce has favoureda 'front-loaded' approach towards meeting thegoal of zero revenue deficit by 2008-09, as perthe FRBM Act.

•••


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Banking is defined as the accepting, forthe purpose of lending or investment ofdeposits, money from the public, repayable ondemand or otherwise and withdrawable bycheque, draft, and order or otherwise. Thusthe two essential functions of banks are toaccept chequable deposits from the public andlending.

Acceptance of chequable deposits is anecessary, but not sufficient condition forFinancial Institution (FI) to be a bank. Forexample, post office savings banks are not banksin this sense of the term even though theyaccept deposits from the public. This is becausethey do not perform the other essential functionof lending.

Similarly, lending alone does not make FIa bank. For example, many FIs like LIC, UTI,and IFC, etc, lend to others but they are notbanks in this sense of the term, as they do notaccept chequable deposits.

The main functions that commercial banksperform are:

1. Acceptance of Deposits

The bank accepts three types of deposits fromthe public:

• Current Account Deposits: Deposits incurrent accounts are payable on demand.They can be drawn upon by chequewithout any restriction. These accountsare usually maintained by businesses andare used for making business payments.No interest is paid on these deposits.However, the banks offer various servicesto the account holders for a nominalcharge, the most important being thecheque facility. Banks keep regularaccounts of all transactions made in aparticular account and submit statementsof the same to the account-holder atregular intervals.


BANKING SYSTEM

IN INDIA

• Fixed/Term Deposits: These are depositsfor a fixed term (period of time) varyingfrom a few days to a few years. They arenot payable on demand and do not enjoychequing facilities. The moneys depositedin such accounts become payable only onthe maturity of the fixed period for whichthe deposit was initially made. A variantof fixed deposits are recurring deposits.In these accounts, a depositor makes aregular deposit of an agreed sum over anagreed period e.g. Rs. 100 per month for5 years. Interest is paid on the deposits inthese accounts.

• Savings Accounts Deposits: Thesedeposits combine the features of bothcurrent account deposits and fixeddeposits. They are payable on demand andalso withdrawable by cheque, but withcertain restrictions on the number ofcheques issued in a period of time. Interestis paid on the deposits in these accountsbut the interest paid on savings accountdeposits is less than that of the fixeddeposits.

2. Giving Loans

The deposits received by the bank are notallowed to lie idle by the bank. After keepinga certain portion of the deposits as reserves,the bank gives the balance to borrowers in theform of loans and advances. The different typesof loans and advances made by banks are asfollows:

• Cash Credit: In this arrangement an eligibleborrower is first sanctioned a credit limitupto which he may borrow from the bank.This credit limit is determined by thebank’s estimation of the borrower’screditworthiness. However, actualutilisation of credit by the customerdepends upon his withdrawing power.The withdrawing power depends on thevalue of the borrower’s current assets,


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which comprise mainly of stocks of goods-raw materials, semimanufactured orfinished goods, and bills receivable (dues)from others. The borrower has to submita stock statement of his assets to the bankshowing evidence of on-going trade andproduction activity and acting as a legaldocument in possession of the bank, to beused in case of default. The borrower hasto pay interest on the ‘drawn’ or utilizedportion of the credit only.

• Demand Loans: A demand loan is one thatcan be recalled on demand. It has no statedmaturity. The entire loan amount is paidin lump sum by crediting it to the loanaccount of the borrower. Thus, the entireloan amount becomes chargeable tointerest. Security brokers and others whosecredit needs fluctuate day to day usuallytake these loans. The security against theseloans may be personal, financial assets orgoods.

• Short-term Loans: - Short-term loans maybe given as personal loans, loans to financeworking capital or as priority sectoradvances. These loans are secured loans,i.e. they are loans made against somesecurity. The whole amount of the termloan sanctioned is paid in lump sum bycrediting it to the loan account of theborrower. Thus, the entire loan amountbecomes chargeable to interest. Therepayment is made as scheduled. eitherin one instalment at the end of the loanperiod, or in a number of instalments overthe period of the loan. In addition,commercial banks extend the followingfacilities when they are demanded by theircustomers.

3. Overdrafts

An overdraft is an advance given byallowing a customer to overdraw hiscurrent account upto an agreed limit. Thesecurity for overdrafts is usually financialassets of the account holder such as shares,debentures, life insurance policies etc.Overdraft is a temporary facility and therate of interest charged on the amountof credit used is lower than that oncash credit because the risk involved andservice cost of such credit is less - it iseasier to liquify financial assets thanphysical assets.

4. Discounting Bills of Exchange

A bill of exchange is a documentacknowledging an amount of money owedin consideration for goods received. Forexample, if A buys goods from B, he maynot pay B immediately. He may give B abill of exchange, stating the amount ofmoney owed and the time when the debthas to be settled, If B wants moneyimmediately, he will present the bill ofexchange to the bank for discounting. Thebank will deduct a commission and paythe present value of the bill to B. Uponmaturity of the bill; the bank will securepayment from A.

5. Investment of funds

The banks invest their surplus funds inthree types of securities - Governmentsecurities, other approved securities, andother securities. Government securities aresecurities of both the central an stategovernments such as treasury bills,national savings certificates etc.Other approved securities are securitiesapproved under the provisions of theBanking Regulation Act, 1949. Theseinclude securities of state associated bodieslike electricity boards, housing boards,debentures of Land Development Banks,units of UTI, shares of Regional RuralBanks etc.Part of the banks investment ingovernment securities and other approvedsecurities are mandatory under theprovisions of the Statutory Liquidity Ratiorequirement of the RBI. However, bankshold excess investments in these securitiesbecause banks can borrow against thesesecurities from RBI and others, or sell thesesecurities in the open market to meet theirneed for cash. Banks hold them eventhough the return from them is lowerthan that on loans and advances becausethey are more liquid.

TYPES OF BANKS IN INDIA

1) Reserve Bank of India

The Reserve Bank of India Act of 1934established the Reserve Bank as the centralbanking institution of India which controls themonetary policy of the rupee as well as thecurrency reserves. The shares were entirely


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owned by private shareholders. Finally ReserveBank of India was nationalized in the year1949.

The Bank was constituted for thefollowing basic functions:

• To regulate the issue of Bank Notes• To maintain reserves with a view to

securing monetary stability and• To operate the credit and currency system

of the country to its advantage.

2) Commercial Banks

Commercial Banks are banking institutionsthat accept deposits and grant short-term loansand advances to their customers. In additionto giving short-term loans, commercial banksalso give medium-term and long-term loan tobusiness enterprises. Now-a-days some of thecommercial banks are also providing housingloan on a long-term basis to individuals. Thereare also many other functions of commercialbanks, which are discussed later in this lesson.

Types of Commercial banks:

(i) Public Sector Banks: These are bankswhere majority stake is held by theGovernment of India or Reserve Bank ofIndia. Examples of public sector banks are:State Bank of India, Corporation Bank,Bank of Baroda and Dena Bank, etc.

(ii) Private Sectors Banks: In case of privatesector banks majority of share capital ofthe bank is held by private individuals.These banks are registered as companieswith limited liability. For example: TheJammu and Kashmir Bank Ltd., Bank ofRajasthan Ltd., Development Credit BankLtd, Lord Krishna Bank Ltd., BharatOverseas Bank Ltd., Global Trust Bank,Vysya Bank, etc.

(iii) Foreign Banks: These banks are registeredand have their headquarters in a foreigncountry but operate their branches in ourcountry. Some of the foreign banksoperating in our country are Hong Kongand Shanghai Banking Corporation(HSBC), Citibank, American ExpressBank, Standard & Chartered Bank,Grindlay’s Bank, etc. The number offoreign banks operating in our country hasincreased since the financial sector reformsof 1991.

3) Regional Rural Banks

Regional Rural Banks were establishedunder the provisions of an Ordinancepromulgated on the 26th September 1975 andthe RRB Act, 1976 with an objective to ensuresufficient institutional credit for agriculture andother rural sectors. The RRBs mobilize financialresources from rural / semi-urban areas andgrant loans and advances mostly to small andmarginal farmers, agricultural labourers andrural artisans. The area of operation of RRBs islimited to the area as notified by Governmentof India covering one or more districts in theState.

RRBs are jointly owned by Government ofIndia, the concerned State Government andSponsor Banks (27 scheduled commercial banksand one State Cooperative Bank); the issuedcapital of a RRB is shared by the owners in theproportion of 50%, 15% and 35% respectively.

4) Co-operative Banks

Co-operative banks are small-sized unitsorganized in the co-operative sector whichoperate both in urban and non-urban centers. Co-operative Banks in India are registeredunder the Co-operative Societies Act. Thecooperative bank is also regulated by the RBI.They are governed by the Banking RegulationsAct 1949 and Banking Laws (Co-operativeSocieties) Act, 1965.

Types of Co-operative Banks

(i) Primary Credit Societies: These areformed at the village or town level withborrower and non-borrower membersresiding in one locality. The operations ofeach society are restricted to a small areaso that the members know each other andare able to watch over the activities of allmembers to prevent frauds.

(ii) Central Co-operative Banks: These banksoperate at the district level having someof the primary credit societies belongingto the same district as their members. Thesebanks provide loans to their members (i.e.,primary credit societies) and function asa link between the primary credit societiesand state co-operative banks.

(iii) State Co-operative Banks: These are theapex (highest level) co-operative banks inall the states of the country. They mobilisefunds and help in its proper channelisation


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among various sectors. The moneyreaches the individual borrowers from thestate co-operative banks through thecentral co-operative banks and theprimary credit societies.

Cooperative banks in India finance rural areasunder:

a) Farming b) Cattlec) Milk d) Hatcherye) Personal finance

Cooperative banks in India finance urban areasunder:

a) Self-employment b) Industriesc) Small scale units d) Home financee) Consumer finance f) Personal finance

WHAT IS KYC NORM?

KYC is an acronym for “Know yourCustomer”, a term used for customeridentification process. It involves makingreasonable efforts to determine true identity andbeneficial ownership of accounts, source offunds, the nature of customer’s business,reasonableness of operations in the account inrelation to the customer’s business, etc whichin turn helps the banks to manage their risks

prudently. The objective of the KYC guidelinesis to prevent banks being used, intentionally orunintentionally by criminal elements for moneylaundering.

KYC has two components - Identity andAddress. While identity remains the same, theaddress may change and hence the banks arerequired to periodically update their records.

WHAT IS PRIORITY

SECTOR LENDING?

Priority sector refers to those sectors of theeconomy which may not get timely andadequate credit in the absence of this specialdispensation. Typically, these are small valueloans to farmers for agriculture and alliedactivities, micro and small enterprises, poorpeople for housing, students for education andother low income groups and weaker sections.

Priority Sector includes the followingcategories: Agriculture; Micro and SmallEnterprises; Education; Housing; Export Creditand Others.

WHAT IS FINANCIAL INCLUSION?

A vast section of Indians, particularlythose living on low incomes, can not access

Targets and Sub-targets for banks under priority sector are as follows:

Categories Domestic commercial banks / Foreign banks with Foreign banks with 20 and less than 20 branches “

above branches “

Total Priority 40 3220 branches “

Total agriculture 18 No specific target.

Advances to 10 No specific target.Weaker Sections

mainstream financial products such as bankaccounts and low cost loans. This financialexclusion forces them to borrow from themoney lenders at high cost. Thus to overcomethis problem, serious attention was given to theaccess to banking, access to affordable credit,and access to free face-to-face money advice.

Financial Inclusion is the process ofensuring access to appropriate financialproducts and services needed by all sections ofthe society in general and vulnerable groups

such as weaker sections and low income groupsin particular at an affordable cost in a fair andtransparent manner by mainstream institutionalplayers.

In advanced economies, FinancialInclusion is more about the knowledge of fairand transparent financial products and a focuson financial literacy. In emerging economies, itis a question of both access to financial productsand knowledge about their fairness andtransparency.


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The financial services include the entiregamut - savings, loans, insurance, credit,payments etc.

RBI has taken following steps for financialinclusion in India:

• No-Frill accounts: In November 2005, RBIasked banks to offer no-frills savingsaccount which enables excluded peopleto open a savings account. Normally, thesavings account requires people tomaintain a minimum balance and mostbanks now even offer various facilitieswith the same. No-frills account requiresno (or negligible) balance and is withoutany other facilities leading to lower costsboth for the bank and the individual. Thenumber of no-frills account has increasedmainly in public sector banks from about0.4 million to 6 million between March2006 and March 2007. The number of No-frill accounts in private sector banks alsoincreased from 0.2 million to 1 million inthe same period. Recently RBI has directedall the commercial banks to offer zerobalance account with minimum facilitieslike cheque book and ATM to allcustomers.

• Usage of Regional language: The Bankswere required to provide all the materialrelated to opening accounts, disclosuresetc in the regional languages.

• Simple KYC Norms: In order to ensurethat persons belonging to low incomegroup both in urban and rural areas donot face difficulty in opening thebank accounts due to the proceduralhassles, the KYC procedure for openingaccounts has been simplified for thosepersons who intend to keep balances notexceeding rupees fifty thousand (Rs.50,000/-) in all their accounts takentogether and the total credit in allthe accounts taken together is notexpected to exceed rupees one lakh(Rs.1,00,000/-) in a year.

• KYC norms include proof of identity andproof of address. Passport, voter's ID card,PAN card or driving license are acceptedas proof of identity, and proof of residenceas on ration card, an electricity ortelephone bill or a letter from the employeror any recognised public authority

certifying the address in order to preventidentity theft, identity fraud.

• Easier Credit facilities: Banks have beenasked to consider introducing Generalpurpose Credit Card (GCC) facility up toRs. 25,000/- at their rural and semi urbanbranches. GCC is in the nature of revolvingcredit entitling the holder to withdrawupto the limit sanctioned. The limit forthe purpose can be set Based onassessment of household cash flows, thelimits are sanctioned without insistence onsecurity or purpose. The Interest rate onthe facility is completely deregulated. Asimplified mechanism for one-timesettlement of overdue loans up toRs.25,000/- has been suggested foradoption. Banks have been specificallyadvised that borrowers with loans settledunder the one time settlement scheme willbe eligible to re-access the formal financialsystem for fresh credit.

• Using Information Technology: A fewPilot projects have been initiated to testhow technology can be used to increasefinancial inclusion such as

a) Smart cards for opening bank accountswith biometric identification.

b) Link to mobile or hand held connectivitydevices ensure that the transactions arerecorded in the bank's books on real timebasis.

c) Issuance of AADHAR numbers.d) Some State Governments are routing

payments under the National RuralEmployment Guarantee Scheme throughsmart cards. The same delivery channelcan be used to provide other financialservices like low cost remittances andinsurance.

• Financial Education: RBI has takennumber of measures to increase financialliteracy in the country. It has set up amultilingual website in 13 languagesexplaining about banking, money etc. Ithas started putting up comic strips toexplain various difficult subjects likeimportance of saving, RBI's functions etc.These comics explain myriad and complexconcepts in an entertaining manner. Thewebsite states: The Reserve Bank of Indiahas undertaken a project titled "ProjectFinancial Literacy". The Objective of theproject is to disseminate information


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regarding the central bank and generalbanking concepts to various target groups,including, school and college goingchildren, women, rural and urban poor,defence personnel and senior citizens.The ultimate objective of financial inclusionis to ensure that banking services reaches tothe poor to ensure inclusive growth.

WHAT IS NEFT AND RTGS?

• NEFT : National Electronic FundsTransfer SystemThis system is a nationwide funds transfersystem to facilitate transfer of funds fromany bank branch to any other bank branch.Under this Scheme, individuals, firms andcorporates can electronically transfer fundsfrom any bank branch to any individual,firm or corporate having an account withany other bank branch in the countryparticipating in the Scheme.Even such individuals who do not have abank account (walk-in customers) can alsodeposit cash at the NEFT-enabledbranches with instructions to transferfunds using NEFT. However, such cashremittances will be restricted to amaximum of Rs.50,000/- per transaction.Such customers have to furnish full detailsincluding complete address, telephonenumber, etc. NEFT, thus, facilitatesoriginators or remitters to initiate fundstransfer transactions even without havinga bank account.The NEFT system also facilitates one-way cross-border transfer of funds fromIndia to Nepal. This is known as the Indo-Nepal Remittance Facility Scheme. Thebeneficiary would receive funds inNepalese Currency.

Advantages:

a) The remitter need not send the physicalcheque or Demand Draft to the beneficiary.

b) The beneficiary need not visit his / herbank for depositing the paperinstruments.

c) The beneficiary need not be apprehensiveof loss / theft of physical instruments orthe likelihood of fraudulent encashmentthereof.

d) Cost effective.

e) Credit confirmation of the remittances sentby SMS or email.

f) Remitter can initiate the remittances fromhis home / place of work using the internetbanking also.

g) Near real time transfer of the funds to thebeneficiary account in a secure manner.

RTGS: Real Time Gross Settlement System

RTGS stands for ‘Real Time GrossSettlement’. It can be defined as the continuous(real-time) settlement of funds transfersindividually on an order by order basis (withoutnetting).

'Real Time' means the processing ofinstructions at the time they are received ratherthan at some later time. 'Gross Settlement'means the settlement of funds transferinstructions occurs individually (on aninstruction by instruction basis i.e. on one toone basis). Considering that the funds settlementtakes place in the books of the Reserve Bank ofIndia, the payments are final and irrevocable.This is the fastest mode of funds transferavailable in India through banking channel.

The RTGS system is primarily meant forlarge value transactions. The minimum amountto be remitted through RTGS is ` 2 lakh. Thereis no upper ceiling for RTGS transactions.

Advantages:

a) Since the funds transfer instructions areprocessed and settled in real time, thecredit and liquidity risks are eliminated.

b) Leads to a seamless movement of fundsfrom one end to another using the ITplatform and reduces the systematic risksin the settlement system.

c) As the funds are received instantly online,in the RTGS system, the collecting banksand their customers can use the fundsimmediately without exposing themselvesto settlement risk.

