Finance

New Exchange Rate Regime: Partial and Full Convertibility, Capital Account
Convertibility

Note: Capital account covers variety of financial flows, such as FDI, portfolio flows
(investment in equities and debt), and bank borrowing, all of which have in
common the acquisition of assets in one country by residents of another country.

There are no set benchmarks for measuring a country’s capital account openness-
the IMF maintains a list of each country’s capital account restrictions, but there’s
no way to quantify their ‘intensity’.

Current indicators:
 External debt to GDP: 23% (was 29% in 1991)
 Forex reserves to External debt: 70% (7% in 1991)

Until the early 1990s, India had very strict capital controls, which allowed for
monetary policy independence along with fixed exchange rates. Since 1993,
however, India substantially eased capital and current account restrictions, and
hence had to deal with increased money flows, meaning that exchange rate no
couldn’t be strictly fixed.

India’s exchange rate regime has been, on paper, one of market-determined

exchange rates. In reality, the RBI intervenes regularly in currency markets, and
the rupee is de-facto loosely pegged to the USD. The extent of the pegging does
vary according to market conditions, but is usually not allowed to fluctuate
wildly.This leads to some loss of monetary policy autonomy.

India currently has full convertibility of the rupee in current account, but for
capital account, there are ceilings, including on government debt, external
commercial borrowings, and equity.

Full Capital Account Convertibility (FCAC) allows local currency to be

exchanged for foreign currency without any restrictions on the amount. Although
CAC freely enables investment in the country, it also enables quick liquidation
and removal of capital assets from the country, both domestic and foreign. It also
exposes domestic creditors to overseas credit risks, fluctuations in fiscal policy,
and manipulation.

Reasons countries want to shield themselves from unbridled global capital flows:
 Stabilization of exchange rate
 If domestic banking systems are not well developed, exodus of domestic
savings to foreign countries
 Short-term capital flows can be reversed quickly, thereby adversely
affecting the macroeconomic situation of the country
 Controls allow for directing the flows towards more stable forms of
capital inflows, such as FDIs, rather than ‘hot money’ flows
Arguments in favor of capital account liberalization:

 Achieves optimum allocation of global financial resources; helps

attract foreign investment, and also allows domestic companies to
better tap foreign markets
 Allows EMEs to raise the level of capital formation above their
domestic savings rate
 Access to capital markets can allow countries to ‘insure’ themselves to
some extent against fluctuations in their national incomes such that
national consumption levels are relatively less volatile
 It can signal a country’s commitment to good economic policies. A
perceived deterioration in a country’s policy environment could result
in capital flight. This provides a strong incentive for policymakers to
maintain sound policies
 Inflows stemming from liberalization should also facilitate the transfer
of foreign technological and managerial know-how and encourage
competition and financial development, thereby promoting growth

What does the evidence say?

 The linkage between capital account liberalization and sustained high

growth is weak at best
 EMEs have not been able to use international financial markets effectively
to reduce consumption volatility; there is a significant pro-cyclical
element to international fund flows for such countries. Thus, investors
pull back in hard times, thereby deepening domestic crises
 Open capital accounts can lend a hand to imprudent fiscal policies, by
providing access to excessive external borrowing
 Open capital accounts along with efforts at maintaining a stable exchange
rate regime has led to macroeconomic crises; countries that have only
gradually eased capital account restrictions seem to have had overall
better outcomes
 One of the key pillars of the success and stability of East Asian
economies was that debt was largely domestically financed. This
allowed these countries to sustain high levels of leverage as well as
high levels of investments for a long time. Capital controls ensured
that external dependence was minimal. But once the capital account
was opened up, these economies became extremely vulnerable to
global funding shocks 

Nevertheless, sound domestic policies and institutions, a regulatory framework

that promotes a strong and efficient financial sector, and effective capital flow
monitoring systems greatly improve the chances of ensuring stable and
beneficial flows.

Before 2008, the IMF was overwhelmingly of the view that full capital account
openness and free exchange rates were necessarily a good thing. Since 2008,
however, there is an emerging consensus the world over that countries should
have sufficient tools at their disposal to tide over difficult times, and hence
capital account liberalization should be slow and well thought out.

Some questions for India to consider:

Should all inflows be made completely free? Currently, there are restrictions,
mainly in the form of limits on amounts invested by foreign investors in
government and corporate bonds. This is to promote financial stability. The
policy objective here should be to create domestic market conditions that will
minimize the potentially destabilizing effects of foreign investment. We need to
figure out if such conditions exist and can realistically be created; if not, some
prudence, in the form of caps, may continue to be justified

Critically, capital controls cannot go unless there is macroeconomic

stability, a healthy fiscal situation, and the inflation is low. India is a long
way away from this.In general, given the international experience, India should
keep prioritizing FDI as the preferred route for foreign investments into India,
and go slow on completely opening up the capital account.

