2. Economics Notes Extra 03

Elaborate Notes

LONDON INTERBANK OFFERED RATE (LIBOR)

• Benchmark Rate and Significance: The London Interbank Offered Rate (LIBOR) was a globally accepted benchmark interest rate that represented the average interest rate at which major international banks would lend to each other in the London interbank market for short-term loans. For decades, it served as the primary reference for pricing a vast array of financial products worldwide, including derivatives, corporate loans, mortgages, and bonds, estimated to be worth over $200 trillion at its peak. Financial benchmarks are critical indices or reference rates used for pricing, settlement, and valuation of financial contracts, providing a standard measure of value.

• Historical Context and Regulation: LIBOR’s informal origins date back to the 1960s, but it was formally adopted in 1986. It was initially administered by the British Bankers’ Association (BBA), a private industry body. This self-regulatory model came under intense scrutiny following the 2008 financial crisis. The LIBOR scandal, which came to light around 2012, revealed that traders at several major banks had been systematically manipulating their LIBOR submissions to profit from their trading positions or to project a misleadingly positive picture of their financial health. This widespread fraud eroded trust in the global financial system. In response, the U.K. government commissioned the Wheatley Review (2012), which recommended significant reforms. Consequently, in 2014, the administration of LIBOR was transferred from the BBA to a regulated entity, and its oversight was brought under the purview of the U.K.’s Financial Conduct Authority (FCA).

• Calculation and Vulnerabilities: The calculation of LIBOR was based on a survey methodology. A panel of major banks would submit the interest rate at which they estimated they could borrow funds from other banks for various tenors. The highest and lowest submissions were discarded, and the average of the remaining was taken as the LIBOR rate. Before its phase-out began, LIBOR was calculated for five major currencies (U.S. Dollar - USD, Euro - EUR, Pound Sterling - GBP, Swiss Franc - CHF, and Japanese Yen - JPY) across seven different maturities or tenors (from overnight to 12 months). The reliance on expert judgment rather than actual transaction data was its fundamental flaw, making it susceptible to manipulation.

• The Transition and Phase-Out: In 2017, Andrew Bailey, then-chief of the FCA, announced that LIBOR would be phased out due to its inherent weaknesses. The global financial system has since transitioned to more robust, transaction-based Alternative Reference Rates (ARRs). For instance, the U.S. transitioned to the Secured Overnight Financing Rate (SOFR), and the U.K. to the Sterling Overnight Index Average (SONIA). The publication of most LIBOR settings ceased at the end of 2021. As mentioned in the summary, certain key U.S.-dollar LIBOR tenors were allowed to be published until mid-2023 to allow legacy contracts to mature without disruption.

LIBOR TRANSITION BENEFITS TO INDIA

• Reduction in Financing Cost: The new ARRs, like SOFR, are based on actual overnight transactions in the repurchase agreement (repo) market and are considered nearly risk-free. LIBOR, being an unsecured lending rate, inherently included a credit risk premium, which made it higher and more volatile, especially during times of market stress. For Indian corporations and banks borrowing in foreign currency, the transition to lower and more stable ARRs can lead to a reduction in their overall financing costs.

• Reduced Borrowing Costs and Market Confidence: The increased robustness and transparency of the new benchmarks reduce the uncertainty and risk premium that lenders and investors might demand. This restored confidence in the benchmark’s integrity can translate into lower interest rates or spreads on loans and bonds for Indian entities accessing international capital markets.

• Enhanced Competition: The shift away from a single, dominant global benchmark like LIBOR has encouraged the development and adoption of various ARRs across different jurisdictions. This fosters a more competitive environment for reference rates, providing borrowers and lenders with more choices and potentially spurring innovation in financial products. It also reduces systemic risk associated with over-reliance on a single benchmark.

FINANCIAL BENCHMARK INDIA PRIVATE LIMITED (FBIL)

• Genesis: The FBIL was established in December 2014 as a direct response to global and domestic concerns regarding the integrity of financial benchmarks, highlighted by the LIBOR scandal. Its creation was based on the recommendations of the Committee on Financial Benchmarks, chaired by then RBI Deputy Governor P. Vijaya Bhaskar. It was incorporated as a private limited company under the Companies Act, 2013.