MONETARY POLICY

The use by the Central Bank of interest rateand other instruments to influence money supplyto achieve certain macro economic goals is knownas monetary policy. Credit policy is a part ofmonetary policy as it deals only with how muchand at what rate credit is advanced by the banks.Objectives of monetary policy are: accelerating


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growth of economy, maintaining price stability,stabilization of exchange rate, balancing savingsand investment and generating employment.

Monetary policy is generally referred to aseither being an expansionary policy, or acontractionary policy, where an expansionarypolicy increases the total supply of money in theeconomy, and a contractionary policy decreasesthe total money supply. Expansionary policy istraditionally used to combat unemployment in arecession by lowering interest rates, whilecontractionary policy has the goal of raisinginterest rates to combat inflation.

Tools of Monetary Policy

The tools available for the central bank toachieve the above ends are: Bank rate, Reserveratios, Open market operations, Intervention inthe forex market and Moral suasion

Bank rate

Bank Rate is the rate at which RBI lends tocommercial banks. Bank Rate is a tool which RBIuses for managing money supply and credit. Anyrevision in Bank Rate by RBI is a signal to banksto revise deposit rates as well as Prime LendingRate. It stands at 6% presently (2008 July)

Reserve Requirements

In economics, fractional-reserve banking isthe near-universal practice of banks in whichbanks keep a fraction of the total depositsmanaged by a bank as reserves and are not belent. The reserve ratios are periodically changedby the RBI. The reserve requirement (or requiredreserve ratio) is a bank regulation that sets theminimum reserves each bank must hold as a partof the deposits. These reserves are designed tosatisfy various needs like providing loans to theGovernment (SLR) and inflation management(CRR). They are in the form of RBI approvedsecurities (SLR) kept with themselves or cash thatis kept with the RBI (CRR).

Statutory liquidity Ratio (SLR)

It is the portion of time and demandliabilities of banks that they should keep in theform of designated liquid assets like governmentand other RBI-approved securities like publicsector bonds; current account balances with otherbanks and gold. SLR is aimed at ensuring thatthe need for government funds is partly but surely

met by the banks. The commitment of theGovernment to reduce fiscal deficit means that itwill borrow less and so the SLR was progressivelybrought down from 38.5% in 1991 to 25% today.

The Reserves Bank of India Act, 1934 andthe Banking Regulation Act, 1949 fixed the floorand cap on SLR at 25% and 40% respectively.But the amendment made in these statutesremoved the limits-lower and upper: RBI has, asa result, the freedom to fix the SLR at any ratedepending on the macro economic conditions.The amendment was an enabling one.

Cash Reserve Ratio (CRR)

CRR is a monetary tool to regulate moneysupply. It is the portion of the bank deposits thata bank should keep with the RBI in cash form.CRR deposits earn no interest

The Reserve Bank of India Act, 1934and the Banking Regulation Act, 1949 fixedthe floor and cap on CRR at 3% and 20%respectively. But the amendment made inthese statutes removed the limits-lower andupper. RBI has, as a result, the freedom to fix theCRR at any rate depending on the macroeconomic conditions. The amendment was anenabling one.

CRR is adjusted to manage liquidity andinflation the more the CRR, the less the moneyavailable for lending by the banks to players inthe economy. CRR was 15% in 1991 and todayit is 8.75%. If inflation is high, money supplyneeds to be taken out and so CRR is generallyincreased. But in a regime of moderate inflation,low CRR is in place.

RBI increases CRR to tighten credit forexample, CRR today (July 2008) stands at 8.75%-high because inflation is also at 13-year high at1.89% on WPI (July 2008). It needed to becontrolled by a variety of means one of whichwas hike in CRR.

CRR as a tool of monetary policy is usedwhen there is a tremendous need to reduceinflation and tighten credit as in 2008. Otherwise,normally, RBI relies on open market operationsfor liquidity management.

Open Market Operations (OMOs) of RBI

OMOs of the RBI can be described as:Purchases and sales of government and certainother securities in the open market (banks and


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financial institutions) by the RBI in order toinfluence the volume of money and credit in theeconomy: Purchases of government securitiesinjects money. Into the market and thus expandsmoney and credit; sales have the opposite effect– absorb excess

Liquidity and shrink credit. Open marketoperations are RBI’s most important andflexible monetary policy tool. Open marketoperations do not change the total stock ofgovernment securities but change the proportionheld by the RBI, commercial and cooperativebanks.

Ready Forward Contracts (Repos)

It is a transaction in which two parties agreeto sell and repurchase the same security. Undersuch an agreement the seller sells specified securitieswith an agreement to repurchase the same at amutually decided future date and a price. Similarly,the buyer purchases the securities with an agreementto resell the same to the seller on an agreed date infuture at a predetermined price.

In India, RBI lends on a short term basis tobanks on the security of the government paper(repo). Banks undertake to repurchase the securityat a later date-over night or few days. RBI chargesa repo rate for the money it lends. It is 8.5%presently (2008 July).

Reverse repo is when RBI borrows from themarket (absorbs excess liquidity) with the sale ofsecurities and repurchases them the next day orafter a few days. The rate at which it borrows iscalled reverse repo rate as it is the reverse of therepo operation. Reverse repo rate presently is 6%(July 2008)

The repo rate and reverse repo rate are 6%and 8.5% respectively today (July 2008)

The Repo/Reverse Repo transaction canonly be done at Mumbai and in securities asapproved by RBI (Treasury Bills, Central/StateGovt securities). RBI uses Repo and Reverse repoas instruments for liquidity adjustment in thesystem.

Selective Credit Controls

Certain businesses can be given more andcertain others may get less credit from banks onthe orders of the RBI. Thus, selective credit controlscan be imposed for meeting various goals likediscouraging hoarding and black-marketing of

certain essential commodities by traders etc.Either credit can be rationed or interest rate canbe hiked by RBI as a part of SCCs. In SCCs, thetotal quantum of credit does not change, but theamount lent and the cost of credit may bechanged for specific sector or sectors.

Moral suasion

A persuasion measure used by central bankto influence and pressure, but not force, banksinto adhering to policy. Measures used are closed-door meetings with bank directors, increasedseverity of inspections discussion, appeals tocommunity spirit etc.

Recently the RBI Governor appealed tobanks not to raise rates even though the centralbank was following a tight money policy.

When is the Monetary Policy announced?

Historically, the Monetary Policy is an-nounced twice a year - a slack season policy(April-September) and a busy season policy(October-March) in accordance with agricul-tural cycles. These cycles also coincide with thehalves of the financial year.

Initially, the Reserve Bank of India an-nounced all its monetary measures twice a yearin the Monetary and Credit Policy. The Mon-etary Policy has become dynamic in nature asRBI reserves its right to alter it from time totime, depending on the state of the economy.

However, with the share of credit to agri-culture coming down and credit towards theindustry being granted whole year around, theRBI since 1998-99 has moved in for just onepolicy in April-end. However a review of thepolicy does take place later in the year.

How is the Monetary Policy different from theFiscal Policy?

Two important tools of macroeconomicpolicy are Monetary Policy and Fiscal Policy.

The Monetary Policy regulates the supply ofmoney and the cost and availability of credit inthe economy. It deals with both the lendingand borrowing rates of interest for commercialbanks.

The Monetary Policy aims to maintain pricestability, full employment and economicgrowth.

The Reserve Bank of India is responsible for


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formulating and implementing Monetary Policy.It can increase or decrease the supply of cur-rency as well as interest rate, carry out openmarket operations, control credit and vary thereserve requirements.

The Monetary Policy is different from FiscalPolicy as the former brings about a change inthe economy by changing money supply andinterest rate, whereas fiscal policy is a broadertool with the government.

The Fiscal Policy can be used to overcomerecession and control inflation. It may be de-fined as a deliberate change in government rev-enue and expenditure to influence the level ofnational output and prices.

For instance, at the time of recession the gov-ernment can increase expenditures or cut taxesin order to generate demand.

On the other hand, the government can re-duce its expenditures or raise taxes during in-flationary times. Fiscal policy aims at changingaggregate demand by suitable changes in gov-ernment spending and taxes.

The annual Union Budget showcases thegovernment's Fiscal Policy.

What are the objectives of the MonetaryPolicy?

The objectives are to maintain price stabilityand ensure adequate flow of credit to the pro-ductive sectors of the economy.

Stability for the national currency (after look-ing at prevailing economic conditions), growthin employment and income are also looked into.The monetary policy affects the real sectorthrough long and variable periods while thefinancial markets are also impacted throughshort-term implications.

There are four main 'channels' which the RBIlooks at:

• Quantum channel: money supply andcredit (affects real output and price levelthrough changes in reserves money,money supply and credit aggregates).

• Interest rate channel.• Exchange rate channel (linked to the cur-

rency).• Asset price.There are other secondary goals which mon-

etary policy is supposed to take care, growth inincome output and employment. But in develop-

ing countries like India the problem of trade cycleis not the only concern. In such countries mon-etary policy is framed in such a manner that itpromotes capital formation on the one hand andaddresses the problems of interpersonal, inter-regional and intersectoral inequality on the other.Monetary policy has many instruments such asbank rate, reserve ratio and open market opera-tion policies. These instruments affect the quan-tity of money supply in the economy directly;hence they are called quantitative instruments.

There are other instruments, which affectthe direction and amount of credit available tovarious sectors and regions through (a) changein marginal requirements, (b) putting ceiling tothe amount of maximum credit and (c) charg-ing different interest rates for various economicactivities. These instruments are known as in-struments of selective credit control or qualita-tive method of credit control. They are veryrelevant in case of developing countries likeIndia. Monetary policy is framed and imple-mented by the Central Bank (RBI in case ofIndia).

With the introduction of the Five Year Plans,the need for appropriate adjustment in mon-etary and fiscal policies to suit the pace andpattern of planned development became im-perative.

The monetary policy since 1952 emphasisedthe twin aims of the economic policies of thegovernment.

1. Speed up the economic development inthe country to raise national income andthe standard of living.

2. To control and reduce the inflationarypressure on the economy.

This policy of the Reserve Bank of India sincethe First Plan period was termed broadly asone of 'controlled expansion' i.e. a policy of"adequate financing of economic growth andat the same time ensuring reasonable price sta-bility." Expansion of currency and credit wasessential to meet the increased demand for in-vestment funds in an economy like India, whichhad embarked on rapid economic development.

RBI recognized and appreciated the needfor expansion of credit and money supply com-mensurate with the rapid development and di-versification of the economy. At the same timeit was equally aware that an excessive expan-sion of money and credit would be clearly in-flationary and would ultimately endanger the


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financial stability of the economy. Accordingly,the RBI helped the economy to expand throughthe expansion of money and credit and at-tempted to check rise in prices through selec-tive controls.

Monetary policy is formulated with the con-sideration of macroeconomic objectives gener-ally determined by the government within theframe of a fiscal budget or annual plan. Themajor macroeconomic concerns in India havebeen the usual ones - aggregate growth, infla-tion and the balance of payments.

Until 1974, the preoccupation with inflationwas the concern of monetary policy. After theabrupt reduction of inflation in the second halfof 1974-75, the emphasis shifted toward achiev-ing higher rates of aggregate growth. After1979-80, policy efforts shifted, first graduallyand then sharply towards financial restraint asefforts were mounted to limit the price effectsof a severe drought and sharply reducedgrowth.

Thus in the pre-reform period monetarypolicy played a largely accommodative role tofiscal policy. The central government had freeaccess to borrowing from the RBI through adhoc treasury bills. It helped to adopt an expan-sionary fiscal policy and had a multiplier effecton expansion of money supply.

CREDIT CONTROLSGeneral Credit Controls: These weapons of

control are broadly two: quantitative and quali-tative controls. Quantitative controls are usedto control the volume of credit and indirectlyto control inflationary and deflationary pres-sures caused by expansion and contraction ofcredit. Quantitative controls consist of bank ratepolicy, open market operations and cash re-serve ratio. All these methods have been usedwith discretion since the beginning of Planningin India. Since 1955-56 and particularly after1973-74 the inflationary rise in price has beensteadily increasing. Increased government ex-penditure financed through deficit spending hasthe direct effect of increasing prices, wages andincomes. Shortfalls in production, and hoard-ing and speculation in essential commoditieshave contributed to this inflationary pressure.RBI has various weapons of control and,through using them; it hopes to achieve itsmonetary policy.

Bank RateThe bank rate is an important monetary in-

strument in modern economies. Its most usefulrole is to signal and/or clarify the central bank'smonetary and interest rate stance to all partici-pants in the financial sector and particularly tobanks. If monetary policy is effective and cred-ible, a change in the bank rate will result in achange in the prime lending rates of banks andthus act as an independent instrument of mon-etary control. However, the role of bank rateas an instrument of monetary policy has beenvery limited in India because of the followingbasic factors:

• The structure of interest rates is adminis-trated by the RBI - they are not automati-cally linked to the bank rate.

• The commercial banks enjoy specific refi-nance facilities, and do not necessarilyrediscount eligible securities at the bankrate.

• The bill market is under developed andthe different sub markets of the moneymarket are not influenced by the bankrate.

In other words, the bank rate in India is notthe pace setter to other market interest rates ofinterest and the money market rates do not au-tomatically adjust themselves to changes in thebank rate. At the same time, the deposit andlending rates of banks (and of development fi-nancial institutions) are not related to the bankrate.

Cash Reserve Requirements (CRR)Another weapon available to the RBI for

credit control is use the of variable cash reserverequirements. Under the RBI Act 1934, everycommercial bank has to keep certain minimumcash reserves with the RBI. Initially it was 5%against demand deposits and 2% against timedeposits. These are known as the statutory cashreserves. Since 1962, the RBI was empoweredto vary the cash reserve requirements between3% and 15% of total demand and time depos-its. The RBI has varied the CRR a number oftimes to reduce or increase bank credit.

In accordance with the Narasimham Com-mittee recommendations the CRR has been keptlow since 1992.

Statutory Liquidity Requirements (SLR)


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Apart from the cash reserve requirementswhich the commercial banks have to keep withthe RBI, all banks have to maintain with theRBI or with themselves liquid assets in the formof cash, gold and unencumbered approved se-curities equal to not less than 25% of their totaltime and demand deposits. This is known asthe statutory liquidity requirement as has to bemaintained in addition to the CRR. A higherSLR ratio works in two ways:

• It reduces the money supply in theeconomy and thus is deflationary

• It can also be used to divert funds tofinance government expenditure

Open Market Operations

In economies with well developed moneymarkets central banks use open market opera-tions - i.e. buying and selling of eligible securi-ties by the central bank in the money market -to influence volume of cash reserves with thecommercial banks and thus influence the vol-ume of loans and advances that they can maketo the commercial sector. The RBI had not usedthis instrument for many years. Since 1991, theenormous inflow of foreign funds into the Indianeconomy created the problem of excess liquiditywith the banking sector and the RBI undertooklarge scale open market operations. When RBIsells government securities in the open market, itwithdraws a part of the cash reserves of thecommercial banks, and thereby reduces theirability to lend to industrial and commercial sec-tors. Thus money supplies contracts.

The opposite will happen if the RBI buyssecurities from the open market and pays forthem. The commercial banks will find that theyhave more surplus cash. Thus money supplyincreases.

Selective and Directed Credit Controls

Under the Banking Regulation Act 1949,Section 21 empowers RBI to issue directive tothe banking companies regarding their ad-vances. These directives may relate to:

• The purpose for which advances may ormay not be made.

• The margins to be maintained with regardto secured advances.

• The maximum advance to any borrower.

• The maximum amount upto, whichguarantees may be given by the bankingcompany on behalf of any firm, company,etc.

• The rate of interest and other terms andconditions for granting advances.

Since 1956-57 the RBI has made full use ofSection 21 of the Banking Regulation Act, 1949to check speculation and rising prices, the con-trols are selective as they are used to check therising tendency of prices of certain individualcommodities of common use.

Generally the RBI uses three kinds of Selec-tive Credit Controls:

• Minimum margin for lending against cer-tain specific securities.

• Ceiling on amounts of credits for certainpurposes.

• Discriminatory rates of interest charged oncertain types of advances.

While imposing selective controls, RBI takesgreat care that bank credit for production andtransportation of commodities exports is notaffected. Selective credit controls are mainlyfocussed on credit to traders for financinginventories (for purpose of hoarding and specu-lation).

Non-Performing Assets

In common parlance, the loans which havebecome "bad loans" or such loans whose re-covery is not possible are called Non-perform-ing assets (NPAs). The issue of Non-perform-ing assets (NPAs) in the financial institutionsin India has assumed a disturbing dimension.The problem of NPAs, however, is not peculiarto India alone. Countries such as Japan andChina are notoriously known for their hugeNPAs.

Meaning of NPAs

An asset is classified as non-performing as-set (NPAs) if dues in the form of principal andinterest are not paid by the borrower for aperiod of 180 days. However with effect fromMarch 2004, default status has been given to aborrower if dues are not paid for 90 days. Ifany advance or credit facilities granted by bankto a borrower become non-performing, then thebank will have to treat all the advances/credit


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facilities granted to that borrower as non-per-forming without having any regard to the factthat there may still exist certain advances /credit facilities having performing status.

Difference between Gross NPAs and NetNPAs

In view of the time lag in recovery processand the detailed procedures and safeguards in-volved in regard to write-off, even after mak-ing provisions for advances considered as irre-coverable banks continue to hold such advancesin their books. These are termed as gross NPAswhile provisioning adjusted NPAs are termedas net NPAs.

CLASSIFICATION OF BANK ASSETS

RBI Guidelines on Classification of BankAadvances

Reserve Bank of India (RBI) has issued guide-lines on provisioning requirement with respectto bank advances. In terms of these guidelines,bank advances are mainly classified into:

Standard Assets: Such an asset is not a non-performing asset. In other words, it carries notmore than normal risk attached to the busi-ness.

