Global Banking and Finance

GLOBAL BANKING & FINANCE
(FOR PRIVATE CIRCULATION ONLY)

2018
PROGRAMME COORDINATOR
Prof. Prashant Ubarhande
COURSE DESIGN AND REVIEW COMMITTEE

Dr. N.M. Vechlekar Dr. Ravi Chitnis
Prof. Abhinav D. Jog Dr. Bhama Venkataramani
Prof. Dalip Mehra Dr. Deepa Gupta
Prof. Sudhir Gijre Prof. Arun Vartak
Dr. Swati Oza Prof. Avinash Nene
Prof. Prashant Ubarhande Dr. Sudeep Limaye
COURSE WRITERS
Prof. Dalip Mehra Prof. Jyoti Chandiramani
Prof. Sudhir M. Gijare Prof. Anil Agashe
Prof. Rajul Agarwal
EDITOR
Ms. Neha Mule
Published by Symbiosis Centre for Distance Learning (SCDL), Pune

July, 2011 (Revision 04, 2018)
Copyright © 2018 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.
Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologisesfor the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
The ever changing complex economic environment has made the line of difference between financial
institutions very thin. Keeping the fact in mind, it has become imperative to understand Banking and
Finance through Global perspective.
The units on banking and non banking institution in international banking would give an idea to
students about different players in the world market. They would learn about financial regulations,
exchange rate mechanism, new financial instruments credit ratings, factoring & forfeiting in global
prospect.
The unit on derivatives gives an insight into the meaning of derivatives and the important role they
play in the global financial market. The different types of derivative contracts have been explained
in detail along with the motives that are achieved with each of the contracts. Emphasis has also been
given on the techniques of foreign exchange risk management.
Unit of Divestment of PSUs would make students aware about various issues related to divestment
policy of Government of India in Globalization era.
Insurance is one of the most commonly used risk mitigation tool and the unit highlights the importance
and different types of insurance.
The Financial Intelligence Unit -India has issued guidelines for prevention on money laundering.
The process of money laundering and its different stages have been explained in a very easy-to-
understand manner.
Dalip Mehra
Sudhir M. Gijare
Rajul Agarwal
Jyoti Chandiramani
Anil Agashe
iii
ABOUT THE AUTHORS
Dalip Mehra is M.Sc. LL.B CAIIB, DBM. He is Ex-Deputy General Manager, Bank of Maharashtra.
He has written over 37 books on various subjects like Banking, Risk Management, Finance,
Economics, Law and Management. Two of his books have been recognized and awarded by Ministry
of Finance and Ministry of Agriculture.
Sudhir M. Gijare is Dy. General Manager (Retd) from State Bank of India. He has wide experience
in Credit Management, International Banking, Risk management for more than 30 years. He has used
his long standing experience while writing the units in this book.
Rajul Agarwal has completed her CA from The Institute of Chartered Accountants of India. She has
also done her Diploma in Information System Audit and holds AMFI Certification. Rajul Agarwal
has over 9 years of domain knowledge and experience of functioning of Indian Accounting and
Taxation system.
Jyoti Chandiramani is a teacher of Economics having a rich experience of more than 22 years. She
has pursued a career in teaching both at the undergraduate and postgraduate level. She specializes in the
areas of Managerial Economics, International Economics, Banking & Finance and Macroeconomics.
Anil Agashe has a Master’s degree in Political Science and Public Administration from Pune
University, and a Certificate in Foreign Exchange from Bankers’ Training College of Reserve Bank
of India. He has been a banker and has also worked in Corporate with an experience in the field of
Finance and Project Management.
iv
CONTENTS
Unit No. TITLE Page No.

1 Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 1 - 24
1.1 Introduction to Global Banking & Finance
1.2 Definition of NRIs/PIOs/OCBs
1.3 Non-Resident Indians under Income Tax Act, 1961& FEMA, 1999
1.4 Types of Non-Resident Indians Bank Accounts
1.5 Investment facilities for NRIs
1.6 Returning NRIs/PIOs – Back to India
1.7 Exchange Earner’s Foreign Currency Account
1.8 Terminologies used in Global Trade & Finance
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Financial Regulations 25 - 52
2.1 Introduction
2.2 International Organisations for Trade & Development
2.3 RBI - Banking Sector Reforms
2.4 RBI - Exchange Control Authority
2.5 Exchange Control related to Import of Goods and Services
2.6 Exchange Control related to Export of Goods and Services
2.7 Highlights of Foreign Trade Policy 2015 -2020
Summary
Key Words
Suggested Reading
3 Banks engaged in Business of International Banking 53 - 74
3.1 Introduction
3.2 Correspondent Banks
3.3 Import Finance
3.4 Export Finance
3.5 Different Stages of Export Finance
3.6 Pre-shipment Credit in Foreign Currency (PCFC)
3.7 Post Shipment Export/Finance
3.8 Risk Management in International Banking
3.9 Deemed Exports
Summary
Key Words
Suggested Reading
v
4 Exchange Rate Mechanism 75 - 106
4.1 Introduction
4.2 Exchange Rate Theories
4.3 Fixed Versus Flexible Exchange Rate System
4.4 Factors Influencing Exchange Rates
4.5 Exchange Regimes in Practice
Summary
Key Words
Suggested Reading
Annexure
5 Developmental Financial Institutions & International Banking 107 - 128
(Specialised Institutions in International Banking)
5.1 Introduction
5.2 Export Credit Guarantee Corporation of India (ECGC)
5.3 ECGC – Types of Credit Insurance Policies
5.4 Types of Guarantees to Banks
5.5 Export Import Bank of India (EXIM Bank)
5.6 Functions of EXIM Bank
5.7 EXIM Bank Programmes
5.8 Foreign Exchange Dealers Association of India (FEDAI)
5.9 Directorate General of Foreign Trade (DGFT)
Summary
Key Words
Suggested Reading
6 New Financial Instruments Objectives 129 - 144
6.1 Introduction
6.2 Classification of Financial Instruments
6.3 Traditional Financial Instruments
6.4 Emergence of Complex Financial Instruments
6.5 Meaning of Derivatives
6.6 Derivative Markets/Contracts
6.7 Various Types of Derivatives
6.8 Permissible Derivative Instruments in India
6.9 Reasons for Popularity of Derivatives
Summary
Key Words
Suggested Reading
vi
7 Derivatives 145 – 168
7.1 Introduction to Derivatives
7.2 Uses of Derivatives
7.3 Types of Derivatives
7.4 Types of Derivative Contracts
7.5 Classes of Underlying Assets
7.6 Foreign Exchange Risk Management-Process and Necessity
7.7 The Forward Contract
7.8 Futures Contracts
7.9 Swaps
7.10 Options
Summary
Key Words
Suggested Reading
8 Credit Rating 169 – 180
8.1 Introduction and Need of Credit Rating
8.2 Credit Rating
8.3 Factors that Contributed to the Growth of Credit Rating
8.4 Factors Considered by Credit Rating Agencies while Rating an
Instrument
8.5 Flow Chart of Rating Process
8.6 CRISIL’s Long-Term Rating Symbols
8.7 Recent Developments
Summary
Key Words
Suggested Reading
9 Factoring & Forfeiting 181 – 198
9.1 Introduction
9.2 Factoring
9.3 Functions of Factor
9.4 Factoring Mechanism
9.5 Legal Aspects involved in Factoring
9.6 Types of Factoring
9.7 Advantages of Factoring
9.8 International Factoring
9.9 Factoring in India
9.10 Factors Inhibiting the Growth of Factoring in India
9.11 Forfeiting
9.12 Mechanism of Forfeiting Transaction
9.13 Difference between Forfeiting and Factoring
Summary
Key Words
Suggested Reading
vii
10 Introduction to Insurance 199 – 216
10.1 Introduction
10.2 Insurance Regulatory and Development Authority (IRDA)
10.3 Types of Insurance
10.4 Life Insurance
10.5 Non - Life Insurance
10.6 Reinsurance
Summary
Key Words
Suggested Reading
11 Disinvestment of PSUs 217 – 234
11.1 Introduction
11.2 Disinvestment Policy
11.3 Different Approaches to Disinvestments
11.4 Need for Disinvestment
11.5 National Investment Fund
11.6 Issues in the Disinvestment process
11.7 Government Policy on Disinvestment
11.8 Conclusion
Summary
Key Words
Suggested Reading
12 Prevention of Money Laundering Act (PMLA), 2002 235 – 252
12.1 Introduction to Money Laundering
12.2 Introduction to Financial Intelligence Unit – India (FIU-IND)
12.3 Offence of Money Laundering
12.4 Definitions
12.5 Obligations of Banks & Financial Institutions under PMLA
12.6 USA Patriot Act
12.7 Provisions for Prevention of Money Laundering under USA Patriot Act
12.8 Amendments In PMLA in 2018
Summary
Key Words
Suggested Reading
viii
Introduction to Global Banking & Finance (Introduction
to NRI/PIOS) UNIT
Structure: 1
1.1 Introduction to Global Banking & Finance
1.2 Definition of NRIs/PIOs/OCBs
1.3 Non-Resident Indians under Income Tax Act, 1961& FEMA, 1999
1.4 Types of Non-Resident Indians Bank Accounts
1.5 Investment facilities for NRIs
1.6 Returning NRIs/PIOs – Back to India
1.7 Exchange Earner’s Foreign Currency Account
1.8 Terminologies used in Global Trade & Finance
Summary
Key Words
Suggested Reading
Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 1

Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Recognise the importance of NRIS
----------------------
• Define NRIs/PIOs
---------------------- • Distinguish between the definitions under FEMA and IT Act
---------------------- • Describe the facilities offered to NRIs
---------------------- • Define the terminologies used in foreign trade
---------------------- 1.1 INTRODUCTION TO GLOBAL BANKING & FINANCE

---------------------- Globalisation refers to the expansion of economic and financial activity
across national boundaries and encompasses all operations in a globally
----------------------
competitive environment. This translates itself in actual practice into free
---------------------- movement of goods, services and factors of production across national and
regional boundaries. As a prerequisite for such free flows, the barriers to trade
---------------------- and services have to be reduced/eliminated and structural adjustments in the
economy need to be made as well in the form of privatisation. Since July
----------------------
1991, Government of India has taken series of measures with an aim towards
---------------------- achieving such an environment necessary for globalisation. A few important
environmental changes are as under:
----------------------
• FERA relaxation and introduction of a new law of FEMA in 1999
---------------------- • Rupee Convertibility on Current account in 1994 and limited capital account
---------------------- convertibility
• Greater autonomy to banks and ADs and Restructuring of banking system
---------------------- and their practices and greater FDI in banks
---------------------- • Reduction of direct and indirect taxes and rationalisation and simplification
of tax structure
----------------------
• Import liberalisation in the direction of eliminating the negative list, subject
---------------------- to controls
---------------------- • Increasing access to foreign currency markets by both banks, FIs, and
corporate
----------------------
•
RBI policy is to integrate domestic financial markets with foreign markets,
---------------------- as a step in the direction of globalization in the financial sector
In the Indian scenario, the commercial banks (ADs) are one of the most crucial
----------------------
participants in the foreign exchange market, either as intermediaries or as
---------------------- counter parties to a foreign exchange contract. In Global Banking and Finance,
we will study about various facets of International Banking.
----------------------
Background - NRIs
---------------------- Indians have emigrated and blended with different cultures and nations since
2 Global Banking & Finance

ancient times. There were close contacts with Arab traders and European Notes
merchants. In its prime, the kingdom of the Cholas in South India had well-
settled colonies in Malaysia and Indonesia. During the British Raj, Indians were ----------------------
deported to far-off places like Africa, South Africa in particular, the Caribbean
and Mauritius. Large groups of Indians are present in these countries even today. ----------------------
The diversity of the NRI community stems from the diversity in the history of ----------------------
Indian emigration. The total number of NRIs is around 30 million. NRIs are
a varied lot. It consists of people like Mr Lakshmi Mittal, the billionaire steel ----------------------
tycoon in the UK, Ms. Indra Nooyi (PepsiCo’s CEO) and Mr Bobby Jindal
(Governor of Louisiana) in the US to the humble migrant worker in Dubai ----------------------
or Singapore. The non-resident Indian population in different countries is ----------------------
increasing gradually and the NRI population outside India is becoming more
powerful as well. The NRI population in various countries is now greatly ----------------------
respected with most of them holding high offices in government, academics
and business as well as a host of other fields. ----------------------
In 1970, the Govt. of India introduced NRI Banking in order- ----------------------

