Rajesh Nayak

CONTENTS
INDIA UNDER THE BRITISH RULE
INFLATION IN INDIA
MONETARY POLICY OF INDIA
MONEY MARKET
ROLE OF RBI
NATIONALISATION OF BANKS, JULY 1969
NARSIMHAN COMMITTEE (1991)
FISCAL POLICY OF INDIA
FISCAL RESPONSIBILITY AND BUDGETARY MANAGEMENT ACT, 2003
ROLE OF RBI
GENERAL ROLES
INDIA REFORMS EXPERIENCE
EXTERNAL SECTOR REFORMS
FINANCIAL SECTOR REFORMS
FINANCIAL INCLUSION AND CUSTOMER SERVICES
PROSPECTS, CHALLENGES AND STRENGTHS OF THE ECONOMY NOW
INDIAN PUBLIC FINANCE
VALUE ADDED TAX
GOODS AND SERVICE TAX
STATE FINANCES
PUBLIC DEBT
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India under the British Rule

The economic consequences of the British rule can be studied under three heads:

Decline of Indian Handicrafts and progressive ruralisation of the Indian economy

Growth of the new land system and the commercialisation of Indian agriculture
Process of industrial transition of India

Decline of Handicrafts

While India was an exporter of Handicrafts before the Industrial Revolution, the revolution
reversed the character of Indias foreign trade
o Increase in demand for raw material for British industries
o Hence, steps were made to crush Indian handcrafts as well as commercialise
agriculture to meet the interests of the British industries
Principle causes for the decline of Indian handicrafts
o Disappearance of Princely courts
o Hostile policy of the East India Company and the British Parliament
o Competition of machine-made goods
o The development of new forms and patterns of demand as a result of foreign
influence
Economic consequences of the decline of handicrafts
o Increased unemployment
o Back-to-the-land movement: handicrafts were forced to take up agriculture or
become landless labourers. This increased the pressure on land. This trend of
growing proportion of the working force on agriculture is described as progressive
ruralisation or deindustrialisation of India. Thus, the crisis in handicrafts and
industries seriously crippled Indian agriculture.

Land System during 1793-1850

1793: permanent settlement

Zamindari, Ryotwari, Mahalwari systems
Absentee landlordism emerged
The result of the whole change in the land system led to the emergence of subsistence
agriculture
It helped the concentration of economic power in the hand of absentee landlords and
moneylenders in rural India.

Commercialisation of Agriculture (1850-1947)

Define: Production of crop for sale rather than for family consumption
What distinguished commercial agriculture from normal sales of marketable surplus was
that it was a deliberate policy worked up under the pressure from British industries. It was
thus forced upon the Indian peasantry.
Resistance: Indigo revolution etc
Why CA? Industrial Revolution
Impact of railways and road transport: Railways and road transport made possible a huge
expansion in cash cropping, for national and international markets, and production regimes
across the subcontinent were placed in a new context of opportunity
Impact of CA
o Mass movement to commercial agriculture caused decline in food production,
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increase in prices and famines.
o Halted the process of industrialisation in India

Industrial Transition in India

The process of industrial transition divided into: industrial growth during the 19th century
and industrial progress during the 20th century
Industrial growth during the 19th century
o Decline of indigenous industries and the rise of large scale modern industries
o 1850-55: first cotton mill, first jute mill and the first coal mine established.
Railway also introduced.
o Despite some industrialisation, India was becoming an agricultural colony
o The thrust to industrialisation came from the British because
They had capital
They had experience in setting up industries in Britain
They had state support
o British industrialists were interested in making profits rather than economic growth
of India
o Parsis, Jews and Americans were also setting industries
o No Indian industrialists because
Neither the merchants nor the craftsmen took the lead in setting industries
While the craftsmen didnt possess capital, the merchants were happy with
trading and money lending activity which was also growing at that time.
o However, some Parsis, Gujaratis, Marwaris, Jains and Chettiars joined the ranks
of industrialists
Industrial Growth in the first half of the 20th century
o Imp events that stimulated industrial growth
1905: Swadeshi Movement
First WW
Second WW
o Great stimulus was given to the production of iron and steel, cotton and woollen
textiles, leather products, jute.
o Tariff protection was given to Indian industries between 1924 and 1939. This led
to growth and Indian industrialists were able to capture the market and eliminate
foreign completion altogether in important fields
o The increase in industrial output between 1939 and 1945 was about 20 percent
o After the WW I, the share of the foreign enterprises in Indias major industries began
to decline.
Causes for the slow growth of private enterprise in Indias industrialisation
o Inadequacy of entrepreneurial ability
Indian industrialists were short-sighted and cared very little for replacement
and renovation of machinery
Nepotism dictated choice of personnel
High profits by high prices rather than high profits by low margins and
larger sales
o Problem of capital and private enterprise
Scarce capital
Few avenues for the investment of surplus
No government loans
Absence of financial institutions
Banking was not highly developed and was more concerned with commerce
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rather than industry
o Private enterprises and the role of government
Lack of support from the government
Discriminatory tariff policy: one way free-trade
Restrictions transfer of capital equipments and machinery from Britain
Almost all machinery was imported
Despite these difficulties, the Indian indigenous business communities continued to grow,
albeit at a slow pace.

