Chapter 6: FINANCIAL FACTS

Foreign direct investment vs. Foreign Institutional Investment

1.      Any investment in unlisted companies i.e. Companies not on stock exchanges is considered as F.D.I. But investment > 10% in listed companies is F.D.I and <10% is F.I.I / F.P.I [foreign portfolio investment].

2.      F.D.I is long term relation with the company and F.I.I is short term and anonymous.

3.      F.D.I is investment in equity instruments not debt instruments. F.I.I can’t invest in T-Bills; they can buy G-Secs of Rs.30 billion and corporate bonds Rs. 50 billion. Their investment can be in debt or equity.

Foreign exchange reserves:

The country foreign exchange reserves are the foreign exchange with the R.B.I, gold reserves with R.B.I, special drawing rights with I.M.F and reserve tranche with the I.M.F.

Exchange rates – the price of foreign currency in terms of domestic currency. This is also called the bilateral nominal exchange rate.

Real exchange rate – ratio of foreign to domestic prices measured in the same currency.

RER = e * P_f /P

E.g. A pen cost $4 in USA [P_f] and nominal exchange rate is Rs. 50 per dollar [e]. And the RER is 1. Then the pen should cost Rs. 200 [p] in India. If the RER is more than 1 it means price of goods abroad have become more expensive than at home. RER is taken as the measure of international competitiveness.

Nominal effective interest rate NEER and real effective exchange rate REER – it gives the movement of domestic currency relative to other currencies. It is a multilateral exchange rate representing price of a representative basket of foreign currency each weighted by its importance to India as a trade partner.

REER > 100 means overvalued currency and <100 means undervalued.

Floating exchange rates:

The exchange rate is determined by market forces of demand and supply.

Exchange rate of a country depreciates with respect to other if its inflation is higher than other. Similarly the demand for imports increase than exports its currency depreciates. When interest rates rise the currency at home appreciates.

However due to volatility countries prefer to have a “managed” floating exchange rate. Hence RBI buys or sells dollars from its reserve to prevent high volatility.

Fixed exchange rates or pegged exchange rate:

Bretton woods system of 1944 succeeded the gold standard system that was being followed from 19^th century to the outbreak of the WWI. All currencies were valued in terms of the gold they could purchase. Example, if 1 unit of currency A was worth 1 gram of gold and 1 unit of currency B was worth 2 grams then currency A was valued at half of currency B.

The Bretton woods system was established in 1944 along with the World Bank and the IMF. A two tier system of currency was established at the center of which was the dollar. The USA monetary authorities pegged the exchange rate at $35 per ounce of gold. The second tier of the system was the guarantee of each member of the IMF to convert their regional currency to the dollar at a fixed rate.

E.g.: the Indian rupee could be converted to dollar for Rs. 50 per dollar [fixed rate]. The dollar would be converted to one ounce of gold at $35 for 1 ounce. Thus Rs. 35*50 would be the price of 1 ounce of gold. USA was chosen as it had 70% of the worlds gold reserves.

Pros and cons of fixed rate system:

1. Good for trade as it promotes flexibility and predictability in exchange rates.
2. Since dollar was pegged to gold the USA wars in Vietnam, Korea reduced the value of dollar but gold price increased in the open market.
3. Gold could now be purchased at lower price from us and sold in market for higher price.

Fig 1: Exchange rates

Capital Gains Tax

It is a Direct tax which is levied on land [Except Agriculture land] , building factory, machinery, shares, debentures, mutual funds, jewellery, paintings, sculptures, archaeological items.

So if we buy a house for Rs. 1 crore and sell it for Rs. 2 crore then the gain on this transaction shall be charged i.e. Rs. 1 crore profit made by us. Capital Gains tax is paid by the buyer of the Asset. So in the given example the buyer of the house shall deduct the Capital gains tax from the price and pay to the government.

There are two types of Capital Gains Tax:

Short term: The tax shall be levied on Capital gains arising out of selling of the above items within 36 months of buying them.

Long term: The tax shall be levied on Capital gains arising out of selling of the above items after 36 months of buying them.