Sub-standard Assets: It is classified as non-per-forming asset for a period not exceeding 18 months.

Doubtful Assets: Asset that has remainedNPA for a period exceeding 18 months is adoubtful asset.

Loss Assets: Here loss is identified by thebanks concerned or by internal auditors or byexternal auditors or by Reserve Bank India (RBI)inspection.

In terms of RBI guidelines, as and when anasset becomes a NPA, such advances would befirst classified as a sub-standard one for a pe-riod that should not exceed 18 months andsubsequently as doubtful assets.

RBI guidelines on Provisioning Requirementof Bank Advances

As and when an asset is classified as anNPA, the bank has to further sub-classify itinto sub-standard, loss and doubtful assets.Based on this classification, bank makes thenecessary provision against these assets.

Capital Adequacy RatioCapital Adequacy Ratio or Capital to RiskWeighted Assets Ratio (CRAR) refers to the ratiobetween total capital and risk weighted assets ofa bank. Risk weighting became necessary in viewof the adoption of Basel-I by the Indian banks.

Basel Committee on Banking SupervisionThe Basel Committee on Banking Supervisionis an institution created by the central bankGovernors of the Group of Ten nations. It wascreated in 1974 and meets regularly four timesa year. The Committee's members come fromArgentina, Australia, Belgium, Brazil, Canada,China, France, Germany, Hong Kong SAR, In-dia, Indonesia, Italy, Japan, Korea, Luxem-bourg, Mexico, the Netherlands, Russia, SaudiArabia, Singapore, South Africa, Spain, Swe-den, Switzerland, Turkey, the United Kingdomand the United States. The Committee usuallymeets at the Bank for International Settlements(BIS) in Basel, Switzerland, where its 12 mem-ber permanent Secretariat is located. The Com-mittee is often referred to as the BIS Committeeafter its meeting location. However, the BIS andthe Basel Committee remain two distinct enti-ties.

The Basel Committee formulates broad super-visory standards and guidelines and recom-mends statements of best practice in bankingsupervision.

Basel IBasel I is the round of deliberations by centralbankers from around the world, and in 1988,the Basel Committee (BCBS) in Basel, Switzer-land, published a set of minimal capital require-ments for banks. This is also known as the 1988Basel Accord, and was enforced by law in theGroup of Ten (G-10) countries in 1992 . BaselI is now widely viewed as outmoded. Indeed,the world has changed as financial conglomer-ates, financial innovation and risk managementhave developed. Therefore, a more comprehen-sive set of guidelines, known as Basel II are inthe process of implementation by several coun-tries and new updates in response to the finan-cial crisis commonly described as Basel III. BaselI, that is, the 1988 Basel Accord, primarily fo-cused on credit risk. Assets of banks were clas-sified and grouped in five categories accordingto credit risk, carrying risk weights of zero (forexample home country sovereign debt), ten,


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twenty, fifty, and up to one hundred per cent(this category has, as an example, most corpo-rate debt). Banks with international presenceare required to hold capital equal to 8 % of therisk-weighted assets. However, large banks likeJPMorgan Chase found Basel I's 8% require-ment to be unreasonable, and implementedcredit default swaps so that in reality theywould have to hold capital equivalent to only1.6% of assets. Since 1988, this framework hasbeen progressively introduced in member coun-tries of G-10, currently comprising 13 coun-tries, namely, Belgium, Canada, France, Ger-many, Italy, Japan, Luxembourg, Netherlands,Spain, Sweden, Switzerland, United Kingdomand the United States of America.

Basel II

Basel II is the second of the Basel Accords,which are recommendations on banking lawsand regulations issued by the Basel Committeeon Banking Supervision. The purpose of BaselII, which was initially published in June 2004,is to create an international standard that bank-ing regulators can use when creating regula-tions about how much capital banks need toput aside to guard against the types of finan-cial and operational risks banks face. Advo-cates of Basel II believe that such an interna-tional standard can help protect the interna-tional financial system from the types of prob-lems that might arise should a major bank ora series of banks collapse. In theory, Basel IIattempted to accomplish this by setting up riskand capital management requirements designedto ensure that a bank holds capital reservesappropriate to the risk the bank exposes itselfto through its lending and investment prac-tices. Generally speaking, these rules mean thatthe greater risk to which the bank is exposed,the greater the amount of capital the bankneeds to hold to safe-guard its solvency andoverall economic stability.

Basel IIIBasel III is a new global regulatory standardon bank capital adequacy and liquidity agreedby the members of the Basel Committee onBanking Supervision. The third of the BaselAccords was developed in a response to thedeficiencies in financial regulation revealed bythe global financial crisis. Basel III strengthensbank capital requirements and introduces newregulatory requirements on bank liquidity andbank leverage. The OECD estimates that theimplementation of Basel III will decrease an-nual GDP growth by 0.05 to 0.15 percentagepoint.

Securitisation Bill (2002)It's a known fact that the banks and financialinstitutions in India face the problem of swell-ing non-performing assets (NPAs) and the is-sue is becoming more and more unmanage-able. In order to bring the situation under con-trol, some steps have been taken recently. TheSecuritisation and Reconstruction of FinancialAssets and Enforcement of Security Interest Act,2002 was passed by Parliament, which is animportant step towards elimination or reduc-tion of NPAs.

An economy with foreign trade with the rest ofthe world is known as 'open economy'. Aneconomy with no foreign trade is known as a'closed economy'. Erstwhile Soviet Union was aclosed economy. At present all the economiesare 'open economies'. "Autarky" is a term usedfor self-sufficient closed economy. "Globalisation"means opening up of the economy and integrat-ing it with world economies. International tradeinvolves exchange of goods and services as wellas foreign currencies. Trade in goods is knownas merchandise trade, while trade in services isknown as 'invisible trade'. Real Investment orinvestment in productive/industrial activities byforeigners is known as Foreign Direct Invest-ment (FDI). Investment in financial instrumentssuch as banks and stock market is known asportfolio investment.

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Inflation is a rise in the general level ofprices of goods and services in an economy overa period of time. When the general price levelrises, each unit of currency buys fewer goodsand services. Consequently, inflation also reflectserosion in the purchasing power of money.

As for exampleIf we were able to buy 1kg of rice at say

Rs.50 but due to price rise same amount iscosting Rs.70. The price rise of the commoditiesover a period of time is inflation that is affectingthe purchasing power of the people. This inturn reduces the value of money as for eachcommodity we have to spend more than theprevious one.

Types Of Inflation

1. Demand pull inflation: This type ofinflation occurs when total demand forgoods and services in an economy exceedsthe supply of the same. When the supplyis less, the prices of these goods andservices would rise, leading to a situationcalled as demand-pull inflation. This typeof inflation affects the market economyadversely during the wartime.

As for exampleHigh prices of onions: Due to the cropfailure the supply of onions decreased butthe demand among the masses remainedthe same. Thus as a result prices increaseddrastically reached around Rs.80. Thegovernment had imported the onions fromPakistan. As the supply increases in themarket the prices automatically decrease.Thus this is demand pull inflation. Thevicious circle of demand and supplycontrols the prices.“

2. Cost-push Inflation: If there is increasein the cost of production of goods andservices, due to increase of wages and rawmaterials cost, there is likely to be aconsequent increase in the prices offinished goods and services.


As for example

High petrol prices: ongoing increase inthe prices of petrol is resulting in highinflation rate. Since petroleum is soimportant to developing economies, alarge increase in its price can lead to theincrease in the price of most products,raising the inflation rate.

3. Pricing Power Inflation: Pricing powerinflation is more often called asadministered price inflation. This type ofinflation occurs when the business housesand industries decide to increase the priceof their respective goods and services toincrease their profit margins. A pointnoteworthy is pricing power inflation doesnot occur at the time of financial crisisand economic depression, or when thereis a downturn in the economy. Thistype of inflation is also called asoligopolistic inflation because oligopolieshave the power of pricing their goods andservices.

As for exampleIncrement in prices of cars: due toincrease in cost of steel, plastic etc and tomaintain profit margins the price of carshave to be increased.

4. Sectoral Inflation: The sectoral inflationtakes place when there is an increase inthe price of the goods and servicesproduced by a certain sector of industries.For instance, an increase in the cost ofcrude oil would directly affect all the othersectors, which are directly related tothe oil industry. Thus, the ever-increasingprice of fuel has become an importantissue related to the economy all over theworld.

As for exampleIncrement in airfare: In Aviation industrywhen the price of oil increases, the ticketfares also go up.

INFLATION


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Concepts related to Inflation

• Stagflation: It is a situation in whichthe inflation rate is high and the economicgrowth rate is low. It raises a dilemma foreconomic policy since actions designed tolower inflation may worsen economicgrowth and vice versa.

There can be two reasons for stagflation:Firstly, stagflation can result when theproductive capacity of an economy isreduced by an unfavorable supply shock,such as an increase in the price of oil foran oil importing country. Such anunfavorable supply shock tends to raiseprices and slows the economy by makingproduction more costly and less profitable.Secondly, stagflation can result due toinappropriate macroeconomic policies.For example, central banks can causeinflation by permitting excessive growthof the money supply and the governmentcan cause stagnation by excessiveregulation of goods markets and labourmarket.

• Reflation: It is the act of stimulatingthe economy by increasing the moneysupply or by reducing taxes. It is an act ofpumping money in the market to increasethe circulation so that economy can bestipulated again.As in U.S to increase the growth rategovernment has announced special bailoutpackages for the companies thus trying topump economy out of recession.

• Disinflation: It is a decrease in the rateof inflation – a slowdown in the rate ofincrease of the general price level of goodsand services in a nation's gross domesticproduct over time.

• Deflation: It is a decrease in thegeneral price level of goods andservices. Deflation occurs whenthe inflation rate falls below 0% (anegative inflation rate). This should not beconfused with disinflation which is a slow-down in the inflation rate (i.e. wheninflation declines to lower levels).

• Hyper inflation: It is the extremely rapidescalation of prices (typically more than50% per month) for goods and services.The most famous hyperinflation of themodern era occurred in Germany in 1920-1923 when the government began printing

money to make up for revenue lost. TheGerman hyperinflation resulted in apercentage increase in prices in themillions per month. Other cases ofhyperinflation (Greece, Hungary)following World War II were even moreextreme. The root cause of hyperinflationtends to be the excessive printing ofcurrency by the monetary authority.Hyperinflation is extremely disruptive bymaking savings worthless very quickly,thus encouraging workers to spend moneyas fast as it is earned.

• Recession: A significant decline in activityacross the economy, lasting longer than afew months is recession. It is visible inindustrial production, employment, realincome and wholesale-retail trade. Thetechnical indicator of a recession is twoconsecutive quarters of negative economicgrowth as measured by a country's grossdomestic product (GDP).

• Depression: It is a sustained, long-termdownturn in economic activity in one ormore economies. A depression ischaracterized by its length, by abnormallylarge increases in unemployment, falls inthe availability of credit— often due tosome kind of banking or financial crisis,shrinking output—as buyers dry up andsuppliers cut back on production, andinvestment, large numberof bankruptcies—including sovereign debtdefaults, significantly reduced amountsof trade and commerce—especiallyinternational, as well as highly volatilerelative currency value fluctuations—mostoften due to devaluations.

How Inflation Is Measured

Inflation is measured using two priceindexes CONSUMER PRICE INDEX andWHOLESALE PRICE INDEX.

A price index is a normalized weightedaverage of prices for a given class ofgoods or services in a given region, during agiven interval of time. It is a statistic designedto help to compare how these prices, taken asa whole, differ between time periods

Price indices have several potential uses.For particularly broad indices, the index canbe said to measure the economy's price level ora cost of living.


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A price index is selected and its index isassumed as 100 and on this basis price indexfor the current year is calculated. If index isbelow 100 it indicates deflation whereas if highthen inflation.

CONSUMER PRICE INDEX

A consumer price index (CPI) measureschanges in the price level of consumergoods and services purchased by households. Itis a measure that examines the weightedaverage of prices of a basket of consumer goodsand services, such as transportation, foodand medical care. The CPI is calculated bytaking price changes for each item in thepredetermined basket of goods and averagingthem; the goods are weighted according to theirimportance. Changes in CPI are used to assessprice changes associated with the cost of living.

In India CPI is calculated in different fieldsas:

• CPI-IW i.e. Consumer Price Index forIndustrial Workers (BASE YEAR IS 2001)

• CPI-AL i.e. Consumer Price Indexfor Agricultural Labour (BASE YEAR IS1986-87)

• CPI-RL i.e. Consumer Price Index for RuralLabours (BASE YEAR IS 1986-87)

WHOLESALE PRICE INDEX

The Wholesale Price Index or WPI is theprice of a representative basket of wholesalegoods. The Indian WPI figure is releasedmonthly and influences stock and fixed pricemarkets. The Wholesale Price Index focuses onthe price of goods traded between corporations,rather than goods bought by consumers, whichis measured by the Consumer Price Index. Thepurpose of the WPI is to monitor pricemovements that reflect supply and demand inindustry, manufacturing and construction. Thishelps in analyzing both macroeconomic andmicroeconomic conditions. Base year for WPIis 2004-05.

The limitations of WPI are related to

(a) Non-inclusion of services;(b) following a fixed weighting scheme while

the economy is undergoing majorstructural changes, and

(c) use of gross transactions data rather thandata on final purchases.

MONETARY MEASURES

TO CONTROL INFLATION

(GIVEN BY RBI)

• Cash reserve ratio:

Cash reserve Ratio (CRR) is the amountof funds that the banks have to keep with RBI.If RBI decides to increase the per cent of this,the available amount with the banks comesdown. RBI is using this method (increase ofCRR rate), to drain out the excessive moneyfrom the banks.

Effect on inflation

The foremost reason of inflation isincrement in money supply in the market. Cashreserve ratio is the amount kept by banks inRBI. If for example the bank has 100000 rupeesand CRR is 10% then 10% of 100000 has to bekept with RBI i.e. 10000 rupees. Now if theCRR increased to 12% then banks has to kept12% of 100000 i.e. 12000 with RBI. Hence themoney with the banks decreases as CRRincreases and thus money supply in the marketdecreases too and hence the inflation decreases.

• Statutory liquidity ratio:

Statutory Liquidity Ratio is the amount ofliquid assets, such as cash, precious metals orother approved securities, that a financialinstitution must maintain as reserves other thanthe Cash with the Central Bank

Effect on inflation

As we have understood that the foremostreason of inflation is increment in money supplyin the market. SLR is the amount of assetsmaintained by a bank. If for example the bankhas 1000000 rupees and SLR is 20% then 20%of 1000000 have to be maintained by banks i.e.200000 rupees in form of gold, securities etc.Now if the SLR increased to 30% then bankshas to kept 30% of 1000000 i.e. 300000. Hencethe money with the banks decreases as SLRincreases and thus money supply in the marketdecreases too and hence the inflation decreases.

• Bank rate:This is the rate at which central bank

(RBI) lends money to other banks or financialinstitutions. If the bank rate goes up, long-term interest rates also tend to move up, andvice-versa. Thus, it can said that in case bankrate is hiked, in all likelihood banks will hikes


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their own lending rates to ensure and theycontinue to make a profit.

Effect on inflation

When the private or public banks are inneed of money, they borrow from RBI. RBIlends them at a rate known a bank rate (simplythe interest at which money is given).

As for example if the bank rate increasesinterest given by banks to RBI increases thusbanks money circulation decreases. Decrementin money circulation decreases inflation.

• Repo rate and reverse repo rate:A repurchase agreement is the sale

of securities together with an agreement for theseller to buy back the securities at a later date.The repurchase price should be greater thanthe original sale price, the difference effectivelyrepresenting interest, called the repo rate. Theparty that originally buys the securitieseffectively acts as a lender. The original seller iseffectively acting as a borrower, using theirsecurity as collateral for a secured cash loan ata fixed rate of interest.

A reverse repo is simply the samerepurchase agreement from the buyer'sviewpoint, not the seller's. Hence, the sellerexecuting the transaction would describe it asa "repo", while the buyer in the sametransaction would describe it a "reverse repo".So "repo" and "reverse repo" are exactly thesame kind of transaction, just described fromopposite viewpoints. The term "reverse repo andsale" is commonly used to describe the creationof a short position in a debt instrument wherethe buyer in the repo transaction immediatelysells the security provided by the seller on theopen market.

Effect on inflation

A reduction in the repo rate will help banksto get Money at a cheaper rate. When the reporate increases borrowing from the central bankbecomes more expensive. In order to increasethe liquidity in the market, the central bankincreases or decreases the rate. Thus inflationget automatically controlled.

•••


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FISCAL FEDERALISMFISCAL FEDERALISMFISCAL FEDERALISMFISCAL FEDERALISMFISCAL FEDERALISM

IN INDIAIN INDIAIN INDIAIN INDIAIN INDIACHRONICLEIAS ACADEMYA CIVIL SERVICES CHRONICLE INITIATIVE

Fiscal federalism concerns the division ofpublic sector functions and finances amongdifferent tiers of government. In undertaking thisdivision, economics emphasizes the need tofocus on the necessity for improving theperformance of the public sector and theprovision of their services by ensuring a properalignment of responsibilities and fiscalinstruments. While economic analysis, asencapsulated in the theory of fiscal federalism,seeks to guide this division by focusing onefficiency and welfare maximization indetermining optimal jurisdictional authority, itneeds to be recognized that the construction ofoptimal jurisdictional authority in practice goesbeyond purely economic considerations. Politicalconsiderations, as well as historical events andexigencies, have in practice, played major rolesin shaping the inter–governmental fiscalrelations in most federations.

Even in non–federal states, there has been agrowing movement towards greater fiscaldecentralisation in recent years. Some analystshave attributed this to globalisation anddeepening democratisation the world over onthe one hand and increasing incomes on theother.