Forms and Consequences of Colonial Exploitation

Main forms of colonial exploitation
o Exploitation through trade policies
o Exploitation through export of British Capital to India
o Exploitation through finance capital via the Managing agency system
o Exploitation through the payments for the costs of the British administration
Exploitation through trade policies
o Exp of cultivators to boost indigo export: forced
o Exp of artisans by compulsory procurement by the Company at low prices: gomastas
were the agents of the Company who used to do this
o Exp through manipulation of export and import duties:
Imports of Indian printed cotton fabrics in England were banned
Heavy import duties on Indian manufactures and very nominal duties on
British manufactures.
Discriminating protection was given (to industries that had to face
competition from some country other than Britain). This was whittled down,
however, by the clause of Imperial Preference under which imports from GB
and exports to GB should enjoy the MFN status.
Exploitation through export of British Capital to India
o There were three purposes of these investment (in transport and communication)
To build better access systems for exploited Indias natural resources
To provide a quick means of communication for maintaining law and order
To provide for quicker disbursal of British manufactures throughout the
country and that raw materials could be easily procured
o Fields of FDI
Economic overhead and infrastructure like railways, shippings, port, roads,
communication
For promoting mining of resources
Commercial agriculture
Investment in consumer goods industries
Investments made in machine building, engineering industries and chemicals
o Forms of investment
Direct private foreign investment
Sterling loans given to the British Government in India
o Estimates show that foreign capital increased from 365 mn sterling in 1911 to 1000 mn
sterling in 1933.
o British multinationals were the chief instruments of exploitation and it were they
who drained out the wealth of India.
o These investments show that
British were interested in creating economic infrastructure to aid
exploitation and resource drain

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They invested in consumer goods and not in basic and heavy industries to
prevent the development of Indian industries
Ownership and management of these companies lay in British hands
Exploitation through finance capital via the Managing agency system
o Managing agency system: The British merchants who had earlier set up firms acted as
pioneers and promoters in several industries like jute, tea and coal. These persons were
called managing agents
o It may be described as partnerships of companies formed by a group of individuals
with strong financial resources and business experience
o Functions of managing agents
To float new concerns
Arrange for finance
Act as agents for purchase of raw materials
Act as agents to market the produce
Manage the affairs of the business
o They were important because they supplied finance to India when it was starved of
capital
o In due course, they started dictating the terms of the industry and business and
became exploitative and inefficient
o They demanded high percentage of profits. When refused they threatened to
withdraw their finance
Exploitation through payments for the costs of British administration
o British officers occupied high positions and were paid fabulous remunerations.
o These expenditures were paid by India
o They transferred their savings to Britain
o India had to pay interest on Sterling Loans
o India has to pay for the war expedition of the Company and later the Crown
Consequences of the exploitation

India remained primarily an agricultural economy

Handcrafts and industries were ruined
Trade disadvantage developed due to the policy of the British
Economic infrastructure was developed only to meet the colonial interests
Drain of Wealth
The net result of the British policies was poverty and stagnation of the Indian economy

Drain Theory <take notes from History NCERT>

Dadabhai Naoroji: Poverty in India (1876)

He claimed that the drain of wealth and capital from the country which started after 1757
was responsible for absence of development in India.
Drain was done through trade, industry and finance
Two elements of the drain
o That arising from the remittances by European officials of their savings, and fro their
expenditure in England
o Arising from remittance by non-official Europeans
India has to export much more than she imported to meet the requirements of the
economic drain
In 1880 it amounted to 4.14% of Indias national income
Consequences of the Drain
o Prevented the process of capital formation in India
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o Through the drained wealth, the British established industrial concerns in India
owned by British nationals
o It acted as a drag on economic development

Inflation in India
<use fundaes from your MAP> this question is very likely to be asked given the present inflationary
trend.