However for Shares, Debentures, Mutual funds etc. the short term capital gains tax is if these are sold within 12 months of purchase. Long term capital gains on these is not levied.

Miscellaneous

Business cycle has four stages:

1. Depression: Extremely low aggregate demand, low inflation, factories try to reduce production cost by labor cuts and so high unemployment.


2. Recovery: The economy tries to revive demand and production. The producers increase production and this creates more jobs and so employment increases and so does inflation.


3. Boom: This is the period when the economy is at its peak with high demand and high supply. Employment is also high and then we see a demand supply mismatch due to which inflation starts increasing.


4. Recession: In this we see the symptoms of depression but in lesser amount.


5. Growth recession: Here the economy is advancing but at a low pace such that more jobs are reduced than added.


6. Double dip recession: This is recession followed by a period of recovery and then again recession.

Abenomics:

PM of Japan coined this term and indicates the set of measures he took to recover the Japanese economy from recession.

Fiscal stimulus: Fiscal stimulus to increase investment in the field of infrastructure of both public and private sector.

Quantitative easing: The regulator maintains almost sub-zero rates of interest. This makes it easier to borrow money for investment and spending. This increases the cash in circulation and so also increase inflation and causes currency to depreciate. However inflation of up to 2% is good for the economy and so this measure is useful.

Structural reforms: These reforms aim at increasing the aggregate output of the economy to match the boosted demand.

Angel investors are those individuals who provide the initial support for an entrepreneur.

Rajiv Gandhi equity saving scheme is exclusively for first time retail investors. They shall get 50% of the amount invested in stocks of big companies as deduction in income tax. People who are first time investors in stock market and with income below Rs. 10 lakh are eligible only. This tax deduction is over the Rs. 1.5 lakh available for PPF, NPS etc.

When RBI purchases dollars it creates an infusion of rupees and the economy sees inflationary effects.

World bank publishes – International Debt Statistics

Special Economic Zone – SEZ

It is an industrial cluster meant for export promotion. These zones are marked as foreign territory only for purpose of trade operations, duties, tariff and have the best infrastructure and least red tape.

Features

1. The units have to become net foreign exchange earners in 3 years.


2. No routine checks by customs.


3. Full freedom in sub-contracting


4. Both manufacturing and services activities are allowed.


5. The SEZ has a non-processing areas where the infrastructure for supporting the activities of the SEZ like civic amenities and infrastructure shall come up.

UN Population divisions – World population prospects

World Bank – World development indicators

Effective revenue deficit – Revenue deficit excluding those revenue expenses which have been given for creation of capital assets.

Labor factor productivity – Measure of the active portion of an economy’s labor force.

Total factor productivity – Measures how productive the job actually is capturing technology used, efficiency with which job is carried out. This can be increased by moving labor force from low productive sectors like agriculture to highly productive sectors like manufacturing.

Mawlynnong, Meghalaya – Asia’s cleanest village.

MANAS – Scheme for upgrading entrepreneurial skills in minority youth.

Hamari Dharovar – A centrally sponsored scheme to preserve minority culture under overall concept of Indian culture.

Islamic banking – This is banking practised as per principles of Islam as stated in the Shariat. Interest is prohibited on loans and deposits. The depositors can’t get a guaranteed income or interest on their deposits. The banks can offer variable bonuses to depositors. The banks can also charge fees for the services that it offers. Banks lend money to clients by purchasing an item on his behalf and he agrees to repay the bank along with the agreed profit later on. Bank participates as a joint venture partner for clients that need investment capital and an agreement on profit sharing is made. The depositors share the risk of loss with the bank.

Liquidity trap – The situation where interest rates are so low that people prefer holding money than investing it.

The economies produce goods that have wear and tear. The rates of wear and tear “depreciation” are decided by the Ministry of Commerce and Industry.

Gross National Product = GDP + Income from abroad. This is always negative in India due to the high outflow from trade imbalance and repayment of loans taken from abroad. GNP indicates the internal and external strength of the economy (qualitative aspects of the economy) which GDP can’t measure and so is a better measure of National Income.

