Economics_RS Class 05

A BRIEF OVERVIEW OF THE PREVIOUS CLASS

BALANCE OF PAYMENT (05:05 PM)

• Balance of Payment

  Current account Settled simultaneously.  Trade account Goods / Merchandise trade It is visible Imports Exports    Invisibles Transfer payments such as gifts, remittances and grants Services Factor Income Capital Account Investments Borrowings

• In Remittances, Incoming dollars are more than outgoing. So in Remittances, we have positive. 
• Services- Here also we have positive. 
• Factor Income- Here We are having a slight negative. Income is not the same as investments. After investing in bonds we get interest and after investing in shares we get dividends. So these dividends, profit, and interest are incomes. 
• Investments
• a) Foreign Direct Investment  
• Any foreign investment which is having an intention of doing business or acquiring the existing firm or setting up a new firm (Subsidiary firm) is called FDI.
• If in a listed company, the entity is purchasing more than or equal to 10% then that investment will be treated as FDI. If in the next year, the entity is selling 2% then also that investment will be treated as FDI. 
• Foreign institutional investment with certain conditions will be treated as FDI
• In an unlisted company, the investment will be treated as FDI
• Benefits of this investment 
• a) Creation of new jobs
• b) It brings new modern technology, management, and other resources [* Technology transfer]
• c) FDI is more stable than FII
• Why a foreign Investor will invest in India?
• a) Cheap labor- In the 1960s more FDI moved into China due to this cheap and efficient labor. 
• b) Policies of the government-Pro-business policy (No restriction on trade, Government tax policy- Transparency in tax laws, open trade, labor laws of the country- easy hire and fire policy etc
• c) EASE OF DOING BUSINESS- Ease of doing business reforms- India implemented reforms since the License raj, especially LPG reforms, single window clearances, relaxing the government permissions, etc
• d) Structural reforms- First-generation and second-generation etc
• Before 1991, India was a closed economy, and thus India was not receiving FDI, and in Trade, India was having a Trade deficit. Thus India was having a BoP deficit. To bridge the deficit RBI can interfere and sell the Dollars in the market, but in 1991 the RBI's forex reserve was also empty thus India need to borrow from outside. 
• b) Foreign institutional investment (FII) (05:38 PM)
• In India, SEBI regulates the Stock market. 
• Suppose, Foreign institutions such as Morgan Stanley got a license to trade in the Indian stock market from SEBI. Now foreigners who want to buy Indian shares can buy the shares through the licensed Institution. 
• FII investors' general intent is not to do business but they are mostly interested in earning profit. When the profit margin increases then they can sell the shares. When they sell the shares in one go the stock market falls. 
• There is an easy flight of capital and these FII investments are more volatile than the FDI. Thus FII investments are called HOT MONEY. 
• If the FII investment is coming to a listed company and it is purchasing a 10% or more stake then it will be treated as FDI. For selling the stake, it requires permission.
• Borrowings (05:58 PM)
• External commercial borrowing- More ECB borrowing means, more inflow of dollars. 
• External assistance- It is a kind of soft loan. Example- Long-term loans at a subsidized interest from IMF, World Bank, etc, Zero-interest loan is also a loan. 
• Keywords related to the balance of payment (06:09 PM)
• Current account deficit- It is one of the most important economic indicators which can indirectly affect the Ruppe value, Inflation, and also the Fiscal deficit of the government. 
• Current account and Fiscal deficit are called "Twin deficits". When CAD is increasing then it will lead to an increase in Fiscal deficit and this increased FD will again increase the CAD. Therefore,  CAD should be maintained under 3-3.5% of GDP. 
• How CAD and FD are related? 
• When CAD is increasing it means more dollars are moving outside the country, it means the Ruppe value is depreciating and Imports are becoming costly. Even essential imports like food, oil, and fertilizer become costly. These are not only economic goods but also political goods. The government will increase the subsidy. 
• Thus, the government will give fiscal stimulus, and for this government needs to borrow to increase this fiscal space. This borrowing is called a Fiscal deficit.  
• When the government is giving more subsidies and gives fiscal stimulus, then people will also consume more imported items. 
• Companies are also given more subsidies so they will also import materials. 
• So this will again lead to a Trade deficit. Thus FD is increasing the CAD. 
• Capital account 
• Investments
• a) Foreign direct investment (FDI)- Foreign investments which are moving into the country with the intention of doing business, setting up a subsidiary firm, or acquiring an existing company, etc. FDI can move into Brownfield and Greenfield projects. FDI helps in creating jobs and also brings modern technology into the country. FDI is not a portfolio investment.
• b) Foreign institutional investment- These are indirect investments that can get into stock markets as well as bond markets. FIIs are highly volatile and also called as "Hot Money". FIIs are regulated by SEBI. [* An institution established or incorporated outside India that proposes to make investments in India and which is registered with the Securities and exchange board of India.  ]
• Borrowings
• a) External commercial borrowing- These are long-term loans raised by corporates from outside India. 
• b) External assistance- These are soft loans generally taken by governments. 
• Bonds 
• Convertible bonds- These are bonds that are converted into equity. [* The bonds can be converted to equity and can be sold in the market. The risk of inflation is less in the case of Convertible bonds. Here the interest paid is less as these Bonds are less risky. ]
• Non-convertible bonds- These bonds can not be converted into equity. [* The risk of inflation is high. Thus a person should pay MORE interest so that one will be motivated to buy these bonds. ]
• If a company is raising money by raising bonds then it is considered a Borrowings. If a certain portion of the Bond is converted into equity then it is called an investment.  