• Ownership and Governance: FBIL is a collaborative venture jointly owned by three key industry associations: the Fixed Income Money Market and Derivatives Association of India (FIMMDA), the Foreign Exchange Dealers Association of India (FEDA), and the Indian Banks’ Association (IBA). This structure ensures that the benchmark administration process is grounded in market expertise while being managed by an independent entity.

• Objective and Functions: The primary objective of FBIL is to act as an independent administrator for developing and administering critical benchmarks in India’s money markets, government securities, and foreign exchange markets. Its functions include the computation and dissemination of benchmarks such as the Mumbai Interbank Outright Rate (MIBOR), reference rates for the Indian Rupee against the USD, EUR, GBP, and JPY, and various other benchmarks for government bonds and money market instruments.

• Regulation: To ensure credibility and robustness, FBIL is regulated by the Reserve Bank of India (RBI). The RBI provides oversight, ensuring that FBIL adheres to best practices in benchmark administration, governance, and methodology, aligning with international standards set by bodies like the International Organization of Securities Commissions (IOSCO).

CROSS BORDER PAYMENT

• Definition and Mechanism: A cross-border payment is a financial transaction where the originator (sender) and the beneficiary (recipient) are located in different countries. Traditionally, these transactions have been complex, relying on a network of correspondent banks and utilising the SWIFT (Society for Worldwide Interbank Financial Telecommunication) messaging system to communicate payment instructions. This multi-layered process often results in high costs, slow settlement times (taking several days), and a lack of transparency regarding fees and final payment status.

• Market Scale and Modernisation: The global cross-border payments market is economically significant, with projections indicating its value could reach $290 trillion by 2030. In recent years, the sector has seen significant disruption from fintech companies offering faster and cheaper alternatives. Furthermore, initiatives like India’s Unified Payments Interface (UPI) being linked with similar systems in other countries (e.g., Singapore’s PayNow) and the exploration of Central Bank Digital Currencies (CBDCs) for cross-border transactions are paving the way for more efficient payment systems. The G20 has identified enhancing cross-border payments as a key priority.

FOREIGN PORTFOLIO INVESTMENT (FPI)

ISSUES IDENTIFIED

• Circumvention of Press Note 3 (PN3): Press Note 3, issued by the Department for Promotion of Industry and Internal Trade (DPIIT) in April 2020, amended India’s Foreign Direct Investment (FDI) policy. It stipulated that any investment from an entity based in a country sharing a land border with India would require prior approval from the Government of India. This was a measure to prevent opportunistic takeovers of Indian companies during the COVID-19 pandemic, with a primary focus on investments from China. However, PN3 applies specifically to FDI. A significant regulatory gap exists as these restrictions do not apply to Foreign Portfolio Investment (FPI), which involves investments in financial assets like stocks and bonds. This loophole could potentially be exploited to bypass the intended government scrutiny.

• Failure to Disclose Related Party Transactions (RPTs): An RPT is a transaction between a company and an entity or person who has a close relationship with the company (e.g., promoters, key management personnel, or their relatives). The Companies Act, 2013, and SEBI regulations mandate strict disclosure of RPTs to ensure transparency and protect the interests of minority shareholders. The concern is that FPIs with opaque ownership structures, often domiciled in tax havens, can be used by company promoters to indirectly hold shares in their own companies. This can be used to circumvent minimum public shareholding norms or engage in undisclosed transactions that benefit the related party at the expense of other shareholders. Recent reports, such as the Hindenburg Research report on the Adani Group (2023), brought these concerns about opaque FPI structures to the forefront.

SEBI PROPOSAL FOR FPI REGULATION

• Categorisation of FPIs: To address these risks, the Securities and Exchange Board of India (SEBI) has proposed a risk-based framework for FPIs:

  • Low-risk FPIs: These include government and government-related entities like central banks, sovereign wealth funds, and multilateral organisations, which are considered highly transparent and stable.
  • Moderate-Risk FPIs: This category covers pension funds and public retail funds (e.g., mutual funds) that have widespread and dispersed investors, making them less likely to be vehicles for concentrated, opaque holdings.
  • High-risk FPIs: This is a residual category that includes all other FPIs, such as hedge funds, family offices, and corporate bodies, particularly those that are concentrated in a single corporate group or have opaque structures.