•
to carry out financial transactions like that of attracting their savings by ----------------------
way huge deposits and other remittances to India through banking channels.
Funds held in these kinds of accounts enjoy certain tax exemptions, free ----------------------
repatriation facilities etc.
----------------------
• to bolster the balance of payments between Indian banks and NRI’s through
Non- Resident (External) Accounts Rules, which are governed by the ----------------------
Exchange control regulations.
----------------------
The flow of foreign exchange deposits in 2008-09 by non-resident Indians to
banks has increased by almost 22 times over the previous year to $3.99 billion ----------------------
(Rs19, 671crore), which is very vital to a developing country like India.
----------------------
1.2 DEFINITION OF NRIS/PIOS/OCBS ----------------------
An individual who has gone out of India for seeking employment ----------------------
/ carrying on business or vocation, profession outside India or stays abroad
under circumstances indicating an intention for an uncertain duration of stay ----------------------
abroad is a Non-resident Indian. (an Indian citizen posted in U.N organisations ----------------------
and officials deputed abroad by Central/State Government and Public Sector
Undertakings on temporary assignments are also treated as non-resident) Non- ----------------------
resident foreign citizens of Indian Origin are treated on par with non-resident
Indian citizens. ----------------------
How do we define PIO (Person of Indian Origin)? ----------------------
For the purpose of availing of the facilities of opening and maintenance of bank ----------------------
accounts and investments in shares/ securities in India:
----------------------
A foreign citizen (other than a citizen of Pakistan or Bangladesh) is deemed to
be of Indian Origin, if, ----------------------
• he, at any time, held an Indian passport,
----------------------

Notes • he or either of his parents or any of his grandparents was a citizen of India by
virtue of the Constitution of India or Citizenship Act, 1956(57 of 1955).
---------------------- Note:
---------------------- – spouse (not being a citizen of Pakistan or Bangladesh) of an Indian Citizen
or of a person of Indian Origin is also treated as a person of Indian origin
----------------------
for the above purpose.
---------------------- – for investment in immovable properties:
---------------------- A foreign citizen (other than a citizen of Pakistan, Bangladesh, Afghanistan,
Bhutan, Sri Lanka or Nepal), is deemed to be of Indian origin if,
----------------------
He held an Indian passport at any time, OR
---------------------- He or his father or paternal grand-father was a citizen of India by virtue of the
---------------------- Constitution of India or the Citizenship Act, 1955 (57 of 1955).
Definition of Overseas Corporate Bodies (OCBs)
----------------------
Overseas Corporate Bodies predominantly owned by Individuals of Indian
---------------------- Nationality and origin resident outside India (OCBs) include overseas
Companies, partnership firms, societies and other corporate bodies which are
----------------------
owned, directly or indirectly to the extent of at least 60% by individuals of
---------------------- Indian Nationality or Indian Origin resident outside India as also overseas
trusts in which at least 60% of the beneficial interest is irrevocably held by such
---------------------- persons. Such ownership interest should be actually held by them and not in the
capacity as nominees.
----------------------
Various facilities granted to NRIs are also available with certain exceptions
---------------------- to OCBs as long as the ownership/Beneficial interest held in them by NRIs
continues to be at or above the level of 60%.
----------------------
In order to establish that the ownership/beneficial interest in any OCB held by
---------------------- NRIs is not less than 60%, the corporate body/trust concerned is required to
furnish a certificate from an overseas Auditor/Chartered Accountant/Certified
----------------------
Public accountant in form OAC, where ownership/beneficial interest is directly
---------------------- held by NRIs, and in form OAC-1 where it is held indirectly by NRIs.
---------------------- Check your Progress 1

----------------------
State True or False.
----------------------
1. One of the economic measures taken by Government of India since
---------------------- mid-1991 is convertibility of rupee on current and capital account.
---------------------- 2. Simple definition of NRI can be ‘an Indian citizen who has gone
abroad for seeking gainful employment/profession for indefinite
---------------------- period’.
---------------------- 3. A foreign citizen (other than a citizen of Pakistan and Bangladesh)
is deemed to be a Person of Indian Origin provided he has held an
---------------------- Indian passport.

1.3 NON-RESIDENT INDIANS UNDER INCOME TAX ACT, Notes
1961 & FEMA, 1999 ----------------------
In India, neither nationality nor domicile status of an individual is the ----------------------
basic criterion for determining his liability to pay tax. However, it depends on
his residential status. ----------------------
Residential Status is determined on the basis of physical presence i.e. the ----------------------
number of days of stay in India in any year.
----------------------
Who is a Resident?
An individual is a resident if any of the following conditions is/are satisfied: ----------------------
– He stayed in India for 182 days or more during the previous year, or ----------------------
– He stayed in India for 365 days or more during the four preceding years and
----------------------
stays in India for at least 60 days or 182 days in case of an Indian citizen, or
a person of Indian Origin coming on a visit to India, or 182 days in case of ----------------------
an Indian citizen going abroad for an employment during the previous year.
The stay in India for the above criterion may be continuous or intermittent. ----------------------
 H
indu Undivided Family (HUF) or firm or other Association of persons is ----------------------
a resident of India except in cases where the control and management of its
affairs is wholly situated outside India in the previous year ----------------------
 A company is resident in India if ----------------------
– It is an Indian company, or – during the previous year, the control and
management is situated wholly in India. ----------------------
– A person resident in India, in a previous year in respect of any source of ----------------------

income shall be deemed to be resident in India with respect to his other
sources of income. ----------------------
Who is a Non - Resident? ----------------------

A person is a non- resident if he is not resident in India. ----------------------
The term “Non- Resident” under Tax laws is based on the number of days
----------------------
of stay in India during the previous/financial or accounting year and covers twelve
st st
months from 1 April to 31 March. For example There are two different definitions ----------------------
of the term “Non-Resident”–one under the Income Tax Act,1961(IT Act) and the
other under Foreign Exchange Management Act,1999 (FEMA),The definition ----------------------
under the Income Tax Act is based on the number of days of stay in India i.e.
physical presence of a person in the current financial year. ----------------------
Previous Accounting year ending on or before Assessment year for tax ----------------------
31-3-2001 2001-2002
31-3-2002 2002-2003 ----------------------
31-3-2003 2003-2004 ----------------------
The definition under the Foreign Exchange Management Act,
1999(FEMA) is based on the number of days of stay in India during the course ----------------------
of the preceding financial year with the result that a person might have to wait ----------------------
for one and a half year to become a resident of India.

rd
Notes For example, Mr. Gururaj Patel comes to India on 3 October 2001. He
st
stays in India throughout the financial year 2002-2003 i.e.from1 April, 2002 to
st
---------------------- 31 March 2003. He would be a Non- Resident under FEMA for the financial
year 2002-2003 notwithstanding the fact that he was in India for more than 182
----------------------
days as his presence in India during the preceding financial year i.e. 2001-2002
---------------------- was for a period of less than 183 days.
Status of an Individual assessee:
----------------------
Sections 2(U), 2(V) and 2(W) of Foreign Exchange Management Act.1999
---------------------- define “Person” and “Person resident in India” and Person resident outside
India” as follows:
----------------------
1) Non Resident
----------------------
2) Resident in India
---------------------- 3) Not Ordinarily Resident
---------------------- Sections 2(U), 2(V) and 2(W) of Foreign Exchange Management Act.1999
define “Person” and “Person resident India” and Person resident outside India”
----------------------
as follows:
---------------------- First, we will refer to Sec. 2 (u) of FEMA-“Person” includes
---------------------- • An individual
---------------------- • A Hindu Undivided Family

