Unit 4

Monetary And Fiscal Policy

Concept of Monetary policy

• Monetary policy refers to the use of instruments within the control of the Central Bank to influence the level of aggregate demand for goods and services or to influence the trends in certain sectors of economy.

• Monetary policy operates through varying the cost and availability of credit, these producing desired changes in the assets pattern of credit institutions principally commercial banks.

• These variations affect the demand for, and the supply of credit in the economy, and the level and nature of economic activities.

Monetary policy and Money Supply

• Money supply comprises currency with the public and demand deposits. Both the monetary and fiscal policies can affect money supply.

• The budgetary operations of the Government considerable affect the money supply. If the Government meets its budgetary deficits by borrowing from the Reserve Bank, there will be an increase in money supply.

• Another source of variation in money supply, over which the RBI influence is restricted, is the country’s international payments position.

• Demand deposits are a very important determinant of money supply. In advanced countries demand deposits form a major part of money supply.

• Commercial banking instrument so control operate by varying the cost and availability of credit, and these produce desired changed in the assets pattern of credit institutions, principally commercial banks.

Instruments of Monetary Policy

1. General (Quantitative) methods2. Selective (Qualitative) methods

General Credit Controls:

1. Bank Rate Policy: The Bank Rate, also known as the Discount Rate, is the oldest instrument of monetary policy. The traditional definition of Bank Rate is that it is the rate at which the central bank discounts or, more accurately, rediscounts-eligible bills.

2. Open Market operations: Open market operations refer broadly to the purchase and sale by the Central Bank of a variety of assets such as foreign exchange, gold, Government securities and even company shares.

3. Variable Reserve Ratios: Commercial banks in every country maintain, either by the requirement of law by or custom, a certain percentage of their deposits in the form of balances with the central bank.

• Cash Reserve Ratio: The RBI is empowered to vary the cash reserve ratio between 3 per cent and 15 per cent of the total demand and time liabilities.

In March 2001, the Reserve Bank of India cut the CRR by half a percentage to 7.5 per cent and this was estimated to release over Rs. 4000 crore to the economy.

• SLR: The Banking Regulation Act has been amended, requiring all banks to maintain a minimum amount of liquid assets which shall not be less than a certain specified percentage of their demand and time liabilities in India, exclusive of the cash balances maintained under Section 42 of the Reserve Bank of India Act in the case of schedule banks, and exclusive of the cash balances maintained under Section 18 of the Banking Regulation Act of non scheduled banks.

Selective Credit Regulation:

Selective and qualitative credit control refers to regulation of credit for specific purposes or branches of economic activity. Selective controls relate to the distribution or direction of available credit supplies

The Banking Regulation Act confers on the RBI to give directions To commercial banks

a) The purpose for which advances may or may not be madeb) The margin to be maintained in respect of secured advances.c) The maximum amount of advances or other financial accommodation which,

having regard to the paid-up capital, reserves .d) The maximum amount up to which having regard to the considerations

referred to in clause(c) guarantees may be given by a banking co. on behalf of any one company, firm

1. Moral Suasion: In addition to the above mentioned methods of credit control, both quantitative and qualitative, it may be noted that the use has also been made in this country of moral suasion.

Fiscal Policy

• Fiscal policy is that part of Government policy which is concerned with raising revenue through taxation and other means and deciding on the level and pattern of expenditure.

• The fiscal policy operates through the budget. The Budget is an estimate of government expenditure and revenue for the ensuing financial year, presented to Parliament usually by the Finance Minister. Occasionally, in times of financial crisis, interim Budgets may be introduced later in the year to increase taxation, expenditures, etc.

The Union Budget

• The Constitution of India provides that-1. No tax can be levied or collected except by

authority of law.2. No expenditure can be incurred for public funds

except in the manner provided in the constitution.3. The executive authorities must spend public

money only in the manner sectioned by Parliament in the case of the Union and by the State legislature in the case of a State

Cont…

• An estimate of all anticipate revenue and expenditure of the Union Government for ensuing financial year is laid before Parliament on the last working day of February every year. This known as the Annual Financial Statement or the Budget

The Structure of Budget

• The Budget is divided vertically into revenue (receipts) expenditure (disbursements). Horizontally, it is divided into revenue account and capital account. The receipts are, thus, broken up into Revenue Receipts and Capital Receipts; and disbursements are broken up into Revenue Expenditure and Capital Expenditure.

