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MS-03
ECONOMIC AND SOCIAL ENVIRONMENT
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Q1. Explain environment of business in detail and examine the interaction

between economic environment and business management giving suitable
examples.
Ans:

A business organization can not exist a vacuum. It needs living persons, natural resources and
places and things to exist. The sum of all these factors and forces is called the business
environment.

Business environment is of two types-

(i) Micro environment or the internal environment

(ii) Macro environment or the external environment

(i) Micro environment / Internal Environment of Business

Micro environment comprises of the factors in the immediate environment of the company that
affect the performance of the company. In includes the suppliers, competitors, Marketing
intermediaries, customers, pressure groups and the general public. Supplier form an important
factor of the micro environment of business as the importance of reliable sources of supply are
obvious. Supplier include the financial labor input. Stock holders, banks and other similar
organizations that supply money to the organization are also termed as suppliers. Managers always
strive to ensure a study flow of inputs at the lowest price. Customers are also an important factor in
the internal environment of business. The customers or the clients absorb the output of an
organization and a business exists to meet the demands of the customers. Customers could be
individuals, industries, government and other institutions. Labor force is also an important part of
the internal environment of business. Other than these the business associates, competitors,
regulatory agencies and the marketing intermediaries are also a part of the micro business
environment.

Macro environment / External environment of Business :

The forces and institutions out side of the organization that can potentially affect the performance
of the organization come under the external environment of Business. The macro environment of
business consist of the economic, demographic, natural, cultural and political forces. The external
environment of business is often categorized into the economic environment, political and
government environment, socio cultural environment and the international environment.

Economic Environment and Business Management

The economic environment in which a business operates has a great influence upon it. In this
lesson, you'll learn about the economic environment in business, including its various factors and
importance.
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The economic environment consists of external factors in a business' market and the broader
economy that can influence a business. You can divide the economic environment into the
microeconomic environment, which affects business decision making - such as individual actions of
firms and consumers - and the macroeconomic environment, which affects an entire economy and
all of its participants. Many economic factors act as external constraints on your business, which
means that you have little, if any, control over them. Let's take a look at both of these broad factors
in more detail.

Macroeconomic influences are broad economic factors that either directly or indirectly affect the
entire economy and all of its participants, including your business. These factors include such
things as:

 Interest rates
 Taxes
 Inflation
 Currency exchange rates
 Consumer discretionary income
 Savings rates
 Consumer confidence levels
 Unemployment rate
 Recession
 Depression

Microeconomic factors influence how your business will make decisions. Unlike macroeconomic
factors, these factors are far less broad in scope and do not necessarily affect the entire economy as
a whole. Microeconomic factors influencing a business include:

 Market size
 Demand
 Supply
 Competitors
 Suppliers
 Distribution chain, such as retailer stores

As discussed above, profits are central to the goals of a firm and managerial decision making. Thus,
to understand the theory of firm behavior properly, one must have a clear understanding of profits.
While the term profit is very widely used, an economist's definition of profit differs from the one
used by accountants (which is also usually used by the general public and the business community).
Profit in accounting is defined as the excess of sales revenue over the explicit accounting costs of
doing business. This surplus is available to the firm for various purposes.

An economist also defines profit as the difference between sales revenue and costs of doing
business, but includes more items in figuring costs, rather than considering only explicit accounting
costs. For example, inputs supplied by owners (including labor, capital, and space) are accounted
for in determining costs in the definition used by an economist. These costs are sometimes referred
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to as implicit costs—their value is imputed based on a notion of opportunity costs widely used by
economists. In other words, costs of inputs supplied by an owner are based on the values these
inputs would have received in the next best alternative activity. For illustration, assume that the
owner of the firm works for ten hours a day at his business. If the owner does not receive any
salary, an accountant would not consider the owner's effort as a cost item. An economist would,
however, value the owner's service to his firm at what his labor would have earned had he worked
elsewhere. Thus, to compute the true profit, an economist will subtract the implicit costs from
business profit; the resulting profit is often referred to as economic profit. It is this concept of profit
that is used by economists to explain the behavior of a firm. The concept of economic profit
essentially recognizes that owner-supplied inputs must also be paid for. Thus, the owner of a firm
will not be in business in the long run until he recovers the implicit costs (also known as normal
profit), in addition to recovering the explicit costs, of doing business.

As pointed out earlier, a given firm attempts to maximize profits. Other firms do the same.
Ultimately, profits decline for all firms. If all firms are operating under a competitive market
structure, in equilibrium, economic profits (the excess of accounting profits over implicit costs)
would be equal to zero; accounting profits (equal to explicit costs), however would be positive.
When a firm makes profits above the normal profits level, it is said to be reaping above-normal
profits.

PROFIT-MAXIMIZING POINT

A manufacturing Tata Steel Ltd. firm, motivated by profit maximization, calculates the total cost of
producing any given output level. The total cost is made up of total fixed cost (due to the
expenditure on fixed inputs) and total variable cost (due to the expenditure on variable inputs). Of
course, the total fixed cost does not vary over the short run—only the total variable cost does. It is
important for the firm to also calculate the cost per unit of output, called the average cost. In
addition to the average cost, the firm calculates the marginal cost. The marginal cost at any level of
output is the increase in the total cost due to an increase in production by one unit—essentially, the
marginal cost is the additional cost of producing the last unit of output.