SITUATION POST-1991 (06:40 PM)

• In 1991, India faced a BoP crisis. So India started LPG reforms and India saw a flow of foreign capital. SEBI lacked much experience and It failed in regulation.  
• India asked IMF for help. IMF gave conditional loans. India had to implement LPG reforms. 
• India brought STRUCTURAL reforms- Reforms related to industrial policy, FOREX-related reforms, and Foreign exchange reforms (FERA and FEMA).
• One of the important reforms was related to Taxation reforms. 
• All the reforms implemented post-1991, were called as First generation reforms. It was related to a market economy, Forex, liberalizing norms with respect to the current account. 
• 1999-2000- The reforms brought in this period were called as Second generation reforms. These reforms were difficult to implement. These were related to bringing reforms in laws. These were legal reforms. [* There was a protest from trade unions when India tried to bring reforms in labor laws]. These are related to factor market reforms. 

FIRST-GENERATION REFORMS (07:05 PM)

• All reforms implemented by the government immediately after the 1991 economic crisis. It focussed on tax reforms, industrial policy reforms, Financial sector reforms
• Second-generation reforms- These are reforms implemented in 1999-2000 to mainly extend the benefits achieved through first-generation reforms and also rectify the problems in the Indian economy. 
• These second-generation reforms are difficult to implement and they mainly focussed on factor market reforms, legal reforms, Agriculture related reforms, capital account convertibility, etc. 
• Currency convertibility- Before the 1990s, With respect to capital as well as the current account it was regulated by the government. 
• By 1996, the government reduced all the restrictions on capital accounts. The current account was made fully convertible. The government will not interfere. 
• Till today, the capital account is not fully convertible, even today there are restrictions. For example- FDI is not allowed to take all the money, it needs to take permission. The government is putting restrictions on ECB also. 
• India tried to bring full capital account convertibility, BUT 
• A committee recommended that capital account convertibility should be allowed within 3 years in a phased manner but a crisis happened in 1997
• a) 1997, East Asian crisis- These countries had full capital account convertibility. In 1997, the USA was struggling and stopped trading thus the companies based in East Asian countries faced losses. 
• b) In 2006, again a committee recommended adopting capital account convertibility. Then 2008 global financial crisis happened. 
• So India decided to make the capital account convertibility in a gradual way. 
• Convertibility of currency- Converting one currency into another. Even today, the Indian rupee is partially convertible. It is fully convertible with respect to the current account and it is partially convertible with respect to the capital account. 
• Government is going ahead with the gradual liberalization of the capital accounts. 