• The revenue expenditure includes all current expenditure of the Government on administration, and the capital expenditure includes all the capital transactions of the Government.

• The revenue receipts include revenue from taxes, while capital receipts include market loans, external aid, income from repayments and other receipts, such as income from public

Finances of the Union

• Examples of Sources of Revenue for the Union1. Taxes on income2. Duties and customs3. Duties of excise on tobacco4. Estate Duty in respect of property5. Duty in respect of succession of property

• Examples of sources of Revenue for the State1. Land revenue, including the assessment and

collection of revenue.2. Taxes on agricultural income.3. Duties in respect of succession to

agricultural lands.4. Taxes on building and land

• Concurrent List:1. Stamp duties other than duties or fees

collected by means of judicial stamps but including rates of stamp duty.

2. Fees in respect of any of the matters in this list but no including fees taken in any court.

Importance of the Budget

• The Budget should set the stage for the achievement of economic and social goals.

• In India, today, about a half of the GDP is channeled into the Government sector by the Union, State and UT Budgets and disbursed by the Union, State and UT Govt. under various development and non development heads. These indicate the development and distributive importance and implications of the Budgetary operations

• In India the Budget policy aha to serve the following purposes:

1. Accelerate the pace of economic development by mobilizing resource for the public sector and their optimal allocation;

2. Effect improvement in production in the private sector in accordance with the national priorities;

3. Effect Improvements I income distribution;4. Promote exports and encourage import substitution and 5. Achieve economic stabilization

Financial Market Structure

Financial Market

Structure

Credit Market

Money Market

Capital market

Foreign exchange

market

Debt market

Derivatives market

Credit markets

• The credit market is the predominant source of finance. As the Indian capital market is relatively underdeveloped, firms or economic entities depend largely on financial intermediaries for their fund requirements.

• The major institutional surveyors of credit in India are banks and non banking financial institutions, i.e., development financial institutions (DFI) and other financial institutions (FI) and non banking financial companies(NBFC)

Banks

• An important development in the financial sector in the recent years has been the diversification and growth of para banking activities such as, leasing, hire purchase, factoring, etc.

• Merchant Banking is an important area where subsidiaries of banks have made their presence felt (stock market)

• The dealing in government securities is another area where banks have been fairly active, Venture capital , housing finance, credit card business.

• Regulations: There is a shared responsibility between the Reserve Bank and SEBI in the regulation of para banking activities of banks.

Financial Institutions

• A large variety of financial institutions has come into existence over the years to perform a variety of financial activities.

• All India development banks (IDBI, IFCI, ICICI, SIDBI) occupy an important position in the financial system as the main source of medium and long term project finance to industry.

• Besides, specialized financial institutions are also operating in the areas of export import (EXIM Bank), NABARD, UTI for investment in mutual fund

Non Banking Financial Companies (NBFC)

• NBFC are financial intermediaries engaged primarily in the business of accepting deposits and making loans and advances, investments, leasing, hire purchase, etc. for example Nidhi’s and chit funds

Housing Finance Companies

• The formal segment of housing finance includes funding provided by the Central and State Governments and funds from financial institutions like GIC, LIC, commercial banks and specialized housing finance institutions .

• The National Housing Bank Act, 1988, as a wholly owned subsidiary of the Reserve Bank.

• NHB regulates HFCs, refinance their operations and expands the spread of housing finance to different income groups.

Foreign Exchange Market

• The foreign exchange market in India comprises customers, authorized dealers and the Reserve Bank

PART I. INTRODUCTION

A . The Currency Market:where money

denominated in one currency is bought and

sold with money denominated in another currency.