The average cost is made up of two components: the average fixed cost (the total fixed cost
divided by the number of units of the output produced) and the average variable cost (the total
variable cost divided by the number of units of the output produced). As the fixed costs remain
fixed over the short run, the average fixed cost declines as the level of production increases. The
average variable cost, on the other hand, first decreases and then increases; economists refer to this
as the U-shaped nature of the average variable cost. The U-shape of the average variable cost curve
is explained as follows. Given the fixed inputs, output of the relevant product increases more than
proportionately as the levels of variable inputs used increase. This is caused by increased efficiency
due to specialization and other reasons. As more and more variable inputs are used in conjunction
with the given fixed inputs, however, efficiency gains reach a maximum—the decline in the average
variable cost eventually comes to a halt. After this point, the average variable cost starts increasing
as the level of production continues to increase, given the fixed inputs. First decreasing and then
increasing average variable cost lead to the U-shape for the average variable cost. The combination
of the declining average fixed cost (true for the entire range of production) and the U-shaped
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average variable cost results into an U-shaped behavior of the average total cost, often simply called
the average cost.

The marginal cost also displays a U-shaped pattern—it first decreases and then increases. The logic
for the shape of the marginal cost curve is similar to that for the average variable cost—both relate
to variable costs. But while the marginal cost refers to the increase in total variable cost due to an
increase in the production by one unit, the average variable cost refers to the average variable cost
per unit of output produced. It is important to notice, without going into finer details, that the
marginal cost curve intersects the average and the average variable cost curves at their minimum
cost points.

In a graphic rendering of this concept there would be a horizontal line, in addition to the three cost
curves. It is assumed that the firm can sell as many units as it wants at the given market price
indicated by this horizontal line. Essentially, the horizontal line is the demand curve a perfectly
competitive firm faces in the market—it can sell as many units of output as it deems profitable at
price "p" per unit (p, for example, can be $10 per unit of the product under consideration). In other
words, p is the firm's average revenue per unit of output. Since the firm receives p dollars for every
successive unit it sells, p is also the marginal revenue for the firm.

A firm maximizes profits, in general, when its marginal revenue equals marginal cost. If the firm
produces beyond this point of equality between the marginal revenue and marginal cost, the
marginal cost will be higher than the marginal revenue. In other words, the addition to total
production beyond the point where marginal revenue equals marginal cost, leads to lower, not
higher, profits. While every firm's primary motive is to maximize profits, its output decision
(consistent with the profit maximizing objective), depends on the structure of the market it is
operating under. Before we discuss important market structures, we briefly examine another key
economic concept, the theory of consumer behavior.

Q2. Evaluate the working and performance of public sector in India.

Ans:

The public sector, with more than 130 Government of India Undertakings today, occupies a
key position in the economy of the country. It has already grown into an industrial giant
with more than Rs. 20,000 crores of investment. About one-fourth of it fin the railways, but
steel, heavy electricals and oil industries also have a sizeable portion of the total
investment.

The private entrepreneurs are always in search of profit and this motive urges them to
move in fields where the returns are high and certain. In a developing country or in an
under-developed country, this tendency has many drawbacks. First, as more and more
capital is injected in to the same type of business, competition increases and with it the
costs go up. With increasing costs, prices also increase and markets arc hit. Second,
development in an under-developed country is usually lopsided and only in certain
directions. It is never equitably distributed over various regions of production.
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Consequently, people are seldom self-sufficient in respect of their needs and remain
virtually slaves to outside or foreign traders. Before the introduction of planning in India,
Indian businessmen put their money mainly in traditional business like jute and cotton, or
in iron and steel. Jute and cotton was pre¬ferred because of their greater demand in foreign
markets and iron and steel because of greater domestic potentialities. During the British
regime, industry in India was yoked to subserve the needs of the British overlords and was,
therefore, encouraged in branches or iieids which helped the British rulers. Even in those
lields industrial development was carried out in a haphazard manner. It was only when the
government entered the economic lields after independence and divided the country’s
economic activity in three fields, heavy and basic industries, concurrent in¬dustries and
private enterprise industries, that an all-round planned development was envisaged. The
government alone was of course not in a position to plan socially and adjust their actions to
make improvements, in all aspects of the citizen’s life so that social welfare and national as
well as per capita incomes could be maxi¬mised. One of the vital arguments in favour of the
public sector is that the government is better capable of controlling the greatest brains by
virtue of the stability and status that go with government jobs. The government also has at
it disposal the country’s resources, men and material, besides money It is the government
that can stand losses in one direction and cover them from gains hi another. Lastly, the
government can float an undertaking

on the principle of minimum profits, or on a no-loss basis. These activities fall beyond the
purview of private business enter¬prise and hence governmental undertakings in industry
are desirable^ oi- rather necessary, in an under-developed country. In other words, the
economy of such a country needs to be duly controlled and unless and until capital acquires
free movement and diverse channels to cater for highest tastes and improve the standards
ol living, a free economy in a country would not work well.