TAXATION (07:24 PM)

• How to increase tax revenue?
• 1) In the short term, Government can increase tax revenue by increasing tax rates.
• 2) Government can also increase tax revenue by widening of Tax base. 
• More formalization will lead to more widening of the tax base. Filing GST returns is one of the ways to increase formalization. 
• It is better to widen the tax base than to increase the tax rate, especially in India. Why?
• a) Tax affects the poor man more.
• Relationship between tax rate and tax revenue- laffer curve
• 
• b) When the tax rate is increased people may resort to tax evasion. This is not a viable option 
• c) Corporates will also not comply and they may resort to tax avoidance. 
• 3) Increasing the tax efficiency or reducing the tax inefficiency
• India was facing certain challenges such as Logistics inefficiencies and tax on tax paid by the poor man. 
• Direct and indirect tax
• Direct tax- Where the incidence and impact of tax collection are the same
• Indirect tax Where the impact and incidence are on different persons. 
• In a Welfare state, it is better to increase direct tax rates as indirect taxes hurt the poor person more. 
• Excise duty- It is levied on production or manufacturing. It is handled by the center. It was levied/ imposed by the center. 
• Criteria for levying a tax by center or state?
• It will be decided based on the lists (Union list, state list, Concurrent list) i.e. the tax falls in which list of the constitution.
• Excise duty falls in the union list and Sales tax falls in the state list. 
• Tax on Tax/ cascading effect
• Suppose the price of a phone is 20000 and the central government levied 10% as excise duty (i.e. 2000) thus the cost is 22000. 
• After this the state government also levied a 10% sales tax on 22000 which leads to 2200 (2000+200).
• This 200 is paid on already paid tax (i.e on excise duty of 2000).
• This is called a tax on tax. It is an example of inefficient taxation and it is also called the cascading effect. 
• Had the tax been only 20% (10% by center and 10% by state) then the price would have been 24000 but now because of Tax on Tax the price is 24200.

The topic for the next class:-Taxation and related keywords. 

Questions for practice

1)

With reference to the Balance of Payments, which of the following constitute(s) the Current Account?

Balance of trade

Foreign assets

Balance of Invisibles

Special Drawing Rights

Select the correct answer using the code given below.

(a)1 only                                        

(b)2 and 3 only

(c)1 and 3 only                             

(d)1, 2 and 4 only

2)

Consider the following statements:

FDI is a short-term investment in a country’s economy by a foreign company.

FDI is included in a country’s Current Account balance sheet.

Select the correct answer using the code given below.

(a)1 only

(b)2 only

(c)Both 1 and 2

(d)Neither 1 nor 2

3)

Laffer Curve finds the relationship between:

(a)Tax rates and GDP growth

(b)Tax Rates and Government revenue from tax

(c)Interest rates and Fiscal deficit

(d)Interest Rates and GDP

4)

Twin deficit in an economy means

(a)High current account deficit and high fiscal deficit.

(b)High capital account deficit and high fiscal deficit.

(c)High current account deficit and high capital account deficit.

(d)High budget deficit and high fiscal deficit.

5)

Capital Account Convertibility of the Indian Rupee implies

(a)That the Indian Rupee can be exchanged by the authorized dealers for travel

(b)That the Indian Rupee can be exchanged for any major currency for the purpose of trade in goods and services

(c)That the Indian Rupee can be exchanged for any major currency for the purpose of trading financial assets

(d)All of the above

6)

Consider the following statements with respect to the current account deficit (CAD):

It means that there is a deficit of Dollars for the country, so the concerned country has to keep that many dollars in its reserve position.

If a country does not have enough dollars, can be called a Balance of Payment (BOP) crisis.

Which of the statements given above is/are correct?

(a)1 Only 

(b)2 Only 

(c)Both 1 and 2 

(d)None of the Above 

7)

Which of the following comes under the classification of the Capita Account under Balance of Payment?

FDI and FPI

Sovereign Debts and External Borrowings.

Banking Capital.

Select the answer using the codes given below:

(a)1 and 2 only

(b)2 and 3 only

(c)1 and 3 only

(d)1, 2 and 3

8)

With reference to Convertible Bonds, consider the following statements:

As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.

The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.

Which of the statements given above is/are correct?

(a)1 only

(b)2 only

(c)Both 1 and 2

(d)Neither 1 nor 2

9)

Differentiate between Foreign direct investment and Foreign institutional investment. Also, discuss the benefits of FDI. (10 marks/ 150 words)

10)

What to you understand by "Twin deficits"? Discuss the relationship between fiscal deficit and Current account deficit. (10 marks/ 150 words) 

11)

What do you mean by structural reforms? What structural reforms were taken by India post-1991? (10 marks/ 150 words) 

Answers

1) c

2) d

3) b

4) a

5) c

6) c

7) d

8) c

Q1.

Briefly discuss the components of the capital account. Why foreign investments are attracted to India? Give arguments. (10 marks/ 150 words)  

(10 marks)