• Enhanced Transparency Measures: The core of the proposal is to mandate enhanced disclosures for high-risk FPIs. These FPIs, especially if they have a significant concentration of their Indian equity Assets Under Management (AUM) in a single corporate group or have a large overall AUM, would be required to provide granular details about their beneficial ownership, down to the level of the last natural person. This includes disclosing all holders of ownership, economic, and control rights, thereby preventing the use of layered structures to hide the ultimate beneficiary.

CORPORATE DEBT MARKET

• Background and Vulnerabilities: The corporate debt market is a critical source of funding for companies. However, the market for Mutual Funds (MFs) investing in these debt instruments has shown vulnerabilities. Unlike banks, which have access to the RBI as a lender of last resort for liquidity support, MFs face significant redemption pressure during crises. The IL&FS crisis of 2018 and the subsequent credit events, followed by the winding up of six debt schemes by Franklin Templeton in 2020 during the COVID-19 pandemic, highlighted this issue. In a stressed market, MFs find it difficult to sell their holdings of corporate bonds (liquidate their assets) at fair prices to meet investor redemptions, leading to a potential downward spiral in bond prices and systemic risk.

• Corporate Debt Market Development Fund (CDMDF): To address this systemic gap, the Corporate Debt Market Development Fund (CDMDF) was conceptualised and subsequently established.

  • Functioning and Structure: CDMDF is set up as a closed-ended Alternative Investment Fund (AIF). An AIF is a privately pooled fund that collects funds from sophisticated investors. The CDMDF is designed to act as a ‘backstop facility’ or a ‘market maker of last resort’. During periods of significant market stress, it will purchase investment-grade corporate debt securities from specified debt-oriented MF schemes. This provides a crucial liquidity outlet for MFs, enabling them to meet redemption requests without resorting to panic selling.
  • Scope and Objective: The fund will only purchase corporate debt securities that are investment grade, meaning they have a credit rating of ‘BBB’ or higher from a recognised credit rating agency. This ensures that the fund maintains a quality portfolio and does not take on excessive credit risk. The overarching objective is to bolster confidence in the corporate debt market and prevent the contagion effects of redemption pressures.
  • Contribution and Tenure: The fund is financed through mandatory contributions from specified debt-oriented MF schemes and Asset Management Companies (AMCs), creating a pooled, self-sustaining resource. The government of India also provides a guarantee for the fund’s borrowings. As per its initial framework, the fund has a tenure of 15 years, which can be extended by SEBI.

SOCIAL STOCK EXCHANGE (SSE)

• Concept and Purpose: A Social Stock Exchange (SSE) is a specific segment within an existing stock exchange (like the NSE or BSE in India) designed to help Social Enterprises raise funds from the public. This concept was announced in the Union Budget of 2019-20 and was subsequently operationalised based on the recommendations of a technical group constituted by SEBI. It aims to bridge the gap between social development goals and financial markets by creating a regulated platform for impact investing.

• Eligible Entities and Activities: The SSE is open to two types of Social Enterprises:

  1. Not-for-Profit Organizations (NPOs): Can raise funds through instruments like Zero Coupon Zero Principal (ZCZP) bonds, which are essentially philanthropic donations.
  2. For-Profit Enterprises (FPEs): Can raise funds through traditional instruments like equity or debt. To be eligible, these enterprises must be engaged in activities that demonstrate a clear social impact, such as eradicating hunger, poverty, and inequality; promoting education, healthcare, and financial inclusion; environmental protection; and slum area development, aligning with the UN Sustainable Development Goals (SDGs).

• Eligibility Criteria for Social Enterprises: To ensure authenticity and prevent “social washing,” SEBI has laid down stringent criteria to establish the ‘primacy of social impact’. An enterprise must meet at least one of the following three conditions, based on a 3-year average:

  • Revenues: At least 67% of its average revenues must come from providing eligible social activities to a target population.
  • Expenditure: At least 67% of its average expenditures must have been incurred for providing these eligible activities.
  • Beneficiaries: The target population must constitute at least 67% of its total customer base or beneficiaries.