By any standards, the growth of the public sector in India lias been phenomenal, having by
now been able to invest its own productive assets, recruit and train its own staff and
manage¬ment and conceive and execute its own products. This record has justified the
people’s faith in the public sector as an instrument of national growth.

The public sector is playing a prominent role in a wide rauge oLindustries, including steel,
power generation, aircraft, computer and machine tools, coal, petroleum, copper,
aluminium, financial infra-structure consumer items and even films. Each year, the public
secter consolidates its gain, spreads out to new fields and sends shivers down the back of
the private sector.

Alongwith the increase in output and diversification1 of pro¬ducts has come a new outlook
in management and internal relations in the public sector. Better utilisation of installed
capacity, improved inventory and materials management, economy in the use of working
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capital,new monitoring systems, and quick handling to labour problems have inculcated* a
sense of belonging among the employees.

The public sector is now poised for a significant. break¬through. Since 1972-73, it has been
showing net profit. This may not have been commensurate with the huge investment, but
the future prospects are bright. In the year 1976-77 the Public , Sector has made a gross
profit of over Rs.400 crores.

fill now, the main profiteering concerns were commercial ones like the Indian Oil
Corporation, the Food Corportion of India and the State Trading Corporation. Now others,
like the Bharat Heavy Electricals, have also begun to show profit.

Though the concept of public sector was seriously initiated in 1956, it assumed a new
direction in 1969 when the then Prime Minister Mrs. Gandhi embarked on the path of
democratic advance.

At the beginning of the first plan, there were only 5 public sector undertakings with a total
investment of Rs. 290 million, their number increased to 74 at the end of the third plan
with a total investment of Rs. 28,410 million.Since the public sector helps to strength
economic independence of the country.

Apparently, some of these considerations have weighed with the Bureau of Public
Enterprises which is now considering a nine-point action plan for the speedy development
of managerial talent from within the enterprises for manning the top posts. The plan,
drawn up after discussions at a recent seminar, is intended to make the sector self-
sufficient in its managerial resources. The seminar has recommended a fuller utilisation of
the training facilities—part¬icularly those of the larger undertakings—within the sector
and not a proliferation of training institutes. This approach has the great merit of giving the
managers an insight into the peculiar problems of the sector as a whole, which would
facilitate inter-plant mobility. The seminar has also called upon the Bureau to institute a
standing advisory group on management training and development. This is a sector
measure long overdue and will go a long way in creating a public a management cadre in
the place of the novr defunct IMP.

Q3a) Describe the salient features of the protective policy adopted by

the government for Small Scale Industry (SSI).

Ans:

Salient features of the protective policy adopted by the government for

Small Scale Industry (SSI).
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Some of the Government Policies for development and promotion of Small-Scale Industries
in India are:

1. Industrial Policy Resolution (IPR) 1948,

2. Industrial Policy Resolution (IPR) 1956,

3. Industrial Policy Resolution (IPR) 1977,

4. Industrial Policy Resolution (IPR) 1980 and

5. Industrial Policy Resolution (IPR) 1990.

Since Independence, India has several Industrial Policies to her credit. So much so that
Lawrence A. Veit tempted to say that “if India has as much industry as it has industrial
policy, it would be a far well-to-do nation.” With this background in view, in what follows is
a review of India’s Industrial Policies for the development and promotion of small-scale
enterprises in the country.

1. Industrial Policy Resolution (IPR) 1948:

The IPR, 1948 for the first time, accepted the importance of small-scale industries in the
overall industrial development of the country. It was well realized that small-scale
industries are particularly suited for the utilization of local resources and for creation of
employment opportunities.

However, they have to face acute problems of raw materials, capital, skilled labour,
marketing, etc. since a long period of time. Therefore, emphasis was laid in the IPR, 1948
that these problems of small-scale enterprises should be solved by the Central Government
with the cooperation of the State Governments. In nutshell, the main thrust of IPR 1948, as
far as small-scale enterprises were concerned, was ‘protection.’

2. Industrial Policy Resolution (IPR) 1956:

The main contribution of the IPR 1948 was that it set in the nature and pattern of industrial
development in the country. The post-IPR 1948 period was marked by significant
developments taken place in the country. For example, planning has proceeded on an
organised manner and the First Five Year Plan 1951-56 had been completed. Industries
(Development and Regulation) Act, 1951 was also introduced to regulate and control
industries in the country.

The parliament had also accepted ‘the socialist pattern of society’ as the basic aim of social
and economic policy during this period. It was this background that the declaration of a
new industrial policy resolution seemed essential. This came in the form of IPR 1956.
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The IPR 1956 provided that along with continuing policy support to the small sector, it also
aimed at to ensure that decentralised sector acquires sufficient vitality to self-supporting
and its development is integrated with that of large- scale industry in the country. To
mention, some 128 items were reserved for exclusive production in the small-scale sector.