Aside: Participatory notes-

 Participatory Notes commonly known as P-Notes or PNs are

instruments issued by registered foreign institutional investors (FII) to
overseas investors, who wish to invest in the Indian stock markets
without registering themselves with the market regulator (SEBI)
 They account for about 50% of all FII inflows
 Need:
 Anonymity: Any entity investing in participatory notes is not required
to register with SEBI (Securities and Exchange Board of India),
whereas all FIIs have to compulsorily get registered. It enables large
hedge funds to carry out their operations without disclosing their
identity
 Ease of Trading: Trading through participatory notes is easy because
participatory notes are like contract notes transferable by
endorsement and delivery
 Tax Saving: Some of the entities route their investment through
participatory notes to take advantage of the tax laws of certain
preferred countries
 Money Laundering: PNs are becoming a favorite with a host of Indian
money launderers who use them to first take funds out of country
through hawala and then get it back using PNs
 SEBI is not happy with P-Notes because it is not possible to know who
owns the underlying securities and hedge funds acting through PNs might
therefore cause volatility in the Indian markets

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 India’s capital account:

 Two benefits of financial openness- access to foreign capital, and
 development of local finance systems: The principal benefit of financial
openness for developing economies may not be access to foreign capital
that helps increase domestic investment by relaxing the constraint imposed
by a low level of domestic saving. Rather, the main benefits may be indirect
ones associated with openness to foreign capital, including the catalytic
effects of foreign finance on domestic financial market development,
enhanced discipline on macroeconomic policies, and improvements in
corporate governance as well as other aspects of institutional quality
 In recent years, the Reserve Bank of India (RBI) has taken what it calls a
calibrated approach to capital account liberalization, with certain types of
flows and particular classes of economic agents being prioritized in the
process of liberalization
 At this juncture, a more reasonable policy approach is to accept rising
financial openness as a reality and manage, rather than resist (or even try
to reverse), the process of fully liberalizing capital account transactions
 It is not advisable to remove all the restrictions on the capital account in
one broad sweep; rather, a steady progress towards a more open capital
account is needed
 Current evidence as to the impact of having an open capital account on
growth in inconclusive- however, it can be established that usually the
constraint to development in developing economies is not the lack of
domestic savings, but a lack of investments, which is caused by
underdeveloped financial systems. In this regard, an open capital account
can indirectly promote growth by aiding the development of local financial
systems, and hence promoting both domestic and international savings
 India has generally moved towards an open capital account when it comes
to two kinds of flows- FDI inflows and equity portfolio inflows. It has
maintained restrictions on debt flows, which is prudent, given that the
international experience shows that stocks of external debt liabilities are
more risky (I think this means that Indians can not buy debt abroad easily,
and foreigners cannot buy Indian debt easily, but I’m not certain). Evidence
also shows that for developing countries, the benefits to TFP flow from FDI
investments, and not from debt flows (debt flow is when an Indian
company issues debt shares abroad)
 The RBI has in fact eased a number of controls, both on inflows and
outflows. For instance, although capital outflows by individuals are in
principle still restricted, each individual is allowed to take up to $200,000
of capital out of India each year, a generous ceiling by any standards. The
restrictions on outflows by Indian corporates are even weaker. As for
inflows, FDI inflows into certain sectors such as retail and banking are
restricted, and foreign investors are not allowed to participate in the
government debt market. These restrictions are gradually being lifted.
Equity market investments are permitted by registered foreign
institutional investors (although there are limits on their ownership shares
in certain types of Indian firms), and those who do not wish to register can
invest only indirectly through an instrument called participatory notes,
which are tightly regulated by the government.
 Despite this, on relative scales, India’s financial openness ranks towards the
bottom of the pile when compared with other emerging market economies
 (and very much so when compared against the rest of the BRIC countries)
 India’s inflows are majorly composed of FDI and portfolio inflows; outflows
are overwhelmingly FDI, and minuscule portfolio flows
 Foreign investors are not allowed to invest in government debt markets =>
government doesn’t borrow from abroad, but only from domestic investors
 India is still a minor player in the global financial markets- in terms of FDI
inflows, we account for about 5% of total global glows; and about a similar
% of FDI outflows
 Recent global experience suggests that it might be unwise to hastily move
towards full capital account openness- India’s current strategy of
promoting FDI and portfolio flows and limiting debt flows seems to be
working well. However, with the rising integration via FDI and portfolios, it
is near- impossible to limit only certain kinds of flows (debt), and might
well prove impossible. It might thus be better to move towards more
openness, to leverage the indirect benefits (development of local financial
systems)
 In Budget 2015, it has been mentioned that the regulation making power
for equity-related capital flows will now move to the government, while the
RBI will continue to regulate other kinds of flow (primarily, FDI and debt
flows)

