GS Notes

6. Economics Notes 33

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Elaborate Notes

CURRENCY MARKET AND FINANCIAL INSTRUMENTS

  • Insider Trading and the Rajat Gupta Case:

    • Definition: Insider trading is the illegal practice of trading on a stock exchange to one’s own advantage through having access to confidential, or ‘Unpublished Price Sensitive Information’ (UPSI). As per the SEBI (Prohibition of Insider Trading) Regulations, 2015, an ‘insider’ is any person who is a connected person or in possession of or having access to UPSI.
    • Historical Context: The concept gained prominence in the US with the Securities Exchange Act of 1934. In India, robust regulations were framed by the Securities and Exchange Board of India (SEBI) in 1992, which have been periodically strengthened.
    • Example (Rajat Gupta): Rajat Gupta, a former managing director of McKinsey & Co. and a board member of Goldman Sachs, was a high-profile case. In 2012, he was convicted in the US for passing confidential boardroom information about Goldman Sachs to hedge fund manager Raj Rajaratnam. This case underscored the global reach of financial regulations and the severe repercussions of violating fiduciary duties.

  • Initial Public Offering (IPO):

    • An IPO is the process by which a privately held company becomes a publicly traded company by offering its shares to the public for the first time.
    • The primary purpose is to raise capital for expansion, debt repayment, or other corporate purposes. It also allows early-stage investors, like angel investors and venture capitalists, to exit their investments. The process is heavily regulated by market regulators like SEBI in India.

  • Tobin Tax:

    • Proposed by Nobel laureate economist James Tobin in 1972, the Tobin tax is a tax on short-term international currency transactions.
    • Objective: Its primary goal was to deter speculative short-term currency trading, which Tobin believed caused instability in foreign exchange markets. The revenue generated could be used for global public goods. The concept has been debated for decades, with proponents highlighting its potential to curb volatility and opponents citing difficulties in global implementation and the risk of capital flight.

  • Qualified Institutional Buyers (QIBs):

    • As defined by SEBI, QIBs are institutional investors perceived to possess the expertise and financial muscle to evaluate and invest in capital markets.
    • Examples: These entities include commercial banks, public financial institutions, mutual fund companies, and foreign institutional investors registered with SEBI. They are considered sophisticated investors and are thus subject to less stringent regulatory requirements compared to retail investors, especially during IPOs and other capital-raising exercises.

  • Financial Derivatives (OPTIONS, SWAPS, FUTURES, FORWARDS):

    • Derivatives are financial contracts whose value is derived from an underlying asset (e.g., stocks, bonds, commodities, currencies). They are primarily used for hedging (risk management) and speculation.
    • Forwards: A private, customizable contract between two parties to buy or sell an asset at a specified price on a future date. Being over-the-counter (OTC), they carry counterparty risk (risk of default by one party).
    • Futures: A standardized forward contract that is traded on an organized exchange (like NSE or BSE). Standardization and exchange trading eliminate counterparty risk, which is guaranteed by a clearinghouse.
    • Options: Gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specified date. The buyer pays a premium for this right.
    • Swaps: A contract through which two parties exchange financial instruments or cashflows for a certain time. The most common type is an interest rate swap, where one party exchanges a fixed interest rate payment for a floating interest rate payment.

  • Market Sentiments (Bear vs. Bull):

    • Bear: A bear is an investor who acts on the belief that a market or security’s price will decline. A “bear market” is a period of prolonged price declines, typically a fall of 20% or more from recent highs.
    • Bull: A bull is an investor who believes that a market or security’s price will rise. A “bull market” is characterized by sustained price increases and investor optimism.

  • Stock Exchanges and Indices:

    • BSE (Bombay Stock Exchange): Asia’s oldest stock exchange, established in 1875. Its benchmark index is the Sensex (Sensitive Index), which tracks the performance of 30 of the largest and most actively traded stocks on the exchange.
    • NSE (National Stock Exchange): Established in 1992, it was the first demutualized electronic exchange in India. Its benchmark index is the Nifty 50, which represents the weighted average of 50 of the largest Indian companies listed on the exchange.

  • Investment Risk and Beta:

    • Systematic Risk: Also known as market risk or non-diversifiable risk, it is inherent to the entire market or a market segment. It is unpredictable and impossible to completely avoid. Examples include inflation, interest rate changes, and geopolitical events.
    • Unsystematic Risk: Also known as specific risk or diversifiable risk, this type of risk is specific to a company or industry. It can be mitigated through diversification. Examples include labor strikes, management changes, or regulatory penalties on a specific firm.
    • Beta (β): It is a measure of a stock’s volatility, or systematic risk, in relation to the overall market. The market has a beta of 1.0. A stock with a beta greater than 1.0 is more volatile than the market, while a stock with a beta less than 1.0 is less volatile.

DEPOSITORY RECEIPTS (DRs) AND OTHER INSTRUMENTS

  • Depository Receipt (DR):

    • A DR is a negotiable financial instrument (a certificate) issued by a depository bank that represents shares of a foreign company’s stock. These receipts are traded on a local stock exchange.
    • Mechanism: A foreign company deposits its shares with a domestic custodian bank in its home country. An overseas depository bank then issues DRs against these shares, which are then sold to investors in the foreign country. This allows the company to raise capital internationally without the complexities of a direct foreign listing.
    • American Depository Receipt (ADR): A DR issued and traded in the United States. It allows US investors to invest in non-US companies. For example, Infosys was among the first Indian companies to list its ADRs on the NASDAQ in 1999.
    • Global Depository Receipt (GDR): Similar to an ADR, but it is listed on an exchange outside the US, typically in Europe (e.g., London Stock Exchange, Luxembourg Stock Exchange).
    • Indian Depository Receipt (IDR): A DR issued by an Indian depository against underlying equity shares of a foreign company. Standard Chartered PLC was the first company to issue IDRs in India in 2010.

  • Sweat Equity Share:

    • As per the Companies Act, 2013, these are equity shares issued by a company to its directors or employees at a discount or for consideration other than cash.
    • It is a form of non-monetary contribution, rewarding them for their hard work, expertise, or provision of intellectual property that benefits the company. It serves as a tool to retain talent, especially in startups.

  • Angel Investor and Angel Tax:

    • Angel Investor: A high-net-worth individual who provides financial backing for small startups or entrepreneurs, typically in exchange for ownership equity. They are often the first source of external funding for a new venture.
    • Angel Tax: A term used for the income tax payable on capital raised by unlisted companies via the issue of shares where the share price is seen in excess of the “fair market value” of the shares. Introduced in 2012 via Section 56(2)(viib) of the Income Tax Act, it was intended to deter the generation and use of unaccounted money, but it became a major concern for the startup ecosystem.

  • Qualified Foreign Investor (QFI):

    • The QFI framework was a former investment scheme introduced by the Government of India in 2011 to allow foreign individuals, groups, or associations to invest directly in the Indian equity market. This scheme was later merged with the Foreign Portfolio Investor (FPI) regime in 2014 to simplify and streamline foreign investment regulations.

  • Comparison of Investment Vehicles: | | Shares (Equity) | Mutual Funds | Exchange-Traded Funds (ETF) | | :--- | :--- | :--- | :--- | | Risk | High, as it depends on the performance of a single company. It is subject to both systematic and unsystematic risk. | Risk is relatively lower due to diversification across a portfolio of securities managed by a professional fund manager. | Offers diversification of risk similar to mutual funds as it tracks an index or a basket of assets. | | Returns| Potential for high returns, but also high potential for losses. | Returns are generally lower and more stable than individual stocks, reflecting the average performance of the portfolio. | Returns are designed to mirror the performance of the underlying index or asset (e.g., Nifty 50, Gold). | | Market Exposure| Direct exposure to the financial market. Can be bought and sold throughout the trading day on a stock exchange. | Provides indirect market exposure. Units can typically be bought or sold only at the end-of-day Net Asset Value (NAV). Cannot be sold in the secondary market. | Traded on stock exchanges like individual stocks, allowing for intraday buying and selling at market prices. | | Example| Shares of Tata Motors, Reliance Industries. | HDFC Top 100 Fund, SBI Bluechip Fund. | Bharat 22 ETF, an ETF comprising shares of 22 central public sector enterprises, state-owned banks, and other government-held entities. |

PUBLIC DISTRIBUTION SYSTEM (PDS)

  • Concept of PDS:

    • The PDS is a government-sponsored chain of fair price shops entrusted with the work of distributing basic food and non-food commodities to the needy sections of the society at very subsidized prices.
    • It is fundamentally a welfare-oriented system, distinct from private distribution which is profit-driven. The system encompasses the entire chain of operations:
      1. Procurement: Primarily undertaken by the Food Corporation of India (FCI) and state agencies at the Minimum Support Price (MSP).
      2. Storage: Maintaining buffer stocks and operational stocks in FCI godowns.
      3. Allocation: The central government allocates foodgrains to states.
      4. Distribution: State governments are responsible for distributing the grains to beneficiaries through a network of Fair Price Shops (FPS).

  • Pillars of Food Security: The concept of food security, as defined by the UN’s Food and Agriculture Organization (FAO), rests on four pillars, all of which the Indian PDS aims to address:

    • Availability: Ensuring sufficient quantity of food is available. This is achieved through domestic production (supported by MSP, irrigation) and buffer stocks.
    • Affordability (Access): Ensuring people have sufficient resources to obtain food. This is the primary role of PDS, which provides subsidized foodgrains through schemes like the Targeted PDS (TPDS).
    • Stability: Ensuring consistent access to food over time, without losing it due to sudden shocks. This is managed through FCI’s buffer stock operations, which stabilize supply and prices during lean seasons or crises.
    • Nutrition (Utilization): Ensuring proper biological use of food, requiring a diet providing sufficient energy and essential nutrients. This is addressed through schemes like the National Food Security Act (NFSA), 2013, and the Integrated Child Development Services (ICDS).

EVOLUTION OF PDS

  • Phase 1 (1945–1965):

    • The origins of PDS lie in the rationing system introduced by the British during World War II, particularly in the aftermath of the Bengal Famine of 1943.
    • Post-independence, this system continued as a mechanism to distribute scarce commodities, mainly in urban areas.
    • This period was characterized by a “ship-to-mouth” existence, with heavy dependence on food aid from the USA under its Public Law 480 (PL-480) program. Domestic procurement was minimal as procurement prices were not remunerative for farmers.

  • Phase 2 (1965–1975):

    • This phase marked the institutionalization of India’s food security framework, driven by the Green Revolution and the need for self-sufficiency after the stoppage of PL-480 imports following geopolitical pressures (e.g., during the Indo-Pak war of 1965).
    • Key institutions were established in 1965:
      • Food Corporation of India (FCI): To handle procurement, storage, and distribution of food grains.
      • Agricultural Prices Commission (APC): Later renamed the Commission for Agricultural Costs and Prices (CACP) in 1985, to recommend remunerative Minimum Support Prices (MSP) to incentivize farmers.
    • The focus shifted to building a sustainable system based on domestic procurement and buffer stocking. By 1975, India had significantly reduced its dependence on imports.

  • Phase 3 (1975 to Present):

    • With increased food production and burgeoning buffer stocks, the policy emphasis shifted from managing scarcity to managing surplus and improving distribution.
    • Late 1970s-1980s: PDS was still largely an urban phenomenon. Recognizing this, the Sixth Five-Year Plan (1980-85), with its focus on “Garibi Hatao” (poverty alleviation), emphasized extending PDS to rural and tribal areas. Some states like Tamil Nadu and Andhra Pradesh pioneered targeted approaches.
    • 1992: The Revamped Public Distribution System (RPDS) was launched to strengthen and streamline the PDS in 1,775 backward blocks.
    • 1997: A significant policy shift occurred with the introduction of the Targeted Public Distribution System (TPDS). It divided the population into Below Poverty Line (BPL) and Above Poverty Line (APL) categories, with differential pricing. This marked the end of the universal PDS.
    • Post-2000: Schemes like Antyodaya Anna Yojana (AAY) for the “poorest of the poor” were introduced. The system culminated in the National Food Security Act (NFSA), 2013, which made access to subsidized food grains a legal right for nearly two-thirds of the population.

Prelims Pointers

  • Insider Trading: Trading based on Unpublished Price Sensitive Information (UPSI). Regulated by SEBI in India.
  • Tobin Tax: Proposed by James Tobin (1972) as a tax on short-term international currency transactions.
  • QIB: Qualified Institutional Buyer (e.g., Banks, Mutual Funds).
  • Derivatives: Financial instruments whose value is derived from an underlying asset.
    • Forwards: Private, customized, carry counterparty risk.
    • Futures: Standardized, exchange-traded, no counterparty risk.
    • Options: Give the right, not the obligation, to buy (call) or sell (put).
  • ADR: American Depository Receipt, traded in the US market.
  • GDR: Global Depository Receipt, traded in markets outside the US (e.g., London, Luxembourg).
  • IDR: Indian Depository Receipt, allows foreign companies to raise funds from the Indian market.
  • Sweat Equity: Shares issued to employees/directors for non-cash contributions like know-how.
  • Angel Tax: Tax on capital raised by unlisted startups from an issue of shares in excess of fair market value.
  • Beta (β): Measures a stock’s volatility relative to the market. Beta = 1 means stock moves with the market.
  • BSE Sensex: Index of 30 large-cap stocks on the Bombay Stock Exchange.
  • NSE Nifty 50: Index of 50 large-cap stocks on the National Stock Exchange.
  • Bharat 22: An Exchange-Traded Fund (ETF) consisting of shares of select Central Public Sector Enterprises (CPSEs).
  • Food Security Pillars: Availability, Affordability (Access), Stability, Nutrition (Utilization).
  • PL-480 Program: Food aid program through which India imported wheat from the USA, prominent before the mid-1960s.
  • FCI (Food Corporation of India): Established in 1965.
  • CACP (Commission for Agricultural Costs and Prices): Established as APC in 1965. Recommends MSP.
  • TPDS (Targeted PDS): Introduced in 1997, creating BPL and APL categories.
  • NFSA (National Food Security Act): Enacted in 2013.

Mains Insights

Financial Markets and Regulation (GS Paper III)

  • Insider Trading and Corporate Governance: The Rajat Gupta case is a classic example of the failure of corporate governance and breach of fiduciary duty. For Mains, this can be linked to the necessity of robust regulatory frameworks (SEBI’s role), stringent penalties, and the promotion of ethical conduct in corporations (GS Paper IV - Ethics). The debate revolves around strengthening surveillance mechanisms versus promoting a culture of self-regulation.
  • Feasibility of Tobin Tax: This is a relevant topic in the context of global financial stability.
    • Arguments For: It could curb excessive speculation in currency markets, reduce volatility, and generate substantial revenue for international development goals (like climate finance or SDGs).
    • Arguments Against: Unilateral implementation is impossible; it would require global consensus, which is hard to achieve. It could lead to capital flight to non-compliant jurisdictions (tax havens) and increase the cost of legitimate hedging activities for businesses.
  • Start-up Ecosystem Challenges: The issue of “Angel Tax” highlights the friction between regulatory intent (curbing money laundering) and its unintended consequences on innovation and entrepreneurship. A well-rounded answer should analyze how tax policy can either nurture or stifle a nascent start-up ecosystem and suggest a balanced approach that promotes transparency without creating undue compliance burdens.

Public Distribution System and Food Security (GS Paper II & III)

  • PDS: Evolution from Universal to Targeted Approach: The shift from a universal PDS to a Targeted PDS (TPDS) in 1997 is a critical policy debate.
    • Rationale for Targeting: To reduce the fiscal deficit, contain the food subsidy bill, and ensure that benefits reach the most deserving.
    • Criticism of Targeting: It led to large-scale exclusion and inclusion errors due to flawed identification of BPL families. Scholars like Jean Drèze and Amartya Sen have argued that the costs of targeting (administrative, social, and political) often outweigh the benefits, and a near-universal system with minimal exclusions is more effective in a country like India.
  • Challenges in the PDS Mechanism:
    1. Leakages and Diversion: A significant portion of food grains does not reach the intended beneficiaries due to diversion to the open market. The Shanta Kumar Committee Report (2015) estimated leakages to be as high as 40-50% in some cases.
    2. Quality of Food Grains: Beneficiaries often complain about receiving poor-quality food grains.
    3. Financial Viability of FPS: Fair Price Shops often struggle with low commissions, making the business unviable and incentivizing malpractice.
    4. Issue of Buffer Stocks: The FCI holds massive stocks, far exceeding the buffer norms. This leads to high carrying costs, storage losses, and wastage, while depressing open market prices for farmers.
  • The PDS vs. Direct Benefit Transfer (DBT) Debate: This is a central theme in reforming the food security system.
    • Case for Cash Transfers (DBT): Proponents argue that cash transfers empower beneficiaries with choice, reduce leakages and administrative overheads (transportation, storage), and plug corruption. It aligns with the JAM (Jan Dhan-Aadhaar-Mobile) trinity.
    • Case for In-Kind Transfers (PDS): Opponents of DBT argue that in a food-scarce or high-inflation environment, cash may not guarantee access to food. PDS acts as an automatic stabilizer by releasing stocks during shortages. There is also a risk that cash may be used for non-food purposes, particularly affecting the nutritional status of women and children.
    • A balanced view: A hybrid model, allowing states the flexibility to choose between PDS and DBT based on local market conditions and beneficiary preparedness, could be the optimal path forward. The success of in-kind PDS reforms in states like Chhattisgarh and Tamil Nadu demonstrates that the system can be fixed.

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