Besides, the Small-Scale Industries Board (SSIB) constituted a working group in 1959 to
examine and formulate a development plan for small-scale industries during the, Third Five
Year Plan, 1961-66. In the Third Five Year Plan period, specific developmental projects like
‘Rural Industries Projects’ and ‘Industrial Estates Projects’ were started to strengthen the
small-scale sector in the country. Thus, to the earlier emphasis of ‘protection’ was added
‘development.’ The IPR 1956 for small-scale industries aimed at “Protection plus
Development.” In a way, the IPR 1956 initiated the modem SSI in India.

3. Industrial Policy Resolution (IPR) 1977:

During the two decades after the IPR 1956, the economy witnessed lopsided industrial
development skewed in favour of large and medium sector, on the one hand, and increase
in unemployment, on the other. This situation led to a renewed emphasis on industrial
policy. This gave emergence to IPR 1977.

The Policy Statement categorically mentioned:

“The emphasis on industrial policy so far has been mainly on large industries, neglecting
cottage industries completely, relegating small industries to a minor role. The main thrust
of the new industrial policy will be on effective promotion of cottage and small-scale
industries widely dispersed in rural areas and small towns. It is the policy of the
Government that whatever can be produced by small and cottage industries must only be
so produced.”

The IPR 1977 accordingly classified small sector into three broad categories:

1. Cottage and Household Industries which provide self-employment on a large scale.

2. Tiny sector incorporating investment in industrial units in plant and machinery up to Rs.
1 lakh and situated in towns with a population of less than 50,000 according to 1971
Census.

3. Small-scale industries comprising of industrial units with an investment of upto Rs. 10

lakhs and in case of ancillary units with an investment up to Rs. 15 lakhs.

The measures suggested for the promotion of small-scale and cottage industries included:

(i) Reservation of 504 items for exclusive production in small-scale sector.

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(ii) Proposal to set up in each district an agency called ‘District Industry Centre’ (DIC) to
serve as a focal point of development for small-scale and cottage industries. The scheme of
DIC was introduced in May 1978. The main objective of setting up DICs was to promote
under a single roof all the services and support required by small and village
entrepreneurs.

What follows from above is that to the earlier thrust of protection (IPR 1948) and
development (IPR 1956), the IPR 1977 added ‘promotion’. As per this resolution, the small
sector was, thus, to be ‘protected, developed, and promoted.’

4. Industrial Policy Resolution (IPR) 1980:

The Government of India adopted a new Industrial Policy Resolution (IPR) on July 23,
1980. The main objective of IPR 1980 was defined as facilitating an increase in industrial
production through optimum utilization of installed capacity and expansion of industries.

As to the small sector, the resolution envisaged:

(i) Increase in investment ceilings from Rs. 1 lakh to Rs. 2 lakhs in case of tiny units, from
Rs. 10 lakhs to Rs. 20 lakhs in case of small-scale units and from Rs. 15 lakhs to Rs. 25 lakhs
in case of ancillaries.

(ii) Introduction of the concept of nucleus plants to replace the earlier scheme of the
District Industry Centres in each industrially backward district to promote the maximum
small-scale industries there.

(iii) Promotion of village and rural industries to generate economic viability in the villages
well compatible with the environment.

Thus, the IPR 1980 reimphasised the spirit of the IPR 1956. The small-scale sector still
remained the best sector for generating wage and self-employment based opportunities in
the country.

5. Industrial Policy Resolution (IPR) 1990:

The IPR 1990 was announced during June 1990. As to the small-scale sector, the resolution
continued to give increasing importance to small-scale enterprises to serve the objective of
employment generation.

The important elements included in the resolution to boost the development of small-scale
sector were as follows:

(i) The investment ceiling in plant and machinery for small-scale industries (fixed in 1985)
was raised from Rs. 35 lakhs to Rs. 60 lakhs and correspondingly, for ancillary units from
Rs. 45 lakhs to Rs. 75 lakhs.
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(ii) Investment ceiling for tiny units had been increased from Rs. 2 lakhs to Rs. 5 lakhs
provided the unit is located in an area having a population of 50,000 as per 1981 Census.

(iii) As many as 836 items were reserved for exclusive manufacture in small- scale sector.

(iv) A new scheme of Central Investment Subsidy exclusively for small-scale sector in rural
and backward areas capable of generating more employment at lower cost of capital had
been mooted and implemented.

(iv) With a view, to improve the competitiveness of the products manufactured in the
small-scale sector; programmes of technology up gradation will be implemented under the
umbrella of an apex Technology Development Centre in Small Industries Development
Organisation (SIDO).

(v) To ensure both adequate and timely flow of credit facilities for the small- scale
industries, a new apex bank known as ‘Small Industries Development Bank of India (SIDBI)’
was established in 1990.

(vi) Greater emphasis on training of women and youth under Entrepreneurship

Development Programme (EDP) and to establish a special cell in SIDO for this purpose.

(vii) Implementation of delicencing of all new units with investment of Rs. 25 crores in
fixed assets in non-backward areas and Rs. 75 crores in centrally notified backward areas.
Similarly, delicensing shall be implemented in the case of 100% Export Oriented Units
(EOU) set up in Export Processing Zones (EPZ) up to an investment ceiling of Rs. 75 lakhs.