• A Company/body corporate registered or incorporated in India
----------------------
• A firm
----------------------
• An association of persons or a body of individuals, whether incorporated or
---------------------- not
• Every artificial person, not falling within any of the preceding sub-clauses
----------------------
and
---------------------- • Any agency, office or branch owned or controlled by such person
---------------------- This definition and the definition given in Section2 (31) of the Income
Tax Act, 1961 is similar, except that in the definition under IT. Act is included
---------------------- an additional entity called as “Local Authority”, whereas in the definition under
FEMA, there is an additional entity which is called as “an Agency, office or
----------------------
branch owned or controlled by such a person and carrying on similar activity.
---------------------- Resident but not Ordinarily Resident
---------------------- A person and/or Manager of Hindu Undivided Family is treated to be not
ordinarily resident in India in any previous year if he or the manager of HUF
----------------------
•
has not been residing/resident in India in 9 out of 10 previous years preceding
---------------------- the previous year; or
---------------------- •
in previous seven years, the individual has not been in India for seven
Hundred thirty days or more i.e., maximum number of days of stay in India
---------------------- should be seven hundred twenty nine days or less during this seven years
period.
Thus, according to the condition in clause (a) a newcomer to India would Notes
remain not ordinarily resident in India for the first 9 years of his stay in India.
Similarly, in case where a person who is resident in India goes abroad and ----------------------
ceases to be resident in India for at least 2 years, he would, on his return, be
----------------------
treated as, not ordinarily resident for the next 9 years.
How to determine the Residential status of a person:- ----------------------
i) In case of an Indian citizen who leaves India during previous year for the ----------------------
purpose of employment. Such a person is Resident of India if he satisfies
the following conditions: ----------------------
a) He stays in India for at least 182 days during the previous year. ----------------------
b) He is resident in India for at least 9 out of 10 years before the ----------------------
previous year.
c) He is resident in India for at least 730 days during 7 years before the ----------------------
previous year. ----------------------
If such a person satisfies condition (a) but does not satisfy either of the
----------------------
conditions (b) or (c) above, then he would be a resident but not ordinarily
resident. Such person would be non-resident if he does not satisfy ----------------------
condition (a) stated above.
----------------------
ii) In case of an Indian citizen or a person of an Indian origin living abroad
comes to India for a visit during the previous year. The residential status ----------------------
of such a person is to be determined considering the following a) He stays
in India for at least 182 days during the previous year, ----------------------
b) He is resident in India for at least 9 years out of 10 years before the ----------------------
previous year.
----------------------
c) He is resident in India for at least 730 days during seven years
before the previous year. ----------------------
Any person would be a Resident of India if he satisfies all the conditions from ----------------------
(a) to (c).
The person would be a resident but not ordinarily resident if he satisfies the ----------------------
condition ----------------------
(a)But does not satisfy any or either of the conditions of (b) and (c) above
----------------------
The person would be non-resident if he does not satisfy the condition (a)
----------------------
Thus, condition (a) is of fundamental importance and must be satisfied to be a
Resident of India. Conditions (b) and (c) help to qualify for the resident status ----------------------
only.
----------------------
i. In case of any other individual
For individuals other than those included in category (i) or (ii), following ----------------------
four conditions should be considered to determine the residential status: ----------------------
a. He stays in India for at least 182 days during the previous year.
----------------------

Notes b. He stays in India for at least 60 days during the previous year and
for at least 365 days during the 4 years before the previous year.
---------------------- c. He is resident in India at least in 9 out of 10 years before the previous
---------------------- year.
d. He is resident in India for at least 730 days during 7 years before the
----------------------
previous year.
---------------------- A person would be resident in India if he satisfies any of the conditions
(a) or (b) and both the conditions at (c) and (d) i.e. he satisfies either of the
----------------------
conditions (a), (c) and (d) or (b), (c) and (d).
---------------------- A person would be resident but not ordinarily resident if he satisfies either
of the conditions (a) or (b) and does not satisfy both or either of the conditions
----------------------
(c) and (d). In other words, if a person satisfies condition (a) or (b) only but
---------------------- does not satisfy either (c) or (d) or both, he would be treated as resident but not
ordinarily resident in India. If a person satisfies neither of the conditions (a)
---------------------- and/or (b), he is non-resident.
---------------------- Some examples of NRI
---------------------- •
Suppose any of your relatives/friends goes to the USA/Europe on business
visit, for medical treatment, for studies or any such purpose that does
---------------------- not indicate an intention to stay there for an indefinite period will not be
considered as NRI.
----------------------
• M
r. Sanjay, a science graduate resides in India for less than 182 days during
---------------------- the financial year ended 31stMarch, 2001(2000-01), whether or not on a
continuous basis and who would be going abroad for higher studies, shall
---------------------- become a Non-Resident for the current financial year, i.e. 2001-02.
---------------------- •
Tourists and other persons who go abroad otherwise for starting a business
or Vocation or for taking up an employment shall be deemed to be Non-
---------------------- Residents if their stay in India during the preceding financial year was less
than or of 182 days.
----------------------
• A
person going abroad for employment or for starting a business, etc. would
---------------------- become a Non-Resident irrespective of number of days stay in India.
---------------------- An NRI, coming to visit his ailing parents and staying for more than 182 days
would continue to remain an NRI as there is no intention to stay in India for an
---------------------- indefinite period.
----------------------
1.4 TYPES OF NON-RESIDENT INDIANS’BANK ACCOUNTS
----------------------
Introduction
----------------------
In terms of clause(f) of subsection(3) of section 6, and under section(2)
---------------------- of Section 47 of the FEMA, Reserve Bank of India has issued Notification
No.5/2000-RBdated 3rd May 2000 entitled as Foreign Exchange Management
---------------------- (Deposit) Regulation 2000 dealing with deposits by a person resident in India
and a person resident outside India.
----------------------