INTRODUCTION

B. International Trade and Capital Transactions:

- facilitated with the ability

to transfer purchasing power

between countries

INTRODUCTION

C. Location1. no specific

location2. Most trades by phone,

telex, or through internet (online trading)

PART II.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKETA. Participants at 2 Levels

1. Wholesale Level (95%)- major banks

2. Retail Level- business customers.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Two Types of Currency Markets

1. Spot Market:- immediate transaction- recorded by 2nd

business day


2. Forward Market:- transactions take place at a specified future date


C. Participants by Market1. Spot Market

a. commercial banksb. brokersc. customers of commercial

and central banks


2. Forward Marketa. arbitrageursb. tradersc. hedgersd. speculators


CLEARING SYSTEMSA. Clearing House Interbank Payments System (CHIPS)

- used in U.S. for electronic fund transfers.


SIZE OF THE MARKET

A. Largest in the world

1995: $1.2 trillion daily


B. Market Centers (1995): London = $464 billion

dailyNew York= $244 billion

dailyTokyo = $161 billion

daily

PART III.THE SPOT MARKET

I. SPOT QUOTATIONSA. Sources

1. All major newspapers2. Major currencies have four different quotes:

a. spot priceb. 30-dayc. 90-dayd. 180-day

THE SPOT MARKET

E.Currency Arbitrage1. If cross rates differ from

one financial center to another, and profit opportunities exist.

THE SPOT MARKET

2. Buy cheap in one int’l market,sell at a higher price in

another

3. Role of Available Information

THE SPOT MARKET

F. Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of original transaction.

PART III.THE FORWARD MARKET

I. INTRODUCTIONA. Definition of a Forward Contract

an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

THE FORWARD MARKET

2. Purpose of a Forward:

Hedging

the act of reducing exchange

rate risk.

THE FORWARD MARKET

C. Forward Contract Maturities1. Contract Terms

a. 30-dayb. 90-dayc. 180-dayd. 360-day

2. Longer-term Contracts

MARKET

The debt market is any market situation where trading debt instruments take place.

Examples of debt instruments include mortgages, promissory notes, bonds, and Certificates of Deposit

A debt market establishes a structured environment where these types of debt can be traded with ease between interested parties.

INTRODUCTION

The debt market often goes by other names, based on the types of debt instruments that are tradedIn the event that the market deals mainly with the trading of corporate bond issues, the debt market may be known as a bond market.

If mortgages and notes are the main focus of the trading, the debt market may be known as a credit market

When fixed rates are connected with the debt instruments, the market may be known as a fixed income market.

CLASSIFIACTION OF INDIAN DEBT MARKET

Government Securities Market (G-Sec Market): It consists of central and state government securities. It means that, loans are being taken by the central and state government. It is also the most dominant category in the India debt market.

Bond Market: It consists of Financial Institutions bonds, Corporate bonds and Public Sector Units bonds. These bonds are issued to meet financial requirements at a fixed cost and hence remove uncertainty in financial costs.

DEBT INSTRUMENTS

Government Securities

Corporate Bonds

Certificate of Deposit

Commercial Papers

Government Securities

It is the Reserve Bank of India that issues Government Securities or G-Secs on behalf of the Government of India.These securities have a maturity period of 1 to 30 years. G-Secs offer fixed interest rate, where interests are payable semi-annually.

For shorter term, there are Treasury Bills or T-Bills, which are issued by the RBI for 91 days, 182 days and 364 days

Corporate Bonds

These bonds come from PSUs and private corporations and are offered for an extensive range of tenures up to 15 years.

Comparing to G-Secs, corporate bonds carry higher risks, which depend upon the corporation, the industry where the corporation is currently operating, the current market conditions, and the rating of the corporation

Certificate of Deposit

Certificate of Deposits (CDs), which usually offer higher returns than Bank term deposits, are issued in demat form Banks can offer CDs which have maturity between 7 days and 1 year. CDs from financial institutions have maturity between 1 and 3 years

Commercial Papers

There are short term securities with maturity of 7 to 365 days.

Structured Debt

structured debt is some type of debt instrument that the lender has created and adapted to fit the needs and circumstances of the borrower

.

Gilt FundsThe Reserve Bank also encouraged setting up of mutual funds dealing exclusively in gilts, called gilt funds with a view to encouraging schemes of mutual funds dedicated to Government securities.

MONEY MARKET

1! What is Money Market?

As per RBI definitions “ A market for short terms financial assets that are close substitute for money, facilitates the exchange of money in primary and secondary market”.

• The money market is a mechanism that deals with the lending and borrowing of short term funds (less than one year).

