1. Fiscal and monetary policies are the two main policies through which demand and

growth can be increased and prices can be stabilized.

2. Fiscal policy (FP henceforth) is declared by the Ministry of Finance, Govt. of India

(MoF, GOI) whereas the monetary policy (MP henceforth) is under the control of the

Reserve Bank of India.

3. Whereas the immediate goals of FP connect to growth issues, the MP tries to achieve

a tightrope walk between supporting growth on one hand and controlling inflation on

the other.

4. The FP is basically declared through the Union Budget, which is typically presented

on two accounts. These are Revenue Account and the Capital Account.

5. Big ticket revenue account income items include taxes (only Union taxes) whereas

expense items are interest payments, salary bills and subsidies.

6. CENVAT, service tax, customs duties, income and wealth tax are some of the well

known Union taxes.

7. Taxes can be viewed as direct and indirect taxes.

8. Direct taxes are those in which the entity on whom the tax is levied is also the entity

that bears the burden of the tax. Indirect taxes can be pushed from the point of levy to

some other entity that bears the burden of the tax.

9. Indirect taxes cannot be avoided (they feed into the price of a product and so you

automatically pay taxes as you buy goods) and hence are big revenue earners for the

Government.

10. In terms of indirect taxes, CENVAT is the biggest earner. It is the new avatar of

“excise duties”, which were output based taxes

11. An excise is a tax on production. Every time the truck leaves the godowns with

goods, the goods are subjected to payment of excise.

12. An output comprises of inputs and value added. An output based tax hence is a tax on

input and VA. The more the input moves in the value chain, it gets taxed again and

again, which is unfair.

13. Output based taxes lead to “tax cascadation”. They are unfair since they cause

multiple taxation and also increase the price of the commodity higher than what it

could be.

14. Hence, India moved her systems to “Value Added Taxes”. VAT is the name of a

platform or system on which taxes are levied.

15. Service tax is also on a VAT system currently.

16. For payment of taxes, companies have to prove the value added by them by showing

input and output invoices. Hence, VAT framework has encouraged a movement

towards invoicing in India.

17. When companies buy inputs, they automatically pay taxes on the same. When they

sell output, they collect taxes from their client. Before depositing this with the

Government, they can claim a “set off” for their input taxes and hence land up

depositing only the net amount which is the tax on “value added”.

18. Currently, a seller of goods can only claim a set off against the taxes paid on goods

bought by him i.e. he cannot claim a set off against the taxes paid on services

purchased by him.

19. CENVAT rates are different from service tax rates as well.

20. Very soon, India will be on the Goods and Service Tax (GST) platform, on which it is

possible for a goods manufacturer to seamlessly claim a set off on goods tax collected

against service tax paid.

21. The chief 3 subsidy heads in India are food, fuel and fertilizers.

22. The biggest entry on the revenue account expenditure side is interest payments.

23. A deficit on the revenue account is treated to be bad news because it means that the

current income of the Government is not even enough to take care of current

expenses, let alone creating infrastructure from it.

24. The capital account income items include disinvestment proceeds and borrowings

from the RBI and the non-RBI sources.

25. The expense items on the capital account include spendings on infrastructure,

defense, R&D, health, education etc.

26. Ideally the flow should be from Revenue account to Capital account and not the other

way. The income items on the capital account should be used in creation of new

assets.

27. These proceedings should not be used to fund deficit on revenue account. With this

view the Infrastructure fund was created in 1997 to restrict the movement from

capital account to revenue account.

28. It is believed that in order to arrive at the overall “fiscal” deficit of the economy,

borrowings (from both RBI and non-RBI sources) should not be treated as “income”

and hence should not be clubbed together with tax receipts, disinvestment proceeds

etc.

29. Hence, fiscal deficit is the overall deficit as reflected in the budget, with the debt-

creating items on the capital account excluded from being counted as an income for

the GOI.

30. The fiscal deficit hence indicates the total borrowing requirements of the GOI.

31. To the extent that these borrowings are raised from the “market” i.e. non-RBI

sources, it implies that the funds move away from the private sector to the GOI.

32. Thus, market borrowings change the composition of debt, but not the total volume of

liquidity.

33. However increased market borrowings can also result in crowding out of private

investments.

34. On the other hand, to the extent that the GOI borrows directly from the RBI, the RBI

has to “monetize” this deficit by printing of money. This is referred to as deficit

financing.

35. Whilst deficit financing is important because GOI projects would not get completed

without it, it also can create inflationary stimuli in an economic system.

36. However, it is important to remember that creating more money is not always

harmful. Money finally creates demand and so, in a system, where demand is

lackluster, the Central Bank probably would want to support the fiscal programmes

through monetization, and not through market borrowing.

37. In a system with already high inflation (India 2010 is a case in point), monetization

however may land up worsening the inflation issue at hand.

38. The RBI thus has to carefully evaluate the current growth and inflation trends and

then advise the GOI on how much fiscal deficit will be tolerable for the economy and

most importantly, how this deficit is to be funded.

39. When the RBI creates money, it creates liabilities for itself, which have to be

supported by assets such as Govt. paper (T-Bills, G-secs), gold and FOREX reserves.

40. When the GOI runs into a deficit, it issues bonds called as Treasury Bills and

Government securities.

