A

HANDBOOK
OF
ECONOMY

Evolution of Money
Points to Ponder in This Article - Just understand the definitions of money system that were
used over the time from ancient to modern one. Understand the differences between barter
system, bank money and crypto currencies.
Money, as we know it today, is the result of a long process. At the beginning, there was no
money. People engaged in barter, the exchange of merchandise for merchandise, without value
equivalence.
Barter System
Positives Negatives

 Double coincidence of wants was must

 No division of labor
 Exchange of perishable goods
 Simplest in form  No saving capital
 No foreign Exchange regime  No circular flow of income
 No concentration of wealth  No Divisibility or Fungibility of same value
 
Function of Money
Primary Function Derivative Function
Measure of Value + Medium of Exchange as it
is –
 Readily acceptable
 Durable, Portable, Recognizable
 Divisible, Fungible  Store of Value – Savings → Investment
 Hard to Counterfeit  Transfer of Value – Same value from Kashmir to Kany
   Deferred Payment – Time value of Money → Credit c
 
 
Evolution of Money

Commodity Money
 Intrinsic value of commodity was used to make exchanges viz.
 USA   → Tobacco, Corn, Iron nails were used to make exchanges
 Aztec → Cocoa beans were used to make exchanges
 India  → Cowries were used to make exchanges
 Fiji    → Whale teeth were used to make exchanges
 Problems of commodity money
 Face Value was not same throughout region
 Face value was not same for outsiders
 Generally commodity used were perishable in nature → could cause inflation
 Generally bulky to carry
 No fungibility or divisibility → No division of labour
 
Metallic Money
 Started by Kings & Traders with uniformity & precision
 Forged in Gold (Muhr)                            → High value
 Forged in Silver (Rupaiya)                      → Moderate value
 Forged in Copper/ Bronze (Dam, Paisa) → For day to day purchases
 
Positives of Metallic Money
 Intrinsic value + Non-perishable
 Divisible, Fungible
 Foreign trade possible (without exchange rate)
 Production was low → Prices stable →No Hyperinflation
 
Negatives of Metallic Money
  Mansabdari payment system → 50% in Gold +25% in Silver + 25% in Copper
 Copper Dam Debasement → 20 gm copper in Akbar time in a coin | 13 gm copper in
Aurangzeb time 
 People became vary of coin values → Again started barter system
 Tax collection & revenue system started declining
 People started using East India company coins
 Bulky to carry
 Smuggling for intrinsic value to other Kingdoms (Main reason for debasement)
 
Paper Money (Fiat Money)
 Fiat Money →Used by the command of the government
 Examples include → US dollar, Indian Rupee, Euro, Yen, Yuan
 Legally recognized to settle all debts & payments within territorial jurisdiction
 Initially Fiat Money was pegged to Gold viz.
 1 US $ →  22 grains Gold
 1 British Pound → 113 grain gold
 1 Pound → 113/22 →8 US $
 But during world war 2 this system collapsed
 After WW2 Fiat Money was formatted as Paper standard viz.
 Central Bank free to print currency without gold backing
 Exchange Rates→ Fixed Exchange rate + Floating Exchange rate + Managed Exchange
rate
 
What is not Fiat Money?
 Money without government legal backing
 Superstores plastic coins, cards & coupons
 Shares, Bonds, Debentures, G-Sec, T-bill
 DD, Cheques, Credit Card, ATM card
 Bitcoin & other Digital currency
 
Problems of Fiat Money
 Debasement → Over printing → Hyper inflation
 Still Bulky to carry + Theft + Counterfeit
 Change problem → Rounding off problem
 Imagine a petrol pump not returning 60 paise per customer due to change problem
 For Every 1 lakh customers pump is earning 60,000 rupees
 
India → Paper Standard

Government
 Rs. 1 note + All coins
RBI  Coinage Act 2011 Rs. 1 note to hold Financia
 RBI Act 1934 → Notes Printed from Rs. 2 to signature
1000   
 
Bank Money
 Backed by Central bank of the country viz.
 Cheque, Bank Draft, NEFT, RTGS
 Credit card, Debit cards, Visa Card, Master card, Rupay card
  Benefits of Bank money
 Spot payment + Deferred payment + Time saving
 Easy to transfer over long distance
 Exact amount can be transferred (No change problem)
 Hard to counterfeit
 Can be freezed if card is stolen via. KYC norms
 Legally recognized for high value payment
 
Crypto Currency / Virtual Currency → Bitcoin
 Major reasons for birth of crypto currency
 Subprime crisis → US QE → Increased dollar supply → Dollar’s purchasing power
decreased
 Banks charge fees on online transfer, credit card, ATM
 Anarchist groups (a person who believes that government and laws are not necessary)
 Birth of Bitcoin
 Started in 2009 by Satoshi Nakomoto
 1 BTC →10(^8) Satoshi – Virtual money
 Reward distribution for solving algorithm + Exchange by Fiat money + Selling goods &
services
 
RTGS NEFT BITCOIN

 Retail        → 2L to 5L
 Corporate → 5L Less than 2 L No ceiling

Processing fees Processing fees None

Instant Transfer Transfer within 1 hour cycle Transfer upto 10 minu

Specific Timing & days Specific Timing & days None → Can do 24/7

Central monitoring by RBI Central monitoring by RBI None

Can recover account via. password Can recover account via. password Once gone then gone

Requires Account number + IFSC code Requires Account number + IFSC code
for transfers for transfers Only public address o

KYC norms applies KYC norms applies None

 
RBI Stand on Decentralised Digital Currency / Virtual Currency (Bitcoin)
 No central bank has authorized Bitcoins
 Not Traded through BSE, NSE or Commodity exchange (SEBI, FMC)
 No Forex dealers under FEMA can convert Fiat currency into Bitcoin or vice versa
 Bitcoin Exchange website→Legal status unclear
 Danger → Hacking, Phishing, Malware, Password lost
 Consumer courts cannot help
 High speculation & volatility
  Mere digital code, no intrinsic value, not backed by Gold, silver or crude oil
 Media reports on illegal drug, money laundering, terror-financing.
 Unintentionally breaching anti-money laundering / Anti-terror laws
 Same for all Digital currencies / virtual currencies

Evolution of Banking in India

Points to Ponder in This Article - Just read how banking system evolved in India & how was it
before and after the independence. Also look at the committees which led to setting up of new
banks, decrease in CRR, SLR etc. & evolution of banking system.
Banking in India, in the modern sense, originated in the last decades of the 18th century.
Among the first banks were the Bank of Hindustan, which was established in 1770 and
liquidated in 1829–32; and the General Bank of India, established in 1786 but failed in 1791.
East India Co. established three presidency banks viz.
 Bengal 1806
 Bombay 1840
 Madras 1842
 
1861 : All 3 were given right to issue currency
1921 : Formation of Imperial Bank of India by merging all above 3 banks
1955 : Nationalization of imperial bank → Birth of SBI
 
Pre Independence banks in India
Foreign Banks (Pre independence)
 Bombay, Bengal, Madras Presidency Banks → Imperial Bank’ 21 → SBI’ 55
 Catered British Army, Bureaucrats, Judges, merchants
 
Indian Banks (Pre independence)
 Allahabad Bank, PNB, BoB, Canara Bank
 Focus was majorly on Foreign trade
 Catered Merchants, Shroff & Moneylenders
 
Birth of RBI
 By 1930 India had more than 1000 banks working solely on company’s law
 In October 24, 1929, the stock market bubble finally burst, as investors began dumping
shares en masse.
 A record 12.9 million shares were traded that day, known as “Black Thursday.”
 Finally in 1934, to check this kind of situation in future RBI as banker’s bank was
institutionalized.
 
 Financial Institutions in India

Reserve Bank of India (RBI)

The Reserve Bank of India (RBI) is India’s central banking institution, which controls the
monetary policy of the Indian rupee. It was established on 1 April 1935 during British Raj in
accordance with the provisions of the Reserve Bank of India Act, 1934. The RBI plays an
important part in the development strategy of the Government of India.
 The RBI has been fully owned by the Government of India since its nationalization in
1949.
 The Central Office of the RBI initially established in Calcutta, but was permanently
moved to Bombay in 1937.
  The general superintendence and direction of the RBI is entrusted with the 21-member
Central Board of Directors: the Governor, four Deputy Governors, two Finance Ministry
representative, ten government-nominated directors to represent important elements
from India’s economy, and four directors to represent local boards headquartered at
Mumbai, Kolkata, Chennai and New Delhi.
 The Preamble of the RBI describes its basic functions to regulate the issue of bank
notes, keep reserves to secure monetary stability in India, and generally to operate the
currency and credit system in the best interests of the country.
 RBI, founded a subsidiary company – Bharatiya Reserve Bank Note Mudran Limited – in
February 1995 to produce banknotes (Karnataka & Bengal)
 Sir Osborne Smith was the first Governor of the Reserve Bank
 Chintaman Dwarkanath Deshmukh, a member of the Indian Civil Service, was the first
Indian Governor of the Bank. (Youngest)
 
Main functions of Reserve Bank of India (RBI)
 Bank of issue (Supervise & make policies for other banks)
 Monetary authority
 Regulator and supervisor of the financial system
 Managerial of exchange control
 Issuer of currency
 Manager of foreign exchange
 
National Bank for Agriculture and Rural Development (NABARD)
 NABARD is an apex development bank in India having headquarters based in Mumbai
(Maharashtra) and other branches are all over the country.
 Accredited with “matters concerning policy, planning and operations in the field of
credit for agriculture & other economic activities in rural areas in India”
 NABARD was established on the recommendations of Shivaraman Committee on 12
July 1982 to implement
 
NABARD was established in terms of the Preamble to the Act, “for providing credit for the
promotion of agriculture, small scale industries, cottage and village industries, handicrafts and
other rural crafts and other allied economic activities in rural areas with a view to promoting
IRDP and securing prosperity of rural areas and for matters connected therewith in incidental
thereto”.
 
 Known for its ‘SHG Bank Linkage Programme’ which encourages India’s banks to lend
to Self Help Group (SHGs)
 Lends it downwards to State cooperative banks (SCB), Regional Rural banks (RRBs),
Microfinance institutions, cooperative credit societies etc. That’s how farmers, villagers,
cottage/handicraft, self-help group (SHG) get loans at reasonable interest rate.
 Acts as the regulatory authority for cooperative banks and regional rural banks
 Operates the Rural Infrastructure Development Fund (RIDF)
 
Rural Infrastructure Development Fund (RIDF)
 Started in mid 90s → NABARD operates Rural Infrastructure Development Fund (RIDF).
 Banks who do not meet their Priority sector lending requirements, provide money to this
rural infrastructure development fund.
 This fund provides cheap loans to states and state-owned corporations. 
Deposit Insurance and Credit Guarantee Corporation (DICGC)
  HQ: Mumbai , setup by act of parliament (means it is not a company registered under
companies act)
 RBI completely owns DICGC & one of 4 dy. Governors acts as the chairman of DICGC.
 From the name itself, we can see it has two functions
 Deposit insurance
 Credit guarantee
 
Deposit insurance
 Banks have to keep aside some money as ‘backup’, in CRR & SLR but in case of
massive crisis or when RBI cancels banks license, to protect the bank customers,
government enacted Deposit insurance Act
 Under this act, every bank (commercial or cooperative) has to compulsorily take
insurance from DICGC & has to pay the premium to DICGC. So, when bank fails / shuts
down, DICGC will give money to depositors (maximum 1 lakh per depositor).
 RBI can inspect the banks on DICGC’s behalf to make sure they’ve taken adequate
precautions in running the bank.
 
Credit guarantee
 DICGS ‘guarantee’ to bank, so, if a farmer doesn’t repay his loan, we’ll pay you (Bank)
the loan money, one type of insurance.
 