Fiscal Responsibility Act, Fiscal Consolidation

This was introduced in 2003, but scrapped in 2009 following the government’s
rising fiscal deficit following the 2007 financial crisis. The FRBM act was enacted
to:
 Introduce transparent fiscal management systems in India
 Introduce a more equitable and manageable distribution of the country’s
debts over the years
 Aim for fiscal stability for India in the long run

The main aim was to eliminate revenue deficit of the country, and bring down
the fiscal deficit to a manageable 3% of GDP by March 2008.

The average fiscal deficit numbers for a few periods are as follows:

Perio 1985- 1995 2004 2007 2008- 2009 2010 2011 2012- 2013-
d 94 -04 -07 -08 09 -10 -11 -12 13 14
Gross
Fiscal 7% 5.5 3.9 2.7 6 6.9 5.1 5.8 4.9 4.5
Deficit

Thus, it can be seen that before the FRBM act came into place, India’s fiscal deficit
was generally quite high, and the enactment of the act did lead to fiscal
consolidation till the financial crisis hit, and the compulsions of providing a
stimulus package for the economy again led to a widening fiscal deficit. The goal
for the current fiscal year is 4.1%, with the aim of reducing the FD to 3% by
2016-17.
However, while looking at the above table gives the impression that the FRBM
act was an unmitigated success, we need to see where the reduction in the
expenditure was coming from. In essence, there are three ways to reduce the
fiscal deficit: increasing the revenue receipts (generally possible via higher tax
receipts), decreasing revenue expenditure, or reducing capital expenditure.
While the first two are preferred ways to reduce FD, cutting down on CapEx is
easier, but hurts the economy (thereby hurting tax receipts as well), and also
social services expenditure in education and health.

Data shows that the structure of expenditure has worsened in the post-
FRBM phase, with a rising share of revenue expenditure and a falling share of
capital expenditure: share of revenue expenditure in the budget rose from 77%
in 2004 to 89% in 2008, and to xx in 2014-15. Although the fiscal deficit has been
reduced to 4.1% in the current budget, a large part of the decline comes from
declining capital expenditure.

A budget deficit emerging from capital expenditure is much less harmful than
when it emerges from current expenditure, because the latter means the
government has to borrow capital to fund consumption. This reduces the total
savings in the economy and puts pressure on prices. Borrowing for capex does
mean that the government’s over-presence in the debt market will push up
interest rates, but there is no reduction in savings and no pressure on prices.

Thus, the government should try and bring the revenue deficit to zero, but not by
cutting capital expenditure. So far, the gains that have been seen in recent fiscal
consolidation have come from robust economic growth and macroeconomic
stability, coupled with a tax structure based on reasonable rates, fewer
exemptions, and better compliance. The focus has not been on expenditure
restructuring, and that is what we need.

Going forward, we should focus on the following things:

1. Restructuring of expenditure composition
2. Institutional reform: Either instituting an autonomous Fiscal Council that
recommends ways towards fiscal consolidation to the government, or
increasing the current powers of the CAG so that it can play out this role.
3. Deficit reduction targets need not be insisted upon rigidly year to year,
but should be operated with some flexibility depending upon he
exigencies. A golden rule as in UK, i.e., borrowing only for capital
spending, should be instituted
4. Reporting requirements should be made more stringent
5. Escape clause must be tightened and penalties imposed for non-
compliance

Twelfth Finance Commission, Fiscal Federalism

In any federal fiscal system, resources are generally assigned more to the center,
while the states have larger responsibilities. This creates a vertical imbalance.
Also, different states within the union have different revenue-raising capabilities,
which results in horizontal imbalances. The constitution of India mandates the
creation of a Finance Commission every 5 years to suggest ways to correct these
two kinds of imbalances (vertical and horizontal).The role of the FC is generally
two-fold:
 Recommend how to split the total tax revenue accruing jointly to the
union and the states
 Recommend grants-in-aid depending on specific needs of different states
(these can be in the nature of budget support for state plans, block grants
under different sectoral heads (education, health, infrastructure, power,
roads, heritage conservation etc.), centrally planned schemes, part of
centrally sponsored schemes etc.)

While this has been the general trend of the job of FCs, the TFC’s ToRs included
another query- how to ensure fiscal consolidation in the country (i.e., how
to restructure public finances with a view to restore budgetary balances,
maintain macroeconomic stability, and bring about debt reduction along with
equitable growth)? This was something new, only included in the TFC’s
‘questions to answer’ list.

