Economy Notes


India under the British Rule. 2

Inflation in India. 6

Monetary Policy of India. 6

Money Market. 13

Role of RBI 14

Nationalisation of Banks, July 1969. 15

Narsimhan Committee (1991). 15

Fiscal Policy of India. 17

Post 1991. 17

Fiscal Responsibility and Budgetary Management Act, 2003. 17

Pros. 19

Cons. 19

Evaluation. 20

Role of RBI 21

General Roles. 21

India Reforms Experience. 22

External Sector Reforms. 22

Financial Sector Reforms. 22

Financial Inclusion and Customer Services. 23

Prospects, Challenges and Strengths of the economy now.. 23

Indian Public Finance. 24

Value Added Tax. 24

State Finances. 24

Public Debt. 24

Planning in India. 26

Poverty. 27




India under the British Rule


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

  • Decline of Indian Handicrafts and progressive ruralisation of the Indian economy
  • Growth of the new land system and the commercialisation of Indian agriculture
  • Process of industrial transition of India

Decline of Handicrafts

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

Land System during 1793-1850

  • 1793: permanent settlement
  • Zamindari, Ryotwari, Mahalwari systems
  • Absentee landlordism emerged
  • The result of the whole change in the land system led to the emergence of subsistence agriculture
  • It helped the concentration of economic power in the hand of absentee landlords and moneylenders in rural India.

Commercialisation of Agriculture (1850-1947)

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

Industrial Transition in India

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

Forms and Consequences of Colonial Exploitation

  • Main forms of colonial exploitation
    • Exploitation through trade policies
    • Exploitation through export of British Capital to India
    • Exploitation through finance capital via the Managing agency system
    • Exploitation through the payments for the costs of the British administration
  • Exploitation through trade policies
    • Exp of cultivators to boost indigo export: forced
    • Exp of artisans by compulsory procurement by the Company at low prices: gomastas were the agents of the Company who used to do this
    • Exp through manipulation of export and import duties:
      • Imports of Indian printed cotton fabrics in England were banned
      • Heavy import duties on Indian manufactures and very nominal duties on British manufactures.
      • Discriminating protection was given (to industries that had to face competition from some country other than Britain). This was whittled down, however, by the clause of Imperial Preference under which imports from GB and exports to GB should enjoy the MFN status.
    • Exploitation through export of British Capital to India
      • There were three purposes of these investment (in transport and communication)
        • To build better access systems for exploited India’s natural resources
        • To provide a quick means of communication for maintaining law and order
        • To provide for quicker disbursal of British manufactures throughout the country and that raw materials could be easily procured
      • Fields of FDI
        • Economic overhead and infrastructure like railways, shippings, port, roads, communication
        • For promoting mining of resources
        • Commercial agriculture
        • Investment in consumer goods industries
        • Investments made in machine building, engineering industries and chemicals
      • Forms of investment
        • Direct private foreign investment
        • Sterling loans given to the British Government in India
      • Estimates show that foreign capital increased from 365 mn sterling in 1911 to 1000 mn sterling in 1933.
      • British multinationals were the chief instruments of exploitation and it were they who drained out the wealth of India.
      • These investments show that
        • British were interested in creating economic infrastructure to aid exploitation and resource drain
        • They invested in consumer goods and not in basic and heavy industries to prevent the development of Indian industries
        • Ownership and management of these companies lay in British hands
      • Exploitation through finance capital via the Managing agency system
        • Managing agency system: The British merchants who had earlier set up firms acted as pioneers and promoters in several industries like jute, tea and coal. These persons were called managing agents
        • It may be described as partnerships of companies formed by a group of individuals with strong financial resources and business experience
        • Functions of managing agents
          • To float new concerns
          • Arrange for finance
          • Act as agents for purchase of raw materials
          • Act as agents to market the produce
          • Manage the affairs of the business
        • They were important because they supplied finance to India when it was starved of capital
        • In due course, they started dictating the terms of the industry and business and became exploitative and inefficient
        • They demanded high percentage of profits. When refused they threatened to withdraw their finance
      • Exploitation through payments for the costs of British administration
        • British officers occupied high positions and were paid fabulous remunerations.
        • These expenditures were paid by India
        • They transferred their savings to Britain
        • India had to pay interest on Sterling Loans
        • India has to pay for the war expedition of the Company and later the Crown

Consequences of the exploitation

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

Drain Theory <take notes from History NCERT>

  • Dadabhai Naoroji: ‘Poverty in India’ (1876)
  • He claimed that the drain of wealth and capital from the country which started after 1757 was responsible for absence of development in India.
  • Drain was done through trade, industry and finance
  • Two elements of the drain
    • That arising from the remittances by European officials of their savings, and fro their expenditure in England
    • Arising from remittance by non-official Europeans
  • India has to export much more than she imported to meet the requirements of the economic drain
  • In 1880 it amounted to 4.14% of India’s national income
  • Consequences of the Drain
    • Prevented the process of capital formation in India
    • Through the drained wealth, the British established industrial concerns in India owned by British nationals
    • It acted as a drag on economic development


