Compilation from newspaper

1. The Economic Times ET in the Classroom – Archives – 1 (Economics Concepts Explained)
The Economic Times newspaper now and then publishes articles on current economic issues in a question and
answer format under the heading ‘ET in the Classroom’. They are simple to understand and remember.
Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely
available on the net. They are the property of the Economic Times. I have just consolidated all of them here for
the benefit of the readers.
Complete credit is for The Economic Times newspaper for these wonderful articles.
For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop
solution for getting acquainted with many economic jargon and concepts.
ET in the classroom: What is Islamic finance?
What is Islamic finance?
Islamic finance refers to a financial system that is consistent with the principles of Sharia, the sacred law of
Islam. It is different from regular banking in that it prohibits earning of interest (or riba) through the business of
lending. It also prohibits direct or indirect association with businesses involving alcohol, pork products,
firearms and tobacco. It also does not allow speculation, betting and gambling.
How does it work?
Islamic finance takes the form of Islamic banking and Islamic insurance, also known as Takaful.
Islamic banking is done in five ways:
1. Mudarabah, a profit-sharing agreement
2. Wadiah, a safe keeping arrangement
3. Musharakah, a joint venture for a specific business
4. Murabahah, cost plus arrangement where goods are sold with a pre-determined margin of profit
5. Ijirah, a leasing arrangement
Takaful is a form of mutual insurance based on partnership and collective sharing of risk by a group of
individuals.
How has Islamic banking progressed in recent years?
Islamic banking is most prevalent in Malaysia. It is spreading rapidly in West Asia, where the population is
predominantly Muslim. New global financial centers such as Singapore, Hong Kong, Geneva, Zurich and
London have made changes in regulations to accommodate the Islamic finance industry, which is nearly a
trillon dollar in size now.
Indian regulations do not allow Islamic banking but the government is considering allowing it.
What restricts the growth of Islamic finance?
Most banks conducting Islamic operations have a panel of Muslim scholars called Sharia committee or Sharia
board, which determines whether a product or practice complies with Islamic provisions. Also, the accounting is
done differently for which there is an official standard-setting body known as the accounting and auditing
organization for Islamic financial institutions. The strict code makes Islamic banking a very niche product.
ET in the classroom: Infrastructure debt fund
What is the Infrastructure debt fund or IDF?
Infrastructure debt fund is a debt instrument being set up by the finance ministry in order to channelise long-
term funds into infrastructure projects which require long-term stable capital investment. According to the
structure laid out by the finance ministry, after consultations with stakeholders, infrastructure NBFCs, market
regulators and banks, an IDF could either be set up as a trust or as a company.

2. What happens in either of the scenario?
If the IDF is set up as a trust, it would be a mutual fund, regulated by SEBI or the Securities and Exchange
Board of India. The mutual fund would issue rupee-denominated units of five years’ maturity to raise funds for
the PPP, or public private partnership projects. In case the IDF is set up as funds, the credit risk would be borne
by investors and not the IDF.
As a company, it could be set up by one or more sponsors, including NBFCs, IFCs or banks. It would be
allowed lower risk-weightage of 50%, net-owned funds (minimum tier-I equity of 150 crore). It would raise
resources through issue of either rupee or dollar-denominated bonds of minimum five-year maturity. It would
invest in debt securities of only PPP projects, which have a buyout guarantee and have completed at least one
year of commercial operation.
Refinance by IDF would be up to 85% of the total debt covered by the concession agreement. Senior lenders
would retain the remaining 15% for which they could charge a premium from the infrastructure company. The
credit risks associated with the underlying projects will be borne by IDF. As an NBFC, the fund would be
regulated by the Reserve Bank of India.
Who would be the major investors?
Domestic and offshore investors, mainly pension funds and insurance companies, who have long-term
resources, would be allowed to invest in these funds, while banks and financial institutions would act as
sponsors.
ET in the Classroom: Marginal standing facility
What is the marginal standing facility?
The Reserve Bank of India in its monetary policy for 2011-12, introduced the marginal standing facility (MSF),
under which banks could borrow funds from RBI at 8.25%, which is 1% above the liquidity adjustment facility-
repo rate against pledging government securities.
The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Banks can borrow funds
through MSF when there is a considerable shortfall of liquidity. This measure has been introduced by RBI to
regulate short-term asset liability mismatches more effectively.
In the annual policy statement, RBI says: “The stance of monetary policy is, among other things, to manage
liquidity to ensure that it remains broadly in balance, with neither a large surplus diluting monetary transmission
nor a large deficit choking off fund flows.”
What is the difference between liquidity adjustment facility-repo rate and marginal standing facility
rate?
Banks can borrow from the Reserve Bank of India under LAF-repo rate, which stands at 7.25%, by pledging
government securities over and above the statutory liquidity requirement of 24%. Though in case of borrowing
from the marginal standing facility, banks can borrow funds up to one percentage of their net demand and time
liabilities, at 8.25%. However, it can be within the statutory liquidity ratio of 24%.
ET in the classroom: Priority-sector lending
What is priority-sector lending?
Banks were assigned a special role in the economic development of the country, besides ensuring the growth of
the financial sector. The banking regulator, the Reserve Bank of India, has hence prescribed that a portion of
bank lending should be for developmental activities, which it calls the priority sector.

3. Are there minimum limits?
The limits are prescribed according to the ownership pattern of banks. While for local banks, both the public
and private sectors have to lend 40 % of their net bank credit, or NBC, to the priority sector as defined by RBI,
foreign banks have to lend 32% of their NBC to the priority sector.
What is net bank credit?
The net bank credit should tally with the figure reported in the fortnightly return submitted under Section 42 (2)
of the Reserve Bank of India Act, 1934. However , outstanding deposits under the FCNR (B) and NRNR
schemes are excluded from net bank credit for computation of priority sector lending target/subtargets.
Are there specific targets within the priority sector?
Domestic banks have to lend 18 % of NBC to agriculture and 10 % of the NBC has to be to the weaker section.
However, foreign banks have to lend 10 % of NBC to the small-scale industries and 12 % of their NBC as
export credit. However, for the balance, there are a vast number of sectors that banks can lend as priority sector.
The Reserve Bank has a detailed note of what constitutes a priority sector, which also includes housing loans,
education loans and loans to MFIs, among others.
What has been the experience so far?
It has been observed that while banks often tend to meet the overall priority sector targets, they sometimes tend
to miss the sub-targets. This is particularly true in case of domestic banks failing to meet their sub-targets for
agricultural advances. One of the reasons banks often site for not lending to this sector is that recovery is often
difficult.
Is there any penal action in case of non-achievement of priority sector lending target by a bank?
Domestic banks having a shortfall in lending to priority sector/ agriculture are allocated amounts for
contribution to the Rural Infrastructure Development Fund (RIDF ) established in NABARD. In case of foreign
banks operating in India, which fail to achieve the priority sector lending target or sub-targets, an amount
equivalent to the shortfall is required to be deposited with Sidbi for one year.
ET in the Classroom: What the Greek crisis means to the world
Why Does the World Want to Save Greece?
No one can quantify the damage to the world if Greece is allowed to sink. But few are willing to risk it either.
Such a fear owes its origin to the 2008 crisis. Many economists, policymakers and some within central banks
believe that the financial meltdown of 2008 could have been ringfenced, or at least cushioned, if Lehman was
bailed out. But since Lehman was an investment bank, and not a commercial bank holding savings of millions,
Fed and the US government had thought that the collateral damage from its bankruptcy would be contained
within a few blocks of Wall Street, and no one really would lose jobs and take pay cuts. Within months we all
found out how wrong they were. Today, no one wants to take a chance with Greece. Leaders across Europe fear
that a Greece collapse can start a fire that will engulf continents.
How does fear spread when markets are in such a state?
Banks impacted by a default may find themselves cut out from the dollar market — the engine of global
liquidity. As a result, these banks will find it very difficult to roll over their dollar assets as the other banks
which are more solvent would be unwilling to lend them. That’s when the world outside financial markets
would feel the pinch. Suppose, a French bank that had given a dollar line to the European subsidiary of an Asian
company, or to bank in Asia which, in turn, had extended a dollar credit to a local company, would not roll over
the credit line
Will a default cause a dollar scarcity?
Banks and companies are already holding on to the dollar. A default will only deepen it. Consider the Asian
company whose dollar line has been pulled bank. It will somehow try to organise the money by paying a

4. premium. Having sensed a dollar scarcity and fearing that things may turn worse, it will raise more than it
needs. When all companies start doing it, there is artificial scarcity. Not just banks, corporates in Greece would
also default
How will panic boil over to other Euro Nations?
Speculators will target Portugal, and then Italy. The logic is simple: if Germany & ECB do not help Greece,
they will also let Portugal and Italy sink. Soon these will be perceived as basket cases and their bonds, stocks
and currencies will face a brutal attack from short-sellers. That would be a problem as Italy’s debt is more than
the combined debt of Portugal, Spain and Ireland
So, time’s running out for Greece?
Close to $8 billion worth Greek bonds will mature in December. It needs the money before that, failing which a
default is inevitable. IMF is willing to lend a little over $8 billion, but only if Greece takes a string of austerity
measures. IMF is not spelling out exactly when it will sanction the loan. Some economists fear the IMF pressure
can make things difficult for Greece: how will lower consumption help a country which is already doldrums
Isn’t Germany in a bit of a Catch-22 Situation?
It is. German politicians know that if there was no euro, its currency would have gained so much that their
exporters would have been wiped out. It needs the euro. But convincing Germans isn’t easy. They don’t want to
bail out all Europeans, particularly those who don’t work hard. Some think Greece should be exiled from EU
for a few years to should put their house in order
ET in the Classroom: Interest rate futures
What is the interest rate futures on 91-day treasury bill?
Interest rate futures on 91-day Treasury bill are interest rate-driven derivative products that help banks, mutual
funds and primary dealers to hedge their interest rate exposure on treasury bills. Financial institutions can lock
in the interest rate or the yield on the 91-day treasury at a given date when counter parties enter into the interest
rate futures contract.
How are they settled?
The 91-day T-bill interest rate futures are cash settled. In case of the 91-day treasury bill, the final settlement
price of the futures contract is based on the weighted average price/ yield obtained in the weekly auction of the
91-day treasury bills on the date of expiry of the contract. But in case of interest rate futures on the 10-year
benchmark government security, the contract is physically settled.
How is the product structured?
The minimum size of the contract is Rs 2 lakh and the tenor of the contract cannot be more than 12 months,
according to market regulator SEBI, which has designed the product and will supervise its trading. The
maximum maturity of the contract can be for 12 months. The initial margin is subjected to a minimum of 0.1%
of the notional value of the contract on the first day of trading and 0.05 % of the notional value of the contract
thereafter.
What kind of volumes has the product generated so far?
Last week, the average daily trading volume for the 91-day T-Bill IRF was Rs 360 crore. So far, among the
exchanges, only NSE has introduced the product for trading. The interest rate futures (IRF) on 91-day TBills
clocked a volume of around Rs 730 crore on the National Stock Exchange (NSE) on the first day of trading last
Monday.
What are the advantages of the interest rate futures?
It is a good hedging tool for banks, primary dealers and mutual funds who have huge exposure to these money
market instruments such as 91-day treasury bills. There is no securities transaction tax (STT). The initial

5. margins are also lower, which could attract volumes for the product. Interest rate futures can be used by
investors to take a directional call on the interest rates or for hedging their existing position.
ET in the classroom: Central plan and role of plan panel and finance ministry
The government’s budget exercise usually begins with fixing the contribution of the exchequer to the central
plan. Though distributed over many schemes, taken together this is the single biggest item of expenditure in the
annual budget. ET takes a look at the concept of Central Plan and the budget support to the plan.
What is central plan in the context of the budget?
Central or annual plans are essentially the five year plans broken down into five annual installments. Through
these annual plans, the government achieves the objectives of the Five-Year Plans. The details of the plan are
spelled out in the annual budget presented by the finance minister. But the actual responsibility of allocation
funds judiciously amongst ministries, departments and state governments rests with the Planning Commission.
What is gross budgetary support, or GBS?
The funding of the central plan is split almost evenly between government support (from the Budget) and
internal and extra budgetary resources of public enterprises. The government’s support to the central plan is
called the Gross Budgetary Support, or the GBS. In the recent years the GBS has been slightly more than 50%
of the total central plan.
How is the GBS figure arrived at?
The administrative ministries responsible for various development schemes present their demands before the
planning commission. The planning commission aggregates and vets these demand. It then puts forward a
consolidated demand before the finance ministry for the budgetary support it needs from the cental excequer.
The amount approved by the finance ministry is usually less than that demanded by the planning commission
because of the multiple objectives the North Block has to keep in mind will making allocations. The planning
commission in turn adjusts the allocated amount among various demands.
How do GBS, central plan and plan expenditure differ?
Central plan includes the GBS and the spending of the public enterprises that do not figure in the budget. In that
sense the government’s spending on the central plan is limited to GBS. But the centre also provides funds to
states and union territories for their respective plans. This contribution, together with the GBS, makes up the
total plan spending of the government for a year. This is about 30% of the total government expenditure.
ET in the Classroom: Self-help group
What is a self-help group (SHG)?
SHG primarily comprises members with homogenous social and economic backgrounds. It is a voluntarily
formed group consisting of women, rural labourers, small farmers and micro-enterprises. The concept is akin to
the concept of democracy. SHGs are formed by the members, for the members and of the members. The
number of members could be as less as five and could even go up to 20. They save and contribute to a common
fund which is used to lend to the members. Since they know each other, members do not seek collateral from
each other.
What are the goals of an SHG?
An SHG is seen as an instrument for achieving a variety of goals, including empowering women. Data from
NABARD, which pioneered the concept, shows that 90% of members in the SHG are women and most of them
do not have any assets. It also helps in developing leadership abilities among the poor, increasing school
enrolments, improving nutrition and in birth control. An SHG is generally started by non-profit organisations,
such as an NGO with broad anti-poverty agendas. It is also a popular channel of micro-lending by commercial
banks, particularly government-run banks.

6. What are the advantages of financing through an SHG?
A poor individual benefits enormously being part of an SHG. Raising finance through SHGs reduces transaction
costs for both lenders and borrowers. Lenders have to handle only a single SHG account instead of a large
number of small-sized individual accounts, borrowers as part of an SHG cut down expenses on travel to the
branch to get the loan sanctioned.
What are the different ways in which banks fund SHGs?
Banks deal directly with individual SHGs. They provide financial assistance to each SHG for lending to
individual members. Alternatively, banks provide loans to SHGs with recommendation from NGOs. Here the
SHGs are formed by NGOs or government agencies, which raise funds from banks. In this, NGOs would
organise the poor into SHGs, undertake training, help in arranging inputs and marketing and assist in
maintenance of accounts.
ET in the Classroom: Draft Red Herring Prospectus
A company making a public issue of securities has to file a Draft Red Herring Prospectus with SEBI through an
eligible merchant banker prior to filing a prospectus with the Registrar of Companies.
What is Draft Red Herring Prospectus?
A company making a public issue of securities has to file a Draft Red Herring Prospectus (DRHP) with capital
market regulator Securities and Exchange Board of India, or SEBI, through an eligible merchant banker prior to
the filing of prospectus with the Registrar of Companies (RoCs).
The issuer company engages a SEBI registered merchant banker to prepare the offer document. Besides due
diligence in preparing the offer document, the merchant banker is also responsible for ensuring legal
compliance. The merchant banker facilitates the issue in reaching the prospective investors by marketing the
same.
Where is DRHP available?
The offer documents of public issues are available on the websites of merchant bankers and stock exchanges. It
is also available on the SEBI website under ‘Offer Documents’ section along with its status of processing. The
company is also required to make a public announcement about the filing in English, Hindi and in regional
language newspapers. In case, investors notice any inaccurate or incomplete information in the offer document,
they may send their complaint to the merchant banker and / or to SEBI.
What does SEBI do with the DRHP?
The Indian regulatory framework is based on a disclosure regime. SEBI reviews the draft offer document and
may issue observations with a view to ensure that adequate disclosures are made by the issuer
company/merchant bankers in the offer document to enable investors to make an informed investment decision
in the issue. It must be clearly understood that SEBI does not ‘vet’ and ‘approve’ the offer document.
Also, SEBI does not recommend the shares or guarantee the accuracy or adequacy of DRHP. SEBI’s
observations on the draft offer document are forwarded to the merchant banker, who incorporates the necessary
changes and files the final offer document with SEBI, Registrar of Companies (ROC) and stock exchanges.
After reviewing the DRHP, the market regulator gives its observations which need to be implemented by the
company. Once the observations are implemented, it gets final approval & the document then becomes RHP
(Red Herring Prospectus).
How is DRHP useful to investors?
DRHP provides all the necessary information an investor ought to know about the company in order to make an
informed decision. It contains details about the company, its promoters, the project, financial details, objects of
raising the money, terms of the issue, risks involved with investing, use of proceeds from the offering, among
others. However, the document does not provide information about the price or size of the offering.

7. ET in the Classroom: Reserve Bank ‘oversight’ functioning
What is the ‘oversight’ function of RBI?
The Bank for International Settlements defines oversight as “central bank function, whereby the objectives of
safety and efficiency are promoted by monitoring existing and planned systems, assessing them against these
objectives and, where necessary, inducing change”.
The three key ways in which oversight activity is carried out are through (i) monitoring existing and planned
systems; (ii) assessment and (iii) inducing change. In India, the Payment and Settlement Systems Act, 2007, and
the Payment and Settlement Systems Regulations, 2008, provide the necessary statutory backing to the Reserve
Bank of India for undertaking the oversight function. The central bank manages the various settlements system,
including cash, through currency chest and clears cheques, besides various electronic clearing services.
What is Electronic Clearing Service?
It was among the early steps initiated towards moving to a paperless settlement system by the Reserve Bank of
India. The Bank introduced the ECS (Credit) scheme during the 1990s to handle payment requirements like
salary, interest, dividend payments of corporates and other institutions.
The ECS (Debit) Scheme was introduced by RBI to provide a faster method of effecting periodic and repetitive
collections of utility companies. ECS (Debit) facilitates consumers/subscribers of utility companies to make
routine and repetitive payments by ‘mandating’ bank branches to debit their accounts and pass on the money to
the companies.
What are the various settlement systems & agencies?
National Electronic Funds Transfer (NEFT) System: In November 2005, a more secure system was introduced
for facilitating one-to-one funds transfer requirements of individuals/corporates . Available across a longer time
window, the NEFT system provides for batch settlements at hourly intervals, thus enabling a near real-time
transfer of funds.
Real-Time Gross Settlement (RTGS): It is a funds transfer system where transfer of money takes place from
one bank to another on a “real time” and on a “gross” basis . Settlement in “real time” means payment
transaction is not subjected to any waiting period.
“Gross settlement” means the transaction is settled on one-to-one basis without bunching or netting with any
other transaction. Once processed, payments are final and irrevocable. This was introduced in 2004 and settles
all inter-bank payments and customer transactions above Rs 2 lakh.
Clearing Corporation of India (CCIL): The Corporation, set up in April 2001, plays the Central Counter Party
(CCP) in government securities, the US dollar and the rupee forex exchange (both spot and forward segments)
and Collaterised Borrowing and Lending Obligation (CBLO) markets.
CCIL plays the role of a central counterparty whereby, the contract between a buyer and a seller gets replaced
by two new contracts — between CCIL and each of the two parties. This process is known as ‘Novation’.
Through novation, the counterparty credit risk between the buyer and seller is eliminated with CCIL subsuming
all counterparty and credit risks.
What does the National Payments Corporation of India do?
The Reserve Bank set up the National Payments Corporation of India (NPCI), which became functional in
2009, to act as an umbrella organisation for operating various Retail Payment Systems (RPS) in India. NPCI has
taken over National Financial Switch (NFS) from the Institute for Development and Research in Banking
Technology (IDRBT). The National Financial Switch (NFS) is an inter-bank network managed by Euronet
India.

8. What is an EEFC Account?
Exchange Earners’ Foreign Currency (EEFC) account is foreign currency-denominated account maintained
with banks dealing with foreign exchanges. The Reserve Bank of India introduced this scheme in 1992 to
enable exporters and professionals to retain their foreign exchange receipts in banks without converting it into
the local currency. Any person residing in India who receives inward remittances in foreign currency or a
company with foreign currency earnings can open EEFC account but they don’t earn any interest from the
deposits and it is a non-interest bearing scheme.
What is the minimum balance for EEFC?
This is typically a zero-balance account like normal current accounts. In other words, this means no account
holder needs to maintain an average or minimum balance in the EEFC account.
How does EEFC help exporters or individuals earn foreign currency receipts?
As the account is maintained in foreign currency, no depositors are protected from exchange rate fluctuations.
Is there any prescribed limit of deposits in EEFC?
There is no such limit. One can credit his or her entire foreign exchange earnings into this account, subject to
some permissible credits.
Can one take a foreign currency loan and put it in EEFC?
Remittances received on account of foreign currency loan or investment received from abroad can’t be
deposited in EEFC.
What are the permissible credits in this account?
a. Inward remittances received by an individual
b. payments received by a 100% export-oriented unit, export processing zone, software technology park
and electronic hardware technology park
c. payments received in foreign exchange by a unit in domestic tariff area for supply of goods to a unit in
SEZ
d. payment received by an exporter for an account maintained with an authorised dealer for the purpose of
counter trade, which is an adjustment of value of goods imported against value of goods exported
e. advance remittance received by an exporter towards export of goods or services
Can one withdraw in rupees from EEFC account?
There is no such restriction on withdrawal in rupees of funds held in an EEFC account. However, the amount
withdrawn in rupees can’t be converted into foreign currency again and re-credited to the account.
Can one make a payment directly from EEFC account?
One can make a direct payment from EEFC outside India as per the provisions laid down in FEMA regulations.
Fully export-oriented units can also pay in foreign exchange for purchasing goods as per the country’s foreign
trade policy. A person residing in India can use the account for paying airfare or hotel expenditure.
ET In the Classroom: Making a Case of Financial Inclusion
What is a ‘business correspondent’ model?
In 2006, the Reserve Bank of India allowed banks to use non-bank intermediaries as business correspondents, or
business facilitators, to extend banking and other financial services to areas where the banks did not have a
brick and mortar branch present. The objective behind it was to aid the process of financial inclusion and
consequently take banking to the remotest areas of the country and make them bankable.
What do these correspondents do?
The business correspondent is nothing but a bank-in-person, who is authorised to collect deposits and extend
credit on behalf of the bank of small-ticket sizes. He also recovers principal interest of small value deposits, sale

9. of micro insurance, mutual fund products, pension products, receipt and delivery of small value
remittances/other payment instruments.
Who is eligible to be a banking correspondent?
RBI has allowed a host of entities to act as business correspondents (BCs) of banks. These include NGOs/MFIs
set up under Societies/Trust Acts; societies registered under Mutually-Aided Co-operative Societies Acts, or the
Co-operative Societies Acts of States; Section 25 companies, which are not-for-profit companies; companies in
which NBFCs, banks, telecom companies and other corporate entities or their holding companies do not have
equity holdings in excess of 10%; post offices and retired bank employees, ex-servicemen and retired
government employees.
How is a business facilitator different from a business correspondent?
Very often the term ‘business correspondents’ is used interchangeably with the term ‘business facilitators’
(BFs). But RBI makes a clear distinction between the two. BFs are allowed to undertake only facilitation
services like identification of borrowers, collection and preliminary processing of loan applications, including
verification of primary information, creating awareness about savings and other products, processing and
submission of applications to banks and promoting and nurturing SHGs and follow-up of recovery and debt
counseling. However, facilitation of these services does not include conduct of banking business by BFs, which
is the exclusive function of business correspondents.
ET in the Classroom: Take-out financing
What is take-out financing?
Take-out financing is a method of providing finance for longer duration projects of about 15 years by banks
sanctioning medium-term loans for 5-7 years. It is given that the loan will be taken out of books of the financing
bank within pre-fixed period by another institution, thus preventing any possible asset-liability mismatch. After
taking out the loan from banks, the institution could offload them to another bank or keep it.
Though internationally this kind of lending has been in existence for many years, it came to India only in the
late 90s. These long-tenure loans were primarily introduced to incentivise banks to lend to the infrastructure
sector as banks back then had very little exposure to long-term loans, and also because they did not have
adequate resources of similar tenure to create such long-term assets.
What does the Reserve Bank rule say?
Banks/FIs are free to finance technically feasible, financially-viable and bankable projects undertaken by both
public sector and private sector undertakings, provided the amount sanctioned is within the overall ceiling of the
prudential exposure norms prescribed by RBI for infrastructure financing. They should also have the requisite
expertise for appraising technical feasibility, financial viability and bankability of projects.
Which institutions, besides banks, are engaged in this practice?
The government promoted Infrastructure Development Finance Corporation, by setting aside a corpus from the
union budget, with a primary mandate to promote infrastructure funding. Later, India Infrastructure Finance
Company also came up essentially to refinance infrastructure loans of commercial banks.
What are the problems with take-out financing?
Though take-out financing is a permissible practice in India, the concept has not taken off in a big way. Though
the concept in a way addresses the asset-liability issue, regulators still want banks to set aside higher capital for
their exposure. Besides, banks are also wary of taking risks such as construction risks, which may delay the
project as well as increase its cost.

10. LIQUID COAL
Did you know coal can be liquid fuel too?
Coal liquification is seen one of the options to cope up with high crude oil prices. While availability of coal in
plenty goes in favour of this process in the energy-scarce scenario, environmental concerns and high cost has so
far limited the use of coal-to-liquid (CTL) fuel to an insignificant position except in the case of South Africa.
Use of coal for power generation is considered a better option in India as there is no consensus among policy-
makers. Let’s look at the basic issues related to conversion of coal into liquid fuel.
Can coal be converted into liquid fuel?
Yes. Coal can be converted into a synthetic liquid fuel and the process is known as coal-to-liquid (CTL)
worldwide. Broadly, there are two different methods to convert coal into liquid fuels—direct and indirect
liquefaction. Under the direct method, hydrogen is added to crushed coal and liquid is created with the presence
of catalysts.
However, further refining of this liquid is needed to achieve liquid fuel with high-grade fuel characteristics. The
indirect liquefaction process first gasifies coal using oxygen, steam—heating them to very high temperatures.
The resultant gas is purified and mixed with water.
The liquid fuel that is created can be refined to produce diesel, naphtha, jet fuel, cooking gas and lubricants.
Creating this fuel is a very intensive process that requires large amounts of coal, water and energy.
Is CTL commercially viable?
Skyrocketing price of oil and concern over depleting crude reserves are triggers generating interest in CTL.
Ambitious CTL projects are in operation in South Africa—run by Sasol, the company that pioneered CTL.
Liquid fuel generated from coal caters to 30% of the needs of South Africa. Sasol has patented “Fischer
Tropsch” technology of indirect liquefaction, which converts synthetic gas, extracted from coal, into oil.
More than 30 CTL projects across the world are being studied for feasibility, depending on the quality of coal,
availability of water and other local conditions. The initial investment in CTL projects is quite high.
Is India game for CTL?
The government has studied CTL. The Tata Group, in collaboration with Sasol, made a presentation on a $8-
billion indirect liquefaction project using Sasol’s technology to convert high-ash Indian coal into liquid fuel
with a capacity of 80,000 barrels per day of liquid fuel.
An inter-ministerial group (IMG) examined the proposal. The Planning Commission rejected the idea, saying
that coal be better used for electricity generation rather than making liquid fuels. The IMD discussion also led to
a view that those wishing to set up CTL projects should bid for coal blocks, competing with other users.
Finally, the government offered three blocks of coal in Orissa with cumulative reserves of about six billion
tonnes for the project to private players. There were 22 applicants including Reliance Group and the Tatas. The
eligibility criterion says the applicant company should have a minimum net worth of $1 billion, besides having
a tie-up with the proven technology providers.
The IMG has to decide which companies would be allowed to implement CTL projects. What is CTL’s impact
on the environment?
Green lobbies are fighting against CTL tooth and nail, alleging that Sasol has a questionable environmental and
social record in South Africa. They advocate higher investment in renewable resources like wind energy and
solar energy, rather than opting for CTL.
Liquefying large coal reserves will release huge amounts of carbon dioxide, a greenhouse gas. Proponents of
this technology say the gas can be captured and stored underground.
The cost of carbon capture and storage will impact the economics of CTL. Coal liquification requires vast
amounts of water too and this has led to concerns in water-deficient areas.

11. ET in the classroom: Quantitative Easing II
What is quantitative easing II?
The term became fashionable post the global economic crisis in 2008, following which most governments
across the globe had to pump in huge amount of liquidity in the markets to tide over the crisis. Quantitative
easing is the process of infusing money into the system by creating ‘new money’ and eventually buying
financial assets like bonds and corporate debt from financial institutions in the country. This is done by central
banks through what is popularly known as open market operations. The idea essentially is to make adequate
money in the system to spur consumption demand in any economy.
Quantitative easing II is the popular phrase used in the context of American economy these days as the US
Federal Reserve Board is touted to go for another round of quantitative easing to consolidate the recovery of the
American economy, which has slowed down because of fundamental reasons such as lower consumption and
job losses and escape of capital to other economies.
What does it mean for India?
Quantitative easing II could flood emerging economies with the dollars, thus making the dollars cheaper and,
hence, the US exports competitive while forcing other related currencies to appreciate on account of increase in
capital inflows. There is speculation that Federal Reserve chairman Ben Bernanke will push for a fresh infusion
of about a trillion dollars into the markets this week, by way of buying bonds, which will push up bond prices
and bring down the yields, and the bond markets in India would react accordingly.
Since economies like China and Singapore have closed doors, or are at best cautious in their regulation of
capital flows, India is likely to see a gush of capital flows, which is likely to push up the stock prices, and might
eventually call for capital control from regulatory authorities.
What are economists saying?
The expert opinion is mixed on this. Nobel Laureate Paul Krugman, who has been a vehement critic of US
policies, seems to be favouring QE II. Higher commodity prices will hurt the recovery only if they rise in real
terms, he said. And they’ll only rise in nominal terms if QE succeeds in raising real demand. And this will
happen only if QE II is successful in helping economic recovery, he said in a recent media interview.
Another Nobel prize winner, Joseph Stiglitz, who was formerly the chief economist with World Bank, feels that
the Fed and its advocates are falling into the same trap that led us into the crisis in the first place. Their view is
that the major lever for the economic policy is the interest rate, and if one just gets it right, one can steer this.
That didn’t work.
It forgot about the financial fragility and how the banking system operates. They’re thinking the interest rate is a
dial you can set, and by setting that dial, you can regulate the economy. In fact, it operates primarily through the
banking system, and the banking system is not functioning well. All the literature about how the monetary
policy operates in normal times is pretty irrelevant to this situation.
Nouriel Roubini, who gained fame after his prediction of the global economic crisis of 2008, thinks further
quantitative easing will have little effect on the US growth in 2011. He regards QE II as the wrong way to go.
An excessive, permanent increase in money, in his view, is an indirect manipulation of the exchange rate.
ET in a Classroom: Beggar Thy Neighbour Policy
What is beggar thy neighbour policy?
The beggar thy neighbour policy refers to a policy that aims at addressing one’s own domestic problems at the
expense of others — trading partners in particular.

12. What are the instances of such a policy?
The most popular forms of a beggar thy neighbour policy are in the areas of foreign trade and currency
management. Conventionally, countries often impose tariff barriers and restrict imports to protect their domestic
industries. However, with globalisation, such practices are not popular.
But to achieve its domestic policy objective, for instance, encouraging exports, central banks devalue or
encourage the depreciation of their own currencies compared to its trading partners to retain their respective
competitive edge. Sometimes economies compete in encouraging appreciation of their currencies to tame
inflation at the expense of hurting income in the exporting countries.
Is China adopting a beggar thy neighbour policy?
Many economists, especially in the US, say China has deliberately kept the value of its currency low to forge
ahead in exports. But in this case, more than the competitors, the importing country, US, is complaining because
more than anything else, cheap Chinese imports are hurting its domestic economy.
How do current economies policies compare?
Currently, the raging concern among most emerging market economies in Aisa is spiralling inflation on account
of rising global commodity prices. Central banks in most economies, including India’s, are (though not
necessarily planned) encouraging appreciation of their respective currencies.
This is helping them curtail inflation arising out of imported goods as imposing tariff barriers is perceived to be
against the principles of free trade. Such a practice hurts export earnings of the countries from where such
imports are sourced. But the impact also depends on how crucial such exports are for each economy.
What are the limitations of such a practice?
In certain cases, such a policy may prove counterproductive. If, for instance, even the competing country
counters one policy move, of say, depreciation (to protect exports) then such a practice may not have desirable
results, especially the country’s imports are not price elastic (the imports are essential and not dependent on
prices) and instead could end up hurting the trade balance through higher import price and resulting in inflation
in such economies.
ET in the classroom: Systematic Transfer Plan
What is STP?
Mutual funds not only manage our money but also offer us various easy to use tools that are aimed at improving
our investment experience.
Most of us know systematic investment plan, where we invest at regular intervals. But few are aware of
systematic transfer plan (STP).
Under STP, at regular intervals, an amount you opt for is transferred from one mutual fund scheme to another of
your choice. Typically, a minimum of six such transfers are to be agreed on by investors.
You can get into a weekly, monthly or a quarterly transfer plan, as per your needs.
You may choose to transfer a fixed sum from one scheme to another. The mutual fund will reduce the number
of units equal to the amount you have specified from the scheme you intend to transfer money. At the same
time, the amount such transferred will be utilised to buy the units of the scheme you intend to transfer money
into, at the applicable NAV. Some fund houses allow you to transfer only the capital appreciation to be
transferred at regular intervals.
How is it useful?
STP is a useful tool to take a step by step exposure into equities or to reduce exposure over a period of time. Say
you have Rs 10 lakh to invest in equity over a period of time. You could put this amount in the liquid fund of a
mutual fund or a short-term bond fund. This gives an opportunity to earn a better than saving bank account rate

13. of return. You than start an STP where every month a pre-determined amount will be invested into an equity
fund. This helps in deploying funds at regular intervals in equities with minimum timing risk.
ET in the classroom: RBI’s key policy rates
ET guides you through the key policy rates of the Reserve Bank of India
What are the key policy rates used by RBI to influence interest rates?
The key policy or ‘signalling’ rates include the bank rate, the repo rate, the reverse repo rate, the cash reserve
ratio (CRR) and the statutory liquidity ratio (SLR). RBI increases its key policy rates when there is greater
volume of money in the economy. In other words, when too much money is chasing the same or lesser quantity
of goods and services. Conversely, when there is a liquidity crunch or recession, RBI would lower its key policy
rates to inject more money into the economic system.
What is repo rate?
Repo rate, or repurchase rate, is the rate at which RBI lends to banks for short periods. This is done by RBI
buying government bonds from banks with an agreement to sell them back at a fixed rate. If the RBI wants to
make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it
cheaper for banks to borrow money, it reduces the repo rate. The current repo rate is 5.50%.
What is reverse repo rate?
Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. Like
the repo, this is done by RBI selling government bonds to banks with the commitment to buy them back at a
future date. The banks use the reverse repo facility to deposit their short-term excess funds with the RBI and
earn interest on it. RBI can reduce liquidity in the banking system by increasing the rate at which it borrows
from banks. Hiking the repo and reverse repo rate ends up reducing the liquidity and pushes up interest rates.
What is Cash Reserve ratio?
Cash reserve Ratio (CRR) is the amount of funds that banks have to park with RBI. If RBI decides to increase
the cash reserve ratio, the available amount with banks would reduce. The bank increases CRR to impound
surplus liquidity. CRR serves two purposes: One, it ensures that a portion of bank deposits are always available
to meet withdrawal demand, and secondly, it enables that RBI control liquidity in the system, and thereby,
inflation by tying their hands in lending money. The current CRR is 6%.
What is SLR? (Statutory Liquidity Ratio)
Apart from keeping a portion of deposits with RBI as cash, banks are also required to maintain a minimum
percentage of deposits with them at the end of every business day, in the form of gold, cash, government bonds
or other approved securities. This minimum percentage is called Statutory Liquidity Ratio. The current SLR is
25%. In times of high growth, an increase in SLR requirement reduces lendable resources of banks and pushes
up interest rates.
What is the bank rate?
Unlike other policy rates, the bank rate is purely a signalling rate and most interest rates are delinked from the
bank rate. Also, the bank rate is the indicative rate at which RBI lends money to other banks (or financial
institutions) The bank rate signals the central bank’s long-term outlook on interest rates. If the bank rate moves
up, long-term interest rates also tend to move up, and vice-versa.
ET in a Classroom: Currency Peg
As China and the US tussle over the value of the Yuan, ET helps you deconstruct the issue.
What is a currency peg?
There are various ways in which the price of one currency against another is arrived at. In a pegged exchange
rate, the value of the currency is fixed with respect to another currency, usually the US dollar. In other words, it

14. is the rate the country or the central bank of the country maintains as the official exchange rate. Chinese
currency, for example, is pegged at 6.83 yuan to the dollar.
How is the currency peg maintained?
Currency pegs work only when the central bank has the muscle to intervene in the market to check the currency
from going beyond a permissible band. It should be able to supply the market with enough dollars in the event
of a huge demand at the pegged rate and in the event of too much supply be ready to buy dollars from the
market. It implies that the central bank must have large foreign exchange reserves. China has foreign currency
reserves of nearly $2.5 trillion.
How does a currency peg help?
Countries go for a pegged exchange rate to have stability in the foreign exchange market. China had also
effectively gone to a dollar peg in July 2008 keeping its currency steady at 6.83 yuan to a dollar as it fought the
global economic crisis.
The stable currency creates a conductive environment for investments as investors do not fear losses on account
of currency fluctuations. Exports benefit as appreciation is kept in check. However, there are numerous
instances of currency pegs causing financial crises. Pegged values are difficult to maintain if the central bank is
not in position to intervene and defend the peg.
Why is the US so bothered about the currency peg?
The US believes that China accumulates its huge current account surplus (to the tune of 8% of GDP) and the
US, its current account deficit (to the tune of 2.9% of GDP) because its currency is undervalued, making its
exports to the US cheap and its imports from the US expensive. The US blames the pegged yuan for the
resultant global imbalance, and wants the yuan to appreciate.
A bit of history
From 1997 to mid-July 2005, Chinese currency was pegged to the US dollar. On 21 July 2005, China ended the
peg to the US dollar and switched to a crawling peg linked to a basket of currencies. The renminbi gradually
appreciated over 20% over the next three years. In July 2008, China went back to the dollar peg, bringing the
Yuan appreciation to an end. Yuan is now valued a 6.83 to a dollar with a plus/minus 0.5% fluctuation.
ET in the classroom: Quantitative easing
The US seems ready for another round of quantitative easing to boost growth, employment generation and
consumer spending. There is consensus among economists and policymakers in the world’s largest economy
that the Federal Reserve should target a higher level of inflation to spur growth. ET takes a look at the concept
of quantitative easing.
What is quantitative easing?
Central banks usually stimulate a slowing economy by cutting interest rates, which encourage people to spend
by borrowing more or discouraging them to save. But with interest rates in the developed world already close to
zero, that option is no longer available. In such situations , the central banks resort to pumping money directly
into the economy, a process known as quantitative easing. It is done by buying bonds — usually government
paper but can also be private bonds — from banks and financial institutions. The developed countries used
quantitative easing to spur growth in the aftermath of the financial meltdown of 2008.
What is the idea behind quantitative easing?
At any given point of time there is a fixed amount currency /money chasing products and services available in
the economy. The idea essentially is to get more money into the system chasing the same amount of produce to
drive up their prices. In the case of quantitative easing, the bondsellers will receive money that has not been in
circulation, which will increase the money supply in the system. As the money in the economy increases the
demand for different products rises.

15. How does it help?
The flood of cheap money causes asset prices to rise i.e. the price of shares, real estate etc. The notional high
wealth, together with cheap and easy credit, encourages people to spend. Quantitative easing also helps devalue
the currency, thereby encouraging exports further and increasing the level of activity in the economy. The final
consequence is increased demand resulting in ramping up of production, which, in turn, creates more jobs in the
economy.
Why is it important in the current scenario?
Quantitative easing could potentially ward off deflationary expectations and kickstart an uncertain economy.
But in today’s globalised world, cheap money from developed economies may flow into emerging economies
and fuel asset bubbles and inflation there. Brazil has been struggling to deal with the rising tide of inflows .
India, too, is keeping an eye on increasing forex inflows.
ET in a Classroom: Stock Valuation
What are the various analytical approaches for valuation of stocks?
For investing, an investor can use an approach based on either fundamental analysis, technical analysis or
quantitative analysis.
What is Fundamental Analysis?
It is the process of looking at a company’s business from an investment point of view. The process involves
analysing a company’s management capabilities, its competitive advantages, its competitors and the markets it
functions in.
As part of the analysis, you would look at examining key financial ratios like the net profit margins, operating
margins, earnings per share and so on.
After examining the key ratios of a business, one can come at a conclusion about the financial health of a stock
and determine the value of the stock. It further focuses primarily on the valuation of a company and its
relationship with the current share price.
Combining all this, the analyst arrives at a valuation for a stock. Fundamental analysts believe that it is possible
to estimate the true value of a company using these financial valuation methodologies.
If the share price is trading below the value arrived at by a fundamental analyst, investors should buy the stock,
in anticipation of the share price rising to the true value in the future. Conversely, if the share price is higher
than the estimated true value, investors should sell.
What is Technical Analysis?
This technique focuses on the past to predict the value of the future, using share prices and volumes traded in a
stock. It does not look at fundamentals or financial results at all. Technical analysts believe that all information
about a company is factored into the share price.
According to them, share price behaviour is repetitive in nature and hence can be used to predict future share
price movements. Based on historical share price data of a company, technical analysts identify share price
levels that act as support or resistance.
They try to identify support, resistance and breakout levels for stocks. Technical analysts also use various
technical indicators and chart patterns to help them determine probable future share price movements.
What is quantitative analysis?
With the advent of computers, a third type, namely quantitative analysis, has come up. Quantitative analysis
seeks to understand behaviour by using complex mathematical and statistical modelling, measurement and
research. It is a process of determining the value of a security by examining its numerical, measurable
characteristics like sales, earnings and profit margins.

16. Pure quantitative analysts look only at numbers with almost no regard for the underlying business. Although
even fundamental analysis look at numbers from a balance sheet, their primary focus is always the underlying
business, the environment in which the company is operating and so on. Quantitative analysts create
mathematical algorithms, which help them arrive at buy and sell decisions.
Which is the best?
The different analytical tools have different uses. For instance, fundamental analysis could be used to identify
companies with a possibility of strong earnings growth in the future.
Technical analysis could be used to decide when to buy this stock. When you combine technical and
fundamental analysis it is called techno-fundamental research. Depending upon your style and time frame of
investment you could choose among them.
ET in the classroom: Care for a Dim Sum?
China’s growing affluence and influence over the world economy has created huge demand for assets
denominated in yuan, the basic unit of the renminbi. China is also keen to globalise its currency to offset any
losses to its record foreign exchange reserves due to weakness of the dollar. This has led to the creation of
the Dim Sum bond market in Hong Kong. ET explains the concept.
What Is A Dim Sum Bond?
A bond denominated in yuan and issued in Hong Kong. Derived from a traditional Chinese cuisine that offers a
variety of small eats, Dim Sum bonds are issued by Chinese government and companies as well as foreign
entities.
What Makes Dim Sum Bonds Attractive For Investors?
Investors across the world are looking for opportunities to make money out of China’s phenomenal growth, but
the country’s stiff capital controls prohibit them from investing in Chinese debt. Dim Sum bonds offer an
avenue to such investors. Investors are rushing to the Dim Sum market on expectations that Beijing will
continue to let the yuan appreciate. Exposure to yuan-denominated assets also provides an alternative to bonds
issued by western governments and companies and fits well with the Principle of Diversification, that a
portfolio containing different assets and kinds of assets carries lower risk.
Lower interest cost is also encouraging companies to raise money through the Dim Sum market. Last
month, IDBI Bank became the first issuer of Dim Sum bonds from India. It sold 650 million yuan ($102
million) of three-year bonds priced at a fixed coupon of 4.5% per annum. The bank said it cut a percentage
point off its dollar funding costs by going to the Dim Sum market. Reports say infrastructure lender IL&FS is
also planning to raise $100 million through yuan denominated bonds.
Is There A Limit On Such Issuances By Indian Entities?
Recently, the yuan was added to the list of currencies in which Indian companies can raise funds overseas, in
addition to dollar, euro, pound and yen. Indian firms can raise an equivalent of $1 billion in yuan.
How Big Is the Dim Sum Bond Market?
The Dim Sum market has risen from 10 billion yuan in 2007 to more than 100 billion yuan. Analysts forecast
the market to grow beyond 300 billion yuan in 2012.
Where can Indian Issuers deploy The Proceeds?
Indian issuers can deploy the money for capital expenditure within China and use the proceeds for settling trade
accounts. They can also enter into swap contracts to get other currencies. However, if the money is to be
brought back to India, companies will have to comply with the External Commercial Borrowing guidelines set
by the Reserve Bank of India.

17. ET in the classroom: The A-Z of 4G technology
What is LTE?
LTE, or ‘Long Term Evolution’, is the latest wireless mobile broadband technology that will power future 4G,
or fourth generation, networks designed primarily for data transmission at unprecedented speeds. It uses
spectrum to carry data traffic, just as we need roads to carry vehicular traffic. Spectrum may be likened to a
highway of airwaves on which mobile signals travel.
Since LTE uses wider chunks of spectrum, data speeds on LTEbased 4G networks are nearly four times faster
than on 3G. An iPad user, for instance, will be able to watch videos at LTE speeds of 300 Mbps while a laptop
user will be able to download a chunky 25MB file in seconds if adequate spectrum is available. LTE is also a
scalable bandwidth technology that works alongside 2G and 3G. So a 3G operator can easily upgrade his
network to LTE.
When was it developed?
LTE’s genesis goes back to November 2004, when a workshop was held by the 3GPP (3rd Generation
Partnership Project) in Toronto to define ‘Long Term Evolution’. The 3GPP was a global alliance of top
telecom associations who tried to identify the next wave of mobile tech after UMTS, the 3G technology based
on GSM.
Is LTE better than WiMAX?
Wireless communication happens over paired or unpaired spectrum. Paired spectrum is two equal chunks of
airwaves for sending and receiving information while unpaired spectrum is a single strip of airwaves meant to
either receive or send information.
Voice signals travel over paired spectrum while data communications works better on unpaired spectrum as
people download more than upload. WiMAXhad an edge as long as it was the sole wireless technology working
commercially over unpaired spectrum . But the WiMAXparty crashed when an LTE variant, TDD-LTE —
which also worked over unpaired spectrum — arrived.
What’s more, leading vendor’s unveiled compatible gear commercially in 2010. This LTE variant was heralded
by the world’s top telcos as the coolest technology for highspeed data communications on the go.
WiMAXsuffered a body blow when big telcos across China, India and the US also embraced TDD-LTE
Commercialisation of TDD-LTE devices hit fast-track after Qualcomm pitched for wireless broadband
spectrum in the 2010 auction and won 20MHz of BWA airwaves in four circles. Even WiMAXbackers like
Clearwire in the US and Yota in Russia warmed up to LTE. Ditto with WiMAXgear vendors like Nokia and
Cisco.
Is TDD-LTE catching on in India?
Not as yet. But that said, the first seeds of an LTE ecosystem were sown when Bharti Airtel joined some of the
world’s top LTE backers at Mobile World Congress 2011 in Barcelona to launch the Global TD-LTE Initiative
(GTI). Global deployment of this technology was in fact at the heart of last year’s auction of BWA airwaves in
India.
But the big challenge to fast-track deployment of TD-LTE in India is the paucity of compatible devices and
smartphones. Only Qualcomm has launched TDD-LTE multi-mode devices. NSN is slated to unveil 4G devices
by the time LTE network rollouts start happening in India by December ’11 to early-2012.
ET in the classroom: Offshore Banking Unit
What is offshore banking unit?
Offshore banking unit (OBU) is the branch of an Indian bank located in a special economic zone (SEZ), with a
special set of rules aimed at facilitating exports from the region. As laws define it, it’s a “deemed foreign

18. branch” of the parent bank situated within India, and it undertakes international banking business involving
foreign currency denominated assets and liabilities.
The concept comes from the practice prevalent in several global financial centres. Here an OBU can accept
foreign currency for business but not domestic deposits from local residents. This was conceived to prevent
competition between local and offshore banking sectors.
What was the need for OBUs?
In addition to providing power, tax and other incentives to SEZs, policymakers felt a need to provide SEZ
developers access to global money markets at international rates. So in 2002, RBI instituted OBUs, which
would be virtually foreign branches of Indian banks. These would be exempt from CRR, SLR and few other
regulatory requirements.
RBI regulations make it mandatory for OBUs to deal in foreign exchange, source their foreign currency funds
externally, follow all prudential norms applicable to overseas branches and are entitled for IT exemptions. Thus
in many respects, they are free from the monetary controls of the country.
What price, freedom from regulations?
In the eight years that they have been operational, concerns have been raised that, funding by OBUs to SEZs
would lead to increase in external debt of India. Also, some have suggested that OBUs as vehicles for extending
dollar loans have no use as long as they are restricted to doing business only in the zones in which are they
located.
This would create an unnecessary regulatory arbitrage like booking business because there is some arbitrage
advantage on offer. Anyways, ground realities could not be more different. Hardly a handful of banks have set
up their OBUs, so the argument looks very farfetched.
SEZ, itself as a concept has been struggling, given the issues that SEZ developers have faced over acquiring
land from farmers.
What is the future of OBUs?
Most international financial centres still house OBUs, so saying they are not required may be incorrect.
However, some analysts have said OBUs are losing relevance at a time of increasing globalisation.
They say OBUs will be of no use after the economy opens up fully and the rupee is fully convertible. These
experts argue for one or two OBUs, instead of having several of them spread across the country.
ET In the Classroom: Public Debt Office
What is a public debt office?
A public debt office or a debt management office is an autonomous government agency which acts as the
investment banker to the government and raises capital from the markets for the government.
It formulates the borrowing calendar for the government and decides upon the maturities of the securities to be
issued on behalf of the government. A public debt office works separately from the central bank and has
nothing to do with the formulation of the monetary policy or setting interest rates.
What are the conflicts of interests if the body that formulates the monetary policy also acts as the
Centre’s investment banker?
There are certain inherent conflicts of interest when the agency, which raises funds for the government, also
manages its monetary policy and regulates interest rates. The basic conflict of interest is between setting the
short-term interest rates and selling government securities. The Reserve Bank of India, like a good merchant
banker to the government, sells bonds at high prices. At lower interest rates or yields, it runs the risk of adding
to inflationary concerns. Another area of concern is that RBI is also the regulator of all banks, which means the
central bank, could arm-twist the banks to buy bonds at higher prices or for longer tenors.

19. For a very long time now, economists have been arguing in favour of an independent debt management office,
which in the Indian discourse is called ” National treasury management agency” or debt management agency, so
that RBI can be relieved of the burden of being the Centre’s investment banker.
What is the practice in advanced economies?
Developed economies such as the UK, the US and New Zealand, already have independent public debt offices
in place. Former RBI governors have time and again complained about the difficulties in managing government
debt while trying to keep interest rates high to rein in inflation.
Does India have a debt management office?
The finance ministry had proposed setting up of the debt management agency in its 2007-08 Budget. A series of
expert committees have recommended the establishment of the debt management agency. These include groups
headed by the former finance secretary Vijay Kelkar, former World Banker Percy Mistry and ex-IMF chief
economist Raghuram Rajan.
A draft legislation had also been created by the Jahangir Aziz Working Group. While presenting the Budget for
2011-12, finance minister Pranab Mukherjee had announced the government’s intention to introduce the bill for
an autonomous debt management office in the next financial year.
How is it expected to be structured?
The agency is likely to be an autonomous body under the administrative control of the finance ministry. The
central bank will be on the management committee of the agency. A middle office or MoF is already working in
the finance ministry that prepares the borrowing calendar of the Centre.
A mid-office would constitute a single comprehensive database about all liabilities and guarantees of the
government of India. For now, the 21 public debt offices of RBI continue to function. The structure and
functions of the debt management office have been discussed and reworked on for three years now but little
sense of urgency has been seen.
ET in the Classroom: Non-competitive bidder
What is non-competitive bidding in dated government securities?
The Government of India conducts periodic auctions of government securities and of the total amount notified
for auctions, a certain portion is kept aside for the non-competitive bidder, or the small and medium investors.
Non-competitive bidding means a person would be able to participate in the auctions of dated government
securities without having to quote the yield or price in the bid. That saves him the worry, about whether the bid
will be on or off-the-mark.
How is the process useful?
It helps deepen the government bonds market by encouraging wider participation and retail holding of
government securities. It enables the participation of individuals, firms and other mid-segment investors who
neither have the expertise nor the financials to participate in auctions. RBI gives such investors a fair chance of
assured allotments of government securities.
Who can be referred to as the non-competitive bidder?
RBI allows individuals or firms, provident funds, corporate bodies or trusts who do not have current account
(CA) or subsidiary general ledger (SGL) account with the Reserve Bank of India. Regional Rural Banks (RRBs)
and Urban Co-operative Banks (UCBs) can also apply under the non-competitive bidding scheme.
Eligible investors have to place their bid through a bank or Primary Dealer (PD) for auction. Each bank or PD,
on the basis of firm orders, submits a single bid for the total sum of non-competitive bids on the day of the
auction.

20. The bank or PD will furnish details of individual customers, viz., name, amount, etc., along with the
application. The non-competitive bidding facility is available only in dated central government securities and
not in treasury bills.
What happens if the total amount offered for bidding via non-competitive bidding basis exceeds the
amount allotted?
In case the amount bid by PDs on behalf of the investors is more than the reserved amount through non-
competitive bidding, allotment would be made on a pro-rata basis. For example, the amount reserved for
allotment in an auction in noncompetitive basis is Rs 15 crore.
The total amount of bids for noncompetitive segment is Rs 20 crore. The partial allotment percentage is
=15/20=75%. That is, each bank or PD, who has submitted non-competitive bids received from eligible
investors, will get 75% of the total amount submitted.
ET in the classroom: Potential growth rate
The country’s policymakers seem to be fighting a losing battle with Inflation. Some economists link the
persistently high prices to the pace of economic growth. They say Indian economy is expanding at a rate beyond
its ‘potential growth rate’. ET examines the concept and its relationship with prices:
What is the potential rate of growth of an economy?
Potential output is broadly the maximum output growth that an economy can sustain over the medium to long
term without stoking inflation. In a recent report on India, the International Monetary Fund (IMF) estimates
India’s potential growth rate at 7½-8½%.
What factors decide the potential growth rate?
There are two major determinants of the potential rate at which an economy can grow in the long run. One is the
rate of increase in key inputs such as labour and capital, while the other is the rise in productivity. Within the
two key inputs, labour has a bigger say in determining the potential growth rate.
The increase in labour supply – through an increase in number of workers or the numbers of hours put by a
given number of workers – and an increase in labour productivity will result in an increase in the long-term
potential growth rate.
Anything that aids productivity increases can help boost potential growth rate. Infrastructure investments and
skilling of labour can raise India’s potential growth rate because the country has ample labour supply.
How does growing faster than the potential rate cause inflation?
The overall demand in the economy picks up due to fast growth and more resources are used to meet higher
demand. After a point, the economy may not find enough inputs to meet the demand, leading to an increase in
prices.
If there is surplus capacity in the economy then it can grow above the potential rate for a while. But for an
economy already working at full capacity, excessive demand results in increase in the price level.
The IMF says India was growing at a rate faster than its potential rate in 2007-08, but because of the financial
crisis in early 2009 substantial slack emerged in economy. It says the quick rebound from the crisis has
exhausted that slack and now there is a risk of high inflation if the Indian economy grows too fast.
ET in a classroom: How are poverty numbers calculated
Widespread poverty is the biggest challenge for India’s policymakers. The government has drawn criticism for
its inability to tackle the menace despite high economic growth. Some estimates place the number of poor at
40% of the population. ET looks at how poverty numbers are generated:
How is the poverty line defined?

21. The concept of poverty is associated with socially perceived deprivation with respect to basic human needs.
Historically, India has followed a poverty line, which is based on a minimum number of calories that an
individual should consume and a rupee amount was calculated on this basis. The existing rural and urban
official poverty lines were originally defined in terms of per capita total consumer expenditure (PCTE) at 1973-
74 market prices and is adjusted over time and across states for changes in prices.
The method still retains the original 1973-74 all-India reference poverty line baskets (PLB) of goods and
services. These PLBs were derived separately for rural and urban areas, anchored in per capita calorie norms of
2400 (rural) and 2100 (urban) per day. People whose PCTE is below the required minimum are considered to be
below the poverty line.
What is the international poverty line?
The common international poverty line is based on an income of around $1 a day. In 2008, the World Bank
revised the figure to $1.25 at the 2005 purchasing power parity.
What is the new way to define the poor?
As the earlier estimates of poverty have been largely perceived as inadequate, a committee led by Suresh
Tendulkar came up with a new way to define the poor. Tendulkar moved away from calorie anchor while
testing the adequacy of actual food expenditure. The method uses same consumption basket for rural and urban
poor, but applies different price levels of rural and urban areas to arrive at the poverty estimate. The major
departure from the original method is the provision for including expenditure on health and education.
Does India need to redefine poor?
With India hitting a high growth trajectory, the living standards and consumption patterns in both urban and
rural areas have changed, while existing data continues to use consumption baskets that reflect trends prevalent
in 1973-74. Earlier poverty mechanisms also assumed that basic social services like health and education would
be supplied by the state; therefore even as both were covered in base year 1973-74, no account was taken for the
change in the proportion of expenditure in these services since then.
ET in the Classroom: Competition
Why is competition important? What is its economic rationale?
Competition, according to economic theory, forces firms to develop new products, services and technologies
which would give consumers greater choice and better products. If more and more firms deal in a similar
product, consumer choice widens. This causes product prices to drop below the level that would be if there were
no competition; that is, if there was just one firm (monopoly) or a few firms (oligopoly).
How is competition measured?
Competition is generally measured by calculating concentration ratios . Concentration ratios indicate whether an
industry consists of a few large firms or many small firms. Two of the most commonly used metrics are the
Herfindahl Hirschman Index (HHI) and the N-firm concentration ratio.
Herfindahl Hirschman Index:
Under the HHI, the market share of each firm in a relevant sector is squared and added to arrive at a statistical
measure of concentration. The value of the index varies from close to 0, indicating nearly perfect competition,
to 10,000, indicating the presence of just one firm, a monopoly. HHI = s1 2 + s2 2 +3 2 + … + sn 2 (Where sn
is the market share of the nth firm, and s varies from close to zero to 100).
N-firm concentration ratio:
This method measures the dominance of the biggest firms in a particular sector. N in this case is the number of
firms being considered. A four-firm concentration ratio, for instance, would just sum up the market shares of the
four biggest firms in the market. Fewer firms having a large market share would indicate less competition.

22. How are these measures used?
In the US, mergers are scrutinized by analysing concentration ratios. Generally, a market with a HHI of less
than 1,000 is considered competitive. A market with a HHI in the 1,000-1,800 bands is moderately
concentrated. A measure of 1,800 and more indicates a highly concentrated market. As a general rule, mergers
that increase HHI by more than 100 points in concentrated markets raise antitrust concerns and invite further
scrutiny by authorities.
ET in the Classroom: Asset classes
What is asset classification?
In any banking system, loans or assets created by lenders are divided into several qualitative categories. In
simple language, the categories reflect how good or bad an asset is in terms of the possibility of default in
repayment of loan from a borrower. This practice is known as classification of assets.
How is asset classification important to bankers?
This practice helps banks know the strength of its credit portfolio. If there is a risk of non-payment of loans or
defaults, banks would start focusing on their credit monitoring act and take corrective measures. According to
classifications, banks make provisions to take care of the fallout of a default.
What are the broad classifications prescribed by the regulator, the Reserve Bank of India?
The RBI has classified assets into four broad categories. These are prescribed by the Bank for International
Settlements, an inter-governmental body of central banks. However, each central bank is allowed to tweak the
definition as per their loan market.
Standard asset
Asset where borrowers pay their interests on the loan as per the schedule is a standard asset.
Sub-standard asset
A sub-standard asset is one which has remained an NPA for a period less than or equal to 12 months. An NPA
or a nonperforming asset is one where a borrower fails to pay the interest on the loan for three consecutive
months.
Doubtful asset
An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12
months.
Loss asset
When banks see little possibility of recovering the loan, it becomes a loss asset for the bank. Banks or auditors
consider this as a loss for the bank.
What are the provisioning requirements for these assets?
For loss assets, if kept in the book of banks, 100% of the outstanding has to be provided for. For doubtful assets,
if the loan asset has remained in the ‘doubtful’ category for 1 year, then the provisional requirement is 20%. If it
has stayed there for a period of 1-3 years, it calls for a provisional coverage of 30%.
ET in the Classroom: How is infrastructure defined in India?
Policy anomalies and lack of consensus on what constitutes infrastructure have undermined efforts to spur
creation of physical assets. A look at the current status and the need to define infrastructure.
How is infrastructure defined in India?
There is no clear definition as of now. A broad meaning of the term is based on a series of reports and
observations made by different government agencies and committees. A commission chaired by C Rangarajan
in 2001 attempted to define infrastructure according to six characteristics: natural monopoly, high sunk costs,
non-tradability of the output, non-rivalry in consumption (which implies benefit of public good can be extended

23. to additional consumers without any huge additional cost), possibility of price exclusion and bestowing
externalities on society. However, these characteristics were not considered absolute.
For taxation purposes, the income-tax department considers companies dealing with electricity, water supply,
sewerage, telecom, roads & bridges, ports, airports, railways, irrigation, storage (at ports) and industrial parks or
SEZs as infrastructure. However, special tax benefits are also given to sectors like fertilizers, hospitals and
educational institutions, adding to the confusion.
The Reserve Bank of India and the Insurance Regulatory and Development Authority has also tried to define
infrastructure and identify sectors.
Why is a precise definition of infrastructure needed?
A clear understanding of what is covered under the rubric of infrastructure is necessary for policy formulation,
setting of targets, and monitoring projects to ensure consistency and comparability in the data collected and
reported by various agencies. Moreover, the emphasis on infrastructure has led to the government extending
many incentives and tax benefits to infrastructure companies. Without a proper definition these benefits can be
misused.
What is the international norm?
Globally, too, defining infrastructure has been an arduous task. The US and most European countries have
defined infrastructure sectors for tax purposes. There is no consistency across the developed world on what
constitutes infrastructure. Many countries have also identified sub-sectors like core infrastructure, social
infrastructure, retail infrastructure, and urban and rural infrastructure.
How is India approaching the issue?
The finance ministry will identify the sectors primarily based on the characteristics set out by the Rangarajan
committee with some additional requirements. Based on the criteria, the finance ministry is likely to notify 25
sectors as infrastructure. These sectors will be eligible for tax incentives, viability gap funding and will be
covered by regulatory framework for infrastructure which will include levy of user charges.
ET in the Classroom: corporate repo bonds
What is corporate repo bond?
Banks, corporate and primary dealers pledge corporate bonds with each other to raise short-term money. It is
similar to banks pledging government securities (gsec) with RBI to raise short-term money. Unlike pledging of
g-secs, here the borrower who pledges corporate bonds does not receive the entire value of the bond.
When did RBI allow repo in corporate bonds?
RBI guidelines on repo in corporate debt securities came into effect on March 1, 2010.These guidelines were
amended in December 2010 as the market participants demanded a reduction in hair-cut margins. It was
reduced from a flat rate of 25% to a band of 10-15%, depending on the rating of the corporate bond. According
to the amended guidelines, the settlements had to be made within two days of the deal.
How does the repo in corporate bonds work?
Investor A, who needs finance for an interim period, can issue these bonds while entering into an agreement
with investor B that at a given point of time he would buy back the bond from investor B, though the bond
issuer would have to suffer a hair-cut margin of 10-15%, which will vary according to the credit rating of the
bond.
How active is the repo in corporate bonds in India?
Only five deals have been reported so far. Companies that have issued corporate bonds in India are REC,
PFC, HDFC and NHB.

24. Why has repo in corporate debt not taken off?
Lack of market participation could be because of lenders or issuers maintaining a cautious approach as well as
due to lack of proper trade guarantee mechanism. Also, the hair-cut margin of 10-15%, (which is the margin
enjoyed by the investor on the day the agreement is reversed), is still very high from the investors’ point of view
considering the volatility in corporate debt market does not demand such a high haircut. Interest rate is
determined over-the-counter, but there is no mechanism for efficient discovery of prices. There is no centralised
clearing agency like the Clearing Corporation of India (CCIL) for central government securities.
ET in the classroom: What is stagflation?
Stagflation is an economic situation where the growth rate slows down, unemployment levels remain steadily
high & inflation also stays high.
What is stagflation?
Stagflation, a concept which did not gain acceptance till the 1960s, is described as a situation in the economy
where the growth rate slows down, the level of unemployment remains steadily high and yet the inflation or
price level remains high at the same time. At the first instance, high inflation and unemployment or slower
growth seem like opposites and mutually exclusive.
It came to be seen in the 1970s as a situation when the economy has low productivity and yet the goods are
highly priced in spite of low unemployment. The term ‘stagflation’ came to be used for the first time in the
British Parliament by Lain Macleod in 1965. Once stagflation occurs it is difficult to deal with. The measure a
government usually takes to revive an economy in recession (cutting interest rates or increasing government
spending) also increases inflation.
Under normal recessionary conditions, inflationary policies are acceptable, but here, given the already high
inflation, pushing inflation still higher could mean prices spiralling out of control, thus further hitting
productivity and growth.
What causes stagflation?
The major reasons for stagflation, whenever it has occurred in history, have been-supply shocks or shortages
due to unforeseen reasons which push up prices of essential commodities, causing an inflationary situation and
at the same time pushing up production costs, as it happened in 1970s in the US. The other reason is failure of
the monetary authority to control excessive growth of money supply in the economy and excessive regulation of
goods and labour markets by the government. For example, in the 1970s, a similar situation occurred during the
global stagflation, where it began with a huge rise in oil prices, but then continued as central banks used
stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.
Is India on the brink of stagflation?
Though the central bank and the Centre have had to revise their growth targets, which have taken a hit due to
persistently high double-digit inflation, economists are far from assuming a stagflation like situation in India
just as yet. The Reserve Bank of India deputy governor Subir Gokarn has said headline inflation numbers are
much higher than the appropriate rate of inflation that will moderate growth but will keep it steady, which
according to RBI’s estimates, should be between 5% and 6%.
ET Classroom: Casa
What is Casa Ratio?
Casa is basically the current and savings account deposits. Casa ratio is the share of current and savings account
deposits to the total deposits of the bank. In India, interest rates paid on current and savings account deposits is
administered by banking regulator – the Reserve Bank of India.
Why are banks keen on garnering a higher share of Casa?

25. Interest rate paid on Casa is much lower compared to other deposits like term deposits or recurring deposits.
While banks do not pay any interest on current account, interest paid on savings account deposit is 4%. Banks
therefore make maximum effort to increase the share of Casa on their books to reduce their overall cost of
deposits. HDFC Bank has the highest share of Casa to total deposits at 52%, followed by the State Bank of
India at 48% and ICICI Bank at 45%.
What does Casa mean for customers?
Recently, RBI increased interest paid on savings account deposits from 3.5% to 4%. Further a year ago, RBI
told banks to pay interest on savings deposits on a daily basis rather than paying on the minimum balance
maintained by them in six months. As a result, savings account customers earn better returns compared to what
they earned a year ago. Further, interest earned on savings account deposits does not attract TDS (tax deduction
at source). Interest income above 10,000 a year attracts TDS of 10% in case of term deposits. However, there is
no major benefit for current account deposits, which is mainly maintained by corporates and traders.
What are the disadvantages of high Casa?
These deposits can move out of banks’ books anytime, leading to asset-liability mismatches. While in case of
term deposits, banks are almost certain that the depositor may not withdraw money before the maturity of the
deposit and may also renew the deposit on maturity. Further, to finance long-term projects, banks need to have
long-term liabilities on their books to avoid mismatches. Banks cannot rely on Casa deposits to fund long-term
loans.
ET in the Classroom: Sovereign debt crisis
What is sovereign debt crisis?
Sovereign debt crisis means the sovereign government’s borrowing from domestic and external markets is in
excess of its capacity to repay, resulting in loan defaults requiring rescheduling of loans or bailout packages
from other countries or multilateral institutions such as IMF.
How did the Greek crisis originate?
The crisis in Greece surfaced in 2007-08, when it came to be known that Greece was not in a situation to meet
its repayment obligations to its external creditors. The budget deficit of Greece was in the range of 13.6% of its
gross domestic product. The stock of debt was equivalent to 115% of the gross domestic product. The debt
problem was further compounded by the fact that nearly three-fourths of the government debt was held by
foreign institutions, particularly foreign banks. Not only was the high fiscal deficit a problem, it was also
camouflaged by derivative hedging. Reportedly, investment banks misled investors into investing in
government bonds of Greece by being secretive about the actual state of affairs. The rating agencies played
accomplice and allegedly ‘failed’ to assess the correct fiscal position.
Who bailed out Greece?
Greece reached an agreement with IMF, the European Commission and the European Central Bank on a
rigorous programme to stabilize its economy with the support of a $145-billion financing package against which
the Greek government was required to implement fiscal measures, structural policies and financial sector
reforms. Some of the points of the reform package were — reducing the fiscal deficit to 3% by 2014, pensions
and wages to be reduced for three years, government entitlement programs had to be curtailed and social
security benefits cut.
ET in the Classroom: ESSENTIAL COMMODITIES ACT
The Prime Minister will soon hold a meeting of chief ministers to discuss the alarming food price situation and
review the implementation of Essential Commodities Act (ECA). ET looks at the ECA and how it can help
combat the rising prices of food articles.

26. What are essential commodities?
The government has powers under the Essential Commodities Act, 1955 (EC Act) to declare a commodity as an
essential commodity to ensure its availability to people at fair price. The EC Act, 1955 allows the government
to control the production, supply, and distribution of these commodities for maintaining or increasing supplies
and securing their equitable distribution. Essentially, the act aims to ensure easy availability of important
commodities to consumers and check exploitation by traders.
How many commodities are covered by the Essential Commodities Act?
There are seven broad categories of essential commodities covered by the Act. These are (1) Drugs; (2)
Fertilizer, inorganic, organic or mixed; (3) Foodstuffs, including edible oilseeds and oils; (4) Hank yarn made
wholly from cotton; (5) Petroleum and petroleum products; (6) Raw jute and jute textile; (7) (i) seeds of food-
crops and seeds of fruits and vegetables; (ii) seeds of cattle fodder; and (iii) jute seeds. Recently cotton seed was
also included in the list.
How does the Act help check price rise?
The Act is implemented by the state governments and union territories, leaving the central government to
merely monitor the action taken by states in implementing the provisions of the Act. State and UT
administrations use the powers of the Act to impose stock or turnover limits for various commodities and
penalise those who hold them in excess of the limit. Stock limits have been imposed in several states for pulses,
edible oil, edible oilseeds, rice, paddy and sugar.
How effective is the Act?
Over the three years 2006-2008, state and union territory governments prosecuted 14,541 persons under the
provisions of EC Act, 1955 and secured conviction in 2,310 cases. In 2009 as on 31 August 2533 persons had
been prosecuted and 37 convicted. But, doubts have been raised about effectiveness of the Act time and again.
Recently, Parliament’s estimates committee asked the government to come out expeditiously with a new
legislation for controlling the retail prices of essential commodities such as rice, wheat, pulses, edible oils,
sugar, milk and vegetables.
ET in the classroom: What is underrecovery?
It is the gap between the local price of fuel and what would have been the price if the fuel were imported.
Is under-recovery the same as loss?
It is a notional loss in revenue to the extent the international price of the fuel is higher. It may or may not be a
loss-making proposition to produce the fuel when there is an under-recovery.
In case of kerosene, oil companies suffer an under-recovery as well as a loss because the local retail price is
much lower than the cost of crude oil. But sale of a product like petrol can still be very profitable at times, even
if oil companies are reporting under-recovery of a few rupees a litre.
Does a rise in underrecovery make an oil co.’s operation less profitable?
It may not. At times, international crude oil prices remain flat but petrol and diesel prices rise. In such a
situation, an Indian refinery’s profitability will not change because crude oil costs have not gone up. But under-
recovery would have risen because the cost of importing the fuel would have risen.
Has the concept of underrecovery exaggerated the problems of oil firms?
This year it did. Prices of oil products in Asia rose earlier this year, when a fire shut down a large refinery in
Taiwan. This reduced the supply of refined oil products and the change in the demand supply situation made
petrol and diesel more costly.
The Tsunami in Japan and a recent fire at a refinery in Singapore had the same impact. The refining margin for
diesel, called “crack spread” has been $20 a barrel most of this year. In April, diesel margins jumped to a three-
year high of $24 per barrel. Last year, it was $10-15.

27. So, under-recovery on diesel looks higher this year. In other words, oil companies want a higher price for diesel
partly because some refineries in other countries were shut down. Apart from this, oil companies also charge a
customs duty and a marketing margin, in addition to marketing cost, to calculate underrecovery. These are
profits, not costs.
Can oil companies be at a disadvantage by linking prices to under-recovery?
Yes. This may happen next year. In 2010, very little new refining capacity was added in Asia, while demand
was strong. Next year, China and the Middle East will add about 1 million barrels per day of refining capacity.
This is expected to increase supply of products and deflate refining margins. As a result under-recovery is
expected to fall.
ET in the Classroom: Leave Travel Allowance
What is Leave Travel Allowance?
Leave Travel Allowance (LTA) is the part of the remuneration granted to employees by the employer to provide
for personal travel expenses incurred during the year. Apart from the employee, it covers travelling expenses of
spouse, children as well as dependent parents and siblings. Further, the exemption is restricted to two children
born on or after October 1, 1998. There is no restriction on the number of children born before this date.
How does LTA save on tax outgo?
Under section 10 (5) of the Income-Tax Act, if an employee who is in receipt of LTA undertakes a journey
within the country, s/he can claim the value of the allowance exempt from income tax. For the purpose, the
individual should have been on leave for the period during which the journey was undertaken.
Can you claim it every year?
No. The exemption can be claimed only twice in a block of four calendar years. The current block has started
from January 1, 2010, and will last until December 31, 2013. The previous one ended on December 31, 2009. If
you do not avail of the concession in any particular block or undertake just one journey, you become entitled to
carry forward one journey to the next block. However, this has to be utilised in the first year of the new block.
For instance, if you availed of the concession just once instead of twice between January 1, 2006 and December
31, 2009, then you are allowed to carry forward the unused one into the subsequent block (2010-2013),
provided you undertake the journey in 2010 itself. A point to be noted here is that even if you don’t avail of the
concession at all during a particular block, you can carry forward only one entitlement to the next block.
Can the entire amount be claimed as an exemption?
The exemption will depend on certain criteria specified. Firstly, it is the lower of the actual expenses incurred
and the allowance granted by your employer. Let’s assume your LTA is Rs 10,000, but you end up spending Rs
15,000 on travelling. In such a case, the exemption will be allowed to the extent of Rs 10,000. Conversely, if
your LTA stands at Rs 15,000 and your actual expenses amount to Rs 10,000, you will still be entitled to a
deduction of only Rs 10,000.
Other parameters that decide the extent of exemption?
If you have opted to fly to the destination, an amount not exceeding the economy class airfare of the national
carrier by the shortest route to that city would be admissible as deduction. In case you are travelling by road or
rail, the cost of first class air-conditioned ticket to the destination by the shortest route would constitute the
benchmark. Besides, if your travel plan entails visiting multiple places during the trip, the destination farthest
from your place of residence would be taken into account for determining the exemption amount.
What if the travel bills are not submitted before the deadline?
If you fail to submit your travel bills pertaining to LTA claim with your employer within the time prescribed,
your employer would consider the amount of LTA paid as taxable and deduct income tax at the rate applicable
to you. However, you can claim LTA exemption at the time of filing your income tax return.