Financial intermediaries
 Institutions that channel funds from People to Business / Government (b/w surplus &
deficit agents) are called financial intermediaries.
 Financial intermediaries invest in diversified portfolios; and hence suffer less risk
compared to an individual investor.
 Financial intermediaries are supervised & monitored by regulators like RBI, SEBI, IRDA
etc.
 Few Examples of the same are
Financial intermediaries – Banks in India
Points to Ponder in This Article - Understand different types of banks which function in India,
what are their primary goals, the aims with which they were setup, how they function & primary
differences between them. Do not try to cram their definitions and minute differences in their
administration, but what is important is their field area & population they target & with what
motive.
Scheduled Bank
Banks included in the 2nd Schedule to the Reserve Bank of India Act, 1934 are scheduled
banks. Comprise of Scheduled Commercial Banks and Scheduled Cooperative Banks
Commercial Banks
 The main function of these types of banks is to give financial services to the
entrepreneurs and businesses.
 Commercial Banks finance businessmen like providing them with debit cards, banks
accounts, short term deposits, etc. with the money deposited by people in such banks
 Commercial banks lend money to these businessmen in the form of secured loans,
unsecured loans, credit cards, overdrafts & mortgage loans.
 It got the tag of a nationalized bank in the year 1969 & hence the various policies
regarding the loans, rates of interest, etc. are controlled by the RBI
 Further classifications of the commercial banks include private sector banks, public
sector banks, regional banks and foreign banks.
 
Public sector banks
 Owned and operated by the government, who has a major share in them.
 Major focus of these banks is to serve the people rather earn profits.
 Examples include State Bank of India, Punjab National Bank, Bank of Maharashtra,
State bank of Patiala, Allahabad Bank, Canara Bank etc.
 
Private sector banks 
 Owned and operated by private institutes; free to operate and are controlled by market
forces.
 A greater share is held by private players, not by the government.
 For example, Axis Bank, Kotak Mahindra Bank, ICICI Bank, HDFC Bank etc.
 
Foreign banks
 Foreign country banks having several branches in India.
 Some examples of these banks include HSBC, City Bank, Standard Chartered Bank etc.
 
Regional rural banks 
 Came to birth on the recommendations ofMM Narsimhan Committee
 Banks which can only operate in the areas specified by GOI
 They came into operation with the objective of providing credit to the agricultural and
rural regions and were brought into effect in 1975

 
Commercial Banks RRB

HUGE → Whole India (although mainly

concentrated in urban areas and small
Area of operation towns) SMALL → One or a few districts (rural)

 Savings accounts, fixed deposit etc.  Borrowing from NABARD, SIDBI

 Borrowing from RBI and other  They also have savings account
Source of finance sources not sufficient to cover the loan de
 
 
Difference Between Commercial Banks & Cooperative Banks

Cooperative Banks Commercial Banks

Co-operatives banks are co-operative organisations. Commercial banks are joint-stock banks

Governed by the Co-operative Societies Act as well as

Banking Regulation Act Governed by the Banking Regulation Act

Subject to the rules laid down by the Registrar of Co-operative

Societies Subject to the control of the Reserve Bank of

Borrowers are member shareholders, so they have some Borrowers of commercial banks are only acco
influence on the lending policy of the banks, on account of have no voting power as such → Voting powe
their voting power shareholding

Have not much scope of flexibility on account of the rigidities

of the bye-laws of the Co-operative Societies Free from such rigidities

PSL does not applies PSL Applies

Non Banking Financial Intermediaries (NBFI)

All India Financial Institutions (AIFI)

 Export-Import Bank of India – Established in 1982
 Controlled by Government of India (100%)
 Provides Loan/credit/finance to exporters and importers
EXIM Bank  Promotes cross border trade and investment

 National Bank for Agriculture and Rural Development – Established in 1982

 Controlled by → GoI (99.3%) + RBI (0.7%)
 Regulatory authority of Cooperative banks + RRBs
 Manage Rural infra. Development fund (RIFD)
NABARD  Finances State cooperative banks (SCB), RRBs, MFIs, Cottage/handicraft (SHG

 National Housing Bank – Established in 1988

 Apex institution for housing finance in India
 Controlled by RBI (100%)
 Provides finance to banks and NBFCs for housing projects
NHB  Manages RESIDEX index (Housing sector-inflation index)

 Small industries development bank of India – Established in 1990

 Controlled by SBI, LIC, IDBI other public sector banks, insurance companies et
 Manages SEDF (Small enterprises development fund – Funded by Foreign ban
PSL not met)
 Provides finance to State Industrial Development Corporation (SIDC), State fina
SIDBI MSME sector and banks
 
Primary Dealers (PD)
 Deal in “primary” market
 Directly buy G-sec via “auction”.
 Can Participate in OMO (Open Market Operations)
 Must get license from RBI
 Examples → Morgan Stanley, Goldman Sachs, JP Morgan Chase, Standard Chartered
Bank, HSBC + SBI, BoB, Kotak Mahindra etc.
 
Non banking financial companies (NBFC)
 Financial institutions that provide banking services without meeting the legal definition of
a bank, i.e. one that does not hold a banking license.
 RBI is entrusted with the responsibility of regulating and supervising some of the NBFCs
by virtue of powers vested under Reserve Bank of India Act, 1934.
 

 
Difference between Banks and NBFCs
Banks NBFCs

License under Banking regulation Act license under Company Act

Depends
 Insurance Co.     : IRDA
 Merchant Banks  : SEBI
All supervised by RBI  Microfinance Co. : State + RBI + NABARD

 They can accept Time deposit (such NBFC are called Dep
Deposit from public  But They cannot accept demand deposits
 Time deposit (FDRD)  Do not form part of the payment and settlement system →
 Demand deposits (CASA) cheques drawn on itself

PSL applies PSL doesn’t apply

Deposit insurance facility of DICGC

applies Deposit insurance facility of DICGC does not applies

Depends
 Gold Loans → risk factor (15%, 25%)
 Shares: dividend
Loan rates linked with Base Rate system  Bonds: 8/12/16%
  SARFAESI applicable only for Housing finance companies
 Gold loan: auction
 Bonds holders of NBFC: first to get paid
Loan recovery powers under SARFAESI  Shares holders of NBFC: last to get paid

 CRR does not apply

Standard CRR & SLR Ratios apply  Approx. 15% SLR applies only to Deposit taking NBFC

Do provide finance to invest in share

market Can lend money to finance companies for the same
 
GDP & GDP Calculation
Points to Ponder in This Article – Just understand the meaning of different terms related to
GDP, NDP etc. & what is the effect of base year in GDP calculation. The GDP calculation
methods have become redundant over the years & hence just give it a reading but no use of
taking it to heart.
Gross domestic product is the best way to measure a country’s economy. GDP is the total value
of everything produced by all the people and companies in the country. It doesn’t matter if they
are citizens or foreign-owned companies. If they are located within the country’s boundaries, the
government counts their production as GDP.
GDP Market value all final goods & services produced within country for a given time

NDP GDP – Depreciation

GDP Deflator GDP adjusted due to inflation on a base year = Nominal GDP / Real GDP

Factor Cost Labor (Wages) + Land (Rent) + Capital (Interest) + Entrepreneurship (Profit)

Market Price Factor cost + Taxes – Subsidies

GDP @ Market Price GDP @ Factor cost + Taxes – Subsidies

GNP GDP + Net Income from abroad

Net Income abroad Income of Indians abroad – Income of foreigners in India

NNP @ Market Price GNP – Depreciation

NNP @ Factor Cost NNP @ MP – Taxes + Subsidies = National income

Per capita national income National Income / Total Population

National Disposable income NNP @ Market Price + Current account transfers

 
GDP Calculation Methods

Income Method Expenditure Method Production Method (G

 
Income Method → Based on factor cost → WIPR
 Factor cost = Labor (Wages) + Capital (Interest) + Entrepreneurship (Profit) + Land
(Rent)
 GDP @ Current Market Price = GDP @ Factor cost + Taxes – Subsidies
 GDP @ Current Market Price when adjusted for inflation → GDP @ Constant market
prices

Expenditure Method → Private Consumption + Investment + Government + Foreign

Expenditure
 GDP will be calculated as → C + I + G + (X – M)
 Where C → Private Consumption; I → Investment; G → Purchase; X-M → Foreign
Expenditure
 
 Only final consumption is counted
 New Car Purchased → Will be counted
 Existing House → Will be calculated as owner paying “rent” to himself
 Intermediate consumption is not counted
Private  Steel, Rubber used to make product → Will not be counted
Consumption  New house purchased → Will be counted in investment (Not as Private Consump

Investment  New house purchased will be counted

 Purchase of goods that will be used in future production will be counted
 Capital goods, Heavy Machinery, Building, Structure will be counted
  Leftover Inventory [Rubber, steel, car] will be counted
 Share, Bond, Debenture will be counted

 Salary to employees will be counted

 FCI food grain purchase will be counted
 Transfer Payments viz. LPG-DBT, Pension, Scholarship, food coupons etc → → 
Gov. Purchase Private consumption

Foreign  Money earned from export  – invested in imports

Expenditure  As invested in imports is already counted in private consumption
 
Production Method: Gross Value Added (GVA)
 GDP = Total value added at each stage or
 GDP = Total Value of Sale – Cost of intermediate goods
 
GDP doesn’t cover following
 Underground Economy
 Non-Marketed Activities (Mom cooking food for home)
 Barter Exchanges (Rice given for oranges)
 Negative Externality (Acid rain)
 Opportunity cost lost (kids not going to school which could have made difference in
future – Human Dev)- (HDI)
 Income Inequality (Gini Coefficient)
 

CSO GDP calculation till 2015

 Until now CSO used to do GDP Calculation at factor cost by
 Income Method (WIPR)
 Production Method : Gross Value Added (GVA)
 Categorized industries into three parts viz

 CSO utilizes data from the following

 
Goods  Services 
 ASI – Annual survey of industry  CBDT – Central board of direct taxes
 IIP – Index of industrial production  CBEC – Central board of excise & cu
  Economic census
 NSSO Surveys  CPI-Indexes
 
CSO Reforms 2015 for GDP Calculation – Income Method
Before After

Compensation
Wages  Salaries + Social security contribution by
 Only salary Employee
   

Profit Mixed income / OS

 Only workers / laborers get wages

 Entrepreneurs get “profit”
 Informal & unorganized family owned Agro, cottage  Hence the concept of Mixed income (MI)/
industries were not taken into account (OS)

 Corporates calculate profit easily but unorganized

firms find it difficult to separate profit  from wages  Profit of corporates is taken into account a
due to lack of standard accounting income or operating surplus as and where
 

Consumption of fixed capital (CFC)

 System of National Accounts (SNA) → Collaboration among UN, World Bank, IMF,
OECD and European commission.
 If capital asset not used than they fall under the category of intermediate goods
 When production begin & final goods are generated → Calculate CFC accordingly
GVA at Basic Price
 Sector wise estimate of Gross value added (GVA) will now be given at basic prices
instead of factor cost
 GVA at Basic Price → GVA at factor cost + Production taxes + Production subsidies
 
Production Taxes  Production Subsidies 
 Independent of Production Volume  Independent of production volume
 Stamp Duty  Subsidies to Railways
 Land revenue  Input subsidies to Farmers, small industries
 Professional Tax   Administrative subsidies to cooperatives & corpo

Official GDP of India will now be calculated as

 GVA (Basic price) → CE + OS/MI + CFC + Production taxes – Production subsidies
 Sum of GVA at basic price + Product taxes + Product subsidies → GDP at market price
 GDP of India → GDP at market price adjusted for inflation
 
Product Subsidies 
 Calculated on per unit of Production
 Example include:
Product Taxes   Food, Petroleum, Fertilizer
 Calculated on per unit of production  Interest subvention to farmers
 Examples → VAT, EXCISE, Custom, Service Tax  Subsidies for insurance to households