Net National Product is the National Income and when divided by the population gives the “Per Capita Income” of that nation.

Factor cost: input cost which the producer incurs at producing something or the factory price or production price.

Market cost: Indirect taxes are added to the factor cost.

Global Employment trends report is by International Labour Organization.

World tourism barometer is by the UN World Tourism Organization

Deposit insurance facility isn’t available to deposits kept in NBFC’s.

NBFC’s can’t issue current or savings accounts not can they issue cheques to customers.

Base rate is the rate below which the Scheduled Commercial Bank shall not lend to anyone. It replaced the Prime Lending rate or the Benchmark Prime Lending rate.

Bank of International Settlements is a central bank for central bankers. It is a private bank owned by central banks. It is today a meeting place for bank regulators of many countries and a multi-lateral regulatory authority. Basel-I norms of Capital adequacy ratio require banks to maintain a certain amount of free capital to their assets. So if a bank has loaned Rs. 100 it has to maintain free capital of Rs. 8 (CAR – 8%).

Brown label ATM’s are owned by a third party, non-banking firm but are operated by a bank and bear its logo. This bank handles the cash handling and server connectivity.

Central Sector schemes and Centrally sponsored schemes

Central sector schemes are 100% financed and implemented by the center and its agencies. These are areas which come under the Union list. The central sponsored schemes are financed by center and state in a ratio (50:50, 75:25, 90:10) but implementation is by states. These are schemes of the state list and the center funds them to ensure they are not neglected by states. Money is routed through State consolidated funds or directly to district / local authorities.

Central Plan assistance: The centre assists financially in the states five year plans.

1. Normal central assistance: It is made under Gadgil plan and is formula based. This is non-scheme based of the state government.


2. Additional central assistance: This is scheme based assistance and can be one time help for implementing state specific programs or advances given to states which are for help during financial stress and can be recovered in 10 years. Special category states also get a grant to bridge gap between planning needs and resources.

Special category states need (i) hilly and difficult terrain; (ii) low population density or sizeable share of tribal population; (iii) strategic location along borders with neighbouring countries; (iv) economic and infrastructural backwardness; and (v) non-viable nature of state finances. The decision to grant special category status lies with the National Development Council.

Definitions:

1. Inflationary gap: The excess of total government spending above the National Income


2. Deflationary gap: The shortfall in total government spending over the national income.


3. Inflation accounting: The firm calculates its profit after adjusting the effects of the current inflation levels.


4. Phillips curve: It represents the inverse relationship between inflation and unemployment. Thus lower inflation is higher unemployment and higher inflation is low unemployment.


5. Reflation: Situation brought about by government to reduce unemployment and increase demand by going for higher levels of growth.


6. Skewflation: It is price rise of a single or a small group of commodities over a sustained period of time.


7. Consumer Price index [industrial workers] – 260 items with base year 2001. The data is collected from 260 centers and is released with lag of 1 month. The data helps in the biannual revision of the dearness allowance to government employees. It is also used by the Pay Commissions to decide the wage increases.

Labour Bureau has been compiling CPI Numbers for Agricultural Labourers. This series of CPI Numbers was then replaced by CPI for (i) Agricultural and (ii) Rural Labourers with base 1986-87. CPI-AL is basically used for revising minimum wages for agricultural labour in different States.

1. Structural inflation: When an economy see rise in demand for goods but lack of invetible capital to create adequate supply we get structural inflation or bottleneck inflation. However when the economy saw higher spending it created inflationary pressure on the economy and then growth had to be sacrificed to reduce inflation.


2. Fiscal policy: The government was under continuous pressure to spend for development and so resorted to external borrowings. Later it depended more on deficit financing i.e. borrowing from Central banks by printing currency. Such a situation always creates more inflation, depreciating currency and lower savings rate and economic growth. Higher fiscal deficit creates more demand for funds pushing up interest rates.


3. Producer Price Index: PPI calculates the prices changes at the level of producers. Since any increase or decrease in the prices at the producers are passed on to the supply chain, this index can be an indicator of future price changes. PPI does not include taxes, trade margins or transport costs. This index is a better indicator of inflation as price changes at primary and intermediate stages can be tracked before they are built into the finished goods stages.