In all the foreign exchange transactions in India, the Banks play a very Notes
important role. Section10 of FEMA requires a bank to obtain a license from
RBI to deal in foreign exchange and such banks are the “Authorised Dealers” in ----------------------
foreign exchange. Indian nationals and persons of Indian origin (PIOs) resident
abroad can open bank accounts in India freely out of the funds remitted from ----------------------
abroad in foreign exchange. RBI has granted general permission to A Ds to open ----------------------
such accounts freely although in some cases the requests of Non- Residents
need to be approved by RBI. ----------------------
Besides A Ds, RBI has permitted certain State Co-operative Banks, ----------------------
Scheduled Commercial Banks and Urban Co operative Banks, which do not
hold licenses as full- fledged Authorised Dealers, but which fulfill the eligibility ----------------------
criteria prescribed by RBI, to maintain Non-Resident Ordinary Rupee Accounts
(NRO Accounts) and Non-resident External accounts in Rupees. They cannot ----------------------
maintain Foreign Currency (Non-Resident) (FCNR) Accounts (banks) Scheme. ----------------------
Bank accounts of persons going abroad for higher studies, business visits
----------------------
and medical treatment are classified as resident accounts only during their
absence in India. ----------------------
Non-Resident accounts are based on (a) Repatriation and (b) the currency
----------------------
of the account. Under (a), these are two types, namely Ordinary account without
any repatriation facility and external accounts with full repatriation facility. ----------------------
Under (b) Non- Residents can maintain their accounts either in Indian Rupees
or specified foreign currencies. ----------------------
Indian Post Offices are authorised to open/maintain NRO Savings ----------------------
accounts except individuals/entities of Bangladesh and Pakistan. Such persons/
entities require the prior approval of the Reserve Bank. ----------------------
What are the Deposit products ADs can offer to NRI/PIO in India? ----------------------
A. Non-Resident (Ordinary) Rupee Account (NRO Account) ----------------------
NRO accounts may be opened/ maintained in the form of current, savings,
----------------------
recurring or fixed deposit accounts.
1. Savings Bank Account -Normally maintained for crediting legitimate dues ----------------------
/ earnings / income such as dividends, interest etc. The interest rates on
----------------------
NRO Savings deposits shall be at the rate applicable to domestic savings
deposits. Currently the interest rate is 3.5 per cent. ----------------------
2. Term Deposits -Banks are free to determine the interest rates.
----------------------
3. Permissible credits to NRO account are transfers from rupee accounts
of non-resident banks, remittances received in permitted currency from ----------------------
outside India through normal banking channels, permitted currency ----------------------
tendered by account holder during his temporary visit to India, legitimate
dues of the account holder in India like current income, rent, dividend, ----------------------
pension, interest, etc., sale proceeds of assets including immovable
property acquired out of rupee/foreign currency funds or by way of ----------------------
legacy/ inheritance. ----------------------

Notes 4. Eligible debits such as all local payments in rupees including payments for
investments as specified by the Reserve Bank and remittance of current
---------------------- income of the account holder like rent, dividend, pension, interest, etc.,
net of applicable taxes outside India.
----------------------
• NRI/PIO may remit from the balances held in NRO account an amount
---------------------- not exceeding USD one million per financial year, subject to the
payment of applicable taxes
----------------------
• The limit of USD 1 million per financial year includes sale proceeds of
---------------------- immovable properties held by NRIs/PIO
---------------------- • The accounts may be held jointly with residents and / or with non-
resident Indian
---------------------- • The NRO account holder may opt for nomination facility
---------------------- • NRO (current/savings) account can also be opened by a foreign
national of
----------------------
Non-Indian origin visiting India, with funds remitted from outside India through
---------------------- banking channel or by sale of foreign exchange brought by him to India
---------------------- 10. Commercial banks can provide advances to the close relations/friends
against the security of fixed deposits owned by NRIs subject to certain
---------------------- terms and conditions.
---------------------- B. What is NRE account?
---------------------- •
The accounts maintained with the Banks by eligible persons residing outside
India, as per definition of Non-Resident Indian under FEMA are referred to
---------------------- as Non-Resident (external) accounts, i.e. Non- Resident (External) Rupee
account.
----------------------
•
The income earned is free from income tax, the balance is exempt from
---------------------- wealth tax and gifts to close relatives from the balances are free from gift tax.
•
NRE account may be in the form of savings, current, recurring or fixed
----------------------
deposit accounts. Such accounts can be opened only by the non-resident
---------------------- himself and not through the holder of the power of attorney.
• NRE accounts cannot be held jointly with residents
----------------------
• Account will be maintained in Indian Rupees
----------------------
• Balances held in the NRE account are freely repatriable
---------------------- • Accrued interest, income and balances held in NRE accounts are exempt
---------------------- from Income tax and Wealth tax respectively
• Authorised dealers/authorized banks may at their discretion/commercial
---------------------- judgement, allow for a period of not more than two weeks, overdrawing
---------------------- in NRE savings bank accounts, up to a limit of Rs.50,000 subject to the
condition that such overdrawing together with the interest payable thereon
---------------------- are cleared/repaid within a period of two weeks, out of inward remittances
through normal banking channels or by transfer of funds from other NRE/
---------------------- FCNR accounts

•
Savings -The interest rates on NRE Savings deposits shall be at the rate Notes
applicable to domestic savings deposits. Currently the interest rate is 3.5%.
•
Permissible credits to NRE account are inward remittance to India in ----------------------
permitted currency, proceeds of account payee cheques, demand drafts ----------------------
/ bankers’ cheques, issued against encashment of foreign currency,
where the instruments issued to the NRE account holder are supported ----------------------
by encashment certificate issued by AD, transfers from other NRE/FCNR
accounts, interest accruing on the funds held in such accounts, interest on ----------------------
Government securities/dividends on units of mutual funds purchased by
debiting the NRE/FCNR (B) account of the holder, certain types of refunds,
----------------------
etc. ----------------------
• E
ligible debits are local disbursements, transfer to other NRE/FCNR
accounts of person eligible to open such accounts, remittance outside India, ----------------------
investments in shares / securities/commercial paper of an Indian company, ----------------------
etc.
•
NRIs can raise advances from the Banks in their names or in the name of ----------------------
their relatives against their Term Deposits to the extent of Rs.1Crore. ----------------------
Such accounts can be operated through power of attorney in favour of residents
for limited purpose of withdrawal of local payments or remittances through ----------------------
normal banking channels to the account holder himself. ----------------------
C. Foreign Currency Non-Resident (Bank) Account – FCNR (B) Account
----------------------
• FCNR (B) accounts are only in the form of term deposits of 1 to 5 years
----------------------
• All debits / credits permissible in respect of NRE accounts are permissible in
FCNR (B) accounts also ----------------------
• Account can be in Pound Sterling, US Dollar, Japanese Yen, Euro, Canadian,
----------------------
Dollar and Australian Dollar
• In case the depositor desires to place a deposit in these accounts with any ----------------------
convertible currency other than designated currency, authorised dealers may
----------------------
undertake with the depositor a fully covered swap in that currency against
the desired designated currency. Such a swap may also be done between two ----------------------
designated currencies.
----------------------
•
NRIs can raise advances from the Banks in their names or in the name of
their relatives against their FCNR (B) Deposits to the extent of Rs1cr.The ----------------------
interest rates are stipulated by the Department of Banking Operations and
Development, Reserve Bank of India. ----------------------
•
When an account holder becomes a person resident in India, deposits may ----------------------
be allowed to continue till maturity at the contracted rate of interest, if so
desired by him. ----------------------
•
Terms and conditions as applicable to NRE accounts in respect of joint ----------------------
accounts, repatriation of funds, opening an account during temporary visit,
operation by power of attorney, loans/overdrafts against security of funds ----------------------
held in accounts, shall apply mutatis mutandis to FCNR (B).
----------------------