• A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded.

Continued…….

• It doesn’t actually deal in cash or money but deals with substitute of cash like trade bills, promissory notes & govt papers which can converted into cash without any loss at low transaction cost.

• It includes all individual, institution and intermediaries.

Structure of Indian Money Market?

I :- ORGANISED STRUCTURE 1. Reserve bank of India. 2. DFHI (discount and finance house of India).

3. Commercial banks i. Public sector banks SBI with 7 subsidiaries Cooperative banks 20 nationalised banks ii. Private banks Indian Banks Foreign banks4. Development bank IDBI, IFCI, ICICI, NABARD, LIC, GIC, UTI etc.

Continued…..

II. UNORGANISED SECTOR 1. Indigenous banks 2 Money lenders 3. Chits 4. Nidhis

III. CO-OPERATIVE SECTOR 1. State cooperative i. central cooperative banks Primary Agri credit societies Primary urban banks 2. State Land development banks central land development banks Primary land development banks

Functions of Money Market• A well developed money market is the basis for an

effective monetary policy.• A money market functions like a dam-canal-irrigation

system. It collects and augments the resources and channelizes it to the various needed areas.

1. By providing various kinds of credit instruments suitable and attractive for different sections, a money market augments the supply of funds.

2. Efficient market helps to minimize the gluts and stringencies in the money market due to the seasonal variations in the flow of and demand for funds.

Continued3. A money market, helps to avoid wide seasonal

fluctuations in the interest rates.4. A well organized money market, through quick transfer

of funds from one place to another.5. It enhances the amount of liquidity available to the

entire country.6. A money market, by providing profitable investment

opportunities for short-term surplus funds, helps to enhance the profit of financial institutions and individuals.

The Indian Money Market• The money market in India comprise two

sectors which may broadly be termed as the Organized and Unorganized markets, with substantially higher rates of interest in the unorganized sector.

• The organised market comprises in the first place the Reserve Bank which is the key constituent of the money market.

• Then come the commercial banks. They include the public sector banks and other banks including Indian and foreign.

• In the past, quasi government bodies and large size joint stock companies also used to participate in the operations of the money market as lenders, the money lent by them being usually termed ‘house money’.

• Then there are the financial intermediaries such as call loan brokers and stock brokers.

Continued

• The co-operative credit institutions occupy a somewhat intermediate position between the organized and unorganized sectors of the money market.

• A well developed money market will have close links with the leading money markets of the world and will be sensitive to the developments in these foreign markets.

Money market Instruments and Constituents

Money Market consists of a number of sub-markets which collectively constitute the money market. They are,

Commercial bills market or discount market: Commercial Bills or Bills of exchange are important instruments used to facilitate credit sales. Commercial bills can be discounted with banks and the banks, when they are in need of funds, may rediscount them in the money market.

Call Money Market• Call and notice money are money dealt for one to 14

days. • The period of term money ranges from 14 days to 90

days. • This is sometimes a very volatile market and the

interest rate is determined by the market forces• This market is of vital importance to banks and

financial institutions because of the avenue it provides for investing surplus funds and meeting the deficits.

• The inter-bank lending is the major component of this market.

Treasury Bills (T-Bills)

• Treasury bills are promissory notes issued by the Central Government to raise short term funds to bridge short term mismatches between receipts and expenditures.

• The RBI which issues the TBs on behalf of the Government does not purchase them before maturity but investors can sell them in the secondary market.

Certificate of deposit (CD)

• A CD is a time deposit with a bank.• Like most time deposit, funds can not

withdrawn before maturity without paying a penalty.

• The main advantage of CD is their safety.• Anyone can earn more than a saving account

interest.

Commercial paper (CP)

• Commercial Papers are unsecured promissory notes of short term maturity of highly rated companies, issued to meet working capital requirements. The CP is subject to credit rating by any of the recognized credit rating agencies in India.

Repurchase agreement (Repos)

• Repo is a money market instrument, which enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments.

• Under a repo transaction, a holder of securities sells them to an investor with an agreement to repurchase at a pre-determined date and rate.

Capital Market

Capital Market is generally understood as the market for long-term funds

Capital Marketing is defined as “the process of increasing the major part of financial capital required for starting a business through issue of shares to public”.