Monetary Policy of India

Topics

1. MP background
2. Evolution of monetary policy in India: Different phases
3. Transmission Mechanism
4. Goals of MP
5. Instruments of MP
6. Determinants of MP
7. Role of RBI: Pre and post-reforms
8. MP: pre and post reforms
9. Committees on Monetary Management in India
10. MP and Money Market
11. MP and Fiscal Policy
12. MP and the external sector
13. MP and the banking sector
14. MP and Economic growth
15. MP and Inflation
16. Financial Stability: New Challenge
17. Challenges before monetary policy
18. Criticisms of Indias MP

Some background information

An important factor that determines the effectiveness of MP is its transmission a process

through which changes in the policy achieve the objectives of controlling inflation and
achieving growth
MP transmission mechanism describes how MP action affects output and inflation, the final
objectives of MP
Various MP transmission channels
o Quantum Channel relating to money supply and credit
o Interest Rate Channel this has become important in the post reform period
o Exchange Rate Channel
o Asset Price Channel
How these channels function in an economy depends on its stage of development and its
underlying financial structure.
These channels, however, are not mutually exclusive. There could be considerable feedback
and interaction among them.

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Evolution of MP

1935: Proportional Reserve System

1954: Minimum Reserve System
1973-76: Minimum and maximum lending rates for bank loans prescribed
1985: Flexible monetary targeting with feedback
1998: Multiple indicator approach adopted

Functions of RBI

Monetary functions
o Conduct of monetary policy
o Bank of issue
o Banker to the government
o Bankers Bank and Lender of the Last Resort
o Controller of credit
o Custodian of foreign exchange reserves
o Foreign exchange management current and capital account management
o Oversight of the payment and settlement systems
Non-monetary functions
o Regulation and supervision of the banking and non-banking financial institutions,
including credit information companies
o Regulation of money, forex and government securities markets as also certain
financial derivatives
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o Promotional functions: promotion of IFCI, SFC etc

o Developmental role
o Research and statistics

Objective of MP

To catalyse economic growth: by ensuring adequate flow of credit to productive sectors

Price stability
After the financial crisis, achieving Financial Stability has emerged as an important objective.
Exchange rate management can be yet another objective

Tools of MP

General Credit Control (Quantitative Control)

o Bank Rate
o Open Market Operations
o Cash Reserve Ratio
Specific and direct credit control (Qualitative Control)
o Lending margins
o Purpose specific credit ceiling
o Discriminatory interest rates
o Eg: Credit Authorisation Scheme, Credit Monitoring Arrangement.

MP pre-reforms

MP in India was conducted under the monetary targeting framework till 1997-98 with M3 as
an intermediate target. This amounted to regulating money supply consistent with the
expected growth in real income and a projected level of inflation.
During the monetary targeting phase (1985-1998), while M3 growth provided the nominal
anchor, reserve money was used as the operating target and cash reserve ratio (CRR) was used
as the principal operating instrument. Besides CRR, in the pre-reform period prior to 1991,
given the command and control nature of the economy, the Reserve Bank had to resort to
direct instruments like interest rate regulations and selective credit control. These instruments
were used intermittently to neutralize the expansionary impact of large fiscal deficits which
were partly monetised. The administered interest rate regime kept the yield rate of the
government securities artificially low. The demand for them was created through periodic
hikes in the Statutory Liquidity Ratio (SLR) for banks. The task before the Reserve Bank was,
therefore, to develop the financial markets to prepare the ground for indirect operations.
MP post-reform

In the wake of the financial reforms, questions were raised about the appropriateness of this
framework.
Working Group on Money Supply (1998)
o Highlighted that the interest rate channel of transmission mechanism was gaining
importance
On the recommendation of this working group, RBI shifted over to a multiple-indicator
approach from 1998-9
Multiple Indicator Approach: Interest rates or rates of return in different markets (money,
capital and g-sec), along with such data as on currency, credit extended by banks and
financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate,