EXCHANGE RATE MANAGEMENT IN INDIA

METHOD OF EXCHANGE RATE DETERMINATION

• Fixed Exchange Rates: In this system, a country’s central bank pegs or fixes the value of its currency to another currency (e.g., the U.S. dollar), a basket of currencies, or a commodity like gold. The central bank must actively intervene in the foreign exchange market by buying or selling foreign currency to maintain this fixed rate. The Bretton Woods system (1944-1971) is a historical example where most currencies were pegged to the U.S. dollar.

• Flexible/Floating Exchange Rates: Here, the value of a currency is determined purely by the market forces of demand and supply in the international forex market. The central bank does not intervene to influence the rate. Major global currencies like the U.S. dollar and the Euro operate largely on this principle, though central banks may still intervene in extraordinary circumstances.

• Managed Exchange Rates (Managed Float): This is a hybrid system where the exchange rate is determined by market forces, but the central bank occasionally intervenes to prevent excessive volatility or to guide the currency’s value in a particular direction. India currently follows this system. The RBI does not target a specific exchange rate level but acts to curb sharp fluctuations, a policy often referred to as managing volatility.

EFFECT OF EXCHANGE RATE

• Inflation: A currency’s value directly impacts inflation through the cost of imports. An over-valued or strengthening currency (appreciation) makes imports cheaper, which can help lower domestic inflation. Conversely, a weakening currency (depreciation) makes imports more expensive, potentially leading to ‘imported inflation’.
• Interest Rates: Exchange rate management is closely linked to monetary policy, often explained by the concept of the ‘Impossible Trinity’. To manage the exchange rate (e.g., to prevent depreciation), a central bank might raise interest rates to attract foreign capital inflows, which in turn affects domestic credit conditions and economic activity.
• Economic Growth: A weaker currency can boost economic growth by making a country’s exports cheaper and more competitive in global markets. However, it also raises the cost of imported capital goods and raw materials. A stronger currency can harm export-oriented sectors but benefits industries reliant on imports.
• Trade: A stronger currency makes exports more expensive and imports cheaper, which can lead to a widening trade deficit. A weaker currency can help improve the trade balance by making exports more attractive and imports less so.
• Capital Flow: A stable and appreciating currency can attract foreign capital, including Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI), as investors anticipate higher returns.
• Gresham’s Law: This economic principle states that “bad money drives out good.” In its original context of bimetallic currency systems, it meant that an artificially overvalued currency (“bad money”) would be used for transactions, while the undervalued currency (“good money”) would be hoarded. In a modern forex context, it can be seen anecdotally where, during a crisis of confidence in the domestic currency, people might tend to hoard stable foreign currencies (like the USD) and spend the depreciating local currency.

FOREIGN TRADE POLICY

FTP 2023

• Notification and Legal Framework: The Foreign Trade Policy (FTP) 2023 was notified by the Central Government under the authority of Section 5 of the Foreign Trade (Development & Regulation) Act, 1992. This act provides the statutory basis for regulating imports and exports in India.

• Principles and Approach: FTP 2023 marks a philosophical shift. It is based on the principles of ‘trust’ and ‘partnership’ with exporters, moving towards automated, technology-driven processes and risk-based management. A key principle is the move from incentives to a tax remission and neutralization regime, which is more compliant with World Trade Organization (WTO) norms. Unlike previous five-year policies, FTP 2023 has no fixed end date and is designed to be dynamic.

• Context: The previous FTP (2015-20) was extended multiple times until March 2023 due to the uncertainties caused by the COVID-19 pandemic and global geopolitical tensions. The new policy was launched in the backdrop of India achieving a record-high export performance of over $770 billion in goods and services in 2022-23.

• Four Pillars of the New FTP Approach:

  1. From Incentives to Tax Remission: Moving away from subsidy-based schemes (like the Merchandise Exports from India Scheme - MEIS) to WTO-compliant remission schemes like RoDTEP (Remission of Duties and Taxes on Exported Products), which refunds embedded central, state, and local taxes that were not being rebated earlier.
  2. Greater Trade Facilitation: Emphasising technology, automation, and process re-engineering to reduce transaction costs and time for exporters.
  3. Export Promotion through Collaboration: Fostering partnerships with exporters, states, and districts to boost exports from the grassroots level. The Districts as Export Hubs initiative is a central component of this pillar.
  4. Focus on Emerging Areas: Special focus on streamlining policies for high-growth areas like e-commerce exports, and simplifying the SCOMET (Special Chemicals, Organisms, Materials, Equipment and Technologies) policy to facilitate exports of high-tech, dual-use items.