Notes A prior approval of the Reserve Bank is required for opening of accounts
by individuals/entities of Bangladesh / Pakistan nationality. The banks are
---------------------- required to obtain permission from the Chief General Manager-in-Charge,
Foreign Exchange Department, Foreign Investment Division, Reserve Bank of
---------------------- India, Central Office, Mumbai -400 001.
---------------------- An individual resident can borrow a sum not exceeding USD 250,000
or its equivalent from his close relatives staying outside India, subject to the
----------------------
conditions that:
---------------------- • the minimum maturity period of the loan is one year;
---------------------- • the loan is free of interest; and
---------------------- • the amount of loan is received by inward remittance in free foreign exchange
through normal banking channels or by debit to the NRE/FCNR account of
---------------------- the NRI

----------------------
Fill in the blanks.
----------------------
1. The beneficial ownership share of Indian nationals in Overseas
---------------------- Corporate Bodies (OCBs) should not be less than ____ %.
---------------------- 2. Under Income Tax Act, for the accounting year ending 31st March
2001, the assessment year would be______
----------------------
3. A person from India, who has gone abroad for starting a business,
---------------------- shall be deemed a Non-Resident Indian, if his stay in India during the
preceding financial year was less than ____ days.
----------------------
---------------------- Activity 1
----------------------
Visit a Branch of Commercial Bank doing NRI Banking business and
---------------------- ascertain various formalities for NR (E) and FCNR accounts. Write
---------------------- two important points.
----------------------
1.5 INVESTMENT FACILITIES FOR NRIS
----------------------
NRI may, without limit, purchase on repatriation basis:
----------------------
• Government dated securities /Treasury bills;
----------------------
• Units of domestic mutual funds;
---------------------- • Bonds issued by a public sector undertaking (PSU) in India;
---------------------- • Non-convertible debentures of a company incorporated in India;
----------------------

• Perpetual debt instruments and debt capital instruments issued by banks in Notes
India.
----------------------
•
Shares in Public Sector Enterprises being dis-invested by the Government of
India provided the purchase is in accordance with the terms and conditions ----------------------
stipulated in the notice inviting bids.
----------------------
•
Shares and convertible debentures of Indian companies under the FDI scheme
(including automatic route & FIPB), subject to the terms and conditions ----------------------
specified in Schedule 1 to the FEMA Notification No. 20/2000-RB dated
May 3, 2000, as amended from time to time. ----------------------
Portfolio Investment Scheme (PIN): NRI may purchase- ----------------------
Shares and convertible debentures of Indian companies through stock
----------------------
exchange under Portfolio Investment Scheme, subject to the terms and
conditions specified in Schedule 3 to the FEMA Notification No. 20/2000-RB ----------------------
dated May 3, 2000, as amended from time to time.
----------------------
A few important provisions of PIS are as follows:
No day trading (open and close a position the same day) allowed. NRI ----------------------
has to take delivery of the traded instruments after settlement of the trade. ----------------------
Speculative transactions are not encouraged under PINS scheme. An NRI
cannot invest more than 5% in the paid-up capital of an Indian company. As ----------------------
an NRI, the existing demat account, which holds shares that were purchased as
Indian resident, will have to be closed and he would need to transfer the shares ----------------------
to an NRO demat account. He can continue to hold these shares or sell them. ----------------------
If he sells them, the proceeds are credited to the NRO savings account and
there are restrictions on repatriation. This means he can repatriate up to USD 1 ----------------------
million per calendar year (including all other capital account remittances) and
he would need a certificate from his chartered accountant to that effect. ----------------------
For buying shares as an NRI, he would need to open a new demat account ----------------------
under the Portfolio Investment Scheme (PINS). In this demat account, he can
buy shares with funds in his NRE account and its sale proceeds can be credited to ----------------------
NRE account for repatriation. If he chooses to buy the shares on non-repatriable ----------------------
basis, then, the proceeds will be credited to the NRO account.
An NRI should maintain two separate demat accounts for repatriable and ----------------------
non-repatriable shares. The RBI also specified that an NRI should have a separate ----------------------
account linked to the PINS demat account. It cannot be the NRO or NRE account
through which other routine transactions are carried out. Once he becomes a ----------------------
resident again, he should close the PINS account. RBI has allowed Non- Resident
Indians to invest in following securities on non-repatriation basis: ----------------------
• Government dated securities /Treasury bills ----------------------

• Units of domestic mutual funds ----------------------
• Units of Money Market Mutual Funds
----------------------
• National Plan/Savings Certificates
----------------------
• Non-convertible debentures of a company incorporated in India

Notes Shares and convertible debentures of Indian companies through stock exchange
under Portfolio Investment Scheme, subject to the terms and conditions specified
---------------------- in Schedules 3 and 4 to the FEMA Notification No.20/2000-RB dated May3,
2000, as amended from time to time.
----------------------
• Exchange traded derivative contracts approved by the SEBI, from time
---------------------- to time, out of INR funds held in India on non-repatriable basis, subject
to the limits prescribed by the SEBI. NRIs are not permitted to invest in
----------------------
small savings or Public Provident Fund (PPF). Acquisition and Transfer
---------------------- of IP in India by a person residing outside India
•
NRI/PIO/Foreign National who is a person resident in India (citizens of eight
----------------------
countries namely, Pakistan, Bangladesh, Sri Lanka, Afghanistan, China,
---------------------- Iran, Nepal and Bhutan would require prior approval of the Reserve Bank)
may acquire immovable property (IP) in India. Investment in agricultural
---------------------- property, plantation and farmhouse is prohibited for all classes of persons
resident outside India, be it NRIs/OCBs/foreign citizens or other foreign
---------------------- entities. For example, assume that Mr. Bill Gates, US Citizen, commences his
business (say as a proprietor) in Jaipur on1st Nov, 2008. He will be resident
----------------------
of India from that day. On 2nd November he can acquire huge property in
---------------------- India without any restriction whatsoever. Thus, the ‘residential status’ is
the basic criteria for a foreign national for acquiring immovable property in
---------------------- India.
---------------------- • The payment of purchase price, if any, should be made out of