Other specific reasons for increasingdemand for decentralisation are:

• It is becoming increasingly impossible forthe Central Governments to meet all of thecompeting needs of their variousconstituencies, and are attempting to buildlocal capacity by delegating responsibilitiesdownward to their regional governments.

• Central governments are looking to localand regional governments to assist themon national economic developmentstrategies.

• Regional and local political leaders aredemanding more autonomy and want thetaxation powers that go along with theirexpenditure responsibility.

Moreover, in recent years, decentralisationhas become a feature of reform agenda promotedand supported by the World Bank and othermultilateral institutions. The rationale for this hasbeen in part that decentralisation promotesaccountability. It is not therefore surprising thatby 1997, 62 of 75 developing nations hadembarked on one form of decentralisation oranother.

An important feature of a successful systemof fiscal federalism is the assignment of adequaterevenue powers to sub-national governments toforge a strong link between revenue andexpenditures at the margin. This is necessary forboth efficiency and accountability reasons.Assignment of revenue powers is also necessaryto ensure a hard budget constraint.

The transfer system should address theproblem of imbalance between revenue andexpenditure powers and should enable everygovernmental unit to provide comparable levelsof public services at comparable tax rates. At thesame time, it is important to ensure that thetransfer system does not provide the incentiveto “raid the fiscal commons”. Ensuring properincentive structure in the transfer system iscritical to preventing the soft budget constraints.It is necessary to ensure that the transfer systemdoes not enable the states to pass on the burdenof their public services to non–residents. Inaddition to equalisation transfers, specificpurpose matching (open-ended) transfer shouldbe designed to compensate the public servicesprovided by the sub national governments, thebenefit of which spill over the jurisdictions. Amajor advantage of a multilevel fiscal system isthe large common market, but the benefit canaccrue only when not only all impediments totrade in factors of production as well ascommodities are removed, but also mobility ofcommodities, capital and goods is facilitated.Ensuring a common market is at the heart ofcreating dynamism in fiscal federalism. Suchimpediments can be posed by policies restrictingthe movement of labour, capital, and


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commodities. It was also recognised that, giventhe multiplicity of local public goods with varyinggeographical patterns of consumption, there washardly any level of government that couldproduce a perfect mapping for all public goods.Thus, it was recognised that there would be localpublic goods with inter–jurisdictional spill–overs.For example, a road may confer public goodscharacteristics, the benefits of which are enjoyedbeyond the local jurisdiction. The local authoritymay then under-provide for such a good. Toavoid this, the theory then resorts to traditionalPigouvian subsidies, requiring the centralgovernment to provide matching grants to thelower level government so that it can internalisethe full benefits.

Based on the following, the role ofgovernment in maximising social welfarethrough public goods provision came to beassigned to the lower tiers of government. Theother two roles of income distribution andstabilisation were, however, regarded as suitablefor the central government.

PRINCIPLES OF FISCAL FEDERALISM

Independence and Responsibility

The central facet of federations is the divisionof powers and functions between the federalgovernment and the state governments. Thedivision of financial resources and obligations asbetween the two levels of governments shouldcorrespond to the division of powers andfunctions. Earnest efforts have to be made toensure that each level of government isfinancially self–sufficient and independent ofeach other to the maximum extent possible.Political autonomy will be meaningless unless itis supported by financial autonomy. No doubt,concerns which are of national character, orwhich transcend the interests of one unit, shouldbe entrusted to the central government.Functions of a purely local character, confinedto a unit in each and objectives for instance,should generally be left to the CentralGovernment. Normally, there should be occasionfor the central government to encroach uponjurisdiction of the unit governments and vice–versa. In times of national emergencies, however,the Constituent units shed some of their politicaland financial jurisdiction in favour of the centralgovernment for achieving national objectives.Federal Constitutions usually contain specificprovisions to cope with such contingencies.

Adequacy and Elasticity

Financial independence also implies thatcentral and unit governments should haveadequate financial powers to perform theirexclusive functions. The correspondencebetween revenues and functions should beunderstood in a dynamic sense. The sources ofrevenue should be elastic enough to keep pacewith the growth of responsibilities in the specifiedspheres of activity. In order to implement aprocess of national development, the centralgovernments were made financially strong bothin terms of powers and resources. Customsrevenue is, therefore, left in all federations to thecentral government. Same is the case with directtaxation. The sources of revenue for each levelof government should be such that the revenuesgenerated should not remain static but shouldbe quite elastic. The revenues should increase asthe needs of the governments grow. None of thegovernments would want to be burdened withstatic sources which will soon fall behind thedemand that a government will have to face andmeet.

Efficiency

The system of distribution of functions shouldconform to the requirements of efficiency andeconomy. “No matter how well intentioned ascheme may be or how completely it mayharrnonise with the abstract principles of justice,if the tax does not work administratively, it isdoomed to failure”. Two factors determine theeffectiveness of different taxes, namely, natureof the tax and the character of administration.A land tax for instance, may be expected to beadministered best by local authorities because “itis, after all, the local assessors who may bepresumed to possess the most exact knowledgeof the local conditions upon which the value ofthe land depends”. One of the reasons for theformation of a federation is that a governmentat a the federal level will be efficient for thenation as a whole: the division of sources is,therefore, based on the principle of relativeinterest and efficiency. Taxes which have aninter–state base, like customs, income and wealthtax are assigned to the federal government andthose which have a local base, like sales tax andentertainment tax, are assigned to the states.Costs of collection of taxes, the feasibility oflevying taxes at the nationwide level rather thanat the local level are important considerations inthe allocation of powers and functions.


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Equity

Fiscal federation is viewed within theframework of welfare economics. Equitabledistribution of wealth and income of thecommunity are the proper concerns of a welfarestate. Experts argue that the entire system offederal and state taxation and expenditureshould be so framed as to impose equal burdensand confer equal benefits upon similarly placedpersons irrespective of their residence. From thepoint of view of the nation, there is a distinctadvantage in taxing the richer states more andspending that revenue in poorer states since thesacrifice in extra taxation in richer states is lessthan the benefit that will be derived if thatmoney were spent in poorer states. The ideal isto maximise national benefit from the state andfederal expenditure. This would necessitate areduction of welfare generating expenditure inricher states and an increase in such expenditurein poorer states. Federal fiscal operations havean equalizing role in respect of tax burdens andbenefits from public expenditure as between theaffluent and less fortunate states. Distributiveaspects of income and wealth are best performedby the central government. If redistributionpolicy is left to the state governments regionaldisparities may be perpetuated. Rich may leavethe region where redistribution measures aremore egalitarian, while the poor will move tosuch regions. Progressive income tax which isan important redistribution measure must beuniform throughout the country. This is possibleonly when the tax is entrusted to the nationalgovernment.

Salient Features of Indian Fiscal Federalism:

• Most populous and diverse democraticfederal polity

• Transition from plan to market: Need forreforms in policies and institutions (implicittransfers, common market principles,regional equity)

• Globalization and fiscal federalism:Need toreorient the system to create a competitiveenvironment.

• Changing political environment:emergenceof coalition government at Centre, regionalparties in States, latter becoming pivotalmembers in Central coalition government,changing priorities and time horizons ofpolitical parties.

• Notable Feature: Holding the countrytogether for 60 years; Constitution withfundamental rights guaranteed;Independent judiciary; free press and steelframe bureaucracy.

• Dissatisfaction: Has not reaped gains from“magnitude and littleness”; highlycentralised system; impediments to commonmarket; Regional aspirations and demandfor statehood; absence of satisfactoryinstitutional mechanism to resolve withCentre–State and inter-State disputes.

INDIA’S CONSTITUTIONALSTRUCTURE RELATED TO FINANCE

Indian Constitution has made elaborateprovisions, relating to the distribution of the taxesas well as non-tax revenues and the power ofborrowing, supplemented by provisions forgrants-in-aid by the Union to the States.

Article 268 to 293 deals with the provisionsof financial relations between Centre and States.

• The Constitution divides the taxingpowers between the Centre and the statesas follows:

The Parliament has exclusive power to levytaxes on subjects enumerated in the Union List,the state legislature has exclusive power to levytaxes on subjects enumerated in the State List,both can levy taxes on the subjects enumeratedin Concurrent List whereas residuary power oftaxation lies with Parliament only.

• The distribution of the tax-revenuebetween the Union and the States standsas follows:

a) Duties Levied by the Union butCollected and Appropriated by theStates: Stamp duties on bills ofExchange, etc., and Excise duties onmedical and toilet preparationscontaining alcohol. These taxes don’tform the part of the Consolidated Fundof India, but are assigned to that stateonly.

b) Service Tax are Levied by the Centrebut Collected and Appropriated by theCentre and the States.

c) Taxes Levied as Well as Collected bythe Union, but Assigned to the States:These include taxes on the sale and


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purchase of goods in the course of inter-state trade or commerce or the taxeson the consignment of goods in thecourse of inter-state trade or commerce.

d) Taxes Levied and Collected by theUnion and Distributed betweenUnion and the States: Certain taxesshall be levied as well as collected bythe Union, but their proceeds shall bedivided between the Union and theStates in a certain proportion, in orderto effect on equitable division of thefinancial resources. This categoryincludes all taxes referred in Union Listexcept the duties and taxes referred toin Article 268, 268-A and 269;surcharge on taxes and dutiesmentioned in Article 271 or any Cesslevied for specific purposes.

e) Surcharge on certain duties and taxesfor purposes of the Union: Parliamentmay at any time increase any of theduties or taxes referred in those articlesby a surcharge for purposes of theUnion and the whole proceeds of anysuch surcharge shall form part theConsolidated Fund of India.

Grants-in-Aid

Besides sharing of taxes between the Centerand the States, the Constitution provides forGrants-in-aid to the States from the Centralresources. There are two types of grants:-

1. Statutory Grants

2. Discretionary Grants

1. Statutory Grants: These grants aregiven by the Parliament out of theConsolidated Fund of India to suchStates which are in need of assistance.Different States may be granteddifferent sums. Specific grants are alsogiven to promote the welfare ofscheduled tribes in a state or to raisethe level of administration of theScheduled areas therein (Art.275).

2. Discretionary Grants: Center providescertain grants to the states on therecommendations of the PlanningCommission which are at the discretionof the Union Government. These aregiven to help the state financially tofulfill plan targets (Art.282).

Effects of Emergency on Center-State FinancialRelations:-

1. During National Emergency: The Presidentby order can direct that all provisionsregarding division of taxes between Unionand States and grants-in-aids remainsuspended. However, such suspension shallnot go beyond the expiration of the financialyear in which the Proclamation ceases tooperate.

2. During Financial Emergency: Union cangive directions to the States:-

a) To observe such canons of financialpropriety as specified in the direction.

b) To reduce the salaries and allowancesof all people serving in connection withthe affairs of the State, including HighCourts judges.

c) To reserve for the consideration of thePresident all money and financial Bills,after they are passed by the Legislatureof the State.

TYPES OF TAXES IN INDIANFINANCIAL SYSTEM

Taxes represent the amount of money we payto the Government at predefined rates andperiodicity. Taxes are the basic source of revenueto the Government using which it providesvarious kinds of services to the tax payers. Thereare mainly two types of Taxes, direct tax andindirect tax which are governed by two differentboards, Central Board of Direct Taxes (CBDT)and Central Board of Excise and Customs(CBEC).

1) Direct Taxes

Direct taxes are the personal liability of taxpayer. These are collected directly from the taxpayers and they have to be paid by the personson whom it is imposed. Important direct taxesare listed below:

a) Income Tax - This is most importanttype of direct tax and almost everyoneis familiar with it. TDS is its famoussynonym and whosoever is earningabove a minimum amount (taxexemption limit) has to pay income tax.

b) Wealth Tax - This is in addition to theincome tax and is levied if your net


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wealth exceeds Rs. 30 Lakh at the rateof 1% on the amount exceeding Rs 30Lakh. “In Budget 2013-2014 FinanceMinister Mr P. Chidambaramintroduced a surcharge of 10 percenton taxpayers with an annual taxableincome of more than 1 crore (10million) rupees

c) Property Tax/Capital Gains Tax - Thisis levied on the capital gains arrived byselling property and stocks. Tax ratesare different for long term and shortterm capital gains.

d) Gift Tax/ Inheritance or Estate Tax -Amount exceeding Rs. 50000 receivedwithout consideration by anindividual/HUF from any person issubjected to gift tax as income under"other sources". There are exemptionslike money received from relatives isnot taxable. Marriage gifts and moneyreceived through inheritance are alsoexempt from gift tax. Inheritance taxwas earlier in practice but has beenrepealed by the government.

e) Corporate Tax - Companies operatingin India are taxed as per the corporatetax rate on their income. This tax isone of the major sources of revenue forgovernment.“

2) Indirect Tax

Impact and incidence of indirect Taxes fallon different persons as opposed to direct taxeswhere impact and incidence is on the sameperson. These taxes are recovered from differentgroups of people but the liability remains withthe person who collects it. Tax payer recoversthe indirect taxes paid from their consumers andclients and finally pays it to government. Forexample, when we purchase any product we payVAT, when we eat in restaurants we pay servicetax which are ultimately deposited ingovernment's kitty by the service providers. Briefabout various types of indirect taxes is givenbelow:

a) Service Tax

Service providers in India are subject toservice tax, which is charged on the aggregateamount received by the service provider. Serviceslike leasing, internet/voice, transport, etc aresubject to service tax.

b) Custom Duty

Custom duties are indirect taxes which arelevied on goods imported to/exported fromIndia. There are different rules for different typesof goods and sectors. Government keeps onchanging these rates so as to promote import/export of specific goods.

c) Excise Duty

Excise duties are indirect taxes which arelevied on goods manufactured in India fordomestic consumption. Like custom duty, thereare a number of rules which keep on changingas per government discretion.

d) Sales Tax and VAT

Sales tax is levied by the government on saleand purchase of products in Indian market. Ascustomers, whatever you buy from the market,you pay sales tax on it. Now, sales tax issupplemented with new Value Added Tax so asto make it uniform across country.

e) Security Transaction Tax (STT)

STT is levied on transactions (sale/purchase)done through the stock exchanges. STT isapplicable on purchase or sale of variousfinancial products like stocks, derivatives, mutualfunds etc.

FINANCE COMMISSION OF INDIA

The Finance Commission of India came intoexistence in 1951. The Finance Commission isestablished under Article 280 of the IndianConstitution of India by the President of India.The Indian Finance Commission Act was passedto give a structured format to the FinanceCommission of India as per the world standard.The need for the Finance Commission was feltby the British for guiding the finance of India.The structure of the modern Act was laid in theearly 1920’s. The Finance Commission is formedto define the financial relations between theCentre and the State. The Finance CommissionAct of 1951 tells about the qualification,appointment, term, eligibility, disqualification,powers, etc. of the Finance Commission.

Functions of the Finance Commission

The Finance Commission’s duty is torecommend to the President as to-

• The distribution of net proceeds of taxesbetween the Union and the States.


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• To evaluate the increase in the ConsolidatedFund of a state to affix the resources of thePanchayats in the state.

• To evaluate the increase in the ConsolidatedFund of a state to affix the resources of theMunicipalities in the state.

Powers of the Commission

The Finance Commission has the followingpowers:

• The Commission shall have all the powersof the Civil Court as per the Code of CivilProcedure, 1908.

• It can call any witness, or can ask for theproduction of any public record ordocument from any court or office.

• It can ask any person to give informationor document on matters as it may feel to beuseful or relevant.

• It can function as a civil court indischarging its duties.

Qualifications for appointment and themanner of selection:

The Chairman of the Finance Commission isselected among persons who have had theexperience of public affairs, and four othermembers are selected among persons who

• Are, or have been, or are qualified as judgesof High Court, or

• Have knowledge of finance, or

• Have vast experience in financial mattersand are in administration, or

• Have knowledge of economics.

Term of Office of the Members

Every member of the Commission shall be inthe office as specified by the President. He canalso be reappointed, provided that he hasalready addressed a letter to the President forhis resignation.

Conditions of service and salaries andallowance of members:

• Each member should provide whole timeor part time service to the Commission asthe President with respect to each casemight specify.

• Each member shall receive salariesaccording to the provisions made by theCentral Government.

Disqualification:

A member may be disqualified if:

• He is of unsound mind.

• He is involved in a vile act.

• If his interests are likely to affect the smoothfunctioning of the Commission.

THIRTEENTH FINANCE COMMISSION

Terms of Reference of the Thirteenth FinanceCommission:

1. The Commission shall makerecommendations as to the followingmatters, namely :-

(i) The distribution between the Union andthe States of the net proceeds of taxeswhich are to be, or may be, dividedbetween them under Chapter I, Part XIIof the Constitution and the allocationbetween the States of the respectiveshares of such proceeds;

(ii) The principles which should govern thegrants-in-aid of the revenues of theStates out of the Consolidated Fund ofIndia and the sums to be paid to theStates which are in need of assistanceby way of grants-in-aid of their revenuesunder Article 275 of the Constitutionfor purposes other than those specifiedin the provisos to Clause (1) of thatArticle; and

(iii) The measures needed to augment theConsolidated Fund of a State tosupplement the resources of thePanchayats and Municipalities in theState on the basis of therecommendations made by the FinanceCommission of the State.

2. The Commission shall review the state ofthe finances of the Union and the States,keeping in view, in particular, the operationof the States’ Debt Consolidation and ReliefFacility 2005–2010 introduced by theCentral Government on the basis of therecommendations of the Twelfth FinanceCommission, and suggest measures formaintaining a stable and sustainable fiscalenvironment consistent with equitablegrowth.