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refinancing and transactions in foreign exchange available on high-frequency basis, are

juxtaposed with output data for drawing policy perspectives.
LAF: Another important feature post reform is the increased use of LAF. It has enabled RBI
to modulate short-term liquidity under varied financial market conditions, including large
capital inflows from abroad.
CRR: Reduced
1992-93: market borrowing programme of the government was put through the auction
process
SLR was brought down to its statutory minimum of 25 pc by Oct 1997 and 24 pc in 2010
CRR was brought down from 15 pc of NDTL of banks to 9.5 pc in Nov 1997 which
has stabilised at 6 pc for a long time. Not bound by its statutory limit (lower) of 3 pc
now.
Narsimhan Committee (1998) recommended reforms in the money market
o RBI introduced LAF in 2000 to manage market liquidity on a daily basis and also to
transmit interest rate signals to the market. In the post-reform period, LAF, with
OMO, has emerged as the dominant instrument of MP, though CRR continued to be
used as an additional instrument of policy.
o Call money market was transformed into a pure inter-bank market by 2005.
o With the introduction of prudential limits on borrowing and lending by banks in the
call money market, the collateralized money market segments developed rapidly
To absorb the capital inflows in excess of the absorptive capacity of the economy MSS was
introduced in 2004. Interestingly, in the face of reversal of capital flows during the recent
crisis, unwinding of the sterilised liquidity under the MSS helped to ease liquidity conditions.
Increased Micro-finance: To strengthen rural finance RBI has focused on SHGs.
Fiscal Monetary Separation: Automatic monetization of deficit faced out since 1994. Thus
it has separated the monetary policy from the fiscal policy.
Changed interest rate structure: Phased deregulation of lending rates in the credit market.
Minimum lending rates had been abolished and lending rates above Rs. 2 lakh were freed. In
2010, the base rate mechanism was adopted. Savings rate was deregulated in 2011
Higher market orientation for banking: the banking sector got more autonomy
and operational flexibility.
Challenges in the post-reform period

A major challenge is the conduct of monetary policy in surplus liquidity conditions.

Increased capital inflows
o To deal with this, RBI initiated the Market Stabilization Scheme (MSS) in 2004
o Under the scheme RBI issues Treasury Bills and dated government securities. The
money generated from sale of these bills is kept in a different account held by the
government and maintained and operated by RBI. This money is not available for
governments expenditure. Thus, liquidity in the market is mopped.
o The operationalisation of the MSS to absorb liquidity of more enduring nature has
considerably reduced the burden of sterilization on the LAF window.
Financial stability is an emerging concern
The ongoing modernisation of the payments system with the introduction of RTGS would
have a significant impact on MP.
The transmission of policy signals to banks lending rates has been rather slow. <base rate
system introduced to correct this?>
Central bank independence
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Criticisms/Limitations

In case of high fiscal deficit, monetary expansion has continued to happen

Limited coverage: The MP covers only commercial banking system and leaves out the non-
bank institutions. This limits the effectiveness of MP
Unorganised money market: Its pretty large and does not come under the control of the RBI.
Hence, MP does not affect them.
Predominance of cash transcation (?): <check out the current situation> In India, still there is
huge dominance of cash in total money supply. It is one of the main obstables in the effective
implementation of MP. Because MP operates on the bank credit rather than cash.
Increase volatility: As MP has adoptged changes in accordance to the changes in the external
sector as well, it could lead to a high amount of volatility.

Evaluation of the changes in MP and Money Market

In response to the reforms, over the years the turnover in various market segments
increased significantly
The reforms have also led to improvement in liquidity management operations by the RBI as
is evident from the stability in call money rates, which also helped improve integration of
various money market segments and thereby effective transmission of policy signals
The rule based fiscal policy pursued under the FRBM Act, by easing fiscal
dominance, contributed to overall improvement in monetary management.
With the changing framework of monetary policy in India from monetary targeting to an
augmented multiple indictors approach, the operating targets and processes have also undergone
a change. There has been a shift from quantitative intermediate targets to interest rates, as the
development of financial markets enabled transmission of policy signals through the interest rate
channel. At the same time, availability of multiple instruments such as CRR, OMO including
LAF and MSS has provided necessary flexibility to monetary operations. While monetary policy
formulation is a technical process, it has become more consultative and participative with the
involvement of market participant, academics and experts. The internal process has also been re-
engineered with more technical analysis and market orientation. In order to enhance
transparency in communication the focus has been on dissemination of information and analysis
to the public through the Governors monetary policy statements and also through regular
sharing of policy research and macroeconomic and financial information.
The availability of multiple instruments and their flexible use in the implementation of
monetary policy have enabled the RBI to successfully influence the liquidity and interest
rate conditions in the economy.