(i) Funds received in India through normal banking channels by way of
----------------------
inward remittance from any place outside India or
---------------------- (ii) Funds held in any non-resident account maintained in accordance with
the provisions of the Act and the regulations made by the Reserve Bank.
----------------------
Encashment of traveller’s cheques/exchange of foreign currencies, etc;
---------------------- for making payment against acquisition of immovable property by NRI is
---------------------- not allowed.
NRI may acquire any immovable property in India other than agricultural
---------------------- land/farmhouse plantation property, by way of gift from a person resident
---------------------- in India or from a person resident outside India who is a citizen of India
or from a person of Indian origin resident outside India
----------------------
•
NRI may acquire any immovable property in India by way of inheritance
---------------------- from a person resident outside India who had acquired such property in
accordance with the provisions of the foreign exchange law in force at the
---------------------- time of acquisition by him or the provisions of these Regulations or from a
person resident in India.
----------------------
• An NRI may transfer any immovable property in India to a person resident
---------------------- in India
---------------------- • NRI may transfer any immovable property other than agricultural or
plantation property or farm house to a person resident outside India who is a
---------------------- citizen of India or to a person of Indian origin resident outside India

With respect to such investments, NRIs are eligible to repatriate: Notes
• The sale proceeds of immovable property in India if the property was
acquired out of foreign exchange sources i.e. remitted through normal
----------------------
banking channels / by debiting the NRE / FCNR (B) account ----------------------
• The amount to be repatriated should not exceed the amount paid for the
property in foreign exchange received through normal banking channel or ----------------------
by debit to NRE account (foreign currency equivalent, as on the date of ----------------------
payment) or debit to FCNR (B) account
• In the case of residential property, the repatriation of sale proceeds is ----------------------
restricted to not more than two such properties, if the property was purchased ----------------------
from funds held in NRE account
• If the property was acquired out of Rupee sources, NRI or PIO may remit ----------------------
an amount up to USD one million per financial year out of the balances held ----------------------
in the NRO account (inclusive of sale proceeds of assets acquired by way of
inheritance or settlement), for all the bona fide purposes to the satisfaction of ----------------------
the Authorized Dealer bank and subject to tax compliance
----------------------
• Authorised Dealers are permitted to credit refund of (a) application / earnest
money / purchase consideration made by house-building agencies/seller on ----------------------
account of non-allotment of flats / plots and (b) cancellation of booking/deals
for purchase of residential/commercial properties, together with interest, if ----------------------
any (net of taxes), provided original payment is made out of NRE/FCNR(B)
account/ inward remittances and authorised dealer is satisfied about the ----------------------
genuineness of the transactions ----------------------
Repayment of Housing Loan of NRI / PIOs by close relatives of the borrower
in India ----------------------
• H
ousing Loan in rupees availed of by NRIs/PIOs from ADs/Housing ----------------------
Financial Institutions in India can be repaid.
----------------------
• C
ommercial Banks provide for Vehicle loans to the close relatives who are
resident Indians of NRI for purchase of new passenger cars, multi utility ----------------------
vehicles which are guaranteed by NRI.
----------------------
Activity 2 ----------------------
----------------------
Visit a branch of a Commercial Bank and ascertain the formalities for
High value Housing Loan for NRI. Write about five important points ----------------------
of the feedback.
----------------------
----------------------
1.6 RETURNING NRIS/PIOS - BACK TO INDIA
----------------------
A Non-Resident Indian will be treated as a person resident in India if he returns
to or stays in India, in either case: ----------------------
----------------------

Notes a) On taking up employment in India or b) For carrying on in India, a
business or vocation or c) For any other purpose, in such circumstances
---------------------- as would indicate his intention to stay in India for an uncertain period.
---------------------- In other words, for Returning NRIs, the purpose/intention of stay in India
is most relevant factor for determining the residential status of a person. The
---------------------- period of stay is only of secondary importance.
---------------------- For Returning Indians’ moveable assets held outside India, abroad,
FEMA provides that the bank accounts maintained outside India in foreign
---------------------- currencies, stocks and securities, life insurance policies, loans, company
---------------------- deposits, debentures, bonds etc., acquired, held or owned by NRI/ PIO, while
he was abroad can be continued to be so held and owned even after the NRI
---------------------- returns to India for permanent settlement.
---------------------- Such investments can accumulate/accrue income outside India. Such
balances can be utilised for reinvestment and can be repatriated to India at any
---------------------- time. In respect of Returning Indians’ immovable assets held outside India, the
provisions of FEMA provides that they can continue to hold their immovable
---------------------- properties outside India, such properties can be rented out, rentals can be
---------------------- credited to overseas bank accounts. Such properties can be sold/ transferred
and the sale proceeds credited to overseas bank accounts. Expenses relating to
---------------------- such properties, such as maintenance, insurance premium etc. can be paid out
of the overseas balances.
----------------------
For continuation of proprietary/partnership business abroad, as well as
---------------------- for continuation of bank accounts abroad, the Returning NRI should obtain
specific permission from RBI.
----------------------
Bank accounts in India: Immediately on returning to India, NRIs should
---------------------- inform their Bankers so that the Bankers will designate their accounts as
Resident accounts or transfer the balance in their NRE/FCNR accounts to RFC
----------------------
accounts if so desired. FCNR accounts can be continued till the date of maturity
---------------------- and on maturity can be converted to RFC accounts.
---------------------- Resident Foreign Currency (RFC) Accounts Scheme

This is a Scheme introduced by Reserve Bank of India permitting persons
---------------------- of Indian nationality or origin, who have returned to India on or after 18th April
---------------------- 1992 for permanent settlement (Returning Indians), after being resident outside
India for a continuous period of not less than one year, to open foreign currency
---------------------- accounts with banks in India for holding funds brought by them to India.
---------------------- The salient features of the scheme are as under

• RFC account can be held singly or jointly in the names of eligible persons.
----------------------
• RFC account can be maintained in the form of Savings, Current and term
---------------------- deposit.
---------------------- • RFC account can be opened and maintained in designated foreign currencies
like US Dollars, Pounds Sterling etc.,
----------------------