During the time of TFC’s drafting recommendations, the overview was that
almost all state governments had large debt burdens that translated into such
huge interest payments by state governments that they effectively couldn’t
undertake productive social expenditure, leading to deterioration in quality of
public services.

In this light, the major new recommendations of the TFC regarding fiscal
consolidation were as follows:

1. Macroeconomic stability:
i. Increase the combined center-state tax-GDP ratio to 17.6% by 2009-
10 (in 2015, the combined ratio stands at about 15%; and at about
10% only for the center)
ii. Fiscal deficit to GDP ratio for the center and the states must be fixed
at 3% of GDP each
iii. Each state should aim to enact a fiscal responsibility legislation, that
should provide for:
 Eliminating the revenue deficit
 Reducing fiscal deficit to 3% of GSDP

2. Debt relief:
i. Central loans to states outstanding in 2005 were to be consolidated
and given a fresh term of 20 years for repayment, at the rate of 7%
p.a.
ii. Repayments due from 2005-2010 would be waived off, conditional on
when and if the state government enacts the recommended fiscal
responsibility legislation

3. Borrowing by states:
i. Before the TFC, any state that wanted to borrow from commercial
banks had to take written approval from the RBI, and this wasn’t
 always granted; debt provided by multilateral institutes had to be
routed via the central government, which would impose a higher rate
as compared to the lending institution
ii. TFC recommended relaxing the prohibition on states hiring directly
from the market- the center would stop lending to the states, who
would now have to go to market to borrow. It was hoped that this
would inculcate fiscal discipline amongst the states, as they will have
to borrow at market-determined interest rates, and there will be no
expectation of bail-outs by the center
iii. External assistance (from WB, IMF, ADB etc.) was now to be
transferred to the states with no extra T&Cs imposed by the union
government over and above those imposed by the agencies
themselves; i.e., the union government would simply act as an
intermediary and not as a usurious lender
iv. Loan Council:The TFC also stressed the need to have an independent
body like the Loan Council to decide the borrowing limits for the
states and oversee their implementation

Criticisms:

1. The debt relief plan was confined only to a small % of the total debt of the
states

2. There was no real logic behind imposing the exact same numerical limit of
3% of GSDP as fiscal deficit for all states; there also needs to be a
distinction between borrowing for current consumption versus
borrowing for productive capital investments

3. Local Bodies: TFC did not make the local bodies a part of the
restructuring plan. The most important rationale of local governance is
the provision of certain basic services of standard quality at the local
level; while horizontal equity among various local bodies is primarily the
responsibility of SFCs, UFC also has some responsibility. Some stats on
finances of local bodies in India:
 Total expenditure of local bodies as a % of the combined
expenditure of union, state, and local bodies works out to be only
around 5% (as of 2002); in advanced countries, this is usually
around 20-35%
 Tax revenue of local bodies (as a % of local+state tax revenue) is
only about 2%
 Clearly, despite tall claims about decentralization, fiscal
decentralization in particular hasn’t made much progress in India

With regards to local body finances, some urgent steps required are as
follows:
 Building a reliable database of public finance datasets at the local
body level
 Need for real functional mapping and role clarity between state
government and various tiers of sub-state level governments
  Decentralization used to be one of the parameters used till the 11 th
Finance Commission for deciding devolution of funds; FFC did
away with this criteria. There might be some merit in bringing it
back

Fourteenth Finance Commission

Summary of recommendations:

1. 42% of total tax revenue to be devolved to the states:

 Factors for determining which state gets what share of tax revenue:
Population (1971- 17.5% weight; 2011- 10% weight), Area (15%),
Forest Cover (7.5%), Fiscal Capacity, measured as income distance,
which is the difference between the state’s per-capita income and the
per-capita income of the highest earning state in India (50%)

 Central transfers can be divided into the following two categories:

a. Transfers from the divisible pool of taxes (excludes cess etc.)

b. Grants-in-aid, covering grants recommended by the FC, and not the
ones that support state plans/ CCSs

Aside from these, center also does non-FC recommended transfers

that include grants for state-plan support, and grants to fund CCSs.
While the FC transfers are statutory and do not impinge on states’
fiscal autonomy, the other two kinds of grants described above are
tied to conditions/ sectors, and do impinge on fiscal federalism.