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3. In making its recommendations, theCommission shall have regard, among otherconsiderations, to -

(i) The resources of the CentralGovernment, for five years commencingon 1st April 2010, on the basis of levelsof taxation and non-tax revenues likelyto be reached at the end of 2008–09;

(ii) The demands on the resources of theCentral Government, in particular, onaccount of the projected GrossBudgetary Support to the Central andState Plan, expenditure on civiladministration, defence, internal andborder security, debt–servicing and othercommitted expenditure and liabilities;

(iii) The resources of the State Governments,for the five years commencing on 1stApril 2010, on the basis of levels oftaxation and non–tax revenues likely tobe reached at the end of 2008-09;

(iv) The objective of not only balancing thereceipts and expenditure on revenueaccount of all the States and the Union,but also generating surpluses for capitalinvestment;

(v) The taxation efforts of the CentralGovernment and each StateGovernment and the potential foradditional resource mobilisation toimprove the Tax–Gross DomesticProduct ratio in the case of the Unionand Tax–Gross State Domestic Productratio in the case of the States;

(vi) The impact of the proposedimplementation of Goods and ServicesTax with effect from 1st April, 2010,including its impact on the country’sforeign trade;

(vii) The need to improve the quality of publicexpenditure to obtain better outputs andoutcomes;

(viii) The need to manage ecology,environment and climate changeconsistent with sustainabledevelopment;

(ix) The expenditure on the non–salarycomponent of maintenance and upkeep

of capital assets and the non–wagerelated maintenance expenditure onplan schemes to be completed by 31stMarch, 2010 and the norms on the basisof which specific amounts arerecommended for the maintenance ofthe capital assets and the manner ofmonitoring such expenditure;

(x) The need for ensuring the commercialviability of irrigation projects, powerprojects, departmental undertakingsand public sector enterprises throughvarious means, including levy of usercharges and adoption of measures topromote efficiency.

4. In making its recommendations on variousmatters, the Commission shall take the baseof population figures as of 1971, in all suchcases where population is a factor fordetermination of devolution of taxes andduties and grants-in-aid.

5. The Commission may review the presentarrangements as regards financing ofDisaster Management with reference to theNational Calamity Contingency Fund andthe Calamity Relief Fund and the fundsenvisaged in the Disaster Management Act,2005(53 of 2005), and make appropriaterecommendations thereon.

6. The Commission shall indicate the basis onwhich it has arrived at its findings andmake available the estimates of receipts andexpenditure of the Union and each of theStates.

7. The Commission shall make its reportavailable by the 31st day of October, 2009,covering the period of five yearscommencing on the 1st day of April, 2010.

Summary of Key Recommendations made bythe ThFC (Thirteenth Finance Commission):

• Share of the States in the net proceeds ofCentral tax collections fixed at 32% overthe ThFC’s award period (the share wasset at 30.5% by the TwFC).

• Indicative ceiling for revenue transfers(taxes and grants) from the Centre to theStates set at 39.5% of the gross revenuereceipts of the Centre (was set at 38% bythe TwFC).


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• Total grant to be provided by the Centre tothe State Governments over ThFC awardperiod set at Rs. 3,185.81 billion (more thantwice the amount recommended by theTwFC).

• Loans worth Rs. 45.06 billion from GoI tothe State Governments for Centrallysponsored schemes and Central planschemes (administered by ministries/departments other than the MoF) to bewritten off.

• Interest rate on loans to the States from theNSSF contracted until 2006–07 andoutstanding at the end of 2009–10 to bereset at 9% (from either 9.5% or 10.5% atpresent based on the date on which theloans were contracted), with an estimatedbenefit of Rs. 135.17 billion for the StateGovernments. NSSF to be reformed into amarket–aligned scheme.

• Target for reducing the consolidated debtstock of the Centre and the States set at68% of GDP by 2014–15; 45% of GDP forthe Centre and 25% of GDP for the States.

• Timelines specified for elimination ofrevenue deficits and reduction in thefinancing gap to 3% of GDP for the Centreand 3% of GSDP for the States. Thereafter,the States are to maintain their financinggap at 3% of GSDP. In the event ofmacroeconomic shocks, additional resourcesto be raised by the Centre and passed on tothe States in accordance with the horizontaldevolution formula. A long–term andpermanent target of eliminating revenuedeficit of the Centre and the States has alsobeen prescribed.

• Structural shocks such as payout of PayCommission related arrears to be avoidedby making the award take effect from thedate of acceptance of the same.

• Borrowing limits for the States to becalculated by GoI on the basis of therecommended fiscal reform path for theyears between 2011-12 and 2014-15.

The ThFC has recommended higher transfersof Central taxes and Finance Commission grantsto be provided by the Centre to the States as

compared with what the Twelfth FinanceCommission (TwFC) had advised. The ThFC hasrecommended that the share of the States in thenet proceeds of Central tax collections be fixedat 32% over the ThFC’s award period, higherthan the share of 30.5% that had been set by theTwFC for the award period 2005-06 to 2009-10.Additionally, the total grant of Rs. 3,185.81billion to be provided by the Centre to the StateGovernments over the ThFC award period ismore than twice the amount recommended bythe TwFC. The ThFC’s recommendations onCentral tax devolution and grants would serveto reduce the vertical imbalance between theCentre and the States and are a positive fromthe point of view of fiscal federalism. The ThFC,by modifying the criteria and the associatedweights governing horizontal devolution, haschanged the inter se shares of the Indian Stateswithin the overall pool of shareable taxes.Regardless of the lowering of the inter se sharesfor some States, the taxes to be devolved to allthe States over the ThFC period are likely to besubstantially higher than they were during theTwFC period, considering the anticipatedbuoyancy in Central tax collections followingresumption of higher economic growth from2010–11 onwards, reversal of certain tax cutsand the possibility of successful implementationof the Goods and Services Tax (GST). Thus, allStates are expected to witness a significantincrease in the magnitude of transfers (Centraltaxes + Finance Commission grants) during theThFC period over the TwFC period.

Higher transfers would boost the State’srevenue receipts, thereby creating fiscal space forthe State Governments to incur additionalexpenditure while at the same time providingassistance for the attainment of the fiscal targetslaid down by the ThFC. However, maintaininga check on the pace of expenditure growth andenhancing the quality of expenditure would becritical to achieving structural improvement inthe States’ finances over the medium term.Prioritizing of expenditure would be crucial toimprove socio-economic indicators and attaindevelopmental goals.

While higher devolution of taxes to the Statesimplies lower net tax revenues for the CentralGovernment, the anticipated increase in tax


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buoyancy over the medium term suggests thatthe Centre’s net tax collections would also enjoyhealthy growth. Nonetheless, expenditureadjustments at the Centre, rather than over-reliance on revenue growth, remain critical inthe pursuit of sustainable fiscal consolidation atthe national level. The total grant of Rs. 3,185.81billion to be provided by the Centre to the StateGovernments over the ThFC award periodincludes an amount of Rs. 875.19 billion forfurther transfer from the States to their LocalBodies. The latter amount is more than thricethe sum recommended by the TwFC (Rs. 250billion), and being so would augment therevenues and improve the financial position ofthe Local Bodies significantly. However, anincrease in the magnitude and improvement inthe regularity of devolution by the StateGovernments to their Local Bodies would alsobe required to reduce the resource gap of thelatter and enable improved delivery of services.

During the first three years of the TwFCperiod, high revenue growth helped the Centreand the States achieve considerable success intheir endeavor towards fiscal adjustment. Withincentives aimed at encouraging fiscalconsolidation provided by the DebtConsolidation and Relief Facility (DCRF) of theTwFC, a number of States were able to achieveconsiderable improvement in their fiscal balancesin the first three years of the TwFC period.However, this was followed by slippages in thesubsequent two years marked by a slowdownin economic and revenue growth and anincrease in expenses because of Pay Commissionrelated payouts in a number of States.

The ThFC has suggested a revised fiscalroadmap for the Centre and the States to providethe basis for sustainable adjustment of publicfinances going forward. The ThFC has set atarget of reducing the consolidated debt stock ofthe Centre and the States to 68% of grossdomestic product (GDP) by 2014–15 from anestimated 82% of GDP in 2009–10. In accordancewith the projected debt to GDP ratios over theThFC period, the ThFC has drawn up roadmapsfor the Centre and the States, which specifytimelines for the elimination of revenue deficitsand reduction in the financing gap 1 to 3% ofGDP for the Centre and 3% of gross state

domestic product (GSDP) for the States. Theannual borrowing limits of the latter are to bedetermined by GoI on the basis of the level ofthe financing gap envisaged as per the fiscalreform path indicated by the ThFC for the period2011–12 to 2014–15. This mechanism is expectedto induce the States to adhere to the financinggap targets. ICRA believes this mechanismwould help maintain the focus on fiscalconsolidation at the State level. However, in theabsence of a mechanism (like the TwFC’s DCRFfacility) to incentivize compliance with the fiscaltargets set by the ThFC, the efficacy of the ThFC’srecommendations for fiscal consolidationremains to be seen; the extent of success in thisregard is likely to hinge on the commitmentdemonstrated by individual States to the goal offiscal consolidation.

The ThFC has recommended that the Statesmaintain their financing gap at 3% of GSDPbeyond 2014–15, and that the Centre raiseadditional resources and pass these on to theStates in accordance with the horizontaldevolution formula in the event ofmacroeconomic shocks. This would helpmaintain the focus on fiscal consolidation at theState level over the course of business cycles andprevent such slippages as seen during the lasttwo years of the TwFC period, which coincidedwith the macroeconomic slowdown in India.

If implemented, the ThFC’s recommendationthat structural shocks, such as payout of PayCommission related arrears, be avoided andwould help smoothen the revenue expendituresof the State Governments and prevent income–expenditure mismatches. As has historically beenseen in India, settlement of large Pay Commissionrelated arrears imposes considerable stress on thefiscal balances of the State Governments, whichthen take recourse to higher debt, in the processsuffering deterioration in their debt serviceindicators. While avoidance of such structuralshocks would prevent the periodic weakeningof the States’ credit profiles, it remains to be seenwhether this recommendation is politicallyacceptable. The ThFC has suggested resetting ofthe interest rate on loans to the States from theNational Small Savings Fund (NSSF) to reducethe interest asymmetry between the Centre and


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the States. The interest rate on loans contractedby the States from the NSSF until 2006–07 andoutstanding at the end of 2009–10 is to be resetat 9%, from either 9.5% or 10.5% at present basedon the date on which the loans were contracted.This is estimated to provide a benefit of Rs. 135.17billion to the States over the ThFC period.

The ThFC has also recommended write-offof Rs. 45.06 billion worth of loans from GoI tothe State Governments administered byministries / departments other than theMinistry of Finance (MoF). The magnitude ofthese benefits is however small relative to thebenefits that the States derived from the DCRFfacility.

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The money market is a monetary system oflending and borrowing of short-term funds.

Money markets exist to facilitate efficienttransfer of short-term funds between holders andborrowers of cash assets. For the lender/investor,it provides a good return on their funds. For theborrower, it enables rapid and relativelyinexpensive acquisition of cash to cover short-term liabilities. RBI being the main constituent inthe money market aims at ensuring that liquidityand short term interest rates are consistent withthe monetary policy objectives.

Features of Indian Money Market

Money market in India has the followingfeatures.

(I) Existence of Unorganized Money MarketThe existence of the indigenous bankershas always been the major defect of theIndian money market, as these indigenousbankers do not distinguish between thepurposes of finance. RBI’s control over themoney market is limited, to the extent thatthese bankers/companies are outside theorganized money market.

(II) Absence of IntegrationAt one time, Indian money market wasdivided into several segments or sections,loosely connected to each other. Eachsection of the money market limited itselfbroadly to a particular class of businessand remained independent in its ownsphere. Furthermore, relations were notvery cordial between the various sectionsof money market. This prevails even nowbetween Indian banks and foreign banks.

(III) Diversity in Money Rates of InterestThe existence of too many rates of interestis yet another defect of the Indian moneymarket—the borrowing rate of thegovernment, the deposit and lending ratesof commercial banks, deposit and lendingrates of cooperative banks, the lendingrates of Development Financial


MONEY MARKET

INSTRUMENTS

IN INDIA

Institutions, etc are different. Immobilityof fund from one section of the moneymarket to another provides the basicreason for the existence of so many ratesof interest simultaneously. However, differentmoney rates of interest have been promptlyadjusting to changes in the bank rate.

(IV) Seasonal stringency of MoneyThere prevails seasonal monetarystringency and high rates of interestduring the busy season from Novemberto June when funds are required to movethe crops from the village and countrysideto the cities and ports. Banks carry largesurplus funds and the rates of interestreach low levels during the off-season (Julyto October) or slack season. There are evennow wide fluctuations in the money ratesof interest from one period of the year toanother.

(V) Highly Volatile Call Money MarketThe call money rate refers to the rate atwhich funds are borrowed in this market.Call money rates are market-determined—by demand for and the supply of shortterm funds.The demand for the short term fundscomes from public sector banks (about 80per cent of the borrowing) and foreignbanks and private sector banks whichtogether account for the balance of 20 percent. While some banks fulfill theirbanking activities as of both lenders andborrowers, others act either as borrowersor lenders. Non-bank financial institutionssuch as IDBI, LIC, GIC & others accountfor 80 per cent of the total funds supply.While balance 20 per cent of the fundsare supplied by the banks in the callmoney market. The call money marketrates used to rise to 7 to 8 per cent duringthe busy season, even before 1935 whilein the slack season they fell to ½ per centper annum. The call money rates havecontinued to be highly volatile,notwithstanding RBI made all the efforts


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to moderate the fluctuations on the callmoney rates. The high rates reflected thehuge demand for short term funds by thebanking system specially to meet thecondition of minimum CRR.

(VI) Availability of Credit InstrumentsThe Indian money market did not haveadequate short term paper instruments till1985-86. There was only the Treasury Billmarket apart from the call money market.At the same time there were no specialistdealers and brokers dealing in differentsegments of the Indian money market andin different kinds of paper instruments.The Reserve Bank of India startedintroducing new paper instruments onlyafter 1985-86, such as 182 days treasurybills , later converted to 364 days treasurybills, certificate of deposit and commercialpaper.

Different instruments of the Money Market are:

• Call Money:Call money is a method of borrowing andlending for one day. This is also calledovernight money. The rate of interest usedto be decided by RBI earlier. After 1989,the interest rate was deregulated and nowthe liquidity position (availability of funds)determines the rate of interest. Onlypermitted organizations like scheduledcom-mercial banks, large co-operativebanks, DHFI, Primary dealers, NABARDare permitted to borrow funds throughcall money market. However, funds canbe provided or lent even by other entitieslike LIC, GIC, large corporate, big mutualfunds, etc.

• Treasury Bills (T-Bills):Treasury Bills, one of the safest moneymarket instruments, are short termborrowing instruments of the CentralGovernment of the Country issuedthrough the Central Bank (RBI in India).Treasury bills began being issued by theIndian government in 1917. They areshort-term instruments issued by theReserve Bank of India. They are one ofthe safest money market instrumentsbecause they are risk free, but the returnsfrom this instrument are not very high.They have 3-month, 6-month and 1-yearmaturity periods. The price with whichtreasury bills are issued comes separate

from that of the face value, and the facevalue is achieved upon maturity.

Repurchase Agreements

Repurchase transactions, called Repo orReverse Repo are transactions or shortterm loans in which two parties agree tosell and repurchase the same security.Repo/Reverse Repo transactions can bedone only between the parties approvedby RBI and in RBI approved securities viz.GOI and State Govt Securities, T-Bills, PSUBonds, FI Bonds, Corporate Bonds etc.Under repurchase agreement the sellersells specified securities with an agreementto repurchase the same at a mutuallydecided future date and price. Similarly,the buyer purchases the securities withan agreement to resell the same to theseller on an agreed date at apredetermined price.Such a transaction is called a Repo whenviewed from the perspective of the sellerof the securities and Reverse Repo whenviewed from the perspective of the buyerof the securities. Thus, whether a givenagreement is termed as a Repo or ReverseRepo depends on which party initiated thetransaction. The lender or buyer in a Repois entitled to receive compensation for useof funds provided to the counterparty.Effectively the seller of the security borrowsmoney for a period of time (Repo period)at a particular rate of interest mutuallyagreed with the buyer of the security whohas lent the funds to the seller. The rate ofinterest agreed upon is called the Reporate. The Repo rate is negotiated by thecounterparties independently of thecoupon rate or rates of the underlyingsecurities and is influenced by overallmoney market conditions.

Commercial Papers:

Commercial papers are usually known aspromissory notes which are unsecuredand are generally issued by companiesand financial institutions, at a discountedrate from their face value. The fixedmaturity for commercial papers is 1 to 270days. The purposes with which they areissued are - for financing of inventories,accounts receivables, and settling short-term liabilities or loans. The return on


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commercial papers is always higher thanthat of T-bills. Say, for example, acompany has receivables of Rs 1 lacs withcredit period 6 months. It will not be ableto liquidate its receivables before 6 months.The company is in need of funds. It canissue commercial papers in form ofunsecured promissory notes at discountof 10% on face value of Rs 1 lacs to bematured after 6 months. The company hasstrong credit rating and finds buyerseasily. The company is able to liquidateits receivables immediately and the buyeris able to earn interest of Rs 10K over aperiod of 6 months. They yield higherreturns as compared to T-Bills as they areless secure in comparison to these bills;however chances of default are almostnegligible but are not zero riskinstruments. Commercial paper being aninstrument not backed by any collateral,only firms with high quality credit ratingswill find buyers easily without offering anysubstantial discounts. It was in 1990 thatCommercial papers were first issued inthe Indian money market.

Certificate of Deposit:

It is a short term borrowing more like abank term deposit account. It is a promissorynote issued by a bank in form of a certificateentitling the bearer to receive interest. Thecertificate bears the maturity date, the fixed rateof interest and the value. It can be issued in anydenomination. They are stamped and transferredby endorsement. However, on payment of certainpenalty the money can be withdrawn on demandalso. The returns on certificate of deposits arehigher than T-Bills because it assumes higher levelof risk. It was in 1989 that the certificate of depositwas first brought into the Indian money market.