 
 
CSO – GDP Reforms done
 GDP @ Factor cost will not be official GDP of India
 GDP @ (Constant) Market price will be official GDP India’s GDP
 Base year for GDP calculation changed from 2004 → 2012
 Use of internationally valid System of National Accounts (SNA) 2008
 Classified economic activities & their account keeping accordingly
 
 

 
What is Base year Price?
 Represents price of a normal year (Medium term rate of prices – trend rate or average of
some year)
 No major Social, Political or natural disasters to surge or down the prices
Base year price revision
 From 2004-05 to 2011-2012, majorly to -
 Production in consumption basket changing over period of time
 GDP assessment on contemporary moving of prices
 
 
Monetary Policy & Inflation
Points to Ponder in This Article – This is the most important article in one’s upsc economy
preparation. Read each and every word of this article with utter concentration to understand the
nuance of economic system. Data given in this article may have changed over time but the
basics remain same. Hence, read this article from head to toe as the most important one.
Inflation Rise in Prices

Deflation Fall in prices

Disinflation / Creeping Inflation Slow Rate of Inflation

Stagflation / Misery Index Stagnation + Inflation → Prices rise + No new Jobs

Reflation Policy to stop deflation without causing inflation

Galloping Inflation Inflation increasing in AP or GP

Hyper / Runaway Inflation Inflation averaging 100% in 3 years

Recession Decline in GDP for two or more consecutive quarters

Depression An extreme recession that lasts two or more years

Core Inflation Underlying inflation (Judged primarily by mfg sector)

Headline inflation Core inflation + inflation in primary article (food + fuel)

 
Sterilization
A form of monetary action in which a central bank seeks to limit the effect of inflows and
outflows of capital on the money supply. Sterilization most frequently involves the purchase or
sale of financial assets by a central bank, and is designed to offset the effect of foreign
exchange intervention.
 
Core sector India
 The eight core sector industries in India are — Coal, Crude oil, Natural gas, Refinery
products, Fertilizer, Steel, Cement and Electricity
 Core sector contributes 38 % in the overall industrial production; a parameter that RBI
takes into account while framing its monetary policy
 
Monetary policy
 Policy made by Reserve Bank of India to check inflation or deflation viz. to control
money supply in system.
 General fundamentals to check inflation or deflation → Control Money supply in system
are –
 
To Combat Inflation To Combat Deflation
 Reduce Money supply in System  Increase Money supply in System
 Tight Money policy  Easy Money policy
 Dear money policy  Cheap money policy

 
Major Tools Used by RBI to Control the Money Supply
Quantitative, General, Indirect Tools Qualitative, Selective, Direct Tools
 Reserve Ratios (CRR, SLR)  Margin / LTV
 Open market operations (OMO)  Consumer Credit control / Down payment
  Rationing
 Moral Suasion (Speech & seminars by RB
 Rates (Repo, Reverse Repo, Bank, MSF, LAF)  Direct Action
 

Quantitative, General, Indirect Tools to Control Monetary Policy

Reserve Ratios →  Cash Reserve Ratio (4%) + Statutory Liquid Ratio (21.5%)
 To protect your bank against the bank run (When everyone is rushing to take out money
from bank)
 Stated in bimonthly monetary policy review
 Always counted on Demand & Time Liabilities
 
SLR (Statuary Liquidity Ratio)
 A Bank has to put 21.5 % of total money (Demand & Time Liabilities) with RBI in form of
gold, cash or government securities
 On Government securities bank also gets interest
 
CRR (Cash Reserve ratio)
 A bank has to set aside 4 % of total money (Demand & Time Liabilities) with RBI in form
of cash.
 No interest gain to bank
 
 
Net Demand & Time Liabilities
 On a particular day, depositors deposited 150 cr in bank & customers took out 50 cr from
bank
 NDTL → 100 cr → Reserve ratios will be counted on 100 cr.
 CRR (4%) → 4 cr cash kept aside for no use whatsoever → Levied on all banks →No
profit to bank
 SLR (21.5%) → Cash, Gold, RBI approved securities (G Sec, Blue chip company shares
etc.) →5 cr → Levied on all banks →Profit to bank → Government securities (8%),
Bonds, Shares may fetch profit, Gold reserves may fetch profit
 Bank left with 74.5 cr to lend to customers → further classification of this amount in PSL
& commercial lending
 NDTL → Calculated fortnightly every second Friday
 
Time liabilities
Demand Liabilities  Fixed deposits (FD)
 Current Account (CA)  Recurring deposits (RD)
 Savings Account (SA)  Cash certificates
 Demand Draft  Staff security deposits e.g. bond in companies

 
Time liabilities > Demand liabilities as
  Current account fetches 0 % interest
 Saving account fetches 4-6-8 % interest
 FD/RD fetches 9% interest
 
Open Market Operations (OMO)
 When RBI starts buying or selling government securities in open market to control
money supply
 RBI selling government securities → Less money with banks (as they invested in
government securities) →Inflation reduced
 RBI buying government securities → More money with banks (as they sold government
securities) → Deflation reduced
 
Rates → LAF (Repo Rate, Reverse Repo Rate), MSF, Bank Rate
Liquidity Adjustment facility (LAF)
Repo Rate (6.75% at Present) – Policy Rate
 If client borrows money from RBI (for short term – Even overnight) then client has to pay
a fixed interest rate to RBI.
 Collateral → Securities other than of CRR & SLR
 Inbuilt clause of automatic re-purchase after a certain period as decided.
 Client being Central & State Gov., All banks & NBFI
 
Reverse Repo Rate (5.75 % at Present)
 If client lends money to RBI (for short term – Even overnight) then RBI has to pay a fixed
interest rate to client.
 Collateral → Securities other than of CRR & SLR
 Inbuilt clause of automatic re-purchase after a certain period as decided.
 
Repo Rate – 0.25% → Reverse Repo Rate Repo Rate + 0.25% → MSF
 
Marginal Standing facility (MSF)
 Minimum 1 cr loan against 5 cr minimum in case of LAF
 Only scheduled commercial banks can borrow under this window (SBI, PNB, BOB, ICICI
etc.)
 Banks Can use securities from SLR quota
 Maximum credit of 2% of net time & demand liabilities
 
Bank Rate
 When banks borrow long term loans from RBI, they’ve to pay a fixed interest rate to RBI
 No Collateral → Bank can borrow money without pledging government securities to RBI
 Bank rate is linked with penal rates viz.
 If CRR, SLR not maintained
 Penalty → Bank rate + 3%
 For repeat offender → Bank rate + 5%
 Bank Rate increased → Less money with banks → Inflation reduced
 Bank Rate decreased → More money with banks → Deflation reduced

 Qualitative, Selective, Direct Tools to Control Monetary Policy

Loan to Value
 LTV = Loan/ Value of asset purchased
  Asset acts as a collateral
 If LTV is 75% & asset value is Rs. 100 then one will get only 75 Rs. against asset.
 
Margin Requirement
 Minimum margin required in hand to get a loan
 For e.g. Margin required is 75% then one can get only 25% loan.
 
“Increase Margin Requirement or Decrease LTV → Less money to borrower → Less Demand
for product → Inflation reduced”
 
Consumer credit regulation
 RBI rule that minimum down-payment shall be x to get 1-x loan from the bank with
monthly EMI minimum Y.
 Down payment or EMI increased →Product demand decreased → Inflation reduced
 
Selective credit control
 RBI specifically instruct bankers not to give loans to traders of certain commodities viz.
sugar, Gur, edible oil etc. even if the said trader is ready to mortgage anything
 To prevents speculations / hoarding of commodities using money borrowed from banks
 
Rationing
 Putting a ceiling on total loans in each sector
 An example of planned economy
 Example → PSL target of 40% of NDTL
 
Priority Sector Lending (PSL)
 RBI instruction to all domestic banks & foreign banks in India to lend at-least 40% of
their NDTL to priority sectors
 Foreign banks with < 20 Branches → 40% rule applicable but in phased manner from
2015 to 2019
 Priority sectors → Agriculture, Education, Housing, Export, Micro & Small Industries,
RIDF etc.
 
If PSL targets are not met by banks then -
 
 Indian & foreign banks with 20 branches or more –
 Provide remaining money to RIDF (Rural infra. Development fund) managed by
NABARD
 Provide loans to state governments for infrastructure development
 Bank earns interest + Principal
 foreign banks with < 20 branches
 Provide remaining money to SEDF (Small enterprises development fund) managed by
SIDBI
 Lending to state industrial financial corporation
 Bank earns interest + Principal
 
Limitations of Monetary policy – No quick Results
 People don’t have many investment alternatives other than FD, LIC, Saving Accounts &
PF
 Banks have large deposits from main supplier i.e. Public money (RBI is not a prominent
supplier of money to banks)
  Whatever RBI does, its effect will be felt only after 6-8 months but by that time, new
factors would cause another rise in inflation
 Lack of financial inclusion → People relying on moneylenders & barter system of
transaction → Unorganized money market
 Monsoon uncertainty, cyclone, flood, draughts → Supply side constrains→Food inflation
 Crude + Gold import → Weaken Rupee
 Other Factors → Fiscal deficit, Subsidy leakage, Black money, Corruption

Union Government and RBI signed an agreement on Monetary Policy Framework → Finance
Minister to set inflation targets for RBI 
 will specify the inflation targets for RBI, contrary to the recommendation of Urjit Patel
Committee
 Until now, the RBI has the sole power to regulate the monetary policy & set inflation
targets
 
Presently, Union Government and RBI give inflation estimates and do not set targets. But as per
this agreement government has set a target for RBI to bring down inflation –
 
 below 6 % by January 2016
 4 percent +/-2 percentage points for 2016-2017 & all subsequent years
 
Tools to measure inflation → WPI, CPI, GDP DEFLATOR
 Before April 1, 2014 inflation was measured on WPI – (Food + Fuel)
 From April 1, 2014 will be measured on CPI based on Urjit patel committee
recommendations.
 