Inflation in India

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

Monetary Policy of India


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


Some background information

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

Evolution of MP

  • 1935: Proportional Reserve System
  • 1954: Minimum Reserve System
  • 1973-76: Minimum and maximum lending rates for bank loans prescribed
  • 1985: Flexible monetary targeting with feedback
  • 1998: Multiple indicator approach adopted

Divide MP into phases and study

Functions of RBI

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

Objective of MP

  • To catalyse economic growth: by ensuring adequate flow of credit to productive sectors
  • Price stability
  • After the financial crisis, achieving Financial Stability has emerged as an important objective. Exchange rate management can be yet another objective

Tools of MP

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

MP pre-reforms

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

MP post-reform

  • In the wake of the financial reforms, questions were raised about the appropriateness of this framework.
  • Working Group on Money Supply (1998)
    • Highlighted that the interest rate channel of transmission mechanism was gaining importance
  • On the recommendation of this working group, RBI shifted over to a multiple-indicator approach from 1998-9
  • Multiple Indicator Approach: Interest rates or rates of return in different markets (money, capital and g-sec), along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high-frequency basis, are juxtaposed with output data for drawing policy perspectives.
  • LAF: Another important feature post reform is the increased use of LAF. It has enabled RBI to modulate short-term liquidity under varied financial market conditions, including large capital inflows from abroad.
  • CRR: Reduced
  • 1992-93: market borrowing programme of the government was put through the auction process
  • SLR was brought down to its statutory minimum of 25 pc by Oct 1997 and 24 pc in 2010
  • CRR was brought down from 15 pc of NDTL of banks to 9.5 pc in Nov 1997 which has stabilised at 6 pc for a long time. Not bound by its statutory limit (lower) of 3 pc now.
  • Narsimhan Committee (1998) recommended reforms in the money market
    • RBI introduced LAF in 2000 to manage market liquidity on a daily basis and also to transmit interest rate signals to the market. In the post-reform period, LAF, with OMO, has emerged as the dominant instrument of MP, though CRR continued to be used as an additional instrument of policy.
    • Call money market was transformed into a pure inter-bank market by 2005.
    • With the introduction of prudential limits on borrowing and lending by banks in the call money market, the collateralized money market segments developed rapidly
  • To absorb the capital inflows in excess of the absorptive capacity of the economy MSS was introduced in 2004. Interestingly, in the face of reversal of capital flows during the recent crisis, unwinding of the sterilised liquidity under the MSS helped to ease liquidity conditions.
  • Increased Micro-finance: To strengthen rural finance RBI has focused on SHGs.
  • Fiscal Monetary Separation: Automatic monetization of deficit faced out since 1994. Thus it has separated the monetary policy from the fiscal policy.
  • Changed interest rate structure: Phased deregulation of lending rates in the credit market. Minimum lending rates had been abolished and lending rates above Rs. 2 lakh were freed. In 2010, the base rate mechanism was adopted. Savings rate was deregulated in 2011
  • Higher market orientation for banking: the banking sector got more autonomy and operational flexibility.


Challenges in the post-reform period

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


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

Evaluation of the changes in MP and Money Market

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

Changes in MP

Pre-reform Post-reform
Operating Target Reserve Money was used as the operating target in the monetary targeting framework until mid-1990s Multiple Indicator Approach
Monetary Policy Instruments CRR and SLR was heavily used Reliance on direct instruments has been reduced and liquidity management in the system is carried out through OMOs in the form of outright purchases of g-secs and daily repo and reverse repo operations under LAF. MSS also introduced.
Large capital inflows witnessed in recent years have posed a major challenge in the conduct of monetary and exchange rate management.
Phased deregulation of the interest rates
High SLR and CRR Low SLR and CRR


Money Market

  • RBI operationalises its monetary policy through its operations in government securities, foreign exchange and money markets
  • 1985: Money Market reforms begin
  • 1992: Introduction of auction system for government securities
  • 1996: Primary Dealer System initiated
  • 2002: Electronic trading and guaranteed settlement through CCIL for G-Sec starts
  • 2006: RBI expressly empowered to regulate money, forex, G-sec and gold related securities markets

