6. Economics Notes 31

Elaborate Notes

INEQUALITY

Inequality refers to the phenomenon of unequal and/or unjust distribution of resources and opportunities among members of a given society. The United Nations defines it as “the state of not being equal, especially in status, rights, and opportunities.” It is a multi-dimensional concept, encompassing economic, social, and political spheres.

• Economic vs. Social Inequality:

  • Economic Inequality is the disparity in the distribution of economic assets (wealth) and income among individuals in a group, among groups in a population, or among countries. It is typically measured through metrics that assess differences in income, consumption expenditure, and wealth. Renowned economist Thomas Piketty, in his seminal work “Capital in the Twenty-First Century” (2013), argues that when the rate of return on capital (r) exceeds the rate of economic growth (g) over the long term, the result is the concentration of wealth, thereby exacerbating inequality.
  • Social Inequality arises from the differential access to social goods and resources based on identity markers. In the Indian context, this is deeply rooted in historical structures such as the caste system, patriarchy, and religious affiliations. Sociologist André Béteille, in “Caste, Class, and Power” (1965), analysed the complex interplay of these factors in a South Indian village, demonstrating how social hierarchies persist and influence economic opportunities. Gender inequality, for instance, manifests as disparities in wages, property rights, and access to education and healthcare.

• Measurement of Inequality:

  • Quintile Ratio: This is a simple measure that compares the average income or consumption of the richest 20% (top quintile) of the population to that of the poorest 20% (bottom quintile). A higher ratio indicates greater inequality.
  • Palma Ratio: Proposed by economist José Gabriel Palma, this ratio focuses on the extremes of the income distribution. It is the ratio of the income share of the richest 10% of the population to that of the poorest 40%. Palma observed that in most countries, the middle 50% of the population (deciles 5 to 9) tend to have a stable share of the national income (around 50%), while the major variation occurs between the top 10% and the bottom 40%.
  • Lorenz Curve: Developed by American economist Max O. Lorenz in 1905, this is a graphical representation of income or wealth distribution. The cumulative percentage of the population is plotted on the x-axis, and the cumulative percentage of income/wealth they hold is plotted on the y-axis. A perfectly straight 45-degree line represents perfect equality (e.g., 20% of the population holds 20% of the income). The degree to which the actual Lorenz curve bows away from this line indicates the degree of inequality.
  • Gini Coefficient: Developed by Italian statistician Corrado Gini in 1912, this is a numerical representation of inequality derived from the Lorenz curve. It is calculated as the ratio of the area between the line of perfect equality and the observed Lorenz curve to the total area under the line of perfect equality. The coefficient ranges from 0 (perfect equality) to 1 (perfect inequality, where one person has all the income).

• Oxfam International on Inequality:

  • Oxfam, a global confederation of charitable organizations, actively campaigns against inequality. Its annual reports, often released at the World Economic Forum in Davos, highlight the stark concentration of wealth.
  • The “Commitment to Reducing Inequality (CRI) Index” is a significant contribution by Oxfam and Development Finance International (DFI). It ranks governments based on their policies and actions in three areas critical to tackling inequality:
    1. Public Services Pillar: This assesses government spending on essential public services like education, health, and social protection. The premise is that universal access to quality public services is a powerful equaliser.
    2. Progressive Taxation Pillar: This pillar evaluates the progressivity of a nation’s tax system. A progressive system is one where the rich pay a larger proportion of their income in taxes than the poor. It includes policies on personal income tax, corporate tax, and efforts to tackle tax evasion.
    3. Workers’ Rights Pillar: This examines government policies on labour rights, such as the enforcement of minimum wages, protection for unions, and rights for women workers. Fair wages and secure employment are fundamental to reducing income inequality.

• Causes of Inequality in India:

  • Post-1991 Economic Reforms: The shift towards a market-led economy, while boosting overall growth, has been associated with rising inequality. The benefits of growth have disproportionately favoured the skilled and capital-owning classes over unskilled labour. This aligns with the concept of skill-biased technological change.
  • Agricultural Sector Stagnation: Policy failures, such as inadequate investment in irrigation, research, and rural infrastructure, have led to low productivity and stagnant incomes for a large segment of the population dependent on agriculture.
  • Lack of Institutional Credit: Limited access to formal credit forces the poor, particularly small farmers and informal sector workers, to rely on usurious informal lenders, trapping them in a cycle of debt and poverty.
  • Poverty and Unemployment: These are both causes and consequences of inequality. Lack of employment opportunities and persistent poverty prevent individuals from accumulating assets and investing in human capital (education and health).
  • Inefficient Scheme Implementation: Leakages, corruption, and poor targeting in government welfare schemes often mean that the intended benefits do not reach the most vulnerable populations, failing to act as an effective redistributive mechanism.
  • Marketization of Basic Services: The increasing role of the private sector in health and education has made quality services unaffordable for the poor, exacerbating inequalities in human development outcomes.
  • Private Ownership of Property: The constitutional right to property allows for the accumulation and inheritance of wealth, which, without sufficient progressive wealth or inheritance taxes, leads to inter-generational persistence of inequality.
  • Failures in Land Reforms: Despite early post-independence efforts, the implementation of land reforms (e.g., imposition of land ceilings, tenancy reforms) has been patchy and largely ineffective in most states, with the notable exception of states like Kerala and West Bengal. This has left land ownership highly skewed.