WPI – Wholesale price index
 Also known as Headline inflation → Calculated Weekly
 Compiled by Office of Economic Adviser (Under Ministry of Commerce and Industry) on
base year 2012
 Measures inflation at wholesale level (Average of all goods bought by traders) consisting
approx. 676 items
 Does not cover services
 
CPI – Consumer price index
 Used by RBI to formulate Monitory Policies → Calculated Monthly
 Compiled by CSO under statistics Ministry on Base year 2012
 Measures inflation at final level or retail level (Average of all goods bought by
consumers) consisting approx. 200 items.
 Do cover services
 
CPI Before 2011 CPI After 2011

There were 4 subtypes of CPI Now only 3 subtypes of CPI

 Agricultural Labour  Entire Urban population
 Rural Labour  Entire Rural population
  Industrial Worker
 Urban Non Manual Employees  Urban + Rural (Consolidated from ab

 First 3 subtypes of CPI were calculated by Labour

Bureau → Ministry of Labour & Employment
 Last subtype was prepared by Central Statistical  All prepared by Central Statistical Org
Organization (CSO) → Ministry of Statistics & (CSO) → Ministry of Statistics & Prog
Programme implementation implementation

Different base years for different subtypes

 Agricultural Labour → 1986
 Rural Labour → 1986
 Industrial Worker → 2001
 Urban Non Manual Employees → 1984
   Common base year (2012) for all thre
 
GDP Deflator
 Compiled by CSO under statistics Ministry → Calculated Quarterly
 Formula → GDP @current price/ GDP @constant price
 RBI /Government does not use it much for policy making because GDP deflator data
comes quarterly (not weekly/monthly basis)

Government Finance & Budget

Points to Ponder in This Article – Read this article thoroughly as it describes the documents that
forms part of Indian budget system. Know the different between different types of funds along
with their applications & uses in different times.
A government budget is an annual financial statement presenting the government’s proposed
revenues and spending for a financial year that is often passed by the legislature, approved by
the chief executive or president and presented by the Finance Minister to the nation.
 Prepared by  Department of Economic Affairs
Budget  For Current year (April) to next year (March)

 Draft prepared by Dept. of Economic Affairs

 Ministry of Statistics & Programme implementation under CSO provide inputs
 Draft passes through Chief Economic Advisor to FM → Finance Secretary + Finance Mini
Survey  For previous year (April) till current year (March)
 
Types of funds in Budget
Consolidated fund of India (Article 266)
 All revenue received from direct and indirect taxes
 All loans taken by government of India
 Principle + Interest received by Government of India on loans given
 Needs parliament’s approval to spend from this fund
Public Accounts of India (Article 266)
 Bank savings account of the departments/ministries (for day to day transactions)
 National Investment fund (NIF) – Money earned from disinvestment
 National Calamity & contingency fund (NCCF) (Under Home ministry) →Now merged
with National Disaster Relief Fund (NDRF)
 National small savings fund, defense fund, provident fund, Postal insurance etc.
 All Cess & Specific purpose surcharges
 Government schemes Fund (Eg. MNREGA)
 No need of Parliament’s approval to spend from this fund
Contingency fund of India (Article 267)
 Held by the President of India viz. Rs. 500 cr
 Operated by finance Secretary on accounts of President
 President can spend cash from this fund for emergency/unforeseen circumstances
without the authorization of parliament
 Though parliament’s approval is needed to again replenish this fund

National investment fund

 Disinvestment →When Government sells its shares of Public sector undertaking
 Money earned via disinvestment doesn’t go into Consolidated Fund Of India
 It goes to National investment fund (under Public accounts of India), therefore, outside
parliament control.
 Three fund managers look after NIF viz. UTI, LIC and SBI
 Money from NIF goes in
 buying shares of CPSE to ensure 51% government ownership
 recapitalizing public banks and insurance companies
 Investing in EXIM bank, NABARD, Regional rural banks,
 Uranium corporation, Nabhikiya Vidyut Nigam
 Metro projects and Indian railways capital Expenditure

 Documents which form basis of Budget

Annual Financial Statement Article 112 → To show the parliament data about all incoming and outgoing mo

Finance Bill Article 265 → To get permission of parliament to collect taxes from country peo

Appropriation Bill Article 266 → To get permission of parliament to take out cash from consolidat
 
Prominent part of current years’ Budget → Forms Statement 1 of Next Year Annual Financial
Statement

 
Some Basic Terms Commonly Used in Budget
Vote on Account
 Passed By Lok Sabha every year → Bill for only Expenditure permission
 Cash required to meet the expenditure that it incurs mainly during the first two months of
an financial year, until new appropriation bill is passed by the Lok Sabha, to keep the
machinery running
 Cash is given from Consolidate Fund of India
 Generally 1/6thof the total estimated expenditure
 
Interim budget
 Passes in election year or in extreme situation
 Not morally correct for outgoing Government to make drastic changes
 Valid for Entire year viz. 1st April – 31st March; but new Government can change it
 Encloses all major portions of full-fledged budget viz.
 Annual financial statement
 Finance Bill for tax purpose
 Appropriation Bill to take out money from consolidated fund of India to run the system for
given financial year
 Vote on Account to sort out cash problem for first two – four months of new financial
year until new appropriation bill is passed
 
Caretaker Government
 Last Government continues to be in office, till new PM / CM arrives -
 After the term has expired
 After PM / CM has resigned
 No-confidence motion passed
 Parliament / Assembly dissolved

Revenue Part of Indian Budget

Revenue → Receipt → Direct Taxes
The Revenue Budget comprises revenue receipts and expenditure met from these revenues.
The revenue receipts include both tax revenue (like income tax, excise duty) and non-tax
revenue (like interest receipts, profits).

On Income/ Expenditure On properties/assets/Capital transaction

 Income tax  Securities transaction Tax (STT)

 Corporate Tax (and MAT)  Wealth Tax*
 Interest tax (on banks)*  Banking cash transaction tax*
 Fringe benefits tax *  Estate duty* (During inheritance of pr
 Hotel receipt Tax*  Gift tax*
Taxes marked in (*) have been abolished
Direct Tax Positives
 Progressive in nature viz. Richer person will pay higher tax
 Helps to reduce inequality of income
 Certain in nature viz. who to give, when to give & how to give
 Elastic in nature viz. quick results when they are raised or lowered
 
Direct Tax Negatives
 Collection expensive (staff salary, database Management) → Narrow base
 Externality not counted → Income earned by Tata (Production) vs Income earned by film
star (Advertising)
 Hardship not counted → Carpenter earning money vs landlord earning money
 High level of direct taxes -
 less tendency to work
 less foreign investment / foreign workers
 To encourage Savings & investment several tax deduction – exemptions given
 
Direct Taxes of Union Direct Taxes of States

 Taxes on income
 Agriculture income tax
 Taxes on Income  Professional tax
 Income tax  Taxes on properties
 Corporate Tax (and MAT)  Land Revenue
 Taxes on assets  Stamp duty/registration duty
 STT  Property tax in urban areas


Surcharge Cess

A kind of tax on tax (Only by central gov.) A kind of tax on tax (Central + state both can)

Calculated only on tax liability Calculated on tax liability + Surcharge

For example you have to pay 1 lakh as income tax & gov.
demands 12% surcharge then total tax to be paid → 1.12 Now education cess is 3 % then 3 % of 1.12 lak
lakh → Hence you will be paying Rs. 3360 in additio

Taken for a specific purpose viz. Education ces

Not taken for any specific purpose Higher Education cess 1%, Highway renovation

Goes to Consolidated Fund India Goes to Public account of India

Finance Commission can’t share them with states (Not in divisible pool of taxes)
100% income tax deduction on donations towards
 Swatch Bharat Kosh managed by finance ministry
 Clean Ganga Fund managed by finance ministry trust
 National Fund for control of Drug Abuse managed by finance ministry
 
Other Direct Taxes of Union
Corporate tax (Indian company) ~30% (Will be decreased to 25 % till 2019)

Corporate tax (foreign company) ~40%

MAT (Minimum alternative tax) ~18.5%

0.1%-0.25 % (Depending on nature of secur

STT Securities Transactions tax option, equity etc. )
Minimum Alternate Tax
To tax “zero tax companies” which in spite of having earned substantial book profits and having
paid handsome dividends, do not pay any tax due to various tax concessions & incentives
provided under Income-tax Law.  Exemptions include –
 Infrastructure and power sectors companies
  Charitable activities
 Investments by venture capital companies
 Income arising from free trade zones
 
Revenue → Receipt → Indirect Taxes
Indirect taxes (Union) Indirect Taxes (States)

 Sales Tax / VAT (Except newspaper)

 Excise duty on  liquor and Narcotics
 Motor vehicle tax, Taxes on boats and animals
 Toll tax
 Custom Duty (Import, Export)  Electricity tax
 Excise Duty (CENVAT system)  Luxury tax (on restaurant, spa etc.)
 Service Tax  Taxes on Betting and gambling
 Central sales tax (CST)*  Advertisement tax (Other than TV, Radio, Newspaper)
CST (Central sales tax) belongs to Union but entire cash is given to States, hence, in budget
estimates, its collection is listed as “–” or “00″.
Service Tax
 Custom act for custom duty + Excise act for excise duty
 No Service act for service tax but only a chapter in Finance Act 1994
 Article 268-A empowers union to collect service tax & share it with states in certain
percentage
 Service tax is not applicable to service provider for < 10 lakh
 
Service tax 15.00% flat

Effective service tax 15 % flat now → 14 % + .5 Swatch + .5 Krishi

Indirect Tax – Merits
 Convenient → No additional paperwork for the customer
 Wider base → Everyone is covered
 Less evasion, especially under VAT / GST (Invoice credit)
 Highly Elastic → Small increase brings large revenue
 Checks on harmful consumption via. Increasing indirect taxes viz. Cigar, alcohol, even
for gold
 
Indirect Tax – Demerits
 Single point taxes → High level of corruption, evasion, cascading effect e.g. sales tax
 Regressive in nature → Both poor and rich taxed equally for the same item
 Poor people end up paying more portion of their income in indirect taxes
 

Gross Tax revenue

 Total direct + indirect taxes of union + Total direct + indirect taxes of Union territories
without legislature (All except Delhi & Pondicherry)
 
Net Tax revenue
 Gross tax revenue MINUS [revenue shared with states + money sent to National
calamity contingency fund]
  Revenue to Country → Direct Taxes >> Indirect Taxes
 
Revenue → Receipt → Non-Tax
 By providing goods and services → (Other sources)
 All the money earned by Postal department.
 Police income: E.g. CISF giving security to Infosys, airport etc. They have to pay service
fees to CISF.
 UPSC, SSC: their exam fees, RTI fees + fines
 when DRDO sells some technology/patent/product to other PSU or foreign government
 Money by Government Hospitals e.g. AIIMS
 when ISRO sells patent/technology/services to state governments, private companies,
foreign governments/space agencies
 Spectrum Auction=> Ministry of communication & Information Technology.
 India Year Book, Yojana Magazine etc. →Ministry of Information and broadcasting.
 By investment
 Government has shareholding in LIC, Coal India, SAIL, SBI etc. so these organization
have to pay “Dividend” to Government (and to all other shareholders) →If they sell such
shares that’ll be disinvestment and fall under capital receipt part
 Interest received on loan given by Government to any PSU, State/UT/Foreign
government
 Grant /Charity / Aid received by government of India
 All Non Tax revenue collected by UT without legislature (All Except Delhi & Pondicherry)
 Maximum Revenue: Dividend > Others (selling goods / services) > Interest > External
grant > UT
 
Revenue → Expenditure
 Interest paid on the loans borrowed
 Subsidies (because they are short term/non-productive, hence under Revenue outgoing)
 Money paid to produce those goods/services
 Salary-pension-light bill telephone bill (including defense, CRPF etc.)
 Grants given to States/UT/Foreign countries
 Maximum Expenditure: Interest paid on loan > Subsidies > Defense > Pension > Grants
Revenue deficit  → Revenue Expenditure – Revenue Receipt
Effective Revenue deficit → Revenue deficit – Grants given to State/UT for creation of capital
assets

Capital Part of Indian Budget

Points to Ponder in This Article – Understand what constitutes the capital part of the Indian
budget. With time government makes certain changes like planned and non-planned
expenditure has been done away with from 2017 from the annual financial statement, targets of
FRBM act are constantly in question & are debated to change into a range rather than a fix
value. Hence, just understand what comes under the capital part of Indian budget system.
Capital Budget consists of capital receipts (like borrowing, disinvestment) and long period
capital expenditure (creation of assets, investment). Capital receipts are receipts of the
government which create liabilities or reduce financial assets, e.g., market borrowing, recovery
of loan, etc. Capital expenditure is the expenditure of the government which either creates
assets or reduces liability.
Capital Receipt Capital Expenditure

  Debt
 Internal (RBI, Treasury bills, G-Sec etc.)
 External (IMF, WB, ADB, Foreign nations etc.)
 Public money in small savings, State PF (As Gov. needs
to repay it at later stage)
 
Non Debt  Money spent on 5 year plans – capita
 Disinvestment (Selling Shares of PSU) (buildings, machines etc.)- including D
 Loan (principal) recovered from State/UT/PSU/Foreign  Loan (principal) given to State/UT/PS
nations  Loans Paid
 
 Disinvestment matter falls under Department of Disinvestment under Finance minister
 Within Capital Receipt →Debt Internal > External
 Within capital Expenditure → Five year plans > Defense > loans (PSU, State, UT)
 