The issue may be Shares, Debentures , Bonds, etc.Capital market is a market for long term debts and

equity shares

Nature and Constituents

• Players of Capital Market1. Government2. Stock Exchange3. Commercial banks,4. Savings banks5. Development bank6. Insurance companies7. Investment trust

Cont…

• In the capital market, the supply of funds comes from the individual and corporate savings, institutional investors and surplus of governments. The demand for capital comes mostly from agriculture, industry, trade and the government.

Importance of Capital Market

Pooling the capital resources and Developing enterprises investorsSolve the problem of paucity of fundsMobilize the small and scattered savingsAugment the availability of investible fundsGrowth of joint stock businessProvide a number of profitable investment opportunities for a small savers

Capital Market In India

• Indian capital market witnessed some significant changes during the eighties, both the primary and the secondary segments continued to suffer from some serious deficiencies.

• Many unhealthy practices prevailed in the primary market to attract the retail investors.

• Another disturbing feature was the high cost of new issues• The general functioning of stock exchanges was not

satisfactory• .

• Insider trading was rampant and was one of the major causes of excessive speculative activity

• The stock exchanges followed inefficient and outdated trading systems.

• Post trade settlement procedures also suffered from some serious drawbacks, such as, high share of bad deliveries, delayed settlements

Nature of the Indian Capital Market

• Indian capital market also consists of an organized sector and an unorganized sector.

• In the organized market the demand for capital comes mostly from corporate enterprises and govt. and semi govt. institutions and the supply comes from household savings, institutional investors like banks investment trusts, insurance companies, finance corporations, govt. and international financing agencies.

• The unorganized market consists mostly of the indigenous bankers and moneylenders on the supply side.

• A large part of the demand for funds in the unorganized market is for consumption purposes.

Capital Market Structure

• New New New Issues Marketable securities Non-Marketable securities

Govt. sec corporate sec P.S.U.Bonds UTI Mutual Funds

Bank Deposits with companies Loans and Advances of Banks Post office certificates and Deposits

Promoters and Directors Associates and Friends collaborators Employees FIs and Banks NRI’s Public

•Brokers •Jobbers•Dealers•Arbitrageurs

•Merchant Bankers•Collecting Bankers•Brokers•Underwriters•Advertising Agencies

New Issues MarketPlayers-Original

Stock Market:Intermediaries

New Issue MarketPlayers – For Issues

Development of the Market

1. Legislative measures: Laws like the Companies Act, the Securities Contracts Act and the Capital Issues Act.

2. Establishment of development banks and expansion of the public sector: Starting with the establishment of the IFCI, a number of development banks have been established. Life Insurance was nationalized in 1956 and the General Insurance in 1972. With 27 Nationalized banks over 90 % of the commercial banking business came to be concentrated in the government sector

3 Growth of underwriting business: 4. Public confidence: Impressive performance of

certain large companies encouraged public investment in industrial securities.

5. Introduction of Book Building

5. Increasing awareness of investment opportunities: The improvement in education and communication has created more public awareness about the investment opportunities in the business sector.

6. Capital Market Reforms: A number of measures have been taken to check abuses and to promote healthy development of the capital market.

SEBI

• Set up originally in 1988 by Govt. of India Acquired statutory form in 1992 under SEBI Act 1992

• Chairman is Sh. U.K. Sinha Headquartered in Mumbai

Objectives

• Established in 1992 with three main objectives To protect the interest of investors in securities

• To promote the development of securities market

• Make rules and regulations for the securities market

• Focus being the greater investor protection, SEBI has become a vigilant watchdog

Functions & Powers

• Regulating the business in stock exchanges and any other securities market.

• Registering and regulating the working of stock brokers, agents, bankers to an issue, merchant bankers, underwriters, etc.

• Registering and regulating the working of collective investment schemes, including mutual funds.

• Prohibiting fraudulent and unfair trade practices in securities market.

• Promoting investor education and training of intermediaries in securities market.

• Prohibiting insider trading in securities.• Regulating substantial acquisition of shares

and take-over of companies.• Conducting research for the above purpose.

Unit 4

Economy & Finance

Transcript of Unit 4