Role of RBI

Pre-reform Post-reform
Developmental Role: the developmental role has increased in view of the changing structure of the economy with a focus on SMEs and financial inclusion Priority Sector Lending: Introduced from 1974 with public sector banks. Extended to all commercial banks by 1992 In the revised guidelines for PSL the thrust is on ensuring adequate flow of bank credit to those sectors that impact large segments of the population and weaker sections, and to the sectors which are employment intensive such as agriculture and small enterprises
Lead Bank Scheme Special Agricultural Credit Plan introduced.
Kisan Credit Card scheme (1998-99)
Focus on credit flow to micro, small and  medium enterprises development
Financial Inclusion
Monetary Policy: the role of RBI has changed from regulating credit and money flow directly to using market mechanisms for achieving policy targets. MP framework has changed to promote financial deregulations and market development. Role as a facilitator rather than as principal actor. M3 as an intermediary target Multiple Indicator Approach
Regulation of foreign exchange Management of foreign exchange
Direct credit control Open Market Operations, MSS, LAF
Rupee convertability highly managed Full current ac convertability and some capital account convertability
Banker to the government Monetary policy was linked to the fiscal policy due to automatic monetisation of the deficit Delinking of monetary policy from the fiscal policy. From 2006, under FRBM, RBI ceased to participate in the primary market auctions of the central government’s securities.
As regulator of financial sector: As regulator of the financial sector, RBI has faced the challenge of regulating the increasing financial sector in India. Credit flows have increased. RBI had to make sure that financial institutions are regulated in a way to protect the consumers while not impeding economic growth. Reduction in SLR
Custodian of FOREX reserves Forex reserves have increased drastically. Need to manage it adequately and avoid inflationary impact
Inflation Direct instruments were used Multiple indicators
Financial Stability Closed economy Increased FDI and FII has made financial stability one of the policy objectives.
Money Market Narsimhan Committee (1998) recommended reforms in the money market



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

Reforms and the banking sector

Nationalisation of Banks, July 1969

Why? Also, elaborate on the situation in 1969

  • To extend the reach of banks geographically
  • To extend reach of banks functionally to priority sectors. <directed credit>


Narsimhan Committee (1991)

Problems with the banking system:

Revenue Side

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

Expenditure Side

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




Fiscal Policy of India


Post 1991


Fiscal Responsibility and Budgetary Management Act, 2003

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

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

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

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

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

How are these targets monitored?
The Rules have mid-year targets for fiscal and revenue deficits. The Rules required the government to restrict fiscal and revenue deficit to 45% of budget estimates at the end of September (first half of the financial year).

In case of a breach of either of the two limits, the FM will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit.

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

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

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

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

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

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

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

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

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

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

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


The following points are worth notable of FRBM Act.

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

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

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

4) Government to annually reduce the revenue deficit by 0.5% and the fiscal deficit by 0.3% of GDP beginning fiscal 2004-2005

5) Elimination of Revenue deficit and reduction of fiscal deficit to 3% of GDP by March 31, 2009.

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

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

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

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

10) Under exceptional circumstances, Government may be compelled to fall short of the targets. In case of deviations, the Government would not only be required to take corrective measures, but the Finance Minister shall also make a statement in both the House of Parliament.

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

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

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



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


  • The revenue deficit of the government was to be initially wiped out by the end of March 2008; the deadline was extended thereafter
  • Fiscal deficit for 2009-10:
  • Revenue deficit for 2009-10:
  • It can be seen however from the table that there was considerable decline in the RD and FD after FRBM (expect for last two years which could be attributed to the financial crisis)
  • The revenue expenditure as pc of total expenditure increased from 77.14 pc in 2004-05 to 87.89 pc in 2009-10 (BE). Capital expenditure at the same time declined from 22.86 to 12.11. Similarly, for the states the share of capital expenditure has declined from 4.8 pc in 2004-05 to 3.8% in 2007-08.
  • There should be more dynamic sources of resource mobilisation
  • The focus deserves to be shift in favour of not the size of gross fiscal deficit but the productive purposes for which government deficits are incurred.
  • Increasing social expenditure will call for some pressure on the revenue deficit of the government which will have to be tolerated.
  • Fiscal rules could not have been adhered to in the 2009-10 budget in the milieu of the global meltdown.
  • For fiscal responsibility (Rangarajan and Subbarao: 2007)
    • There needs to be fiscal correction not just at the centre but also in the states
    • For sustaining and accelerating growth, achieving the FRBM targets is necessary, but not sufficient. It must, however, be borne in mind that sustained growth is an essential prerequisite for meeting the fiscal caps.
    • We need to pay attention to achieving the targets not only in quantitative terms but also with respect to the quality of adjustment.
  • Plug the inadequacies that have become evident in the Act since it was passed in 2003.


Deficit Indicators of centre as % of GDP

1985-90 1990-95 1995-2000 2000-2004 2004-07 2007-08 2008-09 2009-10 (BE)
Gross FD 7.7 6.3 5.5 5.5 3.9 2.7 6 6.8
Rev Def 2.4 3 3.1 4.1 2.3 1.1 4.4 4.8
Prim Def 4.5 2.2 1.1 0.9 0.1 0.9 2.5 3



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



Role of RBI


General Roles

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


Post 1991



India Reforms Experience

External Sector Reforms

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

Financial Sector Reforms

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

Financial Inclusion and Customer Services

  • No-frills account
  • Use of BC/BF models
  • Encouraging the use of ICT

Prospects, Challenges and Strengths of the economy now

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


Indian Public Finance

Value Added Tax

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

Goods and Services Tax

  • To be introduced from April 1, 2012

State Finances

  • Borrowing by the State governments is subordinated to prior approval by the national government <Article 293>
  • Furthermore, State Governments are not permitted to borrow externally unlike the centre.

Public Debt

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



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