RBI conducts a quarterly “Household inflation expectation” survey.

H.D.I Levels

1. High HDI countries – 0.8 – 1.0


2. Medium HDI countries – 0.5 – 0.799


3. Low HDI countries – 0 – 0.499

Garibi hatao slogan was given to the sixth plan.

Monitor-able targets on the development indicators were given in the 10th plan. The plan also declared agriculture as the prime moving force of the economy.

Q.What is/are the purpose/purposes of the `Marginal Cost of Funds based Lending Rate (MCLR)’ announced by RBI?
1. These guidelines help improve the transparency in the methodology followed by banks for determining the interest rates on advances.
2. These guidelines help ensure availability of bank credit at interest rates which are fair to the borrowers as well as the banks.
Select the correct answer using the code given below. (UPSC CSAT 2016)

• 1 only




• 2 only




• Both 1 and 2




• Neither 1 nor 2

Ans . C

Q.The establishment of ‘Payment Banks’ is being allowed in India to promote financial inclusion. Which of the following statements is/are correct in this context?
1. Mobile telephone companies and supermarket chains that are owned and controlled by residents are eligible to be promoters of Payment Banks.
2. Payment Banks can issue both credit cards and debit cards.
3. Payment Banks cannot undertake lending activities.
Select the correct answer using the code given below. (UPSC CSAT 2016)

• 1 and 2 only




• 1 and 3 only




• 2 only




• 1, 2 and 3

Ans . B

1. Payment banks can’t issue credit card or give loans.

Q.The term ‘Core Banking Solutions’ is sometimes seen in the news. Which of the following statements best describes/describe this term?
1. It is a networking of a bank’s branches which enables customers to operate their accounts from any branch of the bank on its network regardless of where they open their accounts.
2. It is an effort to increase RBI’s control over commercial banks through computerization.
3. It is a detailed procedure by which a bank with huge non-performing assets is taken over by another bank.
Select the correct answer using the code given below. (UPSC CSAT 2016)

• 1 only




• 2 and 3 only




• 1 and 3 only




• 1, 2 and 3

Ans . A

Q.With reference to ‘Financial Stability and Development Council’, consider the following statements :
1. It is an organ of NITI Aayog.
2. It is headed by the Union Finance Minister.
3. It monitors macroprudential supervision of the economy.
Which of the statements given above is/are correct? (UPSC CSAT 2016)

• 1 and 2 only




• 3 only




• 2 and 3 only




• 1, 2 and 3

Ans . C

1. It falls under Dep. Of economic affairs and FM is the chairman.

Q.With reference to ‘Bitcoins’, sometimes seen in the news, which of the following statements is/are correct?
1. Bitcoins are tracked by the Central Banks of the countries.
2. Anyone with a Bitcoin address can send and receive Bitcoins from anyone else with a Bitcoin address.
3. Online payments can be sent without either side knowing the identity of the other.
Select the correct answer using the code given below. (UPSC CSAT 2016)

• 1 and 2 only




• 2 and 3 only




• 3 only




• 1, 2 and 3

Ans . B

1. They’re not tracked by any central bank or authority.

Q.Regarding ‘Atal Pension Yojana’, which of the following statements is/are correct?
1. It is a minimum guaranteed pension scheme mainly targeted at unorganized sector workers.
2. Only one member of a family can join the scheme.
3. Same amount of pension is guaranteed for the spouse for life after subscriber’s death.
Select the correct answer using the code given below. (UPSC CSAT 2016)

• 1 only




• 2 and 3 only




• 1 and 3 only




• 1, 2 and 3

Ans . C

Q.f the interest rate is decreased in an economy, it will (UPSC CSAT 2014)

• decrease the consumption expenditure in the economy




• increase the tax collection of the Government




• increase the investment expenditure in the economy




• increase the total savings in the economy

Ans . C

1. The relationship between interest rate and investment Expenditure is illustrated by the investment curve of the economy. The curve has downward slope, indicating that a drop in interest rate, causes the investment-spending to rise.