Changes in MP

Operating Target
Pre-reform Post-reform
Reserve Money was used as the Multiple Indicator Approach
operating target in the monetary
targeting framework until mid-
1990s

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Monetary CRR and SLR was heavily used Reliance on direct instruments
Policy has been reduced and liquidity
Instruments management in the system is
carried out through OMOs in the
form of outright purchases of g-
secs and daily repo and reverse
repo operations under LAF.
MSS also introduced.
Large capital inflows witnessed
in recent years have posed a
major challenge in the conduct
of monetary and exchange rate
management.
Phased deregulation of the
interest rates
High SLR and CRR Low SLR and CRR

Money Market
RBI operationalises its monetary policy through its operations in government
securities, foreign exchange and money markets
1985: Money Market reforms begin
1992: Introduction of auction system for government securities
1996: Primary Dealer System initiated
2002: Electronic trading and guaranteed settlement through CCIL for G-Sec starts
2006: RBI expressly empowered to regulate money, forex, G-sec and gold related
securities markets
Role of RBI
Pre-reform Post-reform
Developmental Role: the Priority Sector Lending: In the revised guidelines for
developmental role has Introduced from 1974 with PSL the thrust is on ensuring
increased in view of the public sector banks. Extended adequate flow of bank credit to
changing structure of the to all commercial banks by those sectors that impact large
economy with a focus on 1992 segments of the population and
SMEs and financial inclusion weaker sections, and to the
sectors which are employment
intensive such as agriculture
and small enterprises
Lead Bank Scheme Special Agricultural Credit
Plan introduced.
Kisan Credit Card
scheme (1998-99)
Focus on credit flow to micro,
small and medium enterprises
development
Financial Inclusion

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Monetary Policy: the role of M3 as an intermediary target Multiple Indicator Approach

RBI has changed from
regulating credit and money
flow directly to using market
mechanisms for achieving
policy targets. MP framework
has changed to promote
financial deregulations and
market development. Role as a
facilitator rather than as
principal actor.

Regulation of foreign exchange Management of foreign

Banker to the government
As regulator of financial
sector: As regulator of the
financial sector, RBI has faced
the challenge of regulating the
increasing financial sector in
India. Credit flows have
increased. RBI had to make
sure that financial institutions
Direct credit control
Rupee convertability
highly managed
Monetary policy was linked to
the fiscal policy due to
automatic monetisation of the
deficit
Reduction in SLR
exchange
Open Market Operations, MSS,
LAF
Full current ac convertability
and some capital account
convertability
Delinking of monetary policy
from the fiscal policy. From
2006, under FRBM, RBI
ceased to participate in the
primary market auctions of the
central governments
securities.

are regulated in a way to protect

the consumers while not
impeding economic growth.
Custodian of FOREX reserves
Inflation
Financial Stability
Money Market
Direct instruments were used
Closed economy
Forex reserves have increased
drastically. Need to manage it
adequately and avoid
inflationary impact
Multiple indicators
Increased FDI and FII has
made financial stability one of
the policy objectives.
Narsimhan Committee (1998)
recommended reforms in the
money market

Refer to the 2006 report on Currency and Finance for further details. Reforms and the banking sector

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Nationalisation of Banks, July 1969

Why? Also, elaborate on the situation in 1969

To extend the reach of banks geographically

To extend reach of banks functionally to priority sectors. <directed credit>
Narsimhan Committee (1991)
Problems with the banking system:
Revenue Side

High reserve requirements in form of CRR and SLR

Directed credit programme
o The banks were told to shift from security-oriented credit to purpose-
oriented credit.
Political and Administrative Interference. This led to lower income for banks,
inadequate provisioning for bad debt, locking of credit from more productive uses and
erosion of profitability
Subsidizing of credit: Low rate of interest.

Expenditure Side

Phenomenal increase in branch banking led to increased expenditure of the banks.

Rapid increase in the number of staff.
Trade unions contributed to the restrictive practices regarding promotions, transfers,
discipline, work culture etc.
Extension of the coverage of bank credit to priority sectors with higher administrative and
functional costs.

Fiscal Responsibility and Budgetary Management Act, 2003

What is the FRBM Act?
The FRBM Act was enacted by Parliament in 2003 to bring in fiscal discipline. It received the
Presidents assent in August the same year. The United Progressive Alliance (UPA) government had
notified the FRBM Rules in July 2004.

As Parliament is the supreme legislative body, these will bind the present finance minister P
Chidambaram, and also future finance ministers and governments.

How will it help in redeeming the fiscal situation?

The FRBM Rules impose limits on fiscal and revenue deficit. Hence, it will be the duty of the Union
government to stick to the deficit targets.

As per the target, revenue deficit, which is revenue expenditure minus revenue receipts, have to be
reduced to nil in five years beginning 2004-05. Each year, the government is required to reduce the
revenue deficit by 0.5% of the GDP.