MONETARY AND

LIQUIDITY AGGREGATES

The entire quantity of bills, coins, loans,credit and other liquid instruments in a country's economy is known as moneysupply.

Money supply is divided into multiplecategories - M0, M1, M2 and M3 - according to thetype and size of account in which the instrumentis kept. The money supply is important toeconomists trying to understand how policies willaffect interest rates and growth

“M0 = Currency in circulation + bankersdeposits with the RBI + other deposits with RBI

M1 = Currency with the Public + DemandDeposits with the banking system + DemandLiabilities portion of Savings Deposits with thebanking system + other deposits with the bank

M2 = M1 + Savings deposits with Post officesavings banks.

M3 = M2 + Time deposits with thecontractual maturity of over one year with thebanking system + Call Borrowings from ‘Non-Depository’ Financial Corporations by thebanking system

M3 is termed as broad money and M1 isknown as narrow money.

Liquidity aggregates in India

Liquidity is the degree to which an asset orsecurity can be bought or sold in the marketwithout affecting the asset's price. Liquidity ischaracterized by a high level of trading activity.Assets that can be easily bought or sold areknown as liquid assets.

“There are three measures of liquidity inIndia

L1 = M3 + all deposits with post officesavings bank except NSC

L2 = L1 + term deposits with Term LendingInstitutions and Refinancing Institutions (FIs) +term borrowing by FIs and Certificates of Depositsissued by FIs

Quarterly compilation

L3 = L2 + public deposits of non bankingfinancial companies

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The capital market provides an alternativemechanism for allocating resources; channeliseshousehold savings to the corporate sector andallocates funds among firms. In this process itallows both firms and households to share risk.The capital market enables the valuation of firmson an almost continuous basis and it plays animportant role in the governance of thecorporate sector. The reforms in the capitalmarket are aimed at enhancing the efficiency,safety, integrity and transparency of themarket.

Capital market is the market for long termfunds, just as the money market is the marketfor short term funds. Capital market refers toall the facilities and the institutionalarrangement for borrowing and lendingmedium and long term funds. It is concernedwith the raising of money/capital forinvestment purpose. Private sectormanufacturing industries, agriculture and thegovernment predominantly make demand oflong term capital for purpose of investment.The central and state governments requiresubstantial sums from the capital market andthey invest not only on economic overheads astransport, irrigation and power developmentbut also on basic industries and sometimes evenconsumer goods industries. Individual savers,corporate savings, banks, insurance companies,specialized financing agencies and governmentare important supplier of funds for the capitalmarket. Among institutions, commercial banksare important investors, but are largelyinterested in government securities and to asmall extent on investment in debentures ofcompanies; LIC and GIC are of growingimportance in the Indian capital market thoughtheir major interest is still in governmentsecurities; Private funds constitute a majormedium of savings but their investments tooare mostly in government securities; and specialinstitutions, set up since independence—IFCI,ICICI, IDBI, UTI etc.—all these aim at providinglong term capital to the private sector.


Gilt-edged market and the industrialsecurities market are two prominentconstituents of the Indian capital market. Thegilt-edged market refers to the market forgovernment and semi-government securitiesbacked by the Reserve Bank of India.

Structure of the Capital Market

The capital market can be divided into twoconstituents, the financial institutions and thesecurities market. The financial institutionsprovide long term and medium term loans. Thesecurities market is divided into (a) the giltedged market (or the market for governmentsecurities), and (b) the corporate or industrialsecurities market.

INDIAN CAPITAL

MARKET

• Gilt-Edged marketThe gilt-edged market is also known as

the securities guaranteed (both principal andinterest) by the government apart fromgovernment securities. The governmentsecurities are risk free because the governmentcan’t default on its payment obligations andare hence known as gilt-edged (which means'of the best quality'). The importantcharacteristics of the government securities are:

(1) It is without risk and returns areguaranteed. There is no place forspeculation and manipulation of themarket as also no uncertainties regardingyield, payment on time, etc.

(2) Government securities market consists ofthe new issues market and the secondary


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market. R.B.I. is responsible for all the newissues of government loans, as it managesentirely the public debt operations of boththe central and state governments. Thesecondary market deals in old issues.

(3) The investors in the gilt-edged market arepredominantly institutions—commercialbanks, Life Insurance Corporation,General Insurance Corporation and theprovident funds—which are requiredstatutorily to invest a certain portion oftheir funds in government securities. Theseinstitutions mobilise the savings of thepeople through their various scheme andinvest a certain proportion in governmentsecurities.

(4) Government securities are the most liquiddebt instruments.

(5) The transactions in the governmentsecurities market are large.Many private sector mutual funds have

entered this market in a considerable way inrecent times and have floated various gilt-edgefunds for this purpose on account of the risk-free returns guaranteed by the governmentsecurities market and its high liquidity. Manyrisk-averse individual investors ( particularlythose belonging to fixed-income groups) havewelcomed this opportunity as investment inguilt-edged funds is better than investment inbank fixed deposits due to better liquidity andexemption from tax on dividends.

• Corporate Securities MarketSecurities issued by firms (i.e. shares,

bonds and debentures) can be bought and soldfreely in corporate securities market. Itcomprises the new issues market (the primarymarket) and the secondary market (stockexchanges).

• The New Issues Market/Primary MarketThe new issues market is concerned with

the issue of new securities—bonds debentures,shares and so on. Funds are often raised by thepublic limited companies from the primarymarket for setting up or expanding theirbusiness. However, the company has to fulfillvarious requirements and decide upon theappropriate timing and method of issue forselling its securities. The various methodsthrough which capital can be raised are:

(1) By Prospectus: Capital can be raised fromthe general public by the issue of

prospectus which is an invitation to thegeneral public for subscribing to thecapital. The prospectus contains variousdetails regarding particulars of thecompany, its financial position etc.

(2) By Offer for Sale: A method similar tothe prospectus where initially shares aretaken up by a third party in bulk. Thepeculiar feature of this arrangement is thatwhile company already receives themoney, any premium received from thepublic goes to this third party rather thanto the company.

(3) By Private Placing: The shares are sold toindividuals or institutions directly bymaking a private appeal to them. The costof raising capital in this method becomesfar lesser than the cost of raising capitalvia other methods.

(4) By offering Rights Issue: By this,companies raise capital from the existingshareholders. Under this method ofissuance, the shareholders have the rightto a certain number of shares inproportion to the shares held by them.

• The Secondary Market/ Stock ExchangeThe stock exchange or the secondary

market is a highly organized market for thepurchase and sale of second-hand quoted orlisted securities (quoting or listing of a particularsecurity implies incorporating that security inthe register of the stock exchange so that it canbe bought and sold there). A stock exchange isan association, organization or body ofindividuals, whether incorporated or not,established for the purpose of assisting,regulating and controlling business in buying,selling and dealing in securities, as has beendefined by the securities Contracts (Regulation)Act, 1956.

STOCK EXCHANGES IN INDIA

With over 25m shareholders, India has thethird largest investor base in the world afterthe USA and Japan. Over 9,000 companies arelisted on the stock exchanges, which are servicesby approximately 7,500 stockbrokers. The Indiacapital market is significant in terms of thedegree of development, volume of trading andits tremendous growth potential.

Stock exchanges provide an organisedmarket for transactions in securities and other


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securities. There are 23 stock exchanges in thecountry, 21 of them being regional ones withallocated areas. Three others set up in thereforms era, viz., National Stock Exchange(NSE), the Over the Counter Exchange of IndiaLimited (OTCEI) and Inter-connected StockExchange of India Limited (ISE). ImportantStock Exchanges in India are Bombay StockExchange, popularly known as BSE andNational Stock Exchange located in Mumbai.The stock exchanges in India are located atLudhiana, New Delhi, Jaipur, Merrut, Ahmeda-bad, Rajkot, Indore, Vadodara, Bombay, Pune,Hyderabad, Mangalore, Bangalore, Ernakulam,Coimbatore, Madras, Patna, Kanpur,Bhubaneshwar, Calcutta and Guwahati.

Bombay Stock Exchange (BSE)

The Bombay Stock Exchange or BSE is theoldest stock exchange in Asia. The BombayStock Exchange was established in 1875. Thereare around 4,800 Indian companies listed withthe stock exchange. As of 2008, it is among thefive biggest stock exchanges in the world interms of transactions volume. In 2005, the statusof the exchange changed from an Associationof Persons (AoP) to a full fledged corporationunder the BSE (Corporatization andDemutualization) Scheme, 2005 and its namewas changed to the Bombay Stock ExchangeLimited. The BSE Sensex (Sensitive Index), alsocalled the BSE 30, is a widely used market indexin India and Asia.

Sensex or Sensitive Index is a value-weighted index composed of 30 companies withthe base 1978-1979 = 100. It consists of the 30largest and most actively traded blue chipstocks, representative of various sectors, on theBombay Stock Exchange. Inclusion of thecompany is basically on the basis of marketcapitalization. The 30 companies in the indexare revised periodically – some are replaced byothers and new sectors may find representationas the economy evolves.

• National Stock Exchange of IndiaThe National Stock Exchange of India

(NSE) is one of the largest and most advancedstock markets in India. The National StockExchange of India was promoted by leadingfinancial institutions at the behest of theGovernment of India, and was incorporated in1992. In 1993, it was recognized as a stockexchange. NSE commenced operations in 1994.The NSE is the world’s third largest stockexchange in terms of transaction. It is locatedin Mumbai, the financial capital of India.

The Standard & Poor’s CRISIL NSE Index50 or S&P CNX Nifty-Nifty 50 or simply Niftyis the leading index for large companies on theNational Stock Exchange of India. The Nifty isa well diversified 50 stock index accounting for21 sectors of the economy.

The CNX Nifty Junior is an index forcompanies on the National Stock Exchange ofIndia. It consists of 50 companies on theNational Stock Exchange of India. It has thesecond tier of stocks in terms of marketcapitalization, which don’t make it into Nifty.

• Over the Counter Exchange of India(OTCEI)The Over the Counter Exchange of India

(OTCEI), incorporated under the provisions ofthe Companies Act 1956, is a public limitedcompany. It allows listing of small and mediumsized companies. OTCEI is promoted by theUnit Trust of India, Industrial DevelopmentBank of India, the Industrial FinanceCorporation of India and others and is arecognised stock exchange.

• MCX-SXThe MCX Stock Exchange (MCX-SX) has

received approval from the Securities andExchange Board of India and the Reserve Bankof India to launch currency options on itsplatform.

1. The Bombay Stock Exchange (BSE) is the oldeststock exchange in Asia established in 1875. It isthe 4th largest stock exchange in Asia and the 8thlargest in the world (as per 2010 data).

2. The Bombay Stock Exchange developed the BSESENSEX in 1986, giving the BSE a means tomeasure overall performance of the exchange.

3. In 1989 BSE National Index (Base: 1983-84) wasintroduced. It comprised of 100 stocks, listed atfive major stock exchanges in India -Mumbai, Calcutta, Delhi, Ahmadabadand Madras. It was renamed as BSE-100 in 1996.

4. The Bombay Stock Exchange switched to anelectronic trading system in 1995 and introducedautomated, screen-based trading platform calledBSE On-line Trading (BOLT). It currently has acapacity of 8 million orders per day.

5. The BSE has also introduced the world's firstcentralized exchange-based internet tradingsystem, BSEWEBx.co.in to enable investorsanywhere in the world to trade on the BSEplatform.


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The approvals will allow the exchange toexpand its currency derivatives business byintroducing options in the dollar-rupee currencypair. MCX-SX will soon announce the launchdate for live trading.

MCX-SX, which began trading in 2008with currency futures, had won approval fromregulators to start trading equities, equityfutures, interest rate futures and wholesale debtproducts.

MCX-SX is controlled by the Multi-Commodity Exchange of India (MCEI.BO),India’s biggest commodity bourse, which raised$135 million in an initial public offering in thelocal market earlier in 2012.

• GREENEX

The BSE has launched the GreenIndex called Greenex. This is India's firstcarbon-efficient live index. The index has beendeveloped by the BSE in collaboration with IIMAhmedabad. It is the second thematic indexlaunched by BSE. BSE Greenex will measure theperformances of companies in terms of carbonemissions. The index will target socially-awareinvestors. There are many investors willing topay a premium for green investments incompanies to get better returns.

The new index will comprise 20 stocksbased on a minimum carbon footprint, marketcapitalisation and turnover. The BSE Greenexwill assess the energy efficiency of firms, basedon energy and financial data.

The selection of companies was on the basisof greenhouse emissions in the last four financialyears from 2007-08 till 2010-11 . The companieswere tested in different combinations of carbonemission intensity, market capitalisation, andturnover. The index comprises 20 companiesfrom the BSE 100. It gives equal weightage toboth energy efficiency and profitability -together indicating a long-term sustainablestrategy.

This is the first index based on actualperformance on the energy efficiency front,rather than stated future plans. The indexfollows a sector-specific algorithm. Eachcompany is measured only against the best inthe same industry, based on disclosed energyand financial data. The index will have fairrepresentation of firms from all sectors. It willinclude topranking companies from each sector.

The index can be used to develop greenfinancial products including mutual funds,exchange-traded funds and structuredproducts. Further, the index is expected toenable investors to take more informedinvestment decisions on companies in theenergy-intensive sectors. It will help screencompanies doing well on the carbon side, asthe concerns of climate change is growingamong stakeholders.

The index can be used by individual andinstitutional investors such as asset managementcompanies, pension funds, and insurancecompanies looking for investments in companieswith strong long-term prospects and developgreen financial products.

• CARBONEXThe Bombay Stock Exchange (BSE) has

launched BSE Carbonex, the first carbon-basedthematic index in the country, which takes astrategic view of organizational commitmentto climate change mitigation.

This index has been launched with theaim of creating a benchmark, and increasingawareness about the risks posed by climatechange.

It will enable investors to trackperformance of the constituent companies ofBSE-100 index regarding their commitment togreenhouse gases emission reduction.

Constituents of BSE Carbonex are over orunderweighted compared to the benchmarkbased on their performance in the assessmentprocess. In every industry, companies thatachieve the strongest assessment scores arefavoured at the expense of those achieving poorresults.

The British High Commission in Indiathrough the British Foreign & CommonwealthOffice’s Prosperity Fund supported thedevelopment phase of the index. ENDS Carbon,a specialist in environment, social andgovernance (ESG) ratings and benchmarkservices provider, has provided its expertise inassessing the companies with data sourced fromthe carbon disclosure project (CDP), a not-for-profit organisation which holds the largest andmost continuous set of climate change data inthe world.

The top 10 constituents in BSE Carbonexare ITC Ltd having 7.11 per cent market


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capitalisation followed by Reliance Industries(6.48 per cent market capitalisation), ICICI Bank(5.54 per cent), HDFC Bank (5.48 per cent),HDFC Ltd (5.30 per cent), Infosys (5.27 percent), L&T (4.21 per cent), TCS (3.49 per cent),Hindustan Unilever (2.73 per cent) and ONGC(2.68 per cent).

Meanwhile, the carbon credit marketworldwide is now reported to be worth aboutUSD 188 billion, one of the only markets thatcontinued to increase during the recent yearsof worldwide recession.

• Islamic Index

BSE and S&P Dow Jones Indices hasannounced the launch of the S&P BSE 500Shariah index, the first new index resulting fromthe strategic partnership formed between thetwo companies in February 2013.

The S&P BSE 500 Shariah index wasdesigned to represent all Shariah compliantstocks of the broad based S&P BSE 500 index.The S&P BSE 500 consists of 500 of the largest,most liquid Indian stocks trading at the BSE.The S&P BSE 500 represents nearly 93 percentof the total market capitalization on the BSEand covers all 20 major industries of theeconomy.

The S&P BSE 500 Shariah index meets theneed for an investable benchmark in India togauge the performance of some of the mostwidely followed Shariah compliant stockstrading at the BSE.

Shariah is Islamic canonical law, whichobservant Muslims adhere to in their daily lives.Shariah has certain strictures regarding financeand commercial activities permitted forMuslims.

S&P Dow Jones Indices has contractedwith Ratings Intelligence Partners (RI) toprovide the Shariah screens and to filter thestocks. Ratings Intelligence Partners is aLondon/Kuwait-based consulting companyspecializing in solutions for the global Islamicinvestment market.

The partnership brings together BSE’sclosely watched India index suite, whichincludes the SENSEX, with S&P DowJones Indices’ 115 years of experiencein publishing uncompromised globalbenchmarks.

CONCEPTS IN CAPITAL MARKET

Derivatives

It derives from an underlying asset-securities, shares, debt instruments,commodities etc. Derivative is a financialinstrument. The price of the derivative is directlydependent upon the value of the underlyingasset in the present and the projected futuretrends. Futures and options are the two classesof derivates.

Futures

Futures are financial instruments bases ona physical underlying (commodity, equities etc).A futures contract is an agreement betweentwo parties to buy or sell an asset at a certaintime in the future for a certain price.

Options

Options are a class of futures where thebuyer or seller has the option whether to buyor not. Put option is the right but not theobligation to sell. Call option is right but notthe obligation to buy.

Buyback of Shares

Buyback of shares is the process of acorporation’s repurchase of stock or bonds ithas issued. In the case of stocks, this reducesthe number of shares outstanding, giving eachremaining shareholder a larger percentageownership of the company. This is usuallyconsidered a sign that the company’smanagement is optimistic about the future andbelieves that the current share price isundervalued.

Rolling Settlement

Rolling Settlements is a mechanism ofsettling trades. In Rolling Settlements, tradesdone on a single day are settled separately fromthe trades of other day on the basis of Tradeday + 2 days (T+2). Such netting of trades isdone only for the day. As such, in RollingSettlement, is carried out on a daily basis.