41. These bonds are subscribed to by the market and the RBI.

42. When the RBI subscribes to these bonds, the RBI is giving a loan to the GOI i.e. the

bonds held by the RBI as assets are used to create monetary liabilities i.e. money

supply.

43. Similarly, when more FOREX enters the country (this may happen because exports

are greater than imports or because of Foreign Direct Investment (FDI), Foreign

Institutional Investors (FII) or External Commercial Borrowings (ECB) inflows

received by Indian Govt. and non-Govt. entities), equivalent amount of rupees are

released into the system by the RBI. Thus, monetary liabilities are created against

FOREX asset backing.

44. This implies that while FOREX inflows are good, excessive inflows may affect the

inflation quotient in the economy.

45. If too much money supply is created, it can create too much demand and hence,

inflation. Hence the RBI uses certain tools of monetary policy (such as CRR, SLR and

OMOs) to control the inflation.

46. It is useful to remember that the RBI only uses demand management tools.

47. This means that whenever the RBI sees inflation, it tries to control demand and there

through control inflation.

48. Demand can be controlled if the interest rates offered by the banking system increase.

As the lending rates increase, it automatically becomes expensive for consumers to

buy cars or houses, thus softening the demand for these goods.

49. As lending rates shoot up, businesses too may keep expansion plans on hold. New

plans too may be unviable under higher costs of funds. All this implies that consumer

driven and business driven demand softens, thereby reigning in inflation.

50. Thus, the RBI tries to create high interest rate environments during inflation and soft

interest rate environments during recessions (when it wants to create demand).

51. How can the RBI influence the interest rate offered by banks?

52. Cash Reserve Ratio (CRR) are the cash reserves that commercial banks have to

maintain with the RBI. When the CRR is hiked up, more reserves are locked with the

RBI and hence the amount of liquidity that banks have with it is reduced. This

automatically means that the supply of funds with the banks dries up and so banks

increase interest rates.

53. During recessions, however, the CRR will be reduced.

54. The Statutory Liquidity Ratio (SLR) is the percent of bank deposits that bankers hold

in cash, current account balances with other commercial banks and eligible Govt.

bonds.

55. If SLR is hiked up, it again locks up bank funds in Govt. paper, leaving less for the

private sector, hence leading to interest rate hikes and control of demand and

inflation.

56. Thus, a hike in SLR does help to control inflation.

57. But at the same time, a hike in SLR, also changes the composition of bank debt away

from the private sector towards the GOI. Thus, on one hand, SLR is an inflation

control tool and on the other, it is a tool to create a ready market for Govt. bonds.

This implies that the market absorbs more of Govt. bonds, thereby reducing the

pressure on the RBI to monetize the deficit.

58. Open Market Operations (OMOs) by the RBI entail buying and selling of Govt.

bonds by the RBI. Under inflationary conditions, the RBI starts selling bonds, thereby

mopping up excess liquidity from the banks. Under recessionary trends, it buys

bonds, thereby easing liquidity into the banks and markets.

59. The RBI does the job of not only creating a debt market for the GOI, but nurturing the

market and smoothing liquidity conditions constantly.

60. Roles and functions of the RBI:

a. Sole authority of note issue

b. Banker to the GOI

c. Banker to the banks

d. Controller of credit and inflation through tools of monetary policy

e. Official custodian of FOREX reserves

61. When the RBI acts as a banker to the GOI, it advises the GOI on the demand

conditions in the market for Treasury Bills and G-secs. It auctions the T-Bills at a

discount. Govt. bonds are treated as “liquid” securities because the RBI stands ready

to buy these back from the FIs at all times. By declaring certain issues to be “repo-

eligible” or “repoable” securities, it creates a demand for these. When the bonds come

up for redemption, that too is handled by the RBI. If redemption is not possible, then

the RBI carries out bond market transactions such as a “swap” or a “strip”. A swap

happens when a short term bond is switched into a long term maturity instrument

thereby postponing redemption. A strip happens when a long term bond is converted

into several smaller face value bonds of shorter maturity.

62. In its capacity as a banker to banks, RBI is the lender of the last resort. It is

responsible for scrutiny and compliance related issues of the banks. It has created

frameworks such as the call money market, the Collateralized Borrowing and

Lending Obligations (CBLO) market and the repo market, wherein commercial banks

can place their funds for very short maturities. It itself is a player in all these markets.

Repo rate is the rate at which banks borrow from the RBI. Banks sell repoable G-secs

at a discount to the RBI with a promise to repurchase it back at the face value. By

changing the repo, the RBI can change the cost of funds for banks, thereby affecting

the day to day liquidity conditions in the markets.

63. CRR is pure credit control tool.

64. SLR is used for both credit control and liquidity management

65. SLR also acts as an indicator. An increase/decrease in SLR indicates whether RBI

wants to suck/infuse liquidity. A decrease in SLR also indicates that RBI wants to

prevent crowding out.

66. Reasons why banks subscribe to bonds:

a> Banks have to comply with statutory liquid requirements. As banks

receive incremental deposits their statutory liquid requirements also

increase. Hence, there is always a demand for fresh issue of bonds.

b> There exists a secondary market for G-secs and T-bills.

c> These bonds are risk free.

d> In a recessionary environment when private sector has low credit

requirement, banks have large exposure to GOI bonds.

e> Certain bonds are ‘repoable’. Banks need such bonds as collateral for repo

transaction.