What this means for the overall transfers from the center to the
states is as follows:

Transfers as % of GDP (budget 2015/16) 2013/14 2015/16

Total transfers from center to states 5.55 5.95
Tax devolution 2.81 3.71
Grants (cumulating all three kinds of grants-
2.75 2.24
non-plan, state plan support, and CCS support)

Thus, as we can see, the increase in tax devolution is not revenue

neutral for the center- that is, the decline in grants-in-aid does not
cover the increase in tax devolution. This is inevitable, given that some
CCSs like MGNREGA are constitutionally mandated and need to be
funded no matter what.

2. Local governments:
 FFC has been quite generous in recommending a larger grant to local
governments (includes Panchayati Raj Institutions (PRIs) and Urban
Local Governments (ULGs)
  The allocation to local governments is over twice the amount
recommended by the 13th FC, and for ULGs it is nearly three times
relative to the 13th FC recommendations
 While there was a clamour by various state and local governments to
allocate at least 5% of the divisible pool to local governments, the 14th
FC has recommended a grant-in aid for local governments that is equal
to an estimated 3% of the divisible pool
 Distribution of LG grants to the states based on 2 factors: 2011
population (90% weight) and area (10%)
 Grant to each state should be divided into two; one part strictly for
gram panchayats, and the other only for municipalities; the division
should be on the basis of urban and rural population figures for the
states
 Grants for both these kinds of local bodies will be of two kinds: basic
grants (80-90%), and performance grants (10-20%) (rural-urban)
 The performance grant to urban local governments is to be given if
they fulfil three conditions – have their accounts audited, improve own
revenues, and publish service-level benchmarks
 The share of performance grants has been reduced from 35% in ThFC
 SFC to decide the sharing of grants within the state
 State and local governments should explore the possibility of issuing
municipal bonds as a source of finance
 Better accounting and reporting procedures at the LG level

REFORMING THE INDIAN FINANCIAL SYSTEM (Ajay Shah)

In the last decade, India’s domestic savings rate has increased from about 24% to
about 35%. In addition, gross capital formation by the private sector increased
from about 7% to 14% (2008-09 numbers). This implies that the Indian financial
system has grown to a significant size by any international standards, handling
about $400 billion of household savings and about $150 billion of private
corporate investments. However, the financial system still remains
underdeveloped, and even marginal improvements would significantly help
towards promoting growth. Some salient features of the Indian financial system
are as follows:

1. Financial Repression:
 Of the total debt issued by Government of India, only about 15% is held by
private individuals. The pubic sector financial institutions, such as banks,
insurance firms, and pension funds, are forced to hold the rest. The
government, thus, gets about 25% of banks’ assets, about 50% of insurers’
assets, and all of pension funds’ assets
 Banks, insurance companies and pension funds would be safer if their
assets were diversified internationally, including purchases of government
bonds of countries with lower credit risk than that of the Indian
government
 When investors voluntarily buy government bonds, the cost of financing
will reflect perceptions of fiscal stability. Through this, a subtle system of
 checks and balances will arise, nudging the government towards fiscal
prudence

2. Protectionism:
 There are very stringent restrictions on the banking business in India
 The beneficiaries of India’s protectionism in finance are the domestic
financial firms, who face reduced competition and are thus able to pay
elevated wages and generate elevated return on capital. The costs of this
regime are imposed upon households and firms, who obtain financial
services of inferior quality and elevated price
 Indian users of financial services – both households and firms – will benefit
from global standards of quality and pricing of financial services. Some
Indian firms would find it difficult to cope with competitive pressure, and
exit. But many firms would achieve high productivity, and go on to export
and build globalized businesses

3. Public Ownership:
 Roughly 80% of banking, 95% of insurance and 100% of pensions is held in
public sector financial firms
 At the same time, competitive dynamism is found in certain areas. The
barriers are the weakest with securities firms that seek to become
members of exchanges such as NSE and BSE, and with mutual funds. In
these two areas, India is de facto open to private or foreign firms that seek
to establish business. Unsurprisingly, these are also areas where creative
destruction is visible, with both entry and exit taking place every year.
 Government ownership of banks hampers financial development and
reduces economic growth
 One element of the difficulties associated with public ownership is poor in-
vestment decisions, coupled with claims upon the exchequer for
recapitalization
 Under the present legal arrangements in India, deposits with public sector
banks are guaranteed without limit by the government. Under difficult
conditions, such as the financial stress of late 2008, depositors have an
incentive to switch from private banks to public banks. Thus, even a small
presence of public sector banks with unlimited deposit insurance
exacerbates the risk faced by private banks and induces systemic risk