FMC

Forward Markets Commission (FMC)headquartered at Mumbai is a regulatoryauthority, which monitors and disciplines theworking of the exchanges. It recognizes anexchange or can withdraw such recognition. It


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collects and whenever the Commission thinksit necessary publishes information regarding thetrading conditions in respect of goods. It makesinspection of the accounts and other documentsof any recognized association or registeredassociation or any member of such associationwhenever it considerers it necessary.

Mutual Fund

Mutual fund is a financial intermediarythat mops up money from a group of investorsto invest in capital market so as to generatereturns for the investors.

Global Depository Receipts (GDR)

Indian companies are allowed to raiseequity capital in the international marketthrough the issue of Global Depository Receipt(GDRs). GDRs are designated in dollars/euros.They are also called euroissues. The proceedsof the GDRs can be used for financing capitalgoods imports, capital expenditure includingdomestic purchase/installation of plant,equipment and building and investment insoftware development, prepayment orscheduled repayment of earlier externalborrowings, and equity investment in JVs inIndia.

American Depository Receipts (ADR)

American depository receipts are issuedto US retail and institutional investors. Theyare entitled to bonus, stock split and dividend.They are listed either on Nasdaq or NYSE. Theyhelp raise equity capital in forex for variousbenefits like expansion, acquisition etc.

Participatory Notes (PN)

Participatory Notes are instruments usedfor making investments in the stock markets.In India, Foreign Institutional Investors usethese instruments for facilitating theparticipation of overseas funds like hedge fundsand others who are either not interested or noteligible for participating directly in the Indianstock market.

Clearing House

An organization which registers, monitors,matches and guarantees the trades of itsmembers and carries out the final settlement ofall futures transactions. The National SecuritiesClearing Corporation is the clearing house forthe NSE.

Share

Share is a certificate representingownership of the company that issued it. Sharescan yield dividends and entitle the holder tovote at general meetings. The company may belisted on a stock exchange. Shares are alsoknown as stock or equity.

Bond

A debt instrument issued for a period ofmore than one year with the purpose of raisingcapital by borrowing.

Debenture

Debt not secured by a specific asset of thecorporation, but issued against the issuer’sgeneral credit, that is, it is unsecured debt.

Bear Market

A sustained period of falling stock pricesusually preceding or accompanied by a periodof poor economic performance.

Bull Market

A stock market characterized by risingprices over a long period of time. The time spanis not precise, but it represents a period ofinvestor optimism, lower interest rates andeconomic growth.

Market capitalization

It is the market’s total valuation of a publiccompany. Price per share multiplied by the totalnumber of shares outstanding gives marketcapitalization of a company.

Insider Trading

Insider trading occurs when any one withinformation related to strategic and price-influencing information purchases or sells stocksso as to make speculative profits.

National Securities Depository Limited (NSDL)

The enactment of Depositories Act in 1996led to the establishment of NSDL, the firstdepository in India. It holds more than 85% ofthe securities held in dematerialized mode inIndia. Promoted by IDBI, UTI and NSE, NSDLhas established a national infrastructure thathandles most of the securities held and settledin dematerialized form in the Indian capitalmarkets.

•••


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SERVICE SECTOR IN INDIA'S

ECONOMY


Background

India continued to follow importsubstitution strategy (ISS) of growth during theperiod 1951-1980. “The ISS with heavy‘industry’ first strategy with central planningcreated a plethora of controls, procedures,permits and bureaucratic restrictions”. The ISS,along with other factors landed us intoeconomic crisis of 1990-91. The New EconomicPolicy of July, 1991 heralded a new era forIndia by introducing comprehensive reformsin industrial sectors as well as in services sector.It was expected that these policy measureswould restore the health of the economy andput it on higher growth trajectory.

As a consequence of the adoption of theNew Economic Policy(NEP) of 1991, thegrowth rate of the Indian economy which stoodat 3.5 per cent per annum during 1951-79, 5.0per cent per annum during 1980-91, in factaccelerated to 6.1 per cent per annum during1992-2000 (IDR, 2002). The economy hasmoved on from the ‘Hindu Rate of Growth’ of3.5% per annum of yesteryears to ‘unstoppableIndia’ at 9 % per annum at present. Indiaemerged as one of the fastest growingeconomies of the world during the 1990s.Theremarkable performance of India’s economy isattributable in significant part to thespectacular dynamism shown by the servicessector.

Against this background, it would be everyappropriate to answer some questions:

i. Firstly, what are the constituents of servicesector in India?

ii. Secondly, how this sector performed ongrowth and employment fronts?

iii. Thirdly, what happened to service sectorproductivity in post 1980 period?

iv. Fourthly, what are the policies adopted bythe government of India to promote theservices sector?

v. Fifthly, what are the problems or challengesahead in this sector?

vi. Lastly, what are the prospects /potentialfor growth in this sector.

Composition of Service Sector in India

In India, the national income classificationgiven by Central Statistical Organization isfollowed. In the National Income Accountingin India, service sector includes the following:

1. Trade, hotels and restaurants (THR)

• Trade

• Hotels and restaurants

2. Transport, storage and communication

• Railways

• Transport by other means

• Storage

• Communication

3. Financing, Insurance, Real Estate andBusiness Services

• Banking and Insurance

• Real Estate, Ownership of Dwellings andBusiness Services

4. Community, Social and Personal services

• Public Administration and Defense (PA & D)

• Other services

Performance of Services Sector in India

(a) Sectoral Composition of GDP Growth

The analysis of the sectoral composition ofGDP and employment for the period 1950-2000brings out the fact that there has taken place‘tertiarization’ of the structure of productionand employment in India. During the processof growth over the years 1950-51 to 1999-2000,the Indian economy has experienced a changein production structure with a shift away from


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agriculture towards industry and tertiary sector.The share of agricultural sector in real GDP at1993-94 prices declined from 55.53% in the1950’s to 28.66 % in 1990’s.The share ofindustry and services increased from 16% to27.12% and 28.09% to 44.22% respectivelyduring the same period. During the 1950’s itwas the primary sector which was thedominant sector of the economy and accountedfor the largest share in GDP. But the wholescenario changed subsequently, and especiallyin the 1980’s. The service sector outputincreased at a rate of 6.63% per annum in theperiod 1980-81 to 1989-90 (i.e. pre-reformperiod) compared with 7.71% per annum inthe period 1990-91 to 1999-2000 (i.e. post-reform period). The tertiary sector emerged asthe major sector of the economy both in termsof growth rates as well as its share in GDP in1990s. It is to be noted here that whileagriculture and manufacturing sectors haveexperienced phases of deceleration, stagnationand growth, the tertiary sector has shown auniform growth trend during the period 1950-51 to 1999-2000. The share of this sector inGDP further increased to 55.1% in 2006-07.This sector accounted for 68.6% of the overallaverage growth in GDP in the last five yearsbetween 2002-03 and2006-07.

(b) Employment Scenario

The sectoral distribution of workforce inIndia during the period 1983 to 2004-05 revealsthat the structural changes in terms ofemployment have been slow in India as theprimary sector continued to absorb 56.67% ofthe total workforce even in 2004-05, followedby tertiary and industrial sectors (24.62% and18.70%) respectively. There has beendisproportionate growth of tertiary sector, asits share in employment has been far less whencompared to its contribution to GDP.

It is important to point out that, within theservices sector employment growth rate ishighest in finance, insurance, and businessservices, followed by trade, hotels andrestaurants and transport, etc. The community,social and personal services occupy the last rankin growth rates of employment.

Further, there was a sharp drop in labourabsorptive capacity of growth in the economy(employment elasticity of growth) from 0.40 to0.15 during post -reform period (1993-94 to1999-2000) initially, reflecting the phenomenonof jobless growth. However, during 1999-2000to 2004-05 period the employment elasticity ofgrowth registered an increase from 0.15 to 0.51.With the exception of one sub-sector of tertiarysector i.e., transport, storage, communicationand all other sub-sectors of services sectorexhibited an increasing trend in employmentelasticties and thereby overall elasticity ofemployment increased from 0.15 to 0.5.

(c) Productivity Growth in Service Sector --Post-1980 Scenario

The process of acceleration in growthstarted in 1980s rather than in 1990s. “Of the2.4 percentage point increase in the rate ofeconomic growth that took place in the post-1980 period, about 40 per cent is accounted forby a faster growth in TFP in services.” Thethree sectors viz. agriculture, industry andservices have witnessed acceleration in thegrowth rates of output, output per worker andtotal factor productivity (TFP) in the post -1980period. However, the increase is more markedin case of services. Partially the spurt in growthrate is attributable to productivity growth incertain sub-sectors of services sector. It has beennoticed that growth rate in output per man ishighest in case of PA & D and other communitysocial and personal services (4.2% p.a), followedby transport, storage, communication (3.3 %pa), trade, hotels, restaurants (2.9%pa) andbanking, insurance, real estate and businessservices. The acceleration in growth rate ofoutput per worker in PA &D and othercommunity, social and personal services mighthave resulted from the downsizing of the publicsector because of privatisation and hikes in thesalaries of the central and state governmentemployees from time to time (i.e., due toaccounting reasons). Whereas productivitygrowth in THR has derived stimuli from surgein demand for such services with a subsequentexpansion in these activities. Part of theproductivity growth in the services sector mightbe an outcome of application of IT services.Despite increase in growth rate of labourproductivity in service sector, measurement of


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service sector output and productivity are stilldebatable issues.

Policy Measures for the Development of theServices Sector

In post-1991 period, there were severalmeasures undertaken by the government todevelop services sector, especially throughderegulation of some sub–sectors of servicessector. Foreign direct investment (FDI) varyingbetween 26 per cent (in print media) to 100%in information technology (IT) sector, businessprocess outsourcing (BPOs), e-commerceactivities, infrastructure, etc.) has beenpermitted. There are several other promotionalmeasures taken by the government to sustainthe growth of the services sector. For example,having realized that in knowledge- intensiveworld driven by IT, integration with globaleconomy cannot take place without makingquality telecom services accessible at affordableprices, a large number of steps like launchingof National Telecom Policy 1994, New TelecomPolicy 1999, Broad Band Policy 2004, etc wereundertaken. In addition to this, a number ofpromotional measures have been taken up inIT and ITES (Information Technology EnabledServices) segment, trade, tourism, banking andinsurance and real estate sectors.

India has emerged as a top destination foroffshoring as per Global Services Location Index2007. There is a lot of scope for future expansionas only 10 % of the potentially addressableglobal IT/ ITES market has been realized. Theremaining 90% (worth $300 billion) remains tobe tapped.

Problems/Challenges Ahead

The sustainability of impressive growth ofIndian economy has been questioned in thewake of some challenges in the form of lack ofsocial infrastructure, physical infrastructure, ITinfrastructure, agricultural and industrial sectorreforms, rupee appreciation and US sub-primecrisis, etc. Besides, challenges in the field of ITand ITES like rising labour costs, rapid growthin demand for talented manpower/qualitystaff, high attrition rate, outsourcing backlash.etc., are some other limiting factors. The growthof IT and ITES is having social, economic,health, ethical and environmental implicationsalso. Further, delay in the promotion of

conducive business environment and goodgovernance will enable us to catch up with theglobal giants in terms of world-wide presenceand scale. It is also important to point out herethat the measurement of output, productivity,non-availability of data or availability of dataafter a time lag are other problems confrontedwith in case of services . The problem getsfurther compounded because of the entry ofnew species of services (like IT, ITES, etc ) andlack of development of concepts on the onehand and non-inclusion of unpaid householdson the other. Further, quality of each unit ofthe same service varies from the other.Therefore, it is too difficult to achieve the samelevel of output in terms of quality. Further,quality improvements stemming from theapplication of new technologies are extremelyhard to measure.

Prospects for Growth in the Services Sector

One of the major drivers of service sectorgrowth in the post globalization era in India isthe IT and ITES sector. That is why NASSCOM(2005) says that, “The IT and BPO industriescan become major growth engines for India, asoil is for Saudi Arabia and electronics andengineering are for Taiwan. Saudi Arabia’s oilexports accounted for 46% of GDP in 2004;Taiwan’s electronics and engineering exportsaccounted for 17% of GDP in the same year.…. India’s IT and BPO industries could accountfor 10-12% of India’s GDP by 2015”(NASSCOM). There is a huge potential forgrowth in the services sector because of increasein disposable income, increasing urbanization,growing middle class, a population “bulge” inthe working age groups providing‘demographic window of opportunity,’ andemergence of a wide array of unconventional/new services like IT, ITES, new financialservices (ATMs, credit cards) and tourismservices (eco-tourism, health tourism), etc.

Conclusion

To sum up, the present paper provides abrief overview of performance, prospects andproblems encountered by the services sector inIndia’s economy. It is heartening to note thatIndia is called the ‘services hub’ of the world.The traditional perception of India standschanged today from a ‘land of beggars’, ‘snake


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charmers’ and ‘cyber–coolies’ of yesteryears toa ‘land of knowledge workers’ ---Thanks to ITand ITES. Telecom and ITES-BPO revolutionhave already marked their presence in India.A number of sector specific measures have beentaken up by the government of India to promoteIT and ITES and other sun-rise sectors liketelecom, organised retail, hospitality,entertainment and financial services sectors.That is why the futurists are very optimisticregarding the bright future and performance

ahead of the sector. That optimism is wellreflected in the following words of Mr KamalNath, the then Minister of Commerce andIndustry which were a part of his speech atWorld Economic Forum, “…. The question forCEOs the world over is no longer “should mycompany go to India?”, but rather “can mycompany afford not to be in India?”. On thetourism front, it is "Incredible India", but onthe economic front, it is clearly, "OpportunityIndia.”

•••


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The balance of payments of a country is asystematic record of all economic transactionsbetween the residents of the reporting countryand residents of foreign countries during a givenperiod of time.

The balance of payment record ismaintained in a standard double-entry book-keeping method. International transactions areentered into the record as credit or debit. Thepayments received from foreign countries areentered as credit and payments made to othercountries as debit.

A complete BoP account comprises thefollowing two broad accounts: (a) CurrentAccount; and (b) Capital and FinancialAccount.

Current Account Transactions

The current account deals with the tradeof goods and services between two countries.An export is a good (or service) that is sent fromthe domestic country and purchased abroad.An import is a foreign produced good that isimported for domestic consumption. Themonetary value of exports from a country andimports into a country are measured in thecurrent account. If the value of a country'sexports exceeds the value of the goods andservices it imports, then that country has a tradesurplus otherwise a trade deficit.

In brief current account includes:

• Payments related to foreign trade, currentbusiness and services.

• Short term banking and Creditfacilities.

• Payments due as interest on loans anddividends.

• Foreign travel, education, medicalexpenses.

• Remittances i.e. money sent by individualsworking abroad back at home.


BALANCE OF

PAYMENTS

Capital account Transactions

It includes those transactions which areundertaken by a resident of India such thathis/her assets or liabilities outside India arealtered (either increased or decreased). Forexample: - (i) a resident of India acquire animmovable property outside India or acquireshares of a foreign company. This way his/heroverseas assets are increased; or (ii) a residentof India borrows from a non-residentthrough External commercial Borrowings(ECBs). This way he/she has created a liabilityoutside India.

It includes:

Foreign direct investment (FDI) refers tolong term capital investment such as thepurchase or construction of machinery,buildings or even whole manufacturingplants. If foreigners are investing in a country,that is an inbound flow and counts as a surplusitem on the capital account. If a nation'scitizens are investing in foreign countries,that's an outbound flow that will count as adeficit.

Portfolio investment refers to the purchaseof shares and bonds in Indian share market bythe foreigners.

Other investment includes capital flowsinto bank accounts or provided as loans. Largeshort term flows between accounts in differentnations are commonly seen when the market isable to take advantage of fluctuations in interestrates and/or the exchange rate betweencurrencies.

Reserve account, the reserve account is operated by a nation's central bank i.e.RBI to buy and sell foreign currencies; itcan be a source of large capital flowsto counteract those originating from themarket.


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WHAT ARE EXTERNAL

COMMERCIAL BORROWINGS?

External Commercial Borrowings (ECB)refer to commercial loans [in the form of bankloans, buyers’ credit, suppliers’ credit,securitised instruments (e.g. floating rate notesand fixed rate bonds)] availed from non-residentlenders with minimum average maturity of 3years. Even loans from Foreign Equity Holdersare considered as ECBs.

Thus ECBs mean foreign currency loanraised by residents from recognised lenders.

ECB can be accessed under two routes,viz., (i) Automatic Route and (ii) ApprovalRoute

•AUTOMATIC ROUTE

Eligible borrowers

• Corporates (registered under theCompanies Act, except financialintermediaries (such as banks, financialinstitutions (FIs), housing financecompanies and NBFCs) are eligible to raiseECB.

• Individuals, Trusts and Non- Profit makingOrganisations are not eligible to raise ECB.

• Units in Special Economic Zones (SEZ) areallowed to raise ECB for their ownrequirement. However, they cannottransfer or lend ECB funds to sisterconcerns or any unit in the Domestic TariffArea.ECB for investment in real sector –

industrial sector, especially infrastructure sector-in India, are under Automatic Route, i.e. donot require RBI/Government approval.

Recognised lenders

Borrowers can raise ECB frominternationally recognised sources such as(i) international banks, (ii) international capitalmarkets, (iii) multilateral financial institutions (suchas IFC, ADB, CDC, etc.,), (iv) export creditagencies, (v) suppliers of equipment,(vi) foreigncollaborators and (vii) foreign equity holders.

• APPROVAL ROUTE

Eligible Borrowers

The following types of proposals for ECBare covered under the Approval Route:

• Financial institutions dealing exclusivelywith infrastructure or export finance suchas IDFC, IL&FS, Power FinanceCorporation, Power Trading Corporation,IRCON and EXIM Bank are consideredon a case by case basis.

• Banks and Financial Institutions whichhad participated in the textile orsteel sector restructuring package asapproved by the Government arealso permitted to the extent of theirinvestment in the package and assessmentby Reserve Bank based on prudentialnorms.