The fiscal deficit is required to be reduced to 3% of the GDP by 2008-09.It would mean reduction of
fiscal deficit by 0.3 % of GDP every year.

How are these targets monitored?

The Rules have mid-year targets for fiscal and revenue deficits. The Rules required the government to
restrict fiscal and revenue deficit to 45% of budget estimates at the end of September (first half of the
financial year).
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In case of a breach of either of the two limits, the FM will be required to explain to Parliament the
reasons for the breach, the corrective steps, as well as the proposals for funding the additional
deficit.

What is fiscal deficit?

Every government raises resources for funding its expenditure. The major sources for funds are taxes
and borrowings. Borrowings could be from the Reserve Bank of India (RBI), from the public by
floating bonds, financial institutions, banks and even foreign institutions. These borrowings
constitute public debt and fiscal deficit is a measure of borrowings by the government in a financial
year.

In budgetary arithmetic, it is total expenditure minus the sum of revenue receipts, recoveries of
loans and other receipts such as proceeds from disinvestment.

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Do economies need a fiscal deficit?

Many economists, including Lord Keynes, had advocated the need for small fiscal deficits to
boost an economy, especially in times of crises. What it means is that government should
raise public investment by investing borrowed funds. This exercise is also called pump-
priming. The basic purpose of the whole exercise is to accelerate the growth of an economy by
public intervention.
Hence, there is nothing fundamentally wrong with a fiscal deficit, provided the cost of
intervention does not exceed the emanating benefits.

The darker side of the story is that the borrowed funds, which always remain on tap,
have to be repayed. And pending repayment, these loans have to be serviced.

Ideally, the yield on investment on borrowed funds must be higher than the cost of borrowing.

For example, if the government borrows Rs 100 at 10%, it must earn more than 10% on
investment of Rs 100. In that situation, fiscal deficit will not pose any problem.

However, the government spends money on all kinds of projects, including social sector
schemes, where it is impossible to calculate the rate of return at least in monetary terms. So,
one will never know whether the borrowed funds are being invested wisely.

And how grave is the problem of fiscal deficit?

Over the years, public debt has continued to mount and so have interest payments.
According to budget figures (revised estimates for 2003-04) the government borrowed Rs
1,32,103 crore. The interest payment during the year was Rs 1,24,555 crore.

What is alarming is that except for a comparatively small sum of about Rs 7,500 crore, more
than 94% of borrowed funds are being used to pay interest for past loans. This is what is called
the debt trap, where one is compelled to borrow to service past loans.

The other way of looking at the fiscal problem is that more than 66% of government taxes,
totalling Rs 1,87,539 crore in 2003-04 were used to pay interest on past borrowings.

Servicing of loans also erodes the governments ability to spend money on critical areas
such as health and education and on essential sovereign functions like policing, judiciary
and defence.

The following points are worth notable of FRBM Act.

1) The FRBM Rules impose limits on fiscal and revenue deficit. Hence, it will be the duty of
the Union government to stick to the deficit targets.

2) As per the target, revenue deficit, which is revenue expenditure minus revenue receipts,
have to be reduced to nil in five years beginning 2004-05.

3) The target reduction annually is in Deficits, Government borrowings and debt.

4) A cap on the level of guarantee and total liabilities of the government.

5) Prohibits Government to borrow from RBI(major step)

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6) Placing an assessment of trends in receipts and expenditure before both house of the
parliament on a quarterly basis

7) Annual presentation in the Parliament , the Frame work Statement, Medium Term Fiscal
Policy Statement and Fiscal policy strategy statement.

8) Under exceptional circumstances, Government may be compelled to fall short of the

targets. In case of deviations, the Government would not only be required to take corrective
measures, but the Finance Minister shall also make a statement in both the House of
Parliament.

9) Borrowing from RBI is permitted in exceptional situations like natural calamities.

10) The need for fiscal discipline , Increase plan expenditure, Reduce the amount of
borrowings is clear, Particularly in the era of Globalization when penalty for
irresponsibility is high.

11) The government can engage in capital expenditure without violating the FRBM Act.