4. Central Planning:
 Government controls minute details of financial products and processes
 In this environment, the process of change is slow. If a financial firm gets an
idea for an improvement, it does not reap the benefits (of a short-term
advantage over rivals) since it has to go to the regulator for permission, and
that permission would be given for all firms symmetrically. Bereft of
incentive for experimentation and innovation, financial firms in India have
tended to become bureaucracies, merely manning unchanging systems
 Bureaucrats face asymmetric payoffs, where they can be penalized for
actions taken, or when scandals or crises take place. However, bureaucrats
pay no cost when the Indian economy suffers from a poorly performing
financial system
  In an ordinary market economy, competition between private firms (who
have the flexibility to experiment with new ideas) and internationalization
(which brings new ideas through foreign players) generates a steady pace
of change. In Indian finance, all these sources of change have been blocked

5. Regulatory and Legal Arrangements:

 Given that financial regulation in India is dispersed across multiple
agencies, and given the growing complexity of the financial system, better
coordination mechanisms are now called for (see FSLRC recommendations)

ECONOMIC IMPACT OF THESE FEATURES:

1. Suboptimal use of capital

2. Weak monetary policy transmission
3. Lack of financial inclusion
4. Greater systemic risk (adverse impact upon stability)

Financial Sector Legislative Reform Commission- Recommendations

Presently, the structure of regulatory bodies for financial sector in India is

somewhat haphazard- the existing regulatory bodies- RBI, IRDA, SEBI, FMC,
PFRDA- were not created as different parts of an organic whole, but instead their
responsibilities and jurisdictions have developed over time as a result of
piecemeal legislation, usually in response to pressures emanating from
particular incidents. There is, thus, a convoluted structure, significant gaps in
regulation, as also significant overlaps between the functions of various
regulatory bodies. Also, these regulatory bodies work in sector-specific silos,
and thus fail to take a system-wide bird’s eye view of the financial space in the
country.

To remedy this situation, the FSCLR has proposed a new, unified, non-sectoral
‘Indian Finance Code’ that aims to formulate a single, principle-based code for
financial regulators in India. That is, the code outlines certain basic principles, in
the basis of which regulations will be formed. These regulations can of course
change from time to time, based on current needs of the financial structure, but
the principles underlying these rules have to be as outlined in the IFC. These
principles are:

1. Consumer Protection: Make financial firms do more towards consumer

protection (Budget 2015 announced creation of the Financial Redress
Agency, which will be one-stop shop for all kinds of consumer queries/
complaints. So far, given the multiplicity of regulatory agencies, consumers
have often been treated as ‘footballs’, with no clarity on responsibility of
tending to their complaints. FRA is meant to correct this situation)
2. Micro-prudential regulation: Reduce failure probability of individual
financial firms, to ensure that they can follow up on the promises they
made to their consumers
 3. Resolution: Upon failure of firms, ensure quick resolution and winding
down of firms, while protecting interests of small consumers (Budget
2015 announced creation of the Resolution Corporation)
4. Managing systematic risk: Looking at the financial sector as a whole to
avoid undue risks (Budget 2015 announced creation of the Financial Data
Management Centre)
5. Monetary Policy: Create a Monetary Policy Committee at the RBI, move
towards an explicit inflation-targeting regime
6. Public Debt Management: Harmonize the government’s internal and
external obligations, which are currently scattered across the RBI and the
Ministry of Finance; divest RBI of its public debt management function,
and create an independent body for this purpose (Budget 2015 announced
creation of the Public Debt Management Agency, but this was subsequently
rolled back later)
7. Capital Controls: Commission gave no view regarding this
8. Contracts, trading, and market abuse(Budget 2015 announced the
creation of Financial Sector Appellate Tribunal)
9. Development, financial inclusion, and redistribution

The Ministry of Finance has issued a handbook detailing how these reforms are
to be implemented, and the handbook gives instructions to the 5 current
regulatory bodies. It is expected that the introduction of these reforms in the
Indian financial regulatory framework will lead to simpler and more coherent
regulations.

From the news

 Taxation in India:
 Union subjects (ICE-ICE-CT: Income, Customs, Excise – Inheritance,
Capital gains, Estates- Corporation, Transportation by air, rail, or sea)
 State subjects (LSV-LSV-EMP: Land, Stamp, Vehicles- Luxury
(entertainment, gambling, betting, amusement etc.), Sales, VAT (service tax)
– Electricity, Minerals, Professions)

 Minimum Alternative Tax:

 MAT is a way to make companies pay at least a minimum amount of tax
(18.5%)
 It is applicable to all companies (including foreign companies with income
sources in India) except those engaged in infrastructure and power sectors
 Reasons for MAT: The Indian Income-Tax Act allows a large number of
exemptions from total income. Besides exemptions, there are several
deductions permitted from the gross total income. As a result, a lot of
companies used to show considerable book profits, and distribute large
dividends, but were able to use these exemptions to pay close to zero tax.
These came to be known as ‘zero-tax’ companies. MAT was introduced to
counter this
  Tax incentives practically bring down the corporate tax rate, and the
average effective rate is around 23%, while many large corporates that are
investing heavily find the actual rate falls to much lower levels. This is the
reason why the government levies MAT on the book profits of companies at
18.5%, as the threshold below which the rate can’t fall
 There are rumors that the present government might scrap MAT. They
claim that the government is looking at gradually weeding out tax
exemptions and concurrently reducing the corporate tax rate, such that
MAT will become redundant
 Summary article here

 General Anti Avoidance Rules (GARR):

 GARR is an anti-tax avoidance rule which prevents tax evaders from
routing investments through tax havens like Mauritius, Luxemburg,
Switzerland
 Investors had maintained that the ambiguous language used in the draft of
the GAAR could lead to the misuse of the rule
 People adopt various methods so that they can reduce their total tax
liability. The methods adopted to reduce their tax liability can be broadly
put into four categories: Tax Evasion, Tax avoidance, Tax Mitigation, and
Tax Planning. GAAR provides to curb tax avoidance
 GAAR empowers the Revenue Authorities to deny the tax benefits of
transactions or arrangements which do not have any commercial substance
or consideration other than achieving the tax benefit. GAAR is intended to
target tax evaders, especially Indian companies and investors trying to
route investments through Mauritius or other tax havens in order to avoid
taxes. GAAR provides discretionary powers to revenue authorities to tax
impermissible avoidance arrangements. The arrangements as a whole or
aim part may be disregarded and tax benefit denied
 It was first mooted in 2011, but even in Budget 2015, it has been deferred
to 2017, given concerns of some investors who claim that the language
used in the rules might be detrimental to profits

 Goods and Services Tax:

 Read:
http://www.thehindu.com/opinion/op-ed/gst-good-for-business-snag-for-
federalism/article7279180.ece
 Originally recommended by the task force of the 13th Finance Commission,
which pegged the uniform tax rate at 12% (answer why this rate)
 Deliberation conducted by the Empowered Committee of State Finance
Ministers (who set up a Joint Working Group; members: Joint Secretaries of
Dept. of Revenue (Union FinMin) and all Finance Secretaries of the States,
Convenors: Advisor to the Union Finance Minister, Member-Secretary of
the Empowered Committee)
 Why the single rate?: Eliminates production inefficiencies, ensures no
single good is taxed disproportionately
 Consumption tax
 Value-Added Tax => (Output tax – Input tax) is paid to the government (tax
paid only on value added). VAT also follows the destination principle;
hence, the GST will not apply for export goods, but will apply to import
goods. Also, at every step of the production process, the producers get tax
credits, while the end consumer gets no tax credit
 Dual system: Will be imposed both by the center and the state, and will
replace all existing indirect taxes such as excise, sales, service taxes
 Benefits:
 Reduction in the number of taxes at the Central and state levels
 Cut in effective tax rate for many goods by removal of the current cascading
effect of taxes
 Reduction of transaction costs for taxpayers through simplified tax
compliance
 Increased tax collections due to wider tax base and better compliance
 Unification of India into a single market, eliminating the need for border
check posts to collect taxes on goods produced in one jurisdiction but sold
in another
 Good for consumer states
 Controversies:
 Both center and the states want certain high tax-revenue generating goods
(like petroleum, alcohol etc.) removed from the ambit of GST => reduces
tax base
 Some calculations of the revenue-neutral tax rate (post removal of certain
goods) are as high as 27% => incentive for evasion => little improvement in
compliance
 In the currently proposed dual structure, the tax might just be reduced to a
renaming of the existing Central Excise Tax and States’ VAT/ sales tax
 Transaction costs: government will need to make e-infrastructure (‘GST
Network’)
 Attention-diversion cost: other reforms sidelined
 Compromises India’s federal structure by not allowing states to set their
own rates => restricts the ability of states to determine the level of
spending on public goods and services locally
 Bad for states that produce a lot but don’t consume much
 Given that this is a Constitutional Amendment Bill, this cannot be passed
via a Joint Sitting
 Read Pangaria’s article
 In view of the impending changes with the introduction of GST, adequate
compensation to ULGs for their loss of income will need to be ensured. The
past experience has not been very good in this regard. Many state
governments, on abolition of octroi (a tax on entry of goods within the city
limits) and in some cases even property tax, had promised compensatory
grants to ULGs with an annual increase to maintain the buoyancy. However,
 compensation to local bodies has remained static and is often not released
in time