Q3b) State the objective and achievements of administered price mechanism

Ans:

Mentioned below are some objectives of APM:

a) To optimize the utilisation of refining and marketing infrastructure by treating the

facilities of all oil companies as common industry infrastructure, the access of which
would be available to oil companies by hospitality arrangements, thus eliminating
wasteful duplication of investment.
b) To make available all products at uniform price ex-all refineries so as to minimise
cross-haulage of products and associated energy costs.
c) To ensure continuous availability of products/crude to refiners by recognising
import needs wherever there are deficits in indigenous production.
d) To ensure that the returns to oil companies are reasonable, in line with operational
efficiencies as also generation of sufficient resources to enable the industry to set up
facilities to meet the growing needs.
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e) To ensure stable prices by insulating domestic market from the volatility of prices in
the international market.
f) To achieve socio-economic objectives of the government by ensuring availability of
certain products at subsidised rates for weaker sections of the society and priority
sectors in the industry through cross-subsidisation of products.

Achievements of administered price mechanism

major achievement was the abolition of the special permission needed under the MRTP Act
for any investment by the so-called "large houses". This was an additional instrument of
control over large private companies or companies belonging to large groups, in addition to
industrial licensing. Its stated objective was to prevent "concentration of economic power"
but in practice it only served as another barrier to entry, reducing potential competition in
the system. Abolition of these controls has given Indian industry much greater freedom and
flexibility to expand existing capacity, or to set up new units in a location of their choice,
thus increasing the pressure of competition as well as the ability to face competition.

Major progress has also been made in opening up areas earlier reserved for the public
sector. At the start of the reforms 18 important industries, including iron and steel, heavy
plant and machinery, telecommunications and telecom equipment, mineral oils, mining of
various ores, air transport services, and electricity generation and distribution, were
reserved for the public sector. This list has been reduced to 6, covering industries as arms
and ammunition, atomic energy, mineral oils, atomic minerals and railway transport.
Because of this liberalisation, private investment including foreign investment has flowed
into areas such as steel, telephone services, telecommunications equipment, electricity
generation, petroleum etelecommunications equipment, electricity generation, petroleum
exploration development and refining, coal mining and air transport, none of which would
have been possible earlier because of public sector reservation.

An important area where decontrol domestic liberalisation has made very little progress is
relates to the the policy of reserving certain items for production in the small scale sector
defined in terms of a maximum permissible value of investment in plant and equipment.
The policy "protects" small scale units by barring the entry of larger units into reserved
areas also prevents existing small scale units from expanding beyond the maximum
permissible value of investment. India is unique in adopting reservation as an instrument
for promoting small scale producers and Thethe policy obviously entails efficiency losses
and imposes costs on consumers. Several committees have recommended various degrees
of dilution of the reservation policy. Most recently, an Expert Committee on Small
Enterprises set up in 1995, has recommended that reservation should be completely
abolished and efforts to support small scale producers should focus instead on positive
incentives and support measures. None of the governments in the post-reforms period has
been inclined to accept a drastic re-orientation of policy along these lines. The United Front
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Government in 1997 mitigated the rigours of reservation by raising the investment limit
for small scale industries from Rs.60 lakhs to Rs.3 crores. It also removed 15 items from the
reserved list. The successor BJP led government has announced the de-reservationed of
farm implements in 1998.

India’s performance in stabilising the economy was commendable by any standards. The
extent of the achievement can be appreciated only if we recall the severity of the crisis. The
surge in oil prices triggered by the Gulf War in 1990 imposed a severe strain on a balance
of payments already made fragile by several years of large fiscal deficits and increasing
external debt. Coming at a time of internal political instability, the balance of payments
problem quickly ballooned into a crisis of confidence which intensified in 1991 even
though oil prices quickly returned to normal levels. There was a flight of capital in the form
of withdrawal of non-resident deposits from the banking system and an unwillingness of
international banks to extend new loans. Foreign exchange reserves dropped to $1.2 billion
in June 1991, barely sufficient for two weeks of imports and a default on external payments
appeared imminent. The shortage of foreign exchange forced tightening of import
restrictions which in turn led to a fall in industrial output. In November 1991, the
gGovernment entered into a stand-by arrangement under which the IMF would provide $
2.3 billion over a two year period and there was a definite expectation on both sides that
the stand-by arrangement may need to be followed by recourse to the ESAF facility because
adjustment was expected to take longer than two years.

Q4a) Analyse the need for foreign capital for a developing country. Give illustrations

Ans:

Financial globalization and financial integration are, in principle, different concepts. Financial
globalization is an aggregate concept that refers to increasing global linkages created through
cross-

border financial flows. Financial integration refers to an individual country's linkages to

international capital markets. Clearly, these concepts are closely related. For instance, increasing
financial globalization is perforce associated with increasing financial integration on average. In
this paper, therefore, the two terms are used interchangeably.