• ECB with minimum average maturity of5 years by Non-Banking FinancialCompanies (NBFCs) from multilateralfinancial institutions, reputable regionalfinancial institutions, official export creditagencies and international banks tofinance import of infrastructureequipment for leasing to infrastructureprojects.

• Special Purpose Vehicles, or any otherentity notified by the Reserve Bank, set tofinance infrastructure companies /projects exclusively, will be treated asFinancial Institutions and ECB by suchentities and will be considered under theApproval Route.

• Non-Government Organisations (NGOs)engaged in micro finance activities areeligible to avail ECB for Rupee expenditurefor permissible end-uses.

• Corporates in service sector viz. hotels,hospitals and software companies canavail ECB for import of capital goods.

Recognised Lenders

Borrowers can raise ECB frominternationally recognised sources such as(i) international banks, (ii) internationalcapital markets, (iii) multilateral financialinstitutions (such as IFC, ADB, CDC, etc.), (iv)export credit agencies, (v) suppliers’ ofequipment, (vi) foreign collaborators and (vii)foreign equity holders (other than erstwhileOCBs).

WHAT ARE ADR, GDR AND IDR?

A depositary receipt (DR) is a type ofnegotiable (transferable) financial security thatis traded on a local stock exchange but


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represents a security, usually in the form ofequity that is issued by a foreign publicly listedcompany. The DR, which is a physicalcertificate, allows investors to hold shares inequity of other countries.

The increasing demand for DepositaryReceipts is driven by the desire of individualand institutional investors to diversifytheir portfolios, reduce risk and investinternationally in the most efficient mannerpossible. While most investors recognize thebenefits of global diversification, they alsounderstand the challenges presented wheninvesting directly in local trading markets. Theseobstacles can include inefficient tradesettlements, uncertain custody servicesand costly currency conversions. ButDepositary Receipts offer cost benefits andconveniences.

How Does the DR Work?

The DR is created when a foreigncompany wishes to list its already publiclytraded shares or debt securities on aforeign stock exchange. Initial publicofferings, however, can also issue a DepositoryReceipt.

To allow creation of DRs, the shares ofthe foreign company, which the DRs represent,are first of all delivered and deposited with thecustodian bank of the depository throughwhich they intend to create the DR. Onreceipt of the delivery of shares, the custodialbank creates DRs and issues the same toinvestors in the country where the DRs areintended to be listed. These DRs are then listedand traded in the local stock exchanges of thatcountry.

American Depository Receipt

ADRs allow U.S. investors to invest in non-U.S. companies and give non-U.S. companieseasier access to the U.S. capital markets.

The first ADR was created in 1927 by aU.S. bank to allow U.S. investors to invest inshares of a British department store. Today,there are more than 2,000 ADRs availablerepresenting shares of companies located inmore than 70 countries.

ADRs may be “sponsored” or“unsponsored.” Sponsored ADRs are those inwhich the non-U.S. company enters into an

agreement directly with the U.S. depositarybank to arrange for recordkeeping, forwardingof shareholder communications, payment ofdividends, and other services. An unsponsoredADR is set up without the cooperation of thenon U.S. Company and may be initiated by abroker dealer wishing to establish a U.S. tradingmarket.

Global Depository Receipt

A global depository receipt is a certificateissued by a depository bank, which purchasesshares of foreign companies and deposits it onthe account. GDRs represent ownership of anunderlying number of shares. Global depositoryreceipts facilitate trade of shares, and arecommonly used to invest in companies fromdeveloping or emerging markets.

The typical GDR structure offers DRs inEurope or other non-US markets pursuant toRegulation S (Reg S) promulgated under theUS Securities Act of 1933. GDRs are listed ona European stock exchange such as London orLuxembourg and clear through theEuromarkets clearing systems, Euroclear andClearstream. GDRs may also be listed on otherexchanges, such as Dubai and Singapore. Theability of retail investors to purchase GDRswill depend on the type and location ofthe listing. In general, however, GDR offeringsare aimed at institutional investors anddepending on the exchange, they can then bepurchased by retail investors in the secondarymarket.

Indian Depository Receipt

An Indian Depository Receipt (IDR) is aninstrument denominated in Indian Rupees inthe form of a depository receipt created by aDomestic Depository (custodian of securitiesregistered with the SEBI) against the underlyingequity of issuing company to enable foreigncompanies to raise funds from the IndianSecurities Markets.

The foreign company IDRs will depositshares to an Indian Depository. The depositorywould issue receipys to investors in Indiaagainst these shares. The benefit of underlyingshares (like bonus, dividends etc.) would accrueto the depository receipt holders in India

Standard Chartered PLC became the firstglobal company to file for an issue of Indiandepository receipts in India.


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BENEFITS OF

DEPOSITORY RECEIPTS

To the Issuers

• Broaden and diversify a company’sinvestor base.

• Enhance a company’s visibility, status andprofile internationally among institutionalinvestors.

• Establish/increase total global issuerliquidity by attracting new investors.

• Develop and/or increase researchcoverage outside the home market.

• Get an international valuation as theCompany is valued alongside its peer group.

• Offer a new avenue for raising equitycapital.

• Meet internationally accepted corporategovernance standards.

• Trading of GDRs alongside their peergroup in the international markets.

To the Investors

• Easier to purchase and to hold than theissuer’s underlying ordinary shares.

• Trade easily and conveniently in USdollars and settle through establishedclearinghouses.

• Facilitate diversification into securities offoreign issuers.

• Create accessibility of price, tradinginformation and research.

• Represent a way to provide internationalexposure for institutional investors (mutualfunds, pension funds) despite restrictionsagainst investing in certain countries orin foreign investment instruments.

• Eliminate unfamiliar custody safekeepingarrangements.

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The exchange rate expresses the nationalcurrency's quotation in respect to foreign ones.For example, if one US dollar is worth 50rupees, then the exchange rate of dollar is 50.If something costs Rs. 150, it automatically costs3 US dollars as a matter of accountancy. Thus,the exchange rate is a conversion factor, amultiplier or a ratio, depending on the directionof conversion.

Each country, through varyingmechanisms, manages the value of its currency.As part of this function, it determinesthe exchange rate regime that will apply toits currency. For example, the currencymay be free-floating, pegged or fixed, or ahybrid.

When the exchange rate can freely move,assuming any value that private demand andsupply jointly establish, it is called "flexible"exchange rate.

If the central bank timely and significantlyintervenes on the currency market, then a"managed floating exchange rate regime" takesplace.

In "freely" and "managed" floatingregimes, a loss in currency value isconventionally called”depreciation", whereasan increase of currency's internationalvalue will be called "appreciation". If thedollar rises from 50 rupees to 60, then ithas shown depreciation i.e. value ofIndian currency is decreasing with respect toDollar.

But central banks can also declare a fixedexchange rate, offering to supply or buyany quantity of domestic or foreign currenciesat that rate. Under this regime, a loss ofvalue, usually forced by market or a purposefulpolicy action, is called”devaluation", whereasan increase of international value is a"revaluation".


EXCHANGE RATE:

CONCEPT

Merits and demerits of fixed and flexibleforeign exchange rates:

Merits of fixed exchange rate:

• It ensures stability in exchange rate. Theexporters and importers have not tooperate under uncertainty about theexchange rate. Thus it promotes foreigntrade.

• It promotes capital movements. Fixedexchange rate system attracts foreigncapital because a stable currency does notinvolve any uncertainties about exchangerate that may cause capital loss.

• Stable exchange rate prevents capitaloutflow.

• It prevents speculation in foreign exchangemarket.

• It forces the government to keep inflationin check. In case of fixed exchange ratesystem, inflation causes balance ofpayments deficit resulting in depletion offoreign exchange reserves.

Demerits of fixed exchange rate:

• It contradicts the objective of having freemarkets

• Under this system, countries with deficitsin balance of payment run down this stockof gold and foreign currencies. This cancreate serious problem for them. Theymay be forced to devalue their currency.On the other hand countries with surplusin balance of payments will face theproblem of inflation.

• There may be undervaluation orovervaluation of currency. If the fixedexchange rate is at a level which is lowerthen the market level i.e. at which demandfor foreign currency far exceeds its supply,it will result in deficit in balance ofpayment. If it is higher than the marketlevel i.e. at which the supply exceedsdemand then it may create inflationary


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pressure because of balance of paymentssurplus. It is difficult to fix a rate thatmay prove to be equilibrium rate

Merits of flexible exchange rate system

• It eliminates the problem of overvaluationor undervaluation of currencies, Deficit orsurplus in balance of payments isautomatically corrected under this system.

• It frees the government from problem ofbalance of payments.

• There is no need for the government tohold any reserves.

• It enhances the efficiency in the economyby achieving optimum resource allocation.

Demerits of flexible exchange rate system

• It creates situations of instability anduncertainty. Wide fluctuations inexchange rate are possible. This hampersforeign trade and capital movementsbetween countries.

• It encourages speculation which may leadto larger uncertainties and fluctuations.

• The uncertainty caused by currencyfluctuations can discourage internationaltrade and investment.

RUPEE DEPRECIATION CONCEPT

Exchange rate is defined as rate or priceat which one country’s currency is exchangedfor another country’s currencies. It depends onthe comparative trade advantages andeconomic strengths of the countries. Higher thedemand the stronger it becomes. However forcurrencies like Rupee which are not traded onexchanges, the value depends on capital inflowsin the country.

Rupee depre-ci-a-tion means that rupeehas become less valu-able with respect to dol-lar.If the rupee moves upward from 30 per dol-larto 40 per dol-lar then rupee is said todepre-ci-ate. It means that rupee is now cheaperthan what it used to be earlier.

Causes for depreciation

• Stock market performanceIt is a known fact that Indian stock marketis dominated by overseas investors. Whenthe economy is performing well and stockmarket is performing better than othercountries, overseas investors will become

heavy investors here. To invest here, theyrequire rupee. This will increase thedemand for rupee and will result in highervalue for rupee. On the other hand, whenthese investors are pulling money out ofIndian stock market, rupee will bedepreciated. Indian markets are in a badshape for the last 1 year. The sentimentsafter the US downgrade and the Europeancrisis etc. resulted in overseas investorsselling in India and buying dollars.In a bad performing market, when thereis depreciation in rupee, it will bring downthe overseas investors real returns. So theywill start selling, which will again deepenthe situation. Very high prices for goldhave created panic among investors andfearing a bubble there, investors startedmoving towards dollar. This demand indollar is also causing depreciation of rupee.

• InflationAnother factor affecting the currencyvalue is inflation. India is experiencing veryhigh inflation rate. This will decrease thepurchasing power against othercurrencies. Thus leads to depreciation ofthe currency.

• Current account deficitCurrent account deficit occurs when acountry’s total import exceeds the totalexports. This makes the country, a netdebtor to the rest of the world. This is notgood for the country because, the countryneeds to buy more foreign currency. Moredemand for the foreign currency willreduce the value of that country’scurrency. India’s current account deficitis more than the expected level now andthis also contributes to the depreciation ofIndian rupee.

• Corruption and Political paralysisIn the last 1 year, lot of corruption issuescame to limelight thus affecting investorsentiments globally.

Rupee depreciation: who are affected?

a) Foreign investment: Any investmentabroad, whether in stocks or real estate,would become dearer. For instance, to buystocks worth a dollar, now a personwould be required to pay around Rs. 50compared with Rs.45 few months ago.However, since different countries have


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different currencies, the actual impactwould depend upon the fluctuations ofcurrency of a country in which a personis investing. Normally, the rupee is firstconverted into dollars, which in turn isconverted into the currency of the thirdcountry. Hence, the actual impact wouldvary according to the level of depreciationin rupee vis-a-vis the third currency.

b) Foreign education (for aspiringstudents): Students who plan for next yearadmissions will end up paying more forthe forms of exams such as Test of Englishas a Foreign Language (TOEFL), GraduateRecord Exam (GRE) and GraduateManagement Admission Test (GMAT).These are entrance exams that studentstake to prove their eligibility for studyingabroad in terms of basic language, skillsand IQ. Moreover, the application formsof foreign universities, which cost $50-1,000, will be more expensive for Indianstudents.

c) Foreign education (for existingstudents): The overall budget will beaffected as every item in the budget listwill witness a change, as apart from theapplication fee, examination fee and thetuition fee, even the cost of living will behigher for the students. This will have animpact on students who have delayedpaying their fees to the universities for theJuly-September 2011 batch. Students maynow have to pay Rs. 50,000-1 lakh overthe fee which they were to pay earlierthis year.

d) Foreign travel: The depreciating rupeewill increase the cost of foreign travelling.

Rupee depreciation: who are benefited?

a) Remittance to India: those who aredependent on remittances, Rupeedepreciation would benefit them as uponconversion to Indian currency the amountwould be higher.

Effect on Export and Import

For equity investors, the rupee depreciationwould have a twin impact. Some sectors that areprimarily export oriented stand to gain from rupeedepreciation while sectors dependent on import maybe affected adversely. These include petroleumproducts, metals, capital goods and power.

A number of steps have been takenrecently to stimulate capital inflows and curbspeculation in foreign exchange market tostabilize the value of the rupee.

MEASURES TO INCREASE SUPPLY

OF FOREIGN EXCHANGE

Trade Credit

a) All-in-cost ceiling for trade credit has beenincreased from 6 months Libor + 200 basispoints (bps) to 6 months Libor + 350 bps.

ECBs

a) The existing ECB limit under automaticapproval route has been enhanced fromUS$ 500 million to US$ 750 million foreligible corporates. For borrowers in theservices sector, the limit was enhancedfrom US$ 100 million to US$ 200 million.

b) The proceeds of ECBs raised abroad forrupee expenditure in India should bebrought immediately. In other words, ECBproceeds meant only for foreign currencyexpenditure can be retained abroadpending utilization. The rupee fundshowever will not be permitted to be usedfor investment in capital markets or realestate or for inter-corporate lending.

FII Investment

a) The FII limit for investment in governmentsecurities and corporate bonds has beenincreased by US$ 5 billion each to US$ 15billion and US $ 20 billion respectively,from earlier limits of US$ 10 billion andUS$ 15 billion. The investment limit inlong-term infrastructure corporate bonds,however, has been kept unchanged atUS$ 25 billion. With this, overall limit forFII investment in corporate bonds andgovernment securities now stands at US$60 billion.

Major administrative measures

a) Forward contracts involving the rupee asone of the currencies, booked by residentsirrespective of the type and tenor of theunderlying exposure, once cancelled,cannot be rebooked.

b) All cash/tom/spot transactions byauthorized dealers on behalf of clients willbe undertaken for actual remittances/


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delivery only and cannot be cancelled /cash settled.

c) The Board of Directors of AuthorizedDealers was allowed to fix suitable limitsfor various treasury functions with netovernight open exchange position andaggregate gap limits required to beapproved by the RBI.

FOREIGN EXCHANGE

MANAGEMENT ACT (FEMA)

When a business enterprise imports goodsfrom other countries, exports its products tothem or makes investments abroad, it deals inforeign exchange. Foreign exchange means'foreign currency' and includes: - (I) deposits,credits and balances payable in any foreigncurrency; (II) drafts, travellers' cheques, lettersof credit or bills of exchange, expressed ordrawn in Indian currency but payable in anyforeign currency; and (III) drafts, travellers'cheques, letters of credit or bills of exchangedrawn by banks, institutions or persons outsideIndia, but payable in Indian currency.

In India, all transactions that includeforeign exchange were regulated by ForeignExchange Regulation Act (FERA), 1973.

The main objective of FERA wasconservation and proper utilization of theforeign exchange resources of the country. Italso sought to control certain aspects of theconduct of business outside the country byIndian companies and in India by foreigncompanies. It was a criminal legislation(punishable with imprisonment as per code ofcriminal procedure) which meant that itsviolation would lead to imprisonment andpayment of heavy fine. It had many restrictiveclauses which deterred foreign investments.

In the light of economic reforms and theliberalized scenario, FERA was replaced by anew Act called the Foreign ExchangeManagement Act (FEMA), 1999. The Actapplies to all branches, offices and agenciesoutside India, owned or controlled by a personresident in India.

FEMA emerged as an investor friendlylegislation which is purely a civil legislation inthe sense that its violation implies only paymentof monetary penalties and fines. However,

under it, a person will be liable to civilimprisonment only if he does not pay theprescribed fine within 90 days from the date ofnotice but that too happens after formalities ofshow cause notice and personal hearing. FEMAalso provides for a two year sunset clause foroffences committed under FERA which maybe taken as the transition period granted formoving from one 'harsh' law to the other'industry friendly' legislation.

Broadly, the objectives of FEMA are:

(i) To facilitate external trade and payments;and

(ii) To promote the orderly development andmaintenance of foreign exchange market.The Act has assigned an important role to

the Reserve Bank of India (RBI) in theadministration of FEMA. The rules, regulationsand norms pertaining to several sections of theAct are laid down by the Reserve Bank ofIndia, in consultation with the CentralGovernment. The Act requires the CentralGovernment to appoint as many officers of theCentral Government as AdjudicatingAuthorities for holding inquiries pertaining tocontravention of the Act.

There is also a provision for appointingone or more Special Directors (Appeals) to hearappeals against the order of the Adjudicatingauthorities. The Central Government alsoestablishes an Appellate Tribunal for ForeignExchange to hear appeals against the orders ofthe Adjudicating Authorities and the SpecialDirector (Appeals).

The FEMA provides for the establishment,by the Central Government, of a Director ofEnforcement with a Director and such otherofficers or class of officers as it thinks fit fortaking up for investigation of the contraventionsunder this Act.

The Act deals with two types of foreignexchange transactions – Capital AccountTransactions and Current AccountTransactions.

FEMA permits only authorized persons todeal in foreign exchange or foreign security.Such an authorized person, under the Act,means authorized dealer, money changer, off-shore banking unit or any other person for thetime being authorized by Reserve Bank.

•••

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