Annual Financial Statement format changed in 1987

Total Income

Revenue (Receipt) Capital (Receipt)

Tax Non-tax Debt Non Debt

 Dividend-profitOthers (Selling
goods / Services)
 Interest received  Internal
 Direct  Grants received  External  Disinve
 Indirect  UT contributions  Public money  Loan (p
 
Total Expenditure

Plan Expenditure (Revenue + capital) 

 Money given to Union’s own five year plans Non plan Expenditure (Revenue + capital) 
 Money given to States’ five year plans  Anything that doesn’t fall in Plan Expe

 
Non plan Expenditure

Revenue Expenditure Capital Expenditure

 Interest paid on loan taken by UnionSubsidies,

freebies, Debt relief to farmers
 Defense revenue Expenditure (lightbill, phonebill,
diesel, bullets etc.)
 Salaries and pensions  Defense capital Expenditure (e.g. buying
 Losses in Postal dept. etc.)
 Grants given to States/UT/Foreign nations  Loans given to PSUs/States/UT/Foreign n
 
 Non plan expenditure > Plan expenditure
  Majority of government money goes into revenue Expenditure approx. 60% of total
expenditure
 Highest amount of Plan Expenditure goes to Gender Plans > Child Plans > SC Plans >
ST Plans
 Within Non-merit goods subsidies Food >  Fertilizer > Petro (Society pays →individual
benefits)
 

Deficits in Government Budget & Financing

Revenue Deficit Revenue Expenditure – Revenue Receipt

Effective Revenue
Deficit Revenue deficit –  Grants given to State/UT for creation of capital assets

Budget Deficit Total expenditure – Total receipts = Revenue deficit + capital deficit

Fiscal Deficit Budget deficit + Borrowing  = (Total Expenditure – Total Receipts) + Borrowing

Primary Deficit Fiscal deficit – Interest on previous loans

 
 A falling level of primary deficit implies that new borrowings are being used to meet old
debt liabilities.
 Hence decreasing primary deficit means the rise in interest payment → Bad for economy
 Deficits Higher to Lower → FD > RD > ERD > PD > BD
 
Fiscal Responsibility and Budget Management (FRBM) Act targets to FM
Effective Revenue deficit Eliminate (0%) by 31/3/2015

Fiscal deficit Reduce it to 3% of GDP by 31/3/2017

 

Countervailing & Anti-Dumping Duty

Countervailing Duty: To encourage exports, government grants subsidy to exporters which
results in decreased cost of production for them. Hence exports are able to export at cheaper
rates. It largely affects producers of importing country. To counterbalance (countervail) this,
importing countries impose duty on imported good to raise the price of subsidized product to
offset it lower price.
Anti Dumping Duty: Dumping means exporting goods to other country in large quantity at a
cheaper rate. In India, anti-dumping duty is recommended by the Union Ministry of Commerce
while it is imposed by the Union Ministry of Finance.There are 2 types of dumping:
Price Dumping:  selling goods in foreign country at price lower than the price of home country.
Cost Dumping: It means selling goods in foreign countries at a price lower than cost of
production. It is aimed at wiping out the domestic producers from the market. It is also called
Predatory dumping.
 Duty imposed on dumped goods is called Anti-Dumping duty
 Countervailing duty is to counter the low cost of products due to subsidy while Anti-
Dumping duty is to offset voluntary low price to capture the market.
Capital Gains Tax, Transfer Pricing & GAAR
Points to Ponder in This Article – This is an important article to understand the capital gains tax,
GAAR, Transfer pricing & arm length pricing. Understand why IT department is facing
challenges to tax big MNCs who circumvent the money to avoid paying taxes to developing
countries.
Capital Gains Tax (CGT)
A direct tax, Levied on profit, when you sell capital assets (shares, gold, bonds, real estate etc.).
Matter related to Capital Gains Tax falls under IT department.
 Capital Gains Tax Rate depends on time frame viz.
 For bonds & equities CGT is 15 % for time period < 1 year
 For bonds & equities CGT is 20 % for time period > 1 year
 For Gold & Real state CGT is 15 % for time period < 3 year
 For Gold & Real state CGT is 20 % for time period > 3 year
 
 

General Anti-Avoidance Rule (GAAR)

 Originally mentioned in Budget 2012, was to be implemented from 1/4/2014
 IT commissioner can take action against any business deal made outside India, to avoid
taxes
 He can send notice to Indian Citizen, NRI as well as Foreigners, to recover such money
-
 Even if they’re living outside India
 Even for retrospective deals i.e. deals happened before GAAR was implemented
 Even if deals protected under any Double taxation avoidance agreement treaty
 Burden of proof lies with the party and not IT commissioner i.e. Company has to explain
their deal is genuine
 IT commissioner has to decide the case within 12 months.
 Aggrieved party can approach Dispute resolution Panel (DRP) → Income Tax Appellate
Tribunal (ITAT) → High court and finally Supreme Court
 
Shome Panel on GAAR
 IT commissioner should send notices only in rare cases- where he can recover more
than 3 crore rupees.
 GAAR should not be used for filling revenue shortfalls as revenue shortfall
 For retrospective cases- gov. should only recover tax dues & should not demand
additional penalty and interest rate on taxable amount.
 Exempt the buying/selling of company shares from Capital gains tax. Better just increase
the Securities Transaction Tax (STT) on buying/selling of such shares. Then, there is no
litigation about “CGT evasion via Post Box Company”.
 Don’t implement GAAR from 2014. Implement it from April 2016.
 
Transfer Pricing
 When capital assets / shares are transferred from seller to Buyer, then Buyer has to
withhold / deduct the capital gains tax for government.
 So, when shares are transferred from one person to another, we can hope the share
price is decided by market forces of supply, demand and speculation.
 But what if two subsidiary companies transfer shares to each other, and play mischief.
 
Balance of Payment – Current Account & Capital account
Points to Ponder in This Article – An extremely important article from prelims point of view.
Understand what constitutes balance of payments, current account & capital account.
Balance of Payment
Balance of Payment is systematic record of overall economic transaction during specific time
period
 Consists of Current account payments & Capital account payments
 World’s net Balance of Payment is always 0

Systematic Record  Economic Transactions 

 Maintained by Central bank of each country  Resident vs non-resident for e
 As per IMF manual BMP6 India
 All amounts are Expressed in Dollars  In specified time period
 Credit is denoted as incoming money (+) & Debit is denoted as  US Fed Reserve → Outgoing
outgoing money (-)  Indian RBI          → Incoming (

Current Account
Balance of Trade / Visible
 Also known as balance on merchandising goods
 Records all transactions of foreign currencies on account of export & import of goods
only
 BOT is always deficit in India means import >> export
 Means insufficiencies of foreign currency through export to pay for critical imports
Balance of Invisible
 Records all transactions of foreign currencies resulting out of export & import of services
such as banking, insurance, software, consultancy etc.
 Also includes the following :
 Inward & outward tourism
 Inward & outward education
 Inward & outward medical treatments
 Inward & outward Remittances : Indians settled abroad (Indian diaspora) send money in
foreign currency to India & similarly for foreigners in India
 Profit & Interest on ReFI investments outgoing & similarly incoming interest on Indian
investors investing in foreign markets
 
Points to ponder
 Net effect of BOT + BOI leads to Current account surplus (CAS) or current account
deficit (CAD)
 Generally, BOP is negative in India & if BOI is over and above BOT than CAS otherwise
CAD
 CAD + Fiscal deficit = Twin Deficit

Capital Account
 Foreign investment in India (ReFI (FDI, FII), ADR, Direct purchase of land or assets)
 External commercial borrowing (IMF, WB, ADB etc.), External assistance & Grants etc.
 Indian Diaspora maintain deposits in foreign currency in India known as NRI deposits
 Overall BOP cannot tell the health of an economy, weather there is CAD or CAS but
what is important is the manner in which inflow & outflow are matched
 As CAD can be fulfilled by ECB (external borrowings)/RBI (internal borrowings) in capital
account of BOP
 The true picture can be seen from current account of BOP
BOP Crisis 1992
 BOP crisis when capital account surplus are insufficient to finance current account deficit
 Gulf war period → Oil price shoot
 Current account became more negative than positive capital account
 Lead to negative BOP → Rupee value fell → Bad for Indian importers
 RBI sold its own dollars to make BOP Zero
 But RBI did not have enough dollars to make BOP zero
 India pledged 65 tonnes of gold from IMF to make BOP Zero
 
Steps to avoid BOP crisis
 CAD should be kept low (Or Positive) e.g. Germany
 Capital account should be kept largely surplus (attract investment + LPG reforms)
 Central Bank must have large FOREX reserve e.g. China
 
Forex Reserve Consists of -
 Foreign currency
 Gold
 SDR
 Reverse Tansche
 
Reverse Tansche – A certain proportion of a member country’s quota is specified as its reserve
tranche. The member country can access its reserve tranche funds at its discretion, and is not
under an immediate obligation to repay those funds to the IMF. Member nation reserve tranches
are typically 25% of the member’s quota.

Exchange Rates Evolution in India

Fixed Exchange Rate
 Upto March 1992 in India
 1$ was approx. equal to Rs. 40
 Authorized dealers under FEMA → If enough dollars not available, then go to RBI
 If large number of dollar required by people due to any geopolitical or any other factor –
  Devaluation of currency to balance demand of dollar
 Devaluation of national currency increases exports
 
Floating exchange rate
 RBI doesn’t intervene to control exchange rate
 Free market supply-demand came into play to decide the exchange rates
 But too much volatility in exchange rate → Hence in real-life countries use “Managed
floating”
 
Managed floating Exchange Regime
 RBI interfere to manage volatility in floating exchange regime
 To stop depreciation of rupee, RBI should sell dollars from its forex reserve
 To stop appreciation of rupee, RBI should purchase dollars from market
 
NEER vs REER
Nominal Effective Exchange Rate (NEER) Real Effective Exchange Rate (REER)

The weighted average of bilateral nominal exchange rates of Weighted average of nominal exchange rate
home currency in terms of foreign currencies inflation
 

 NEER & REER  → Weighed Geometric mean with foreign countries currencies – 6 or 36

 NEER & REER  → Calculated by CSO & RBI
 REER is an indicator of trade competitiveness
 REER > 100 means national currency is overvalued
 REER < 100 means national currency is undervalued
 Undervalued currency → Good for exports e.g. Chinese Yuan
 

Convertibility of accounts
Why restrictions on convertibility?
 Central bank cannot ”manage” floating exchange rate regime all the time
 Otherwise Forex-reserve will get empty
 Hence quantitative restrictions on rupee-conversion to foreign currency
 
Full Current Account Convertibility
 Indian Rupee is fully convertible into another foreign currency
 For current account transactions and vice-versa
 Though Current account in India is fully convertible but still some restrictions from FEMA
viz.
 Not convertible for betting, gambling, prohibited items
 Travel to Nepal, Bhutan → Can carry Max. $ 10 k || Max. Rs. 100 denomination
 Travel to other countries → Can carry Max. $25 k per visit (beyond that need RBI
permission)
 For Education, Medical treatment, Employment purpose → limit is 1 lakh $
  Gift sending → limit Rs. 5 lakh worth
 
Capital account convertibility
 Indian Rupee is not fully convertible on Capital Account
 Only partial convertibility
 
Restrictions under FEMA
 ECB
 Quota →  1 Billion $ Entire Aviation sector
 Individual company → 300 million $
 Maturity → 3 years minimum + Approval from RBI
 FDI, FII restrictions
 100% for Investment liberty in Bhutan
 Everywhere else → $75 k investment per year by individuals e.g. buying shares,
opening foreign bank accounts
 Financial Action Task Force (FATF) → “Non co-operative countries” [Iran, N Korea] – No
investing in these countries
 