Of more relevance for the purposes of this paper is the distinction between de jure financial
integration, which is associated with policies on capital account liberalization, and actual capital
flows. For example, indicator measures of the extent of government restrictions on capital flows
across national borders have been used extensively in the literature. On the one hand, using this
measure, many countries in Latin America would be considered closed to financial flows. On the
other hand, the volume of capital actually crossing the borders of these countries has been large
relative to the average volume of such flows for all developing countries. Therefore, on a de facto
basis, these Latin American countries are quite open to global financial flows. By contrast, some
countries in Africa have few formal restrictions on capital account transactions but have not
14 | P a g e MS-03 [Economic and Social Environment]

experienced significant capital flows. The analysis in this paper will focus largely on de facto
measures of financial integration, as it is virtually impossible to compare the efficacy of various
complex restrictions across countries. In the end, what matters most is the actual degree of
openness. However, the paper will also consider the relationship between de jure and de facto
measures.

A few salient features of global capital flows are relevant to the central themes of the paper. First,
the volume of cross-border capital flows has risen substantially in the last decade. There has been
not only a much greater volume of flows among industrial countries but also a surge in flows from
industrial to developing countries. Second, this surge in international capital flows to developing
countries is the outcome of both "pull" and "push" factors. Pull factors arise from changes in
policies and other aspects of opening up by developing countries. These include liberalization of
capital accounts and domestic stock markets, and large-scale privatization programs. Push factors
include business-cycle conditions and macroeconomic policy changes in industrial countries. From
a longer-term perspective, this latter set of factors includes the rise in the importance of
institutional investors in industrial countries and demographic changes (for example, the relative
aging of the population in industrial countries). The importance of these factors suggests that
notwithstanding temporary interruptions during crisis periods or global business-cycle downturns,
the past twenty years have been characterized by secular pressures for rising global capital flows to
the developing world.

Another important feature of international capital flows is that the components of these flows differ
markedly in terms of volatility. In particular, bank borrowing and portfolio flows are substantially
more volatile than foreign direct investment. Although accurate classification of capital flows is not
easy, evidence suggests that the composition of capital flows can have a significant influence on a
country's vulnerability to financial crises.

financial globalization can help developing countries to better manage output and consumption
volatility. Indeed, a variety of theories imply that the volatility of consumption relative to that of
output should decrease as the degree of financial integration increases; the essence of global
financial diversification is that a country is able to shift some of its income risk to world markets.
Since most developing countries are rather specialized in their output and factor endowment
structures, they can, in theory, obtain even bigger gains than developed countries through
international consumption risk sharing—that is, by effectively selling off a stake in their domestic
output in return for a stake in global output.

Although it is difficult to find a simple relationship between financial globalization and growth or
consumption volatility, there is some evidence of nonlinearities or threshold effects in the
relationship. Financial globalization, in combination with good macroeconomic policies and good
domestic governance, appears to be conducive to growth. For example, countries with good human
capital and governance tend to do better at attracting foreign direct investment (FDI), which is
especially conducive to growth. More specifically, recent research shows that corruption has a
strongly negative effect on FDI inflows. Similarly, transparency of government operations, which is
another dimension of good governance, has a strong positive effect on investment inflows from
international mutual funds.
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Q4b) Define Balance of Payments (BoP). Briefly discuss the significance and composition

of BoP.

Ans:

The balance of payments (BOP) of a country is the record of all economic transactions between the
residents of a country and the rest of the world in a particular period (over a quarter of a year or
more commonly over a year). These transactions are made by individuals, firms and government
bodies. Thus the balance of payments includes all external visible and non-visible transactions of a
country during a given period, usually a year. It represents a summation of country's current
demand and supply of the claims on foreign currencies and of foreign claims on its currency.

Balance of payments accounts are an accounting record of all monetary transactions between a
country and the rest of the world.These transactions include payments for the country's exports
and imports of goods, services, financial capital, and financial transfers. The BOP accounts
summarize international transactions for a specific period, usually a year, and are prepared in a
single currency, typically the domestic currency for the country concerned. Sources of funds for a
nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus
items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative
or deficit items.

When all components of the BOP accounts are included they must sum to zero with no overall
surplus or deficit. For example, if a country is importing more than it exports, its trade balance will
be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds
earned from its foreign investments, by running down central bank reserves or by receiving loans
from other countries.

While the overall BOP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current account, the capital
account excluding the central bank's reserve account, or the sum of the two. Imbalances in the
latter sum can result in surplus countries accumulating wealth, while deficit nations become
increasingly indebted. The term balance of payments often refers to this sum: a country's balance of
payments is said to be in surplus (equivalently, the balance of payments is positive) by a specific
amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as
paying for imported goods and paying for foreign bonds purchased) by that amount. There is said
to be a balance of payments deficit (the balance of payments is said to be negative) if the former are
less than the latter. A BOP surplus (or deficit) is accompanied by an accumulation (or
decumulation) of foreign exchange reserves by the central bank.

The significance and composition

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1. Trade Account Balance

It is the difference between exports and imports of goods, usually referred as visible or tangible
items. Till recently goods dominated international trade. Trade account balance tells as whether a
country enjoys a surplus or deficit on that account. An industrial country with its industrial
products comprising consumer and capital goods always had an advantageous position. Developing
countries with its export of primary goods had most of the time suffered from a deficit in their
balance of payments. Most of the OPEC countries are in better position on trade account balance.