Cons
The act would, in effect, force the government to undertake market borrowings at
relatively higher rates of interest that, in turn, would increase revenue expenditures
The governments may reduce even productive expenditure in order to meet the fiscal
deficit targets.
There are a series of substantial programmes like Bharat Nirman, SSA, MNREGA
etc that need high government spending. FRBM should not be used as an excuse to
cut spending on the social sector.
The Parliamentary Standing Committee on the FRBM bill had cautioned in 2000
that the rigidities such as ban on government borrowing from RBI (except for
ways and means advances) serve as a binding constraint on capital expenditures
and development programmes and not on revenue expenditures.
Some economists argue that fiscal discipline and prudence are better achieved by
concerted reforms on the administrative front, including effective decentralisation
rather than by controlling single measures like the fiscal and revenue deficits.
Chelliah: Reducing the growth of expenditure and/or raising the rate of growth of
revenue in a mechanical way irrespective of prevalent and emerging economic
conditions might adversely affect the growth rate. Policies need to be calibrated
according to economic trends.
How was it decided that 3% FD is optimal? No economic rule suggests that.
There should be more dynamic sources of resource mobilisation
The focus deserves to be shift in favour of not the size of gross fiscal
deficit but the productive purposes for which government deficits are
incurred.
Increasing social expenditure will call for some pressure on the revenue
deficit of the government which will have to be tolerated.
Fiscal rules could not have been adhered to in the 2009-10 budget in the milieu of
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the global meltdown.

For fiscal responsibility (Rangarajan and Subbarao: 2007)
o There needs to be fiscal correction not just at the centre but also in the
states
o For sustaining and accelerating growth, achieving the FRBM targets is
necessary, but not sufficient. It must, however, be borne in mind that
sustained growth is an essential prerequisite for meeting the fiscal caps.
o We need to pay attention to achieving the targets not only in quantitative
terms but also with respect to the quality of adjustment.
Plug the inadequacies that have become evident in the Act since it was passed in
2003.
Update

Amendment to FRBM Act is being proposed by the finmin

The idea is to have some leeway for counter-cyclical adjustments in case of
economic or political shocks
This will mean the Centre will have the leeway to increase its spending and deviate
from deficit targets in times of economic crisis. But in good times, when the
revenues are buoyant, it would have to perform better
The 13th Finance Commission had also suggested such a cushion and said it can be
used in times of an agrarian crisis, asset price bubble or a global recession
Role of RBI

General Roles
Role in the fiscal system: As the banker and the debt manager of both Central and
State Governments. It also provides temporary support to tide over mismatches in
their receipts and payments in the form of Ways and Means Advances (WMA).

India Reforms Experience

External Sector Reforms

Reforms
o Exchange rate of rupee became market determined from 1993
o 1994: India became current account convertible
o FEMA was enacted in 2000. With this, the objectives of regulation have
been redefined as facilitating trade and payments as well as orderly
development and functioning of foreign exchange market in India.
Effects
o Indias external sector has become more resilient
o Exports growth rate: -- pc
o Current account deficit an issue
o Strengthening of the capital account
o Accretion of the foreign exchange reserves
o Capital outflows: the current regime of outflows in India is characterized by
liberal but not incentivised framework for corporates to invest in the real
economic outside India, including through the acquisition route.

Financial Sector Reforms

Situation before reforms
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o Financial markets were marked by administered interest rates, quantitative

ceilings, statutory pre-emptions, captive market for government securities,
excessive reliance on central bank financing of fiscal deficit, pegged exchange
rate and current and capital account restrictions.
Reforms
o Phased reductions in statutory pre-emption like CRR and SLR
o Deregulation of interest rates on deposits and lending, except for a select
segment.
o Diversification of ownership of banking institutions: private shareholding
in public sector banks
o Financial Markets: removal of structural bottlenecks,
introduction/diversification of new players/instruments, free pricing of
financial assets, relaxation of quantitative restrictions, better regulatory
systems, introduction of new technology, improvement in trading
infrastructure, clearing and settlement practices and greater transparency.
Effects
o The banking sector reform combines a comprehensive reorientation of
competition, regulation and ownership in a non-disruptive and cost-effective
manner.
o FDI in the private sector banks is now allowed upto 74 pc
o 100 pc FDI is allowed under the automatic route in NBFCs
o Urban Cooperative Banks suffer from various problems. Several structural,
legislative and regulatory measures have been initiated in recent years for
UCBs with
a view to evolving a policy framework oriented towards revival and healthy
growth of the sector.
o Fin mkt: the price discovery in the primary market is more credible than
before and secondary markets have acquired greater depth and liquidity.
o Number of steps (like RTGS) for making the payment systems safe,
secure and efficient.

Financial Inclusion and Customer Services

A. Initiation of no-frills account These accounts provide basic facilities of deposit and
withdrawal to accountholders makes banking affordable by cutting down on extra frills that are
no use for the lower section of the society. These accounts are expected to provide a low-cost
mode to access bank accounts. RBI also eased KYC (Know Your customer) norms for opening
of such accounts.