 GST Council: This will be the decision making body that will bring any
changes required to the GST Act. It will be composed of the Center and all
the states, with the center holding 33% of the voting rights, and the states,
67%. To get any changes approved in the operation of GST, 75% or more
votes will need to affirm it. That is, the center has a de-facto veto, whereas a
minimum of 12 states will need to come together to block any changes that
they don’t agree with

 Black Money:
 Estimates by old CBI chief: $500bn; by Swiss authorities: $2bn
 SIT instituted by Supreme Court in 2011 under MC Joshi (then chief of
CBDT)
 Recommends harsher sentences for tax offenders, potentially even making
tax avoidance above Rs. 50 lakh a criminal offense (currently it is a civil
offence)
 Key observations/ recommendations:
 Increase punishment under Prevention of Corruption Act and the Income
Tax Act
 Taxation is a highly specialised subject. Based on domain knowledge, set up
all-India judicial service and a National Tax Tribunal
 Like the USA Patriot Act, India should insist on entities operating in India to
report all global financial transactions above a threshold limit
 Consider introducing an amnesty scheme with reduced penalties and
immunity from prosecution to the people who bring back black money
from abroad
 Device specific regulations to check large scale possession and
transportation of cash, and curb large-scale ‘unreported’ cash dealings
 See the bill under ‘Constitution’ (GS2)

 Important: For recent SIT’s recommendations, see

http://www.insightsonindia.com/2015/05/13/7-a-recently-set-up-
special-investigative-team-sit-on-black-money-has-recommended-several-
measures-to-tackle-the-issue-of-black-money-circulation-in-its-three-
separate-reports-comment-on-the-impor/

 SEBI has come across quite a few cases where GDRs have been used for
round-tripping of funds in the name of capital-raising of listed companies
from abroad
 Undisclosed Foreign Income and Assets (Imposition of Tax) Bill, 2015
 Also known as “black money’ bill
 Provides for separate taxation of any undisclosed foreign income and
assets; such income will now not be taxed under the Income Tax Act
 It will apply to all residents of India
 Tax rate will be a flat 30%
 Proposes very stringent punishments; to the tune of 90% of the value of
undisclosed assets/ income, to three years of rigorous imprisonment

 Liberalized Remittance Scheme:

 The limit for individual remittances abroad has been raised to $250,000
p.a.
 There can be some concern about domestic investors investing more in
foreign equity markets; however, right now Indian stock market is giving
high returns, so might not be a cause for worry

 Micro Units Development and Refinance Agency (MUDRA) Bank:

 Set-up announced by budget 2015
 Initially, this will be a subsidiary of the Small Industries Development Bank
(SIDBI), and will later become and independent, full-fledged bank
 Important thing to note is that MUDRA bank will not be a lending bank, but
will refinance MFIs who are in the business of lending to small entities
 It will also lay down rules and policy guidelines for micro enterprise
financing businesses, registration, accreditation, and starting of MFIs
 This will be a bank to finance the setting up of small and micro-units and
thereby encourage entrepreneurship among SC/STs and OBCs (lending will
be preferentially given to these classes)
 It will regulate and refinance all MFIs that lend to micro/ small business
entities engaged in manufacturing, trading, and services activities
 Logic is to bridge the funding gap that affects the ‘middle’ – top corporates
are funded by the banking system, bottom of the ladder is funded by MFIs,
but the middle rung of micro and small enterprises suffers funding
problems
 According to government estimates, only 4% of 5.77% crore small business
units have access to institutional finance, leaving many to rely on informal
lender
 The bank will regulate MFIs, and lend to ‘last-mile lenders’ that will provide
financing to the businesses being targeted
 Ajay Shah calls this a ‘bad idea’: `Mudra bank' is an old style socialist
initiative, which is inconsistent with all the other modern elements of
financial sector reforms

 Restructuring Public Sector Banks (The Hindu, May 16):

 PSBs account for over 70% of all troubled assets in India’s banking sector
 3 sets of issues: governance (composition and functioning of the board),
management (selection of the CEO), and operational(resolution of NPAs,
infusion of capital by the government)
 Governance:Bank Boards Bureau (BBB) will be set up, and it will select
CEOs, Directors, and Chairmen. BBB will contain 3 former bankers, 2
eminent professionals, and the DoFS Secretary. The government must let
this BBB function independently
 Management: It has been decided that the office of the CMD will be split
into two different offices; this might lead to turf wars, and the actual
independent director being under the thumb of the political appointee
 Operations: The PSBs performed quite well after the bank reforms in 1993,
till about 2010. After that, their finances deteriorated for 2 reasons- they
got into infrastructure financing in a big way,and CEOs selections went
wrong in many places. Now, the government must help by adequate capital
infusion, rather than insisting on banks improving their performance
before they can access capital