• Government Measures to Reduce Inequality:

  • Land Reforms: Post-independence, states like Kerala implemented radical land reforms, as documented by scholars like T. K. Oommen, which successfully redistributed land to tenants and reduced the power of feudal landlords.
  • PSU-led Growth: The Nehruvian model of development prioritized Public Sector Undertakings (PSUs) in core sectors to prevent the concentration of economic power and promote regional development, though its efficiency has been debated.
  • Nationalisation of Banks (1969 & 1980): This was a major policy move to direct credit towards ‘priority sectors’ like agriculture and small-scale industries, thereby expanding financial access for the less privileged.
  • Financial Inclusion Initiatives: Programs like the Pradhan Mantri Jan Dhan Yojana (PMJDY) aim to provide universal access to banking services, fostering inclusive growth by bringing the unbanked into the formal financial system.
  • MSME Sector Promotion: Various acts and schemes have been launched to support Micro, Small, and Medium Enterprises, which are major employment generators and can contribute to a more equitable distribution of economic growth.
  • Focus in Five-Year Plans (FYPs): The Fifth Five-Year Plan (1974-78) famously adopted the slogan “Garibi Hatao” (Remove Poverty) and focused on poverty alleviation and self-reliance. The Sixth Five-Year Plan (1980-85) also emphasized direct anti-poverty programs.

• Relative Inequality:

  • This concept measures inequality in relation to the median income of a society. It is not about whether one can afford basic necessities (absolute poverty) but about how one’s economic standing compares to others. The United Nations Development Programme (UNDP) sometimes uses a measure of relative poverty, defining it as the percentage of the population earning less than 50% of the median income. This highlights social exclusion and the inability to participate fully in the economic and social life of the community.

FINANCIAL MARKET

A financial market is a marketplace where financial instruments like stocks, bonds, currencies, and derivatives are traded. It facilitates the flow of funds from those who have surplus capital to those who need it.

• Difference between Money Market and Capital Market:

  Feature	Money Market	Capital Market
  Maturity	Short-term; for instruments with a maturity of up to one year (364 days).	Long-term; for instruments with a maturity of more than one year.
  Purpose	Meets short-term credit needs, such as working capital requirements and temporary cash flow mismatches.	Meets long-term funding needs, such as capital expenditure for projects, expansion, and modernization.
  Instruments	Treasury Bills, Commercial Papers, Certificates of Deposit, Call Money, Commercial Bills.	Shares (Equities), Debentures, Bonds, Government Securities (Dated).
  Nature of Security	Typically discounted securities (Zero-Coupon Bonds) issued at a discount and redeemed at face value.	Coupon-bearing dated securities, which pay periodic interest (coupon) and are redeemed at face value on maturity.
  Risk	Lower risk due to short maturity and high liquidity.	Higher risk due to longer maturity and potential for price volatility.
  Regulator	Primarily regulated by the Reserve Bank of India (RBI).	Primarily regulated by the Securities and Exchange Board of India (SEBI).

• Money Market:

  • The money market is the segment of the financial market for short-term borrowing and lending. Its primary function is to provide liquidity to the economy.
  • Treasury Bills (T-bills): These are short-term debt instruments issued by the Reserve Bank of India on behalf of the Central Government to meet its short-term funding requirements.
    • They are zero-coupon securities, meaning they pay no interest. Instead, they are issued at a price lower than their face value (a discount) and redeemed at the face value upon maturity. The difference represents the return to the investor.
    • T-bills are currently issued in three tenors: 91 days, 182 days, and 364 days.
  • Cash Management Bills (CMBs): Introduced by the Government of India in consultation with the RBI in 2010.
    • These are functionally identical to T-bills but have a maturity of less than 91 days.
    • Their purpose is to help the government manage temporary cash flow mismatches. Like T-bills, they are issued at a discount and redeemed at face value.

BOND MARKET

The bond market, also known as the debt market or credit market, is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market.

• Sensex: A brief note, the Sensex (Sensitive Index) is the benchmark index of the Bombay Stock Exchange (BSE). It is calculated based on the performance of 30 of the largest, most liquid, and financially sound companies across key sectors of the Indian economy.

• Bond Price and Bond Yield:

  • There is an inverse relationship between the price of a bond in the secondary market and its yield.
  • Bond Yield is the return an investor realizes on a bond. The simplest measure is the current yield, calculated as: Current Yield = Annual Coupon Payment / Current Market Price of the Bond.
  • Example: If a bond with a face value of ₹1000 has a coupon rate of 8% (i.e., it pays ₹80 annually) and its market price increases to ₹1100, its yield falls to (₹80 / ₹1100) ≈ 7.27%. Conversely, if its price drops to ₹900, its yield rises to (₹80 / ₹900) ≈ 8.89%.

• Yield Curve: A yield curve is a line that plots the yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.

  • Normal/Regular Yield Curve: This curve is upward-sloping. It indicates that long-term bonds have a higher yield than short-term bonds. This is the most common shape, as investors demand a higher return (a “term premium”) for the increased risk associated with lending their money for a longer period. It suggests expectations of stable economic growth and inflation.
  • Steep Yield Curve: This is a more pronounced upward-sloping curve. It occurs when long-term yields are rising faster than short-term yields. This typically signals that investors expect strong future economic growth and potentially higher inflation, which would lead the central bank to raise interest rates in the future.
  • Flat Yield Curve: Here, the yields on short-term and long-term bonds are very similar. A flattening curve can indicate that investors are uncertain about the future economic outlook.
  • Inverted Yield Curve: This curve is downward-sloping, meaning short-term yields are higher than long-term yields. This is a rare and significant phenomenon. It has historically been a reliable predictor of economic recessions. This was highlighted by the research of economist Campbell Harvey in the 1980s.
    • Why it indicates a recession: Investors expect a future economic slowdown. They anticipate that the central bank will cut short-term interest rates to stimulate the economy. In anticipation, they rush to lock in current long-term yields, which they believe will be higher than future short-term rates. This high demand for long-term bonds pushes their prices up and, consequently, their yields down, leading to the inversion. It is a classic “flight to safety” where investors prioritize capital preservation over high returns.

• Impact of an Inverted US Yield Curve on India:

  • An inverted yield curve in the US often precedes a recession there. Concurrently, to combat inflation that often precedes a downturn, the US Federal Reserve may be raising its short-term policy rates.
  • Capital Outflows and Rupee Depreciation: Higher short-term interest rates in the US make US assets more attractive to global investors. This can lead to Foreign Portfolio Investors (FPIs) pulling money out of emerging markets like India, a phenomenon known as capital flight. This increased demand for the US dollar leads to the depreciation of the Indian Rupee.
  • Imported Inflation: A weaker rupee makes India’s imports costlier. Since India is heavily dependent on imports for crude oil and other essential commodities, this leads to imported inflation, raising domestic fuel and production costs.
  • Trade Deficit: While a weaker rupee should theoretically make exports cheaper and more competitive, a global recession (as predicted by the inverted curve) would shrink global demand. Therefore, India may fail to increase its export volumes, while the import bill continues to rise due to higher commodity prices, potentially widening the trade deficit.

COMMERCIAL PAPER (CP)

• Introduction: Commercial Paper was introduced in India in 1990 on the recommendations of the Vaghul Committee on the money market.
• Nature: It is a short-term, unsecured promissory note issued by entities to raise funds for their short-term requirements.
  • Unsecured: It is not backed by any collateral. Therefore, only highly-rated and financially sound companies and financial institutions can issue CPs, as investors rely solely on the issuer’s creditworthiness.
  • Promissory Note: It is a promise by the issuer to pay the face value of the instrument to the holder on the maturity date.
  • Privately Placed: It is not offered to the general public but is sold directly to institutional investors like banks, mutual funds, and insurance companies.
• Features:
  • It is a money market instrument with a maturity period ranging from a minimum of 7 days to a maximum of one year.
  • It is issued in the form of a discounted instrument, similar to a T-bill.
  • CPs in India are issued in denominations of ₹5 lakh or multiples thereof.

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Prelims Pointers

• Quintile Ratio: Ratio of the income of the top 20% of the population to the income of the bottom 20%.
• Palma Ratio: Ratio of the income of the top 10% of the population to the income of the bottom 40%.
• Lorenz Curve: A graphical representation of wealth or income distribution. The 45-degree line represents perfect equality.
• Gini Coefficient: A measure of inequality ranging from 0 (perfect equality) to 1 (perfect inequality). It is derived from the Lorenz Curve.
• Commitment to Reducing Inequality (CRI) Index: Published by Oxfam International and Development Finance International (DFI).
• CRI Index Pillars: 1. Public Services (Health, Education), 2. Progressive Taxation, 3. Workers’ Rights.
• Relative Poverty (UNDP definition): Percentage of the population earning less than 50% of the median income.
• Fifth FYP (1974-78): Focused on “Garibi Hatao” (Poverty Removal).
• Money Market: Deals with financial instruments with a maturity of up to one year (364 days).
• Capital Market: Deals with financial instruments with a maturity of more than one year.
• Treasury Bills (T-bills): Short-term, zero-coupon securities issued by RBI for the central government.
• T-bill tenors: 91 days, 182 days, and 364 days.
• Cash Management Bills (CMBs): Introduced in 2010. Similar to T-bills but with a maturity of less than 91 days.
• Sensex: Benchmark index of the Bombay Stock Exchange (BSE), comprising 30 companies.
• Bond Price & Yield Relationship: Inverse. When bond prices rise, bond yields fall, and vice versa.
• Normal Yield Curve: Upward-sloping; long-term yields are higher than short-term yields.
• Inverted Yield Curve: Downward-sloping; short-term yields are higher than long-term yields. It is a strong indicator of a future economic recession.
• Commercial Paper (CP): Introduced in India in 1990.
• CP Nature: Short-term, unsecured promissory note.
• CP Maturity: 7 days to 1 year.
• CP Denomination: Issued in multiples of ₹5 lakh.
• CP Issuers: Corporates, Primary Dealers, and All-India Financial Institutions.

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Mains Insights

On Inequality

1. Growth vs. Equity Debate:

   • The post-1991 experience in India reignites the classic debate on whether a country should prioritize economic growth (assuming benefits will ‘trickle down’) or focus on direct redistribution and equity.
   • Kuznets Curve Hypothesis (Simon Kuznets, 1955): This theory suggests that as an economy develops, market forces first increase and then decrease economic inequality. However, recent evidence from both developed nations (as shown by Piketty) and India suggests that inequality can continue to rise even in later stages of development, challenging the automatic ‘trickle-down’ effect and necessitating active state intervention.
   • For India, the policy challenge is to pursue “inclusive growth,” where the growth process itself is broad-based and creates opportunities for all sections of society, rather than relying solely on post-facto redistribution through welfare schemes.

2. Structural Nature of Inequality in India:

   • Inequality in India is not merely economic; it is deeply structural, with economic disadvantages reinforcing and being reinforced by social identities like caste, tribe, and gender.
   • Policy interventions must therefore be multi-pronged. For example, promoting women’s education (addressing gender inequality) can have a multiplier effect on improving household health, nutrition, and economic prospects, thereby reducing overall economic inequality. Similarly, policies targeting marginalized caste and tribal groups are crucial.

3. Policy Implementation as the Achilles’ Heel:

   • India has numerous well-intentioned schemes for poverty alleviation and social welfare. However, their effectiveness is often crippled by implementation challenges like leakages, corruption, lack of last-mile delivery, and poor targeting.
   • The move towards Direct Benefit Transfer (DBT) using the JAM (Jan Dhan-Aadhaar-Mobile) trinity is a significant step to plug leakages, but challenges of financial literacy, digital exclusion, and banking accessibility remain.

On Financial and Bond Markets

1. Monetary Policy Transmission and Market Development:

   • A well-developed and liquid money market is crucial for the effective transmission of a central bank’s monetary policy. When the RBI changes its policy rate (the repo rate), the effect should ripple through the money market to influence other interest rates in the economy.
   • The development of a corporate bond market is essential for India’s economic growth. It reduces the over-reliance of corporations on bank loans for their long-term funding needs, diversifies financial risk away from the banking sector, and provides a new avenue for long-term investors like pension funds and insurance companies.

2. Navigating Global Spillovers:

   • The analysis of the inverted US yield curve highlights India’s increasing integration with the global economy and its vulnerability to external shocks (‘spillovers’).
   • This presents a policy trilemma for the RBI: it is difficult to simultaneously maintain a fixed exchange rate, have free capital movement, and run an independent monetary policy.
   • In the face of US monetary tightening, the RBI faces a difficult choice: raise its own interest rates to stem capital outflows and stabilize the rupee (which could hurt domestic growth), or allow the rupee to depreciate (which fuels inflation). Building up foreign exchange reserves acts as a buffer but is not a permanent solution.

3. Risk Management in Corporate Financing:

   • Instruments like Commercial Paper provide corporations with a flexible and often cheaper source of short-term funding compared to bank credit. This fosters financial efficiency.
   • However, the unsecured nature of CPs poses systemic risks. A crisis in a major CP issuer (as seen in the IL&FS crisis of 2018) can trigger a chain reaction, freezing liquidity in the money market and creating a confidence crisis that affects even healthy firms. This underscores the need for robust credit rating agencies and regulatory oversight.