The Balance of Trade is also referred as the 'Balance of Visible Trade' or 'Balance of Merchandise
Trade'.

2. Current Account Balance

It is difference between the receipts and payments on account of current account which includes
trade balance. The current account includes export of services, interests, profits, dividends and
unilateral receipts from abroad, and the import of services, interests, profits, dividends and
unilateral Payments to abroad. There can be either surplus or deficit in current account. The deficit
will take place when the debits are more than credits or when payments are more than receipts and
the current account surplus will take place when the credits are more than debits.

3. Capital Account Balance

It is difference between the receipts and payments on account of capital account. The capital
account involves inflows and outflows relating to investments, short tern borrowings/lending, and
medium term to long term borrowing/lending. There can be surplus or deficit in capital account.
The surplus will take place when the credits are more than debits and the deficit will take place
when the debits are more than credits.
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4. Foreign Exchange Reserves

Foreign exchange reserves (Check item No.9 in above figure) shows the reserves which are held in
the form of foreign currencies usually in hard currencies like dollar, pound etc., gold and Special
Drawing Rights (SDRs). Foreign exchange reserves are analogous to an individual's holding of cash.
They increase when the individual has a surplus in his transactions and decrease when he has a
deficit. When a country enjoys a net surplus both in current account & capital account, it increases
foreign exchange reserves. Whenever current account deficit exceeds the inflow in capital account,
foreign exchange from the reserve accounts is used to meet the deficit If a country's foreign
exchange reserves rise, that transaction is shown as minus in that country's balance of payments
accounts because money is been transferred to the foreign exchange reserves.

Foreign exchange reserves (forex) are used to meet the deficit in the balance of payments. The
entry is in the receipt side as we receive the forex for the particular year by reducing the balance
from the reserves. When surplus is transferred to the foreign exchange reserve, it is shown as
minus in that particular year's balance of payment account. The minus sign (-) indicates an increase
in forex and plus sign (+) shows the borrowing of foreign exchange from the forex account to meet
the deficit.

5. Errors and Omission

The errors may be due to statistical discrepancies & omission may be due to certain transactions
may not be recorded. For eg: A remittance by an Indian working abroad to India may not yet
recorded, or a payment of dividend abroad by an MNC operating in India may not yet recorded or
so on. The errors and omissions amount equals to the amount necessary to balance both the sides.

Q5. Briefly review the impact of economic reforms in India in terms of achievements and
failures.

Ans:

Impact of economic reforms in India in terms of achievements

1.1 India — achievements

1.1.1 Overall economic growth

In contrast to China, the sweeping economic reforms in the 1990s in India were not directed at
agriculture and growth in agriculture in India did not result in an immediate increase in growth in
either the rural or urban non-farm sector.

India's growth performance after independence until the 1960s was moderate, edging up slowly in
the 1970s and 1980s to about 5.5 percent per annum. After the 1991 reforms, however, growth has
been much faster: an annual average of 6.8 percent in 1992 to 1997 and 5.6 percent during 1997 to
2002. The average annual growth rate for the decade 1993 to 2004 was 6.2 percent. India's high
growth performance has therefore commenced later than China's, but appears to have reached
sustained high levels over the past 15 years.
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Much of the growth in the economy since the 1990s has centred on the services sector covering
communication services, hotels, restaurants, tourism, finance, insurance and real estate, including
information technology where outsourcing work to India has become a global phenomenon.
Growth of the primary and secondary sectors has not fared as well: Regulations and infrastructural
bottlenecks restrict growth in these sectors. The dramatic success in information technology stands
in contrast to the rest of the economy and in particular the agriculture sector. As with China, so also
with India rural-urban and regional income disparities have widened. The solution seems to lie in
large measure in removing the constraints to growth in the industrial and agriculture sectors, a
process that is now underway.

1.1.2 Growth in agricultural production and productivity

Prior to the mid-1960s India relied on imports and food aid to meet domestic requirements.
However, two years of severe drought in 1965 and 1966 convinced the Indian leadership that they
could not rely on foreign imports for food security. Consequently, they adopted significant policy
reforms focused in particular on the production of cereal grains, and concomitantly, the goal of
foodgrain self-sufficiency that has shaped Indian agricultural policy ever since (Gulati et al. 2005).

India's Green Revolution began with the decision to import seeds of high-yielding varieties of wheat
and large scale adaptive research. The initial increase in production was centred on the irrigated
areas of the Punjab, Haryana and western Uttar Pradesh. Total foodgrain production soared and by
the early 1970s India became self-sufficient. Gulati et al. (2005) attributes this success to the price
incentives provided to farmers, the dynamism of the national research system and the availability
of credit and inputs such as improved seeds, canal irrigation and fertilizer. The success of this
coordinated approach demonstrated that even in a country as diverse as India, the government can
play an important role in setting the agriculture sector on a high growth path.