Liberalized remittance scheme (2004) – Indian residents may spend $2.5 lakh dollars per year
per person abroad apart from FEMA limit
Capital Market – Types of Bonds
Points to Ponder in This Article – Understand the different types of instruments that are used to
raise money from the market. Understand the difference between different types of bonds which
are oftenly used in India.
Ways to raise money from Market
Equity by selling shares and debts by selling bonds are two of the most famous ways to raise
money from the market.
 Bonds
 Junk Bonds
 Gilt Edged Bonds
 Bearer bonds
Borrow Money (Debt)  Bank Loan

 IPO → Shares
 Venture Capitalist
Give Partnership (Equity)   Angel Investors fund
Debt Types
 Bonds, Debentures, Loans, ECB, T-Bills, Commercial Papers, Certificate of deposits
 Creditor to company & First claim during liquidation
 Yield (rate of return) and the maturity always inversely related
 
Bonds
 Carry fixed interest payable every year by the company
 For e.g. To whoever pays me Rs. 1000, I’ll pay annual 10% interest rate (Rs. 100)
 And after 5 years, I’ll also repay the principle amount Rs. 1000
 SEBI Rule → If bond maturity > 18 months then getting credit rating is mandatory
 
Junk Bonds (High Yield Bond)
  Credit rating companies like CRISIL, S&P, Moody’s etc. give credit ratings (AA, A, BBB,
C, D etc.) to a bond based on reliability & market value of a company
 If any Bond gets “C” or “D” rating, it means it is not creditworthy & may default on this
loan; hence not much people will not invest in it.
 Hence to allure investors they provide various schemes or higher Interest rates on bands
 For e.g. “If you give me Rs. 1000, I’ll give you 25% interest rate per year”
 
Gilt Edged Securities
 Government Securities & Treasury Bills (via RBI) & well-known companies with high
credit ratings issues bonds
 High credit ratings assure an investor of its credibility & hence Gilt edged securities pay
low rates generally 4% annually
 
Bearer Bonds
 Same as regular bonds, but don’t have “Holder’s Name” on them, instead have coupons
attached with them.
 So, if anyone doesn’t want to withdraw the whole money, he can cut a few coupons and
sell them to a broker to withdraw partial amount.
 
Bond Yield
 Bond yield to maturity → Total ROI of buyer on maturity
 If bond price decreases, Bond yield increases
 For ex. Bond value is Rs. 1000 for 10 % annually
 Hence initial bond yield is 10% for first investor
 If he sells it to second investor at Rs. 900 then his bond yield will be 10/900 →11%
 
Factors deciding Bond Yield
 Assured return with good credit rating → Low bond yield
 Bankruptcy rumour in market for a company → panic sales by investors →Bond yield
goes high
 Credit rating down → next time have to offer higher interest rate → Junk bond
 

Debt Instruments
 Credit rating → Gilt securities vs Junk bonds
 Bond vs Debenture
 Optionally fully convertible debentures (OFCD)
 Other types of Debentures
 Inflation indexed bonds (IIB)
 
Credit rating for Sovereign Bonds (Rating of Countries)
 Credit rating companies like CRISIL, S&P, Moody’s etc. also give credit ratings (AA, A,
BBB, C, D etc.) to countries based on their eco-political conditions
 India hold a credit rating in medium risk category just above the junk status
Factors affecting credit rating
 Fiscal deficit
 Inflation
 Infrastructure
 Foreign investment
 GDP growth
Bond vs Debenture
 Bond is the terminology used in England while debenture is the terminology used in
America
 The term bond is used for a Government or PSU security while the term debenture is
used for private companies securities
 In India, Bondholders are secured by access to the underlying asset in case of default by
the issuer.
 Debentures, on the other hand, are unsecured, with debenture holders not having
recourse to assets in the case of default by the debenture issuer.
 
Inflation Indexed Bonds – Primary Market Operations
Interest Rate: Real vs. Nominal

Inflation Indexed Bonds

 Inflation Indexed Bonds works on the principle of WPI Inflation Rate + X % Profit
 Compounded half yearly & can be traded at secondary market viz. from one investor to
the other
 IINSS-C (Inflation Indexed National Savings 
IIB (Inflation indexed bonds) Cumulative)

 For Only retail investors viz.

 Individual / NRI
 HUF (Hindu undivided family)
 Charity organizations
 For Institutional Investors (80%) + Retailers (20%)  Educational bodies

 Direct sold by RBI  RBI via. Nationalized banks

 Matures Period of 10 years

 Matures Period of 10 years  Senior citizen has been given some r
 Penalty if redeemed early terms

 Compounded half yearly  Compounded half yearly

 1.44% + WPI (2004)  1.5% + CPI (Combined) 2010 base y

 Can be traded in secondary market  None

 Capital gain tax applies  NA
 
Inflation indexed bonds losing shine
 Mutual funds invested heavily in IIBs during high inflation period
 But WPI is falling gradually since 2015
 Hence net interest rate of IIB stands out near 4 %
 Hence players exiting the game.
 
Credit Default Swap
 Insurance policy on bonds paying a certain premium
 When company defaults & even on liquidation can’t recover the money than insurance
company will pay the investor.

Capital Market – Equity

Financial Intermediaries → Regulate flow of cash b/w businesses & people / Economy & public
Disintermediation            →  If these intermediaries are removed & companies raise money
directly from public
Money Market Miscellaneous Terms
Ways and Means Advances
 Government – temporary mismatch in receipt and payment
 RBI helps to fill mismatch fixes limit
 This mismatch is not counted under fiscal deficit
 
Misc. Debt Instruments
 Upto 364 days maturity period
 Sold at discounted price by the government
T-Bills  Later bought at Par value

Commercial Papers  Same as T Bills but sold by Corporates

Certificate of deposits  Same as T Bills but sold by Banks & Financial Institutes
 
Call money & Notice money
 Short term borrowing among banks and FI
 No collateral required
 Mainly raised to fulfill CRR
 If raised for 1 day → Known as call money
 Over 1 day upto 14 days → Known as notice money

 Difference between T Bills & G Securities

T Bills G Sec

 Sold for upto 364 days  Sold for 1 to 20-30 years

 Sold at discounted price & bought at par value  Sold at Par value with scheduled interest on pr
  Rs. 100 value T bill will be sold at Rs. 80 for 14
days  Rs. 1000 value G sec for 8% annual interest fo

 T-Bills are zero coupon securities  OMC, Fertilizer companies are provided G Sec
 T-Bills don’t pay interest rate subsidies sometimes
 
Zero coupon bonds → Without coupons bonds → Sold at a discounted price

 Equities
 Company has to provide some % of shares out of its 100%
 Shareholders get dividend from profit
 Examples of Equity include IPO, Shares, Venture capital funds, Angel Investor fund
 Have last claim during liquidation of company
 
Securities: Debt vs Equity
Debt (Bond) Equity (Shares)

 Have complete ownership & control over the company

 Don’t have to share profit with anyone
 Can claim income tax deduction for paying loan
 Requires less paperwork & time to borrow money from  Don’t have complete control & owner
market company
 Have to pay said interest irrespective of profit or loss  If company make loss, then it doesn’t
 May have to mortgage property or asset to mortgage profit with shareholders
loan  No regular interest rate payment as in
 
Shares
 Shares provide ownership in the companies
 Under the Company law, one has to constitute a board of directors and hold annual
general meeting of the shareholders
 Board of Directors decides the dividend % of profit to the shareholders & investment of
rest of the profit.
 For important policy decision, one will have to take votes of the shareholders
 One can become CEO of his own company & can withdraw an annual salary along with
the dividend profit from the shares he hold
 An individual who owns 45 % share capital does not own45 % of that company’s assets.
There is a difference between the sale of shares in a company and the sale of assets of
that company.
 
Venture Capitalist
 A company that provides money, to start or expand your company but in return demand
part of ownership
 Invest in big projects after studying their business plans & make an initial investment of
US $ 250,000 to US $ 1.5 million.
 Venture Capitalist companies themselves borrow money from other companies like
mutual funds, pension funds or may issue their own ‘bonds’to get money.
 
Angel Investors
  Rich gentlemen who finance startup companies for getting partial ownership and or
assured returns on investment, after few years
 An Angel investor doesn’t mind taking huge risk by helping even small timers with totally
unique and untested idea, if he think that it’ll grow up to huge success in future.
 Few examples financed by Angel investors → Amazon online shopping website and
Starbucks coffee chain, Apple computers
 
Share versus stock
 Suppose a company has issued 1000 shares, worth Rs. 10 each & You paid Rs. 500 to
purchase 50 shares of this company
 This means you own “50 Shares” of this company and “stock of Rs. 500” in this
company.
 When we talk about shares we refer to the number of papers held by you
 When we talk about stocks, we refer to the money value of those papers held by you
 
Underwriter
 Formulates security papers to cover all the technically things, paperwork, SEBI
regulations etc. for IPO / Bonds sales
 May offer an insurance of buying the IPO/Bonds if others don’t buy it e.g. Kotak
Mahindra, ICICI
 
IPO vs FPO
 Company’s raising money for the 1st time by issuance of shares in primary ma
IPO
Initial public offerings  All IPO, FPO & Bonds issued by the companies are known as Primary marke
(IPO)  Fresh securities → From company to the investors directly

 Those coming out subsequently again to raise more money from the market v
shares is known as FPO
Follow on public  After initial offerings when they stabilize in market & traded (bought & sold) at
offerings (FPO) buyers and sellers are known as Secondary Market Operations
 

 
Derivatives
 Which derive value from assets viz.
 Physical Assets (Home, Office, Machinery)
 Debt / equity
 Forex
 Commodity
 Derivatives Future / forward contracts → Sell / Purchase / Execution of order at future
date
 Derivative options → To minimize risk on future/forward contracts
 Call option → Right to buy, but no obligation to buy
 Put option → Right to sell, but no obligation to sell

 
Some terminologies associated with equity market
Free float market cap (FFMC) Price of each share x total number of shares with public

Stag investor One who buys IPOs to resell it in future

Bull investor Hopes that prices will rise, hence purchase more of shares

Bear investor Fears that prices will fall, hence sells more of shares

Sensex Weighted average of FFMC of top 30 companies of BSE

Nifty Weighted average of FFMC of top 50 companies of NSE

 
Share market position
 Down in situations of War, Inflation & political instability
 UP in case of soft monetary policy, relaxing FDI norms, M & A rumors
 
Problems with Paper shares
 Delivery problem.
 Fear of theft
 Transfer delay
 
Solution → Dematerialization
 A person can open up a Demat account with the help of Pan card, Bank account &
Address proof
 Depositary participants like SBI, HDFC, ICICI etc. provide you an online platform to buy /
sell shares electronically
 Net shares bought /sold are kept with the depositary participants in paper format
 Depositary participant emails the record of net shares bought / sold to NSDL or CSDL
 NSDL or CSDL then issues shares in electronic format to depositary participants
 
 NSDL → National Securities Depository Limited → Deals with National Stock Exchange
(NSE)
 CSDL → Central Depository Services Limited → Deals with Bombay Stock Exchange
(BSE)
 They are electronic depositories to hold all the securities electronically in de-materialised
format

Capital market – FII, QFI, FDI & P Notes

Points to Ponder in This Article – Learn how the foreigners invest in Indian equity market. What
are the different types of instruments available to foreigners to invest in Indian markets.
Foreign Institutional Investor (FII)
A foreign individual seeking to invest in Indian stocks has to be registered as a sub-account of
an FII. FII in turn has to be registered to SEBI on the behalf of such sub-account holder.
 India allows only wealthy foreign individuals or high networth individuals (HNIs);
registered as a sub-account of a foreign institutional investor (FII) to invest directly in
local equities
 
Qualified Foreign Investor (QFI)
 Foreign individual, group or foreign firm can directly invest in Indian stock-market like
any normal Indian citizen, without requiring the sub-account with FII
 Must adhere to anti-money laundering and anti-terrorist financing guidelines as defined
by the financial action task force (FATF), a multi-lateral body
 QFIs shall be allowed to invest through the SEBI-registered Depository Participant (DP)
 QFI is required to open one Demat account and a trading account with any of the
qualified DP and make purchase and sale of equities (shares) through that DP only.
 QFIs can own up to 5% of Indian companies while their cumulative investments are
capped at 10%.
 These limits are over and above the FII and NRI investment ceilings prescribed under
the portfolio investment route for foreign investment in India
 
Depository
 Depository is like a bank locker where securities (shares) are held in electronic
(dematerialized) form.
 In India, there are only two Depositories – National Securities Depositories Limited
(NSDL) and Central Depository Services Limited (CDSL).
 NSDL → National Securities Depository Limited → Deals with National Stock Exchange
(NSE)
 CSDL → Central Depository Services Limited → Deals with Bombay Stock Exchange
(BSE)
 
Depository Participants (DP)
 DP’s are like bank branches where shares in physical (paper) form are deposited for
converting them in electronic (Demat) form, and emailing it to the Depositary.
 Examples of DP include ICICI, SBI, HDFC etc.