• Certain permissible credits viz., remittances in any permitted currency from Notes
abroad, pension or any other monetary benefits received from abroad, interest
on RFC accounts, foreign currency notes/ traveller’s cheques, transfers from ----------------------
other RFC account of the account holder, balance in NRE/FCNR account at
the time of his arrival in India. Funds in RFC accounts can be remitted abroad ----------------------
for any bona-fide purpose of the account holder and his dependents including
exchange required for travel and other personal purposes and investments.
----------------------
The funds in RFC accounts are free from all restrictions regarding utilisation ----------------------
of foreign currency balances including any restriction on investment in any
form outside India. ----------------------
• F
unds can be transferred from one RFC account to another RFC account
----------------------
of the same person. Withdrawals/Payments other than foreign currency
remittance abroad shall be made in equivalent Indian Rupees only. Returning ----------------------
NRIs are required to re-designate their Non-resident accounts as Resident
Rupee/RFC accounts after their arrival in India. ----------------------
• H
owever, RBI has permitted Returning Indians to continue their FCNR (B) ----------------------
deposits till the original maturity date and on maturity be transferred to RFC
accounts. RFC accounts are eligible for interest benefits, as prescribed by the ----------------------
Bank from time to time.
----------------------
No loans/advances are allowed whether directly or indirectly against balance in
an RFC account. If the Returning Indian subsequently goes abroad to become ----------------------
an NRI, the balance in the RFC account can be converted to NRE/FCNR
----------------------
account. Interest income from RFC is exempt from income-tax till the time the
Returning Indian maintains the status of Resident but Not Ordinarily Resident ----------------------
(RNOR). Hence, if the Returning NRI had been non-resident for a continuous
period of 2 years, he gets exemption from income tax for subsequent 9 years. ----------------------
----------------------
Check your Progress 3
----------------------
Fill in the blanks. ----------------------
1. Under Section of 10 of the Foreign Exchange Management Act
(FEMA), a bank needs to obtain a licence from RBI to deal in foreign ----------------------
exchange and such banks are called ______________. ----------------------
2. Non-Resident (external) deposit account cannot be held jointly with ____.
----------------------
3. FCNR(B) account is term deposit account and can be opened only in
designated __________. ----------------------
----------------------
1.7 EXCHANGE EARNER’S FOREIGN CURRENCY
----------------------
ACCOUNT
----------------------
Under FEMA, the Residents in India are permitted to open EEFC account
only in the form of non-interest bearing current account, which is known as ----------------------
Exchange Earners’ Foreign Currency (EEFC) account.
----------------------

Notes Exchange Earners’ Foreign Currency (EEFC) Account is an account
maintained in foreign currency with an Authorised Dealer. It is a facility
---------------------- provided to the foreign exchange earners, including exporters, to credit100
percent of their foreign exchange earnings to the account, so that the account
----------------------
holders do not have to convert foreign exchange into Rupees and vice-versa,
---------------------- thereby minimizing the transaction costs. All categories of foreign exchange
earners, such as individuals, companies, etc. who are resident in India, may
---------------------- open EEFC accounts. The Credits in the account will be by way of Inward
remittance through normal banking channels, other than remittances received
----------------------
on account of foreign currency loan or investment received from outside India.
---------------------- EEFC account can be used for making payments outside India towards current
accounts transactions in accordance with the provisions of the Foreign Exchange
---------------------- Management (Current Account Transactions) Rules, 2000 and towards a capital
account transaction permissible under the Foreign Exchange Management
----------------------
(Capital Account Transactions) Regulations, 2000.
----------------------
1.8 TERMINOLOGIES USED IN GLOBALTRADE & FINANCE
----------------------
The terminology is being given to familiarise the students with it so as to enable
----------------------
them to understand the subject in a better way.
---------------------- • IBOR – LIBOR means London Inter Bank Offered Rate. London, being
L
the premier financial centre in the world, LIBOR is a benchmark floating
----------------------
rate at which bank “A” is willing to lend to bank “B” in inter-bank market.
---------------------- LIBOR is used as benchmark rate in many International lending transactions.
It is available for various tenures.
----------------------
• xchange Control – means that the central bank of a country i.e. RBI
E
---------------------- regulates/ monitors foreign exchange. Exchange of the local currency for
foreign currency should be done through Authorised Person under FEMA.
---------------------- • uthorised Dealer - Authorised Dealers are authorised by RBI to deal in
A
---------------------- foreign exchange and apart from buying and selling foreign currency, they
can open L Cs, open foreign currency accounts abroad as well. Usually,
---------------------- commercial banks/branches of foreign banks in India are the authorised
dealers.
----------------------
• EDAI – Foreign Exchange Dealers Association of India is an Association of
F
---------------------- authorised dealers. It is a self-regulating agency through which RBI controls
foreign exchange market.
----------------------
•
UCPDC 600 - This is a publication of International Chamber of Commerce,
---------------------- Paris which contains rules known as ‘articles’. These are Uniform Customs
and Practices for Documentary Credits. These sets of articles are to be applied
---------------------- to all Documentary credits to the extent, they are applicable. This publication
has been brought out by ICC, Paris to bring uniformity of interpretation in
---------------------- international trade.
---------------------- • R Form – Guaranteed Receipt form or GR form is prescribed by RBI for
G
physical export of goods so as to ascertain the value of export goods and to
---------------------- monitor their realisation. At the time of export, GR form is to be submitted (in

duplicate) to Customs Authority who will certify the same. The original copy Notes
of GR form will be sent by the Customs directly to RBI and the exporter to
forward duplicate copy to the A D along with other documents to the banker ----------------------
for negotiation/collection.
----------------------
• SOFTEX Form – SOFTEX form performs the same function as that of GR
forms for software exports. The SOFTEX form is prescribed by RBI to be ----------------------
submitted by the Units in Software Technology Park (STP) or at the Export
Processing Zone (EPZ) or Special Economic Zones to Customs authority. ----------------------
• PP Form – If the export is done through post then these forms are used like ----------------------
GR forms.
----------------------
• xport Import Policy– Export Import (EXIM) Policy is administered
E
through the Director General Foreign Trade who is an official under Ministry ----------------------
of Commerce, Govt. of India. Earlier the Policy was known as Import Export
Policy and the focus was on controlling imports through licensing. From mid ----------------------
eighties, the Govt. of India realised the importance of promoting exports.
----------------------
From 1992, the policy was rechristened as Foreign Trade Policy by giving
more emphasis on export promotion. It is essentially a roadmap for the ----------------------
development of India’s foreign trade. It was converted to five-year policy
instead of annual policy to impart/maintain stability. ----------------------
•
Star Export House– It is a status symbol for status holder exporter granted ----------------------
by Director General of Foreign Trade (DGFT) in recognition of export
performance made by the Merchant Exporter/Manufacturer exporter. Export ----------------------
Oriented Units located in Hardware/Software Technology Parks, Agricultural
Export Zone Units or Special Economic Zone units are eligible for this status. ----------------------
The status is granted based on the criterion that export performance for the
----------------------
current year and for previous 3 years should be Rs.100 crores or above. Such
units are eligible for certain privileges under the scheme. ----------------------
• uty Entitlement Passbook Scheme (DEPB)– DEPB is issued on post
D
----------------------
export and realisation of export proceeds to products that are notified. