UNIT BUDGETARY POLICY AND

INDIAN FINANCIAL
8tructute
',
4.0 Objectives
4.1 Introduction
4.2 Indian Fiscal Policy '

4.2.1 Budgetary Policy

4.2.2 Budgetary System
4.3 Indian Financial System
4.4 Impact of Budgetary Policy on Financial System
4.4.1 Role of Budgetary Policy in t h e Growth of Financial
lnetitutions
4.4.1.1 Impact of Budgetary Policy on Banks
4.4.2 Budgetary Policy and Financial Markets
4.4.3 Budgetary Policy and Financial Instruments
4.5 The Interest Rate Policy and the Financial System
4.6 Deficit Financing and the Financial System
4.7 Let U s Sum- Up
4.8 Key Words
4.9 Sqme Useful Books
4.10 Answers/Hints to Check Your Progress

4.0 OBJECTIVES
After going through this Unit, you will be able to:

debcribe the concept and objectives of the budgetary policy,

identify the extent of integration between various segments
of financial system and budgetary policy,
evaluate the impact of budgetary policy on different sectors
of the Indian financial system, I

state the role of budgetary policy in the emerging new

economic environment, and
discuss the role of Deficit Finance in financial system.

4.1 INTRODUCTION
The financial system of a State is influenced, to a great deal,
by the economic policy of a country. The fiscal policy a s a
part of economic policy deals with taxation, public
expenditure, public borrowing and debt management. The
budgetary policy and the budget documents are important
parts of fiscal policy. That is why, the budgetary policy and
the budget documents, to a significant extent, influence the
functioning of a financial system of a country. Hence, in
this Unit, we shall discuss the issues relating to budgetary
policy and their bearing upon the lndian financial system.
Let u s begin with explaining the concepts of fiscal policy Budgetary Policy and
~dianFinan clai System
and budgetary policy in the next section.

'4.2 INDIAN FISCAL POLICY

In the process of economic development, fiscal policy as a n
important instrument of economic policy plays a n important
role in the development and planning system of a country.
Through fiscal policy, the Government provides public
services. At the same time, it is an instrument for re-
allocation of resources according to national priorities, re-
distribution, promotion of private savings and investments
and the maintenance of stability. Fiscal policy is concerned
with the aggregate impacts of various policy measures on
the prescribed set of objectives. Therefore, it is in a broader
framework, a measure to achieve the prescribed objectives
in an economy. In other words, fiscal policy is a mean to
achieve the chosen objectives like, economic growth,
generation of employment opportunities, distributive justice,
removal of poverty, price stability, etc.

It is clear from the above discussion that fiscal policy has

a multi-dimensional role. Providing social justice to various
segments is the major objective of this policy. In a developing
country, like India, the fiscal policy has an added importance
a s it is assigned an important role to achieve full employment
and economic stability, and thereby achieving meaningful
growth rate. Fiscal policy, on the one hand, concentrates on
the resource mobilization in the economy. The system of
taxes diverts funds from the private sector to the government
sector. On the other side, the system of public expenditure
diverts funds from government sector back to the people as
they are spent for productive and welfare purposes. Public
borrowings are also used for various purposes. Public debt
management includes functions like floating of government
loans, payment of interest and redemption of debts.
The fiscal policy is formulated to fulfil the following objectives:

i) Mobilization of resources so a s to increase the rate of

investment and capital formation. This, in turn, accelerates
the rate of economic growth,

ii) Reduction of inequalities of income a n d wealth, or

redistribution of income, in other words, a n equitable
distribution of income,
iii) Increase in employment opportunities, and
iv) Price stability.

In order to achieve these objective, the Government resorts

td the following instruments:
The Basics of Finanaial i) Taxation
System
ii) Public Expenditure
iii) Public Debt
These instruments affect the functioning of financial sector
in the following manner :
i) Taxation
Taxation has a direct bearing on savings, investments and
consumption. If the direct tax rates were high, there would
be lesser savings and would also affect the consumption
pattern. At the same time, if the tax rates are brought
down, it would affect public investments. In such a
contradictory situation, the Government has to take very
precautionary step, a s high corporate tax rate would affect
the priCes adversely. At one point of time, the corporate tax
was quite high. However, with the process of liberalization
it has gradually been reduced. The reduction in corporate
tax creates multiple beneficial effects all round and also
attracts foreign investments.
ii) Public Expenditure
Public expenditure, apart from influencing the economic
growth process, has its real bearing on the activities of
financial sector.
In the event of more spending through public investments,
various sectors of the economy flourish, which in turn raise
the demand for private investments from financial system.
For example, if Government develops good infrastructure in
a particular zone, more industries would come u p and will
demand the financial assistance from banks and financial
institutes.
iii) Public Debt
The public debt comprises of internal and external debt.
Internal debt includes market loans, bank temporary loans
by way of treasury bills issued to RBI and commercial banks.
Public debt policy affects financial sector. When Government
has more borrowings, it adopts various tools such as increased
level to statutory liquidity ratio to be imposed on banks,
issue of treasury bills etc. All these measures reduce the
credit capacity of financial institutions and these are left
with less credit availability for productive purposes.
Thus, fiscal policy affects savings, investments, credit
capacity, demand for credit in a financial system etc. that
have direct bearing on operations of financial sector as a
whole in the economy.
1 4.2.1 Budgetary Policy Budgetary Pollcy and
Indian .Financial lyetem

/I Broadly speaking, budgetary policy is a policy through which

the government u s e s i t s expenditure a n d revenue
programmes to produce desirable results a n d avoid
/ undesirable effects on national income, production and
1 employment. Thus, budgetary policy helps in meeting the
I objectives set u p in the fiscal policy.
The objective of budgetary policy cannot be different from
the objective of fiscal policy and consequently economic
1
I
development of the country. Both have to coincide.

4.2.2 Budgetary System

The document integrating the revenue and the expenditure
of Government is called the 'Budget'. A budget contains
the actual estimates of revenue and expenditure of the
Government of preceding year, revised estimates of the
receipts and of the Government for the current
year and the estimates for the next year. It has a role to
ensure that the tax burden is reasonably imposed. On the
other side, it ensures justice in allocation of expenditure
among various sectors of the economy.
The budgetary policy is essentially concerned with:
a) Raising of revenue

b) Incurring of expenditure by the Government

The budgetary policy has been modified from time to time

and made more pragmatic not only to enhance the tax
resources but also to ensure that maximum people are
brought within the tax net. The tax GDP ratio in India was
just 6% in 1950-51, which increased nearly to 14% in 1999-
2000. The Budget statement has been instrumental for .
providing special incentives for private savings and also
encouraging investments in specified areas like housing.
The budget strategies are revised every year keeping in view
the overall economic growth of the country, requirements of
resources, and allocation of funds according to priorities.
Strategies of the Budget (2001-2002)
The broad strategies of the Budget 2001-2002 were
' determined with the objective of the growth in mind and to
ensure:

i) Speeding u p of agricultural sector reforms and better

management of the food economy.
ii) Intensification of infrastructure investment, continued
reformsiin the financial sectors and capital market and
deepening of structural reforms through removal of
The Basics of Financial remaining tiresome controls constraining economic activity.
System
iii) Human development through better educational opportu-
nities and programd of social security.
iv) Stringent expenditure control of non-productive expendi-
ture, rationalization of subsidies and improvement in the
quality of govkrnment expenditure.
v) Acceleration of the privatization process and restructuring
of public enterprises.
vi) Revenue enhancement thrdugh widening of tax base and
administration of a fair and equitable tax regime.

Table 4.1 :Budget [2001-2002)at a Glance

(Rs in Crores)
REVENUE RECEIPTS: 231745
TAX 163031
C
NON-TAX 68714

CAPITAL RECEIPTS: 143478

RECOVERY OF LOANS 151648
OTHERREVENUES 12000
BORROWINGS AND OTHER 116314
LIABILITIES

TOTAL RECEIPTS: 375223

NON-PLAN EXPENDITURE: 275123

REVENUE ACCOUNT 25034 1
INTEREST PAYMENT 1 12300
CAPITAL ACCOUNT 24782

PLAN EXPENDITURE: 95100

REVENUE ACCOUNT 60225
CAPITAL ACCOUNT 34875
LUMP SUM PROVISION
FOR ADDITIONAL PLAN 5000
REVENUE DEFICIT 7882 1
FISCAL DEFICIT 116314
PRIMARY DEFICIT 4014

Check Your Progress 1

1) What do you mean by fiscal policy?

2 ) How public expenditure as a policy instrument can be used

to enhance investment?
 .............................................................. >............................ budgetary Policy and
v Indian Financial Byatem

3) State whether following statements are true or false: 1

I
i) With the process of liberalization, the corporate tax has
been raised. (T/ F)
ii) Human development has been one of the key strategies
of union Budget 200 1-02. (T/F)
iii) The objectives of budgetary policy vary with the objectives
of fiscal policy. (T/F) *~-
** 9

4.3 INDIAN FINANCIAL SYSTEM

We are quite aware of the major components of a financial
system, a s these have been discussed in Unit-1. Let u s
discuss the various components of Indian Financial System
here.

The Indian financial system consists of variety of institutions,

markets and instruments that are closely related with each
other. It provides the principal means by which savings are
turned into investments. Given its role in the allocation of
resources, the efficient functioning of the financial system
is of crucial importance in a developing economy, like India.

The financial institutions/financial intermediaries, a s they

are called, comprise commercial banks, insurance companies,
mutual funds, non-banking financial companies, development
financial institutions etc. The financial markets comprise of
capital market and money market, whereas financial
instruments a r e demand deposits, short-term debt,
intermediate term debt, long-term debt and equity, bonds etc.

Broadly the important functions of financial system can be

described a s under: -

-i) It enab1,es the pooling of funds for setting up large-scale

enterprises.
ii) It provides a way for managing uncertainty and controlling
risks.
iii) It provides a mechanism for spatial and temporal transfer
of resources.
iv) It generates information that helps in coordinating
decentralized decision-making.
v) It provides a payment system for exchange of goods and
services.
vi) It helps in dealing with information gap by handling sensitive
information discreetly
The Basics of Financial
~ystern 4.4 IMPACT OF BUDGETARY POLICY ON
FINANCIAL SYSTEM
The budgetary policy provides a leeway to. integrate various
financial intermediaries and make the financial system more
vibrant. There are various budgetary policy measures, which
set the direction of savings, credit expansion and investments.
Depending o n various policy measures, the extent of growth
of financial system is determined.

4.4.1 Role of Budgetary Policy in the Growth of

Financial Institutions
The primary role of a financial institution is to serve as a n
intermediary between lenders a n d borrowers. These
institutions work under the overall supervision of the Reserve
Bank of India. The funds pooled by the financial institutions
are invested in diversified portfolios of financial assets. The
transaction cost is lower. The financial institutions supply
the ultimate lenders with liquid and less risky financial
assets. Thus, financial institutions act as intermediaries
between investors and savers.
The process of financial intermediation results in:

a) Providing savers with different varieties of financial assets

to invest their funds according to their preferences. It
enables them to increase their savings.
b) Borrowers are also benefited as finance is provided through
the institutions as it is not easily possible to obtain directly
,
from savers.
c) I t raises Lhe productivity of aggregate investment, by
improving its allocation. This apart, financial intermediaries
also perlorm the important function of facilitating the normal
producLion process and the exchange of goods and services.
The financial institutions, thus, play a vital role in the
economic development of the economy. Broadly, these
institutions are classified into following categories:
a) Development financial institutions
b) Insurance companies
c) Other Public sector financial institutions
d) ~ u t u a Funds
l
e) Non-Banking Finance Companies
The objective of budgetary policy is to strengthen the financial
base of these institutions and to provide them operational
freedom. A distinct feature of the Indian financial system is
dominance of public sector institutions. Motivated by socio-
economic considerations, the system h a s been subject to dgetary Policy and
n Finan cia1 System
high degree of regulations. Both entry of a new entity and
its expansion have remained under the control of State.
There has been a mandatory allocation of credit amongst
different sectors including the government. Concessional
interest rates have also been introduced.

In the recent past, the following budgetary policy measures

have been initiated:

i) The financial institutions have been given more autonomy

in their operations. They have also been permitted to expand
their operations in the financial sector by opening new
outfits.
ii) Prudential norms relating to capital adequacy, income
recognition, classification of assets and provisioning have
been made applicable to these institutions.
jii) Insurance sector has been opened to the private sector. This
will not only provide healthy conditions but also better risk
cover and returns to investors. Insurance Regulatory and
Development Authority h a s been set up to monitor the
insurance institutions.
iv) Budgetary allocation h a s been made to expand the
capital base of NABARD, which in turn will accelerate
the growth of agricultural sector and rural development.
v) Certain tax incentives have been extended for investment
in mutual funds.

4.4.1.1 Impact of Budgetary Policy on Banks

The banks mobilize surplus funds through various channels
of savings. The flow of savings in the economy directly
depends on budgetary policy measures. A s already indicated
that taxation policy, public expenditure and public debt
policy affect consumption and savings, the extent of savings
is much related to fiscal measures. Likewise, the expansion
of credit also depends on investment policy being pursued
by the Government to encourage private investments. If
there are more fiscal incentives for industrial expansion, it
will attract more demand for credit. Even Government's
demand to meet current expenditure would limit the
availability of loanable funds from the banking system.

The commercial banks transfer funds from surplus units to

deficit units a t the minimum operating cost. Today, we have
vast network of bank branches operating all over the country.
The nationalization of commercial bank in 1969 was a turning
point in the history of banking in India. There have been
significant achievements and pitfalls during this period. The
budgetary policy has initiated a series of measures to make
the banks more responsive to economic growth.
The Basics of Fillancia1 Some of the recent measures are a s under:
System

i) The banks are required to be more vibrant and their capital

base has been strengthened. To meet the capital adequacy
norm of 8%, a budgetary support of over Rs. 20,000 crore is
provided to weak banks.

ii) To make the bank credit cost effective, tax on loan

interest h a s been withdrawn.

iii) In the budget document, through rigorous exercises,

attempts have been made to bring down the delicit,
which in fact has helped banks to control flow of credit
to government on concessional rate of interest.

iv) To boost the export business, the government has set

u p Export Import Bank of India. The initial capital wp.;
contributed through budgetary resources.

v) Banks have been facing serious problem with regal& t.o

recovery of their loans particularly the non-performing;
assets. The government h a s s e t u p Debt Recovery
Tribunals to expedite the cases of banks and accelerate
recovery process.

vi) The budgetary policy provided specific provisions and

incentives for increasing the credit to high-tech
agriculture projects.

vii) The banking sector has been provided greater autonorny

in their functions. The entry of private and foreign sector
banks has been permitted to bring more competitiveness
and efficiency in the working of banks.

viii) For greater credit expansion and wider acceptability of

banks in rural areas, the Regional Rural Banks (RRBs)
have been set up.

ix) The development of housing sector received prirr~e

attention in the budgetary policy. National Housing Bank
has been set up. Tax concessions have been provided ito
the borrowers.

x) The budgetary policy has initiated several other policy

measures for the benefit of specified sectors like poor
people, agriculturist, educational loans, etc.

xi) The Statuary Liquidity Requirement (SLR) and the Carsh

Reserve Requirement (CRR) of banks have been reducled
significantly to release more loanable funds to the banks.

xii) To reduce its stake in the ownership of nationalized banks,

the Government has decided to reduce its equity to 33% in
case of such banks.
Thus, the budgetary policy h a s provided greater flexibility in Budgetary Policy and
Indian Financial S y sitem
banking operations and h a s made them more stronger to
play a vital role in the financial system.

4.4.2 Budgetary Policy and Financial Markets

In the Indian financial system, there are two broad segments
of the financial market:

i) money market, and

ii) capital market.

i) Money Market
The money market deals with short-term debt. The principal
players in the money market are the commercial and other
banks in addition to LIC, UTI, Mutual Funds, and non-
banking financial companies. These intermediaries lend
funds on a short-term basis to create a n active inter bank
call loan market. The Discount and Finance House of India
(DFHT) provides liquidity to money market instruments by
creating a secondary market.

ii) Capital Market

The capital market deals with long-term debts and stock

(equity and preference). Each of these markets h a s a primary
and secondary segment. New financial assets are issued in
the primary market while existing financial assets are traded
in the secondary market.

The growth of capital market is influenced, to a great extent,

by various budgetary policy measures. For example, the
taxation policy of corporate tax, dividend tax, capital gain
tax, fiscal incentives for small savings etc. have direct impact
and set the direction of growth of capital market. On the
other hand, various fiscal incentives for industrial expansion
would cause more demand from capital market by industrial
sector.

The instruments of capital market have long period for

maturity. It is a source of raising capital by issuing securities.
The primary capital market facilitates the formation of capital.
The secondary market consists of stock exchanges recognized
by the government. The National Stock Exchange and Over
the Counter Exchange of India provide liquidity to the
secilrities. The Securities and Exchange Board of India (SEBI)
oversees and monitors the functioning of securities market
and operations of intermediaries like mutual funds a n d
merchant banks. Besides, there is a market for government
securities which deals with debt securities issued by central/
state governments, all India financial institutions and other
autonomous institutions.
The Basics of Financial The following budgetary provisions helped widening of
System
financial markets and their operations smoothened:

a) With a view to encourage secondary market operations, the

maximum coupon rate which was as low a s 6.5 O/o in 1977-
7 8 was raised to 11.5 O/o in 1985-86 and thereafter
restriction on inaximum coupon rate was removed.

b) A nurnber of insti-uments were introduced irl tlle market

s u c h as 182-day Treasury Bill, certificate o l deposits,
commercial paper and inter- bank participations.

c) The Discouilt and Finance House ol' India (CFI--11)was set

.up in 1988 by Reserve flank of Iizclia and other financial
ii~stitutionsto facilitate sniootheiling of short-ler~nliquidity
imbalances arld l ~ r i i ~ilexibilily
g lo the money i~lm-kcl..

d) The interest ra.tes have 'been largely deregulated.

e) Tax incenl.ives have been provided for c;-lpital gains
investment in mutual funds a n d investment i r ~irll'l-a-
structure developmel~
t bonds.

f) 't'o provide lurlher boost lo nioi~ey1-narltetoperations, banks

and other financial institutions have been allowed to set
ul:, money market mutual funds.

g) Foreign irlstitutional iilvestors have been encourngcrl to

participate iiz ihe financial markets. ,

h ) The concept of tax-free bonds was Introduced for mobilizing

greater resources.

4.4.3 Budgetary Policy and the Financial

Instruxnents
Financial instruments are generally defined a s moizelary
obligation of a borrower of f u n d s ( t h e i s s u e r of the
instrument) to the holder of the instruments. 1701- the
issuer of the instrument, it is a liability or in other worcls,
financial obligation, for the holder it is a financial asset.

Financial instruments may be issued by economic units

(private as well as public). The major financial instruments
in an economy are as under:

i) Demnnd Deposits
Demand deposits are the financial instrument. which are
payable on demand to the owner by the holder. It may or
may not carry interest. These are usually held by the
banks by way of current and savings deposits and by post
offices by way of savings accounts.
ii) Short-Term Debt ~ l u d g e t a r y Policy a l ~ d
Indian Financial System
This is a promise to repay a specified sum along with agreed
rate of interest within a short period of one year. Treasury
bills, commercial papers, certificates of deposits and few
other innovative instruments have been introduced in the
system.

iii) Long-Term Debt

These are the debt instruments repayable over a period of

5 to 7 years in case of corporate sector and over 10 years
in case of government bonds. They carry a specified coupon
rate. Private and public sector debentures and bonds fall in
this category. The debt instruments have been made more
lucrative r i t h variety of options and reasonably better yield.

iv) Equity Stock

This is a popular means of raising resources as capital by

the corporate sector. Being owners, the equity shareholders
have residual interest in the income of the company as they
receive dividend after the' claims of all creditors are met.

The budgetary policy h a s aimed from time to time that

various financial instruments depending on variety of needs
are brought into the system. They perform both the functions
of financial assets and financial liabilities.

In this direction, the budgetary policy has a very important

role because the nature of new financial instruments and
their innovativeness depend on budgetary policy decisions.
Such incentives are in the form of tax incentives to attract
more savings, growth of investments to meet increased money
supply and growth of capital market in tune with changes
in policy measures for industrial growth.

The budgetary policy h a s made the financial instruments a s

discussed above, more acceptable. Some of the other
financial contracts like forward futures, swaps, options and
pension funds have been introduced in the system. The
following are some of budgetary policy measures, which
have increased the utility of above instruments in the financial
system.

i) The ceiling coupon rate on bonds has been abolished.

ii) Some specified bonds such as infrastructure and power

development have been given tax benefit.

iii) The volume of money market instruments h a s been

increased.

iv) Number of steps has been taken to make short-term debt

'I'he Basics of Financial in~trulnclltsmore acceptable. The eligil~ilitynorlils have
System
been li bcralized li-om time to time.

lr) have also bccn jr,ivc~~

Mutual r~inclsirlveslr~~erlts (:el-tail]
rebate in tax .

vij Specific guidelines have been issued for operations of

forward futures, swaps, optiorls etc.

Check Your Progress 2

1) State three ~najorfunctions of financial intermediaries.

2) What major steps have been adopted in the recent years to

make the banks more vibrant?

...........................................................................................
3) State how the budgetary policy affects the financial markets

THE INTEREST RATE POLICY AND

THE FINANCIAL SYSTEM
The interest rate policy basically aims at:

i) ensuring government borrowings a t cheaper rates,

ii) supporting certain activities through concessional lending

rates,

ili) mobilizing substantial savings, and

iv) ensuring stability in the macro-economic system.

*
The interest rates in India had, in the past, been substantially
regulated by thc Reserve Bank of India which had the
following featurcs:

i) Interest ratcs on deposits with commercial banks were

subject to ceiling.

ii) Interest rates on loans were subject to floors.

iii) Interests rates payable by companies on deposits were
subject to a ceiling.
iv) Interest rates charged by development financial institutions Budgetary Policy and
Indian Financial System
were subject to floors.

v) Interests rates payable on small saving schemes were fured

by the government.

The interest rate regime in India has undergone a rapid

transformation during recent years. The structure of interest
r a t e s , which was extremely complex, h a s now been
rationalized. Banks are now free to determine their own
Prime Lending Rate and to prescribe the maximum spread .
over it. Loans upto Rs. 2 lakhs are to b e granted a t rates
not exceeding the Prime Lending Rate of relevant maturity.
The money market rates have been completely freed. So are
the rates a t which corporate entities can borrow funds from
the capital market. Deposit rates have also been deregulated,
except the interest rate on saving accounts, which is
determined by the Reserve Bank of India.

The interest rate deregulation has influenced the government

securities market also. The Central Government has been
able to meet its requirements from the market through the
auction mechanism. The rates of interest settled a t the
auctions have come to reflect truly the market conditions.
This has been proved both in relation to dated securities
and treasury bills. With abundant liquidity, the interest
rates have clearly shown a downward decline. The 364-day
treasury bills are increasingly being used as a benchmark
for fixing other rates in the system. With the development
of an active government securities market, where rates are
more or less determined by the market, the emergence of
the open market operations a s an indirect instrument of
monetary control will assume importance. Steps are being
taken to bring about significant institutional changes in the
government securities market.

With the reform in the interest rate structure, an emphasis

has been placed on widening and deepening of various
segments of the financial sectors of money market and
capital market. In the budget 2002-03, Governement h a s
decided to link interest rate on small savings with the average
yield on Government Securities of comparable maturity.

Role of Budgetary Policy in the emerging new economic

environment:
India has been pursuing the policy of economic reforms
since 199 1-92. The major policy initiatives are:

i) Macro economic stabilization through fiscal policies.

ii) Trade policy reforms to provide stimulus to exports.

iii) Industrial policy reforms to provide greater competitive
environment to industries.
The Basics of Financial iv) Wide spread reforms in financial sectors to achieve financial
System
efficiency.

The monetary and fiscal policies aim a t controlling aggregate

demand in tune with the growth of the economy. These
policies are known as stabilization policies. The budgetary
policieb act as a link between both, the macro economic
stabilization and structural policies. Therefore, budgetary
policy has a very crucial and significant role in creating a n
environment conducive to economic growth.

There h a s been a number of policy measures taken in the

recent years to accelerate the process of economic reforms.
These include:

i) Wide range of financial sector reforms including banking

sector, capital market operations, non-ban king financial
companies and other development financial institutions.

ii) Serious attempts have been made through budgetary policy

to correct fiscal imbalances.

iii) The tax laws has been rationalized to ensure:

a) lower personal and corporate taxes.

b) broaden the tax base; and
c) inflation adjustment of tax rates.
iv) The policy has been adopted for progressive expansion of
MODVAT system.

v) Continued rationalization of custom tariffs structure.

vi) The new economic policy has lent more emphasis on large
flow of direct foreign investment. I

The above analysis indicates that budgetary policy has a n

important contribution in achieving the goals and objectives
of new economic policy.

4.6 DEFICIT FINANCING AND FINANCIAL

SYSYTEM
According to the Planning Commission, the term "Deficit
Financing" is used to denote direct addition to gross national
expenditure lhrough budget deficits whether the deficit is
on revenue or on capital account. The essence of such a
policy lies, therefore, in government spending in excess of
the revenue it receives in the shape of taxes, earnings of
state enterprises, loans from public, deposits a n d funds and
other miscellar~eoussources.

The government may cover the deficit either by:

 i) Running down its accumulated balance ( withdrawing its Budgetary Policy an*
Indian Financial System
cash balances),
ii) Borrowing from the central bank,
iii) Borrowing from commercial banks, or
iv) Creating new money by resorting to the printing press.
In short, deficit financing means incurring public expenditure
in excess of public receipts from all sources. The quantum
of deficit financing in a given period can be measured by
variations in the financial assets and the non-monetary
liabilities of the RBI and of the treasury.

The deficit financing has affected the operations of financing

system to a large extent a s financial system especially the
banks were directed to provide significant credit support for
government expenditure (current and capital both).

The period since early 1970s was characterized by weakening

of fiscal discipline leading to large expansion in the central
government's domestic and foreign currency borrowing
requirements .The ratio of the gross fiscal deficit to GDP
increased irom 3.5 % in 1970-71 to 8.4% in 1990-9 1. The
obligatory cash reserve requirements of scheduled banks
(held a t the central bank) and the stbtutory liquidity ratio
(to be met through holdings of government and other
approved securities), reduce the resources of banks. With a
view to keeping the government's borrowing custs down, the
yield on both treasury bills and long-term paper were left
1 artificially low. This limited the demand for government
I paper by banks (and other financial intermediaries, such a s
insurance companies a n d provident funds). Residual
financing needs of the government were, therefore, met by
the Reserve Bank.

Such a mix of policies had deleterious long-term effects as

large fiscal deficits became chronic and continuous escalation
of the above-mentioned two ratios became necessary. In the
early 1970s the cash reserve ratio for the banks was as low
I as 3% and the statutory liquidity ratio was 25%. By 1991-
92, the CRR rose to 5% and SLR was 38.5%. At the same
time, the Reserve Bank's holding of Central Government
debt (i.e., its monetisation of the Government deficit)
ballooned. By 1991, it was clear t h a t the burden of
Government debt was becoming unsustainable and that a
significant improvement in the primary deficit was needed.

Sustained fiscal adjustments must underpin further reforms.

I
In the absence of credible fiscal control and price stability,
i there is some risk that interest rate deregulation could
I
I result in overshooting and disrupt the reform process. The
I
Government of India has committed itself to continued
I
reduction in its gross fiscal deficit from the level of 5.7%
i 65
The Basics of Financial reached in 1992-93. The fiscal deficit as a proportion of GDP
System
was budgeted, a t 4.7 per cent in 200 1-02 (BE) compared
with 5.5 per cent in 2000-01 on the basis of original
unaudited figures. Trends in the financial year 1993-94
were somewhat worrying, with the seasonally unadjusted
deficit in the first half of the year running- a t an annual rate
roughly triple the targeted level. This reflects revenue
shortfalls partly related to sluggish industrial activity and
delay in sale of equity in public enterprises. There has been
agreement between Reserve Bank and Government that this
incremental deficit should not be monetised. Accordingly,
Government has resorted to additional borrowing through
treasury bills and zero-coupon bonds a t market-related rates.
ort tun at el^, this unplanned increase in the borrowing
requirement has occurred a t the time when the domestic
market i s flush with f u n d s , b u t t h i s i s short-term
phenomenon that cannot be relied on. Nonetheless, the use
of these market instruments has meant that the monetised
deficit can be kept under control.
7
Check Your Progress 3

1) List the three meawires initiated in the budgetary policy to

make the banks more responsive to growth.

2) Name any two measures which have been taken to

strengthen the capital market?

3) Name two measures through which the Government cures

its budget deficit.

4.7 LET US SUM UP

Budgetary Policy a s a part of economic policy deals with
taxation, public expenditure, public borrowings and debt
management. The budgetary and monetary policy and the
budget documents influence the functioning of financial
system to a great extent.
Takation policy has a direct bearing on savings, investments
and consumption. Change in the direct tax rates affect the
level of saving and the consumption patterns. Public expen-
diture also influences the linkage between public investment
Budgetary Policy and
Indian Filluncial S v s t e n ~ I
and its spill over effect on private investment. Public debt
policy also affects financial sector through changes in SLR
and CRR, which in turn, reduce the credit capacity of the
financial institutions. Thus, budgetary policy affects savings,
investments, credit capacity demand for financial system,
which, in turn, have direct bearing on the financial system.

A lot of chanies have been made in the Indian budgetary

policy after July 1991 to boost the financial system and
make it more vibrant. The Financial Institutions have been
given more autonon~yafter the beginning of economic reforms
since July, 199 1. As a major policy change, the insurance
sector has been opened to private sector. Budgetary Policy
h a s also provided greater flexibility in banking operations
and has made them stronger to play a vital role in the
financial system. The budgetary provisions have also helped
widening the financial markets. A number of financial instru-
rnents such a s Treasury Bills of shorter duration, certificate
of deposits, commercial papers etc. have been introduced.

The deficit financing has affected the operations of financial

system to a large extent as financial system, especially the
banks, provide a large amount of support through purchase
and sale of government securities. Since early 1970s, the
domestic and foreign currency borrowing requirements of
the Government have expanded to a great deal. In order to
keep the Government's borrowing cost down, the yield on
the long-term debt h a s been kept low. Such a policy
measures has deleterious long-term impact on the financial
system.

4.8 KEY WORDS

Balance of Payment: A systematic and summary record of
a country's receipts a n d payment
made to the rest of the world.

CRR : Cash reserves to be kept by the Com-

mercial Banks as certain proportion
of their demand and time deposits.

Economic growth : The ex!-,ansion of t h e per capita

output of the economy. In other
words, a tendency of rise in real level
of net national product.

Exchange rate : The price at which one currency can

be exchanged for another.

Human : The process of widening people's

cl~l.~l---d.-t cLn4nam 0-A + L a lavral n f qx~all ke<-m
1
The Basics of Financial Progressive t a x : Progressives taxes refer to increasing
System
rate of taxes a t the increasing level
of income.

Propensity to : The desire to consume expressed a s

consume the proportion of income spent on
goods and services,.

Pump priming : Attempt to reflate the economy by

running a small budgetary deficit.

Redemption of debt: The repayment of a n outstanding

loan by the borrower in order to
cancel it.

4.9 SOME USEFUL BOOKS

Economic Survey - Government of India, 200 1, 2002
Union Budget Document, 200 1-02, 2002-03
I.C. Dhingra (2001)- Macro Economics Analysis and Policy,
Sultan Chand and Sons, New Delhi
Rudra Dutt (2001)- Indian Economy, S. Chand and Company,
New Delhi
Cooper, S.K. and Fraser, D.R. (1990): The Financial Market
Place, IIIrdedition, Westley Publishing Co., Massachuales, New
York.

4.10 ANSWERS/HINTS TO CHECK YOUR.

PROGRESS EXERCISES
Check Your Progress 1

1) Fiscal Policy is a policy instrument, which deals with the

taxation, public expenditure and public debt to achieve the
desired objectives.

2) By making the public expenditure in socio-economic

infrastructure, which in t u r n , motivates the private
investment.

3) (i) False (iiTrue

) (iii) False

Check Your Progress 2

1) i) Serve as a n intermediary between lenders and borrowers.
ii) Provides savers with different varieties of financial assets
to invest their funds.
iii) Provides borrowers with the opportunity to obtain funds.
 'i

I
2) i) Debt Recovery Tribunal has been set u p to expedite the Budgetary Policy and
Indian Financial S y s t e m
cases of banks suffering from the problem of recovery of
their loans.
ii) Entry of private and foreign banks has been permitted
to make the system more competitive and effective.
iii) The Statutory Liquidity Requirements (SLR) and Cash
Reserve Requirements (CRR) have been reduced
significantly to release more lonable funds to the banks.

I
!
3 ) Various policy measures of budgetary policy, such a s
taxation affect the level of saving and investment, which in
turn, affects the functioning of financial markets.
I

Check Your Progress 3

I.) i) Withdrawal of tax on loan interest.
ii) Setting u p Export-Import Bank of India to boost the
export business.
iii) Reduction of CRR and SLR to reIease more loanable
funds to the banks.

2) i) Removal of coupon rate.

ii) Introduction of new instruments like Treasury Bill,

Certificate of Deposits, Commercial Paper and inter-
bank participation.

3 ) i.) Market Borrowing

ii) Deficit Financing