 
Arvind Mayaram Panel on  FDI & FII(FPI)
FDI FII / FPI

 Long-term relation with company & its board e.g.  Short-term relation with the company e.
 Goldman Sach
 Also known as Hot money → Can leave
Walmart phone call

 In any listed company → Investment of 10% or more

is termed as FDI
 In any Unlisted company → Any investment is termed  Any Public ltd. Company (listed) → Inve
as FDI is termed as FII / FPI

 Sectoral caps applies for ex : 49% Defence; 74% in

Private banks  If public listed then anyone can purchas

FDI FII / FPI

 FDI applies to Equity finance only

 Debentures / Bonds → No FDI cap applied  NRI investment not counted
 Fully convertible debenture → FDI applies  Both debt and equity included but can’t
 G-Sec / T-Bill → No FDI cap applied (Debt  G-Sec cap →30 billion
instruments)  Corporate bonds max.→ 51 billion

 Earlier sub-categories → FII, QFI

 Only one category “FDI”  Now SEBI → FPI & RBI → ReFPI

P Notes: Offshore Derivative Instrument

 Financial instruments used by investors or hedge funds which are not registered with the
SEBI to invest in Indian securities & stock market.
 FII such as HSBC registered with SEBI buy India-based securities or shares and then
issue participatory notes to foreign investors.
  P-note owner doesn’t own the shares (as they’re in the DEMAT account of intermediary
FII)
 P-Note owner doesn’t have voting rights in the shareholder meetings
 
In general terms, Foreign institutional investors who do not wish to register with the SEBI but
would like to take exposure in Indian securities also use participatory notes. Brokers buy or sell
securities on behalf of their clients on their proprietary account and issue such notes in favour of
such foreign investors.
 
Why Ban Participatory Notes (P Notes)
 As such the FII has to disclose P-note owner data to SEBI on quarterly basis (every 3
months).
 But often, within 3 months the P-notes would have changed many hands .
 Thus P-note investments are Anonymous. Hard to trace the owner.
 Can be used for money laundering and terror financing.
 Hot Money → Can leave Indian market very soon based on just one phone call from
investor to FII.
 Hot money creates heavy rise or fall in share market, so even genuine investors’ money
is lost.
 RBI’s Tarapore Committee → Recommended Banning P-notes for national security and
to stabilize stock exchanges
 
$ The P Notes are a slap on the face of every citizen who is an investor. For a person to invest
even in one share, several KYC forms have to be filled up, and PAN numbers and proof of
address, etc., provided. For the P Notes investor the system is totally silent on even elementary
information. The FIIs issue PNs to funds/companies whose identity is not known to the Indian
authorities

Mutual Funds, Hedge Funds, ECB, IDR, ADR & GDR

Points to Ponder in This Article – Read through the article to learn about mutual funds, how they
work; Hedge funds and different ways to raise money from oversees markets.
Mutual funds (Asset Management companies (AMC))
Specialized institutions pooling money from the public & investing in the stock market based on
research, past trends, company performance etc. to maximize investors profit. Mutual funds do
not eliminate risk but minimize the risk in term of risk appetite & allow for sharing of risk
 Mutual funds make profit only when market is moving up
 Any investor is welcomed for e.g. SBI mutual fund requires minimum investment of Rs.
100 only
 Strict SEBI regulation with no leverage provided → Has to deal with money in hand
 Managed by MF managers (Asset management companies) for certain commission %
 
Mutual funds types
 Portfolio type → Equity, Debt, Gilt edged fund, Real estate fund
 Income vs risk type 
 Growth Fund → 80 (Equity) + 20 (Debt)
 Balance Fund → 50 (Equity) + 50 (Debt)
 Income Fund → 20 (Equity) + 80 (Debt)
 
Hedge funds (Alternative Investment fund)
  Hedge fund is a similar investment game as mutual funds, where High net worth
individuals pool their money into high risky games to earn high return on investment.
 Trading-techniques are far more complex than mutual funds
 Hedge funds can make money even with share market going down.
 SEBI → Indian hedge fund to starts from 1 crore rupees; Foreign (offshore) hedge fund
to start with 5 lakhs dollars
 Not so strict SEBI regulation with leverage provided twice the amount but only for 2 days
viz. T + 2
 
How Hedge funds make money
Short selling
 Sell a large quantity of shares in the market at once which supposedly decrease the
value of share as a result of mass selling.
 Now, as soon as value of share falls, hedge fund managers buy sold quantity of shares
& make profit.
 
Leverage
 Borrowing money to trade in shares beyond your limit to get good returns
 But if market follows opposite steps against your move then may be risky
 
Arbitrage
 Profit from the price difference of securities between the two markets

 Arrangement of capital from outside India to expand Business

External commercial borrowing (ECB)
 As the name suggest, it is when Indian company borrows money from external (non-
Indian / foreign) sources for minimum average 3 years
 Money is borrowed from foreign lenders via bank loans, fixed rate bonds, non-
convertible shares, optionally convertible or partially convertible preference shares etc.
 ECB money cannot be used to trade in share market or real-estate speculation or to
acquire another company
 
 
American Depository Receipt (ADR)
 ADR is method of trading non-U.S. stocks on U.S. exchanges
 Suppose, Indian company wants to raise money from America, by issuing shares in
American stock exchange
 But then Indian company will have to maintain accounts according to American
standards
 Hence to prevent this problem, Indian company gives its shares to American bank
 American bank gives Indian company certain receipts, called ADR in return of those
shares
 Now Indian company can trade those ADR receipts in American share market, to raise
money
 But Indian company will have to pay dividends to investors in Dollars
 ADR is two way fungible, Meaning, (from American investor’s point of view) if you’ve
ADR, you can convert it into the underlying shares of that (foreign / Indian) company
 
Global Depositary Receipt (GDR)
 Serve as same function like ADR, but on Global scale
  Helps third world countries to raise money from the stock exchanges of developed
countries
 Several international banks such as JPMorgan, Citigroup, Deutsche Bank, Bank of New
York issue GDRs
 
Indian Depository Receipt (IDR)
 As ADR (American depository receipt) is from America’s point of view, Similarly, IDR
(Indian depository receipt) is from India’s point of view
 It allows a foreign company to raise money from Indian financial market
 As part of financial reforms, IDR (Indian depository receipts) are also made two ways
fungible

Economic Development of India

Mixed Economy Model
 Post-Independence condition: Poverty, illiteracy, ruined agriculture &
industry → Distorted Economy.
 Ensuring well-being and economic development were the important challenges for the
Indian leadership.
 To pursue these goals, they had two model of economic development, liberal – capitalist
model followed in USA & Europe, & the socialist model followed in USSR.
 Indian Parliament in 1954 accepted ‘ the socialist pattern of society as the objective of
social & economic policy.
 In fact the model projected was of a “mixed economy” where the public and the private
sectors were not only to co-exist but to be complementary to each other.
 Private sector was encouraged to grow with as much freedom as possible within the
broad objectives of the national plan.

Indi
a adopted the mixed model of economic development, which has features of both the capitalist
& socialist models as there was a mature indigenous entrepreneurial class (Birlas, Tatas,
Singhanias) that developed an independent economic base which was an asset for post-
independence planned development.

New Economic Policy 1991

In the late 1980’s government expenditure began to exceed its revenue by such large margins
that it became unsustainable.Inflation was soaring, imports grew in excess to the export to such
a level that foreign exchange reserves declined to a level that it was not adequate to finance
imports for more than two weeks.

  Foreign exchange was insufficient to pay the interest to international lenders.

 To ward off this precarious situation of economy, India approached the World Bank and
IMF and received $7 billion as loan to manage the crisis.
 In return, these institutions wanted that the Indian should open up the economy by
removing restrictions of the several sectors and reduce the role of government in many
areas and remove trade restrictions.
 
LPG Reforms
 India had no choice but to accept these conditions and announced the New Economic
Policy.
 The Crux of the policy was to remove the barrier to the entry of private firms and to
create more competitive environment for the economy.
  These reforms can be classified into two types:
 The stabilization measures [short term]
 The structural reform measures [Long term]
 Government initiated a variety of policies which fall under three heads viz. Liberalization,
Privatization & Globalization, “LPG Policy”.
 The first two are policy strategies & the last one is the outcome of these strategies.
 

Liberalization 
 Industrial licensing was abolished for almost all but product categories – alcohol,
cigarettes, hazardous chemicals industries, expensive electronics, aerospace drugs and
pharmaceuticals.
 The only industries now reserved for the public sector are defence equipment, atomic
energy generation and railway transport.
 In many industries, the market has been allowed to determine the prices.
 
Financial sector reforms – Major aim was to reduce the role of RBI from regulator to facilitator of
financial sector. These reforms led to the establishment of private sector banks & entry of
foreign banks with certain conditions on FII. 
Tax Reforms – Since 1991, there has been a continuous reduction in the taxes on individual
incomes. The rate of corporation tax was reduced; simplification of procedures to pay the
income tax was also initiated. 
Foreign Exchange Reforms – Initially the rupee was devalued against foreign currencies. This
led to the increase in the inflow of foreign exchange. Now usually, markets determine exchange
rates based on the demand and supply of foreign exchange.

Privatization 
 Government had shed off the ownership and management of various government owned
enterprises.
 Government started disinvestment by selling off equity of PSU’s.
  The purpose behind such move was to improve financial discipline and to facilitate
modernization.
 The government also made attempts to improve the efficiency of PSUs by giving them
autonomy in taking managerial decisions.
 

Globalization 
 Globalisation is the outcome of liberalisation & privatisation.
 Globalisation implies greater interdependence & integration.
 The best example is of outsourcing. e.g. BPOs.
  Globalization is mix bag of results. On one hand it has provided greater access to global
markets, imports of high Technology etc. on the other hand developed countries
expands their markets in other countries.
 It has also been pointed out that markets driven globalization has widened the economic
disparities among nations and people.
 
  Government of India initiated an e-government programme by adopting the Information
Technology Act in 2000.

 Poverty in India: Types of Poverty, Causes of Poverty, Vicious Circle of Poverty

Poverty in India
People living in poverty are often socially excluded and marginalized. Their right to effectively
participate in public affairs is frequently ignored, and thus elimination of poverty is much more
than a humanitarian issue, as it is more of a human rights issue. Thus, eradication of poverty
and hunger is the basis of all development process.
During the last two decades, India has lifted more than 100 million of its citizens from extreme
poverty; still, it is home to a very large number of people living in abject poverty.
The Vicious Circle of Poverty.
Poverty Head Count Ratio versus Poverty Gap Ratio
Poverty Head Count Ratio Poverty Gap Ratio

The Poverty Head Count ratio measures
the proportion of population whose per
capita income/ consumption expenditure
is below the official Poverty line or in
simple terms is measures the total
number of people living below the poverty
line.
The Poverty Gap Ratio is the gap by which mean
consumption of the poor below poverty line falls short
of the poverty line.
It indicates the depth of poverty; the more the PGR,
the worse is the condition of the poor. While the
number of poor people indicates spread of poverty,
PGR indicates the depth.

During 2004-05 to 2011-12, PGR also reduced in

The number of people living below
poverty line has decreased from 74.5
Million in the year 1993-94 to 52.8 Million
in the year 2011-12.
both rural and urban areas. While the rural PGR
declined from 9.64 in 2004-05 to 5.05 in 2011-12 in
the urban areas, it declined from 6.08 to 2.70 during
the same period. A nearly 50% decline in PGR both
in rural and urban areas during 2004-05 to 2011-12,
reflects that the conditions of poor have improved
both in urban and rural areas.

Head Count Ratio is a simpler measure. It

The poverty gap index can be interpreted as the
is widely used and represents the cut-off
average percentage shortfall in income for the
point below which people are considered
population, from the poverty line
as poor.

HeadCount ration does not reflect the A higher poverty gap index means that poverty is
severity of poverty. more severe.
Absolute versus Relative Poverty
Absolute Poverty Relative Poverty

Absolute poverty is when we consider
every poor person as equal. The
general definition of poverty which is
valid at all times and for all economies
is called absolute poverty.
Absolute poverty approach considers a
poor in India as equal to a poor in the
The difficulties involved in the application of the
concept of “absolute poverty”, made some researchers
to abandon the concept altogether. In place of absolute
standards, they have developed the idea of relative
standards that is, standards which are relative to
particular time and place. In this way, the idea of
absolute poverty has been replaced by the idea of

USA.
The simplest definition of being poor is
‘being unable to subsistence’ that is,
being unable to eat, drink, have shelter
and clothing.
A common monetary measure of
absolute poverty is ‘receiving less than
$1 a day…’’. (In 2008, the World Bank
revised this figure to $1.25 a day, and
then again to $1.90 a day in 2015.)
relative poverty.
Just as conventions change from time to time, and
place to place, so will definitions of poverty. In a rapidly
changing world, definitions of poverty based on relative
standards will be constantly changing. Hence, Peter
Townsend has suggested that any definition of poverty
must be “related to the needs and demands of a
changing society.
It can be argued that poverty is best understood in a
relative way – what is poor in New York is not the same
as what is poor in Mumbai (where over 50% of the
population live in slums.

Poverty Lines in India: Estimations and Committees

Poverty Lines in India

 The poverty line defines a threshold income. Households earning below this threshold
are considered poor. Different countries have different methods of defining the threshold income
depending on local socio-economic needs.
 Poverty is measured based on consumer expenditure surveys of the National Sample
Survey Organisation. A poor household is defined as one with an expenditure level below a
specific poverty line.
 The erstwhile Planning Commission was the nodal agency in the Government of India
for estimation of poverty. It estimates the incidence of poverty at the national and state level
separately in rural and urban areas.
 The incidence of poverty is measured by the poverty ratio, which is the ratio of number
of poor to the total population expressed as a percentage. It is also known as head-count ratio.
Time Line of Poverty Estimation in India
The first Poverty line was created in India by the Erstwhile Planning Commission in the mid
1970s. It was based on a minimum daily requirement of 2400 and 2100 calories for an adult in
Rural and Urban area respectively.
YK Alagh Committee (1979):

 In 1979, a task force constituted by the Planning Commission for the purpose of poverty
estimation, chaired by YK Alagh, constructed a poverty line for rural and urban areas on the
basis of nutritional requirements.
 Table 3 shows the nutritional requirements and related consumption expenditure based
on 1973-74 price levels recommended by the task force.  Poverty estimates for subsequent
years were to be calculated by adjusting the price level for inflation.
Poverty Estimation Committees in India
Lakdawala Committee Tendulkar Committee Rangarajan Committee

The committee was The Committee was

The Committee was constituted in the
constituted in the year constituted in the year 2004-
year 2012.
1993. 05

The criteria suggested The committee estimated The Rangarajan Committee goes back to
by the committee was poverty by using basic the idea of Lakdawala committee method
Calorie intake based requirement of the poor such of calculating Rural and Urban Poverty
 as housing, clothing, shelter,
education, sanitation, travel
expense and health etc., to
make poverty estimation
realistic.
on consumption The committee suggested to
expenditure. do away with the calorie-
based criteria.
The committee also
suggested to have a uniform
poverty line across rural and
urban India.
Separately.
The Rangarajan group took the view that
the consumption basket should contain a
food component that satisfied certain
minimum nutrition requirements, as well
as consumption expenditure on essential
non-food item groups (education,
clothing, conveyance and house rent)
besides a residual set of behaviourally
determined non-food expenditure.

C Rangarajan expert group report,

recommended a monthly per capita
consumption expenditure of RS 972 in
rural areas and RS 1,407 in urban areas
The Tendulkar committee
as the poverty line at the all-India level.
stipulated a benchmark daily
Assuming five members for a family, this
The committee per capita expenditure of RS
will imply a monthly per household
recommended for 27 and RS 33 in rural and
expenditure of RS 4,860 in rural areas
state-specific poverty urban areas, respectively,
and RS 7,035 in urban areas.
lines. and arrived at a cut-off of
The Rangarajan committee estimated a
about 22% of the population
daily per capita expenditure of RS 32
below poverty line.
and RS 47, in rural and urban areas
respectively as the poverty line, and
worked out poverty line at close to
29.5%.

As per Tendulkar report, the

As per Ladkawala percentage of people living
committee the below poverty line in the year
percentage of 2004-05 were as follows: The Rangarajan expert group estimates
population living Rural:41.8 that 30.9 percent of the rural population
below poverty line in Urban: 25.7 and 26.4 percent of the urban population
the year 2004-05 was: Total 37.2 were below the poverty line in 2011-12.
Rural: 28.3% In the year 2011-12, The all-India ratio was 29.5 percent.
Urban: 25.7% Rural:25.7
All India: 27.5% Urban: 13.7
Total: 21.9
The Multi-Dimensional Poverty Index

 The Multidimensional Poverty Index (MPI), published for the first time in the 2010
Report, complements monetary measures of poverty by considering overlapping deprivations
suffered by individuals at the same time.
 The index identifies deprivations across the same three dimensions as the HDI and
shows the number of people who are multidimensionally poor (suffering deprivations in 33% or
more of the weighted indicators) and the number of weighted deprivations with which poor
households typically contend with.
Unemployment in India: Types, Causes and Measures
Unemployment in India
Back to Basics. What is Unemployment?
Unemployment is a phenomenon that occurs when a person who is capable of working and is
actively searching for the work is unable to find work.
People who are either unfit for work due to physical reason or do not want to work are excluded
from the category of unemployed.
The most frequent measure of unemployment is unemployment rate. The unemployment rate is
defined as a number of unemployed people divided by the number of people in the labour force.
Labour Force: Persons who are either working (or employed) or seeking or available for work
(or unemployed) during the reference period together constitute the labour force.
Measure of Unemployment in India
Usual Status Approach Weekly Status Approach Daily Status Approach

Usual Status approach

records only those persons
as unemployed who had no
gainful work for a major
time during the 365 days
precedingthe date of survey
and are seeking or are
available for work.
The status of activity on
which a person has spent
the relatively long time of
the preceding 365 days
prior to the date of survey is
considered to be the usual
principal activity status of
the person.
In the Daily status approach, current
The weekly status
activity status of the person with
approach records only
regard to whether employed or
those persons as
unemployed or outside labour force is
unemployed who had no
recorded for each day in the
gainful work for a major
reference week. The measure adopts
time during the seven
half day as a unit of measurement for
days preceding the date
estimating employment or
of survey.
unemployment.

Types of Unemployment
Frictional Unemployment Cyclical Unemployment

Cyclical unemployment is due to deficiency

The minimum amount of unemployment that
prevails in an economy due to workers quitting
their previous jobs and are searching for the new
jobs is called Frictional Unemployment.
or fall in effective demand from consumers
which leads to fall in production and low
demand for labour.
Cyclical unemployment is a type of
unemployment which is related to the
cyclical trends of booms and recessions
called as the business cycle.
If an economy is doing good, cyclical
unemployment will be at its lowest and will
be the highest if the economy faces
recession.

The major reasons for frictional unemployment are The major reason for this type of

lack of information about the availability of jobs
and lack of mobility on the part of workers (it
means workers are not willing to travel to a distant
place or a new state for employment).
Frictionally unemployed person remains
unemployed for a very short period of time.
This type of unemployment is of voluntary nature.
Voluntary Unemployment
Voluntary unemployment refers to a situation where
workers are either not seeking for work or are in
transition from one job to another (quitting one job in
search of another better job).
Voluntary unemployment remains in an economy
during all the time. As there will always be some
workers, who quit their previous jobs in search of
new ones.
Structural Unemployment
Structural unemployment refers to a situation which
arises due to change in the structure of the
economy. Example: An economy transforms itself
from a Labour intensive economy to a Capital
intensive economy.
Structural unemployment usually occurs due to the
mismatch of skills.
Example, due to advance technological progress,
the production of cars is done through robotic
machines rather than traditional Machines. As a
result, those workers who do know how to operate
the new and advanced machines will be removed.
The unemployment happened because the current
workers do not have the required skills as wanted
by their employers.
Technological Advancement, Robotics, Artificial
Intelligence, Mechanisation and Automation are the
main causes of Structural unemployment.
Back to Basics: Disguised Unemployment
unemployment is lack of demand in the
economy and slowdown of economic
activity.
When the demand for goods and services is
low, then the firms stop the production due
to rise in the unsold stock. As a result of
stopping production, the firms lay off workers
and unemployment rises.
This type of unemployment is for a long
period of time and worker remains
unemployed during the entire phase of slow
down or recession.
This type of unemployment is of involuntary
nature.
Involuntary Unemployment
Involuntary unemployment refers to a
situation where workers are seeking work
and are willing to work but are unable to
get work.
Involuntary unemployment happens in an
economy during the time of depression
and fall in aggregate demand for goods
and services.
Seasonal Unemployment
Seasonal unemployment occurs during
certain seasons of the year. In some
industries and occupations like agriculture,
holiday resorts etc., production activities
take place only in some seasons.
Therefore, they offer employment for only a
certain period of time in a year.
People engaged in such type of activities
may remain unemployed during the off-
season.
Seasonal unemployment mainly occurs in
Agricultural sector, Tourism sector and in
factories producing seasonal goods.
 Disguised unemployment is a situation especially prevalent in poor and developing
countries.
 Disguised unemployment is when too many people are employed than what is required
to produce efficiently. This kind of employment is not at all productive.
 It is not productive in a sense that production does not suffer even if some of the
employed people are withdrawn.
 The key point to remember is that the marginal productivity of labourers under disguised
unemployment is zero. The labourers are employed physically, but not economically.
The situation of disguised unemployment is most prevalent in the agriculture sector of the
underdeveloped countries. The key idea is that the amount of population in agriculture which
can be removed from it without any change in the method of cultivation, without leading to any
reduction in output.
Back to Basics: Under Employment.
Underemployment is the most dangerous kind of unemployment in an economy.
Underemployment is a situation under which People with a higher level of skills are employed in
less productive jobs. It simply means that the Labour force of the economy is not fully utilised as
per their skills and experience.
Example: an individual with an engineering or management degree working as a clerk or
accountant in a firm or a social science graduate working as a pizza delivery boy.