The Green Revolution technology spread to rice and, using tubewells, to other parts of India. When
gains from the new technology reached their limits in the states of initial adoption, the technology
spread in the 1970s and 1980s to the states of eastern India — Bihar, Orissa and West Bengal. But
the benefits of the new technology extended principally to the irrigated areas which account for
about one-third of the harvested crop area. In the 1980s the policy also shifted to "evolution of a
production pattern in line with the demand pattern" leading to a shift in emphasis to other
agricultural commodities like oilseed, fruit and vegetables. Impressive strides were also made in
other subsectors such as dairying, fisheries and livestock, and meeting the diversified food needs of
the growing population.

1.1.3 Poverty reduction

Beginning in the late 1960s there was a significant decline in poverty. From the late 1970s to the
late 1980s the poverty ratio fell from 51 to 39 percent (based on India's official poverty line), due
largely to gains in agricultural production and productivity. One difficulty that India faces is the
unequal distribution of landholdings and the large landless population mentioned earlier. As a
result, further reductions in rural poverty depend on the continuing shift of labour out of
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agriculture. There are also significant regional variations within India, such as between states or
between districts. The drop in the proportion of the population below the dollar-a-day poverty
index from 42 percent in 1990 to 34 percent in 2002 seems to have been largely due to the growth
of the industrial and service sectors. Yet due to fairly rapid population growth, absolute numbers in
poverty increased from 351 to 357 million3.

1.1.4 Food security

India achieved national food security and there were several positive developments associated with
the Green Revolution period. Per capita availability of food increased as did per capita generation of
income. Indian agriculture became much more insulated from the effects of drought. There was
greater commercialization and diversification of cropping patterns from foodgrains to higher value
crops, even for small and marginal farmers. There were also improvements in the livestock and
fisheries sector. Consumption patterns also changed, even for the bottom 30 percent of the
population, with the shares of non-cereal food (fruit and vegetables, dairy products) increasing.
Nonetheless, food security and hunger remain a problem particularly in rural areas and in less-
advanced states.

Economic reforms in India in terms of failures

One, slow infrastructure development. Almost all indicators score poorly if one looks at India's
infrastructure compared to countries such as China. Power shortage is perennial and this is one of
the singlebiggest constraints for growth. However, there are some positives during the 11th Plan.
And, in the 12th Plan, of the projected investment of $1 trillion, 47% is expected to be from private
sector.

Not surprisingly, the index of infrastructure across states is highly correlated with per-capita
income and level of poverty. IFPRI's study on India showed that public expenditure on roads has
better impact on poverty compared to antipoverty programmes.

Two, failure to raise labour-intensive manufacturing. In the postreform period, the share of
manufacturing in total employment remained virtually stagnant at 11-12%. In 2010, India
accounted for 1.4% of the world manufacturing exports against China's share of a whopping 15%.

Reforms since 1991 have not been comprehensive enough to remove the bias towards capital and
skill-intensive industries. Also, input markets such as land and labour are riddled with distortions.

Productivity of SMEs and unorganised sector manufacturing has to be enhanced. The role of
agriculture in structural change is not by increasing employment, but through enhancing farm
output. Services and manufacturing have a complementary role.

Three, sluggish progress in education and skill levels of workers. Not taking advantage of
demographic dividend is one of the failures. The draft 12th Plan quotes Prime Minister Manmohan
Singh as saying the young population is an asset only if it is educated, skilled and finds productive
employment.
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Even in 2009-10, around 52% of total workers were either illiterate or had been educated only up
to primary level.

Overall, 10% of the workforce in the age group of 15-59 years received some form of vocational
training. Vast majority of workers have non-formal vocational training. There are huge challenges
in raising education and skills of workers.

Four, slow social sector development. Although there have been achievements in social sector
during the reform period, the progress has been very slow. If we compare 1993-94 to 2009-10, the
rate of decline in poverty for India stood at around 0.97% per annum; inequality increased; poverty
reduction was slower for STs.

In the recent short period 2004-05 to 2009-10, there were improvements: the rate of decline in
poverty was faster at 1.5% per annum; the rate of decline in poverty for SCs and STs was higher
than for all; and inequalities in rural areas declined slightly but increased in urban areas. However,
in the longer period, one expected much more progress in all these indicators.

India has failed to show progress in social indicators or the Millennium Development Goals
including environment. We are not only behind China but the progress is slower than in
Bangladesh.

One study published in India Development Report 2012-13 estimated inequality-adjusted human
development index: it shows the cost of inequality HDI is 32%.

The loss due to inequality is the highest in education dimension (43%), followed by health (34%)
and income (16%). There is a debate about progress of human development in Gujarat and Kerala.
Although there have been improvements in Gujarat, it has to go a long way in raising human
development.

And five, governance failure. Reforms were expected to improve governance at various levels.
However, there are new problems in governance and persistence of old problems including
corruption.

A study on performance of Karnataka's Lokayukta suggests that without overhaul of the country's
administrative structure, ex-post prosecution of corruption or withdrawal from economic activities
cannot reduce corruption.

At present, the design of anti-corruption ombudsman leaves a lot to the personality of Lokayukta.
The analysis also suggests that the overburdened legal system needs reforms.

Bimal Jalan, former Governor of the Reserve Bank of India, and many others feel that problem of
governance is the biggest constraint to achieve our development goals in the country. Fixing this
problem is important for success of the above four issues also.
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