DEEMED EXPORTS

• Definition: Deemed Exports are transactions where the supplied goods do not physically leave the country, but the payment is received either in Indian Rupees or in free foreign exchange. The goods are treated as exports for the purpose of providing certain benefits under the FTP. For example, a domestic manufacturer supplying goods to an Export Oriented Unit (EOU) or a Special Economic Zone (SEZ) unit is considered a ‘deemed exporter’.

• Objective: The primary objective is to create a level-playing field for domestic manufacturers against foreign competitors. By providing export benefits to domestic suppliers of inputs to exporting units, the policy encourages domestic procurement and value addition, thereby promoting the ‘Make in India’ initiative.

DEVELOPING COUNTRY STATUS

• Self-Designation at the WTO: The World Trade Organization (WTO) does not have a formal definition for ‘developed’ and ‘developing’ countries. Member countries are free to self-designate their status. This status grants them access to provisions for Special and Differentiated Treatment (S&DT), which include benefits like longer time periods for implementing agreements and commitments, and measures to increase trading opportunities.

• The US-China Controversy: The United States has enacted legislation and consistently argued that China, given its status as the world’s second-largest economy and a dominant global trader, should no longer be treated as a developing country within the WTO and other international organisations. The US contends that China leverages this status for an unfair competitive advantage.

• UN Position: Similar to the WTO, the United Nations (UN) does not have a single, formal definition of a developing country. For monitoring and analytical purposes, it often uses classifications from other institutions like the World Bank, which categorises countries based on Gross National Income (GNI) per capita. India has consistently advocated for maintaining the principle of S&DT and self-designation at the WTO.

DE-DOLLARISATION

WHY DE-DOLLARIZATION IS TAKING ROOT

• Weaponization of Trade and Finance: The U.S. government’s use of economic sanctions and its influence over the global financial infrastructure have prompted countries to seek alternatives. The exclusion of countries like Russia from the SWIFT messaging system and the freezing of its dollar-denominated foreign reserves following the Ukraine war demonstrated the significant geopolitical risk associated with over-reliance on the dollar-centric system.

• Rise of New Emerging Economies: The increasing economic weight of Asian economies, particularly China and India, has elevated the importance of their respective currencies. China is actively promoting the international use of the Yuan through its Belt and Road Initiative and its own Cross-Border Interbank Payment System (CIPS). Similarly, India has established a framework for settling international trade in the Indian Rupee.

• Benefits of Diversification: Central banks globally are gradually diversifying their foreign currency reserves away from the U.S. dollar towards a multi-currency basket that includes the Euro, Yen, Yuan, and gold. This strategy reduces the exposure of a country’s external sector to fluctuations in the dollar’s value and the spillover effects of U.S. monetary policy.

• Manipulation and Spillovers from the U.S.: The U.S. Federal Reserve’s monetary policy decisions have a profound impact on global financial conditions. For example, interest rate hikes in the U.S. can trigger capital outflows from emerging markets, leading to currency depreciation and financial instability. This has created a strong incentive for other countries to reduce their vulnerability to U.S. policy choices.

LIBERALISED REMITTANCE SCHEME (LRS)

• Scheme Overview: The Liberalised Remittance Scheme (LRS), administered by the RBI, allows all resident individuals in India, including minors, to freely remit up to USD 250,000 per financial year for any permissible current or capital account transaction. These transactions include overseas education, travel, medical treatment, purchase of property and shares abroad, and gifts or donations.

• Inclusion of Credit Card Payments: A significant change was introduced through the Finance Act, 2023, which amended the Foreign Exchange Management Act (FEMA). Under the revised rules, the use of international credit cards by an Indian resident while overseas is now included within the overall LRS limit of $250,000. Previously, such spending was not monitored under the LRS, creating a regulatory loophole. This change aims to ensure parity in the treatment of foreign exchange outflows and allows for better tracking of high-value overseas