B. Banking service reaches homes through business correspondents The banking systems have
started to adopt the business correspondent mechanism to facilitate banking services in those
areas where banks are unable to open brick and mortar branches for cost considerations.
Business Correspondents provide affordability and easy accessibility to this unbanked
population. Armed with suitable technology, the business correspondents help in taking the
banks to the doorsteps of rural households.

C. EBT Electronic Benefits Transfer To plug the leakages that are present in transfer of
payments through the various levels of bureaucracy, government has begun the procedure of
transferring payment directly to accounts of the beneficiaries. This human-less transfer of
payment is expected to provide better benefits and relief to the beneficiaries while reducing
governments cost of transfer and monitoring. Once the benefits starts to accrue to the masses,
those who remain unbanked shall start looking to enter the formal financial sector.
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Why Financial Inclusion?

It mobilizes savings that promote economic growth through productive investment.
It promotes financial literacy of the rural population and hence guides them to avoid the
expensive and unreliable financial services.
This helps the weaker sections to channelize their incomes into buying productive resources or
assets.
In the situations of economic crisis, the rural economy can be a support system to stabilize the
financial system. Hence, it helps in ensuring a sustainable financial system.

Prospects, Challenges and Strengths of the economy now

Prospects
o High growth rate
o Macroeconomic stability
o Service Sector
Challenges
o While over 60 pc of the workforce is dependent on agriculture, the sector
accounts for 20 pc of the GDP
o Slow pace of poverty reduction
o Volatility in agricultural growth
o Inadequate availability of modern infrastructure
o Regulatory framework and overall investment climate
o For fiscal consolidation the subsidies need to be reduced while making the
existing ones more effective
o The delivery of essential public services such as education and health to
a large section of the population is a major challenge
o Governance reforms: they are essential to strengthen state capacity and enable
it to perform its core functions
o Good governance can co-exist only when public sector functions
fairly and efficiently, which is achievable by improving and not
undermining it.
Strength
o Increasing human resource. English speakers.
o Demographics: Young country
Indian Public Finance

Value Added Tax

Under the constitution the States have the exclusive power to tax sales and
purchases of goods other than newspapers
There are however defects of sales tax
o It is regressive in nature. Families with low income a larger proportion
of their income as sales tax.
o Has a cascading effect tax is collected at all stages and every time a
commodity is bought or sold
o Sales tax is easily evaded by the consumers by not asking for receipts.
VAT is the tax on the value added to goods in the process of production and
distribution.
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With the implementation of VAT, the origin based Central Sales Tax is phased out.
Introduced from April 1, 2005
Advantages
o Is a neutral tax. Does not have a distortionary effect
o Imposed on a large number of firms instead of at the final stage
o Easier to enforce as tax paid by one firm is reported as a deduction by a
subsequent firm
o Difficult to evade as collection is done at different stages
o Incentive to produce and invest more as producer goods can be easily
excluded under VAT
o Encourages exports since VAT is identifiable and fully rebated on exports
Difficulties in implementing
o For collection of VAT all producers, distributers, traders and everyone in the
chain of production should keep proper account of all their transactions
o Bribing of sales tax officials to escape taxes
o The government has to simplify VAT procedures for small traders and
artisans

Goods and Services Tax

The Goods and Service Tax Bill or GST Bill, officially known as The Constitution
(122nd Amendment) Bill, 2014, would be a Value added Tax (VAT) to be implemented
in India, from April 2016. GST stands for Goods and Services Tax, and is proposed to
be a comprehensive indirect tax levy on manufacture, sale and consumption of goods as
well as services at the national level. It will replace all indirect taxes levied on goods and
services by the Indian Central and Stategovernments. It is aimed at being comprehensive
for most goods and services
State Finances
Borrowing by the State governments is subordinated to prior approval by the
national government <Article 293>
Furthermore, State Governments are not permitted to borrow externally unlike the
centre.

Public Debt
The aggregate stock of public debt of the Centre and States as a percentage of GDP
is high (around 75 pc)
Unique features of public debt in India
o States have no direct exposure to external debt
o Almost the whole of PD is local currency denominated and held almost
wholly by residents
o The PD of both center and states is actively managed by the RBI ensuring comfort
the financial markets without any undue volatility.
o The g-sec market has developed significantly in recent years
o Contractual savings supplement marketable debt in financing deficits
o Direct monetary financing of primary issues of debt has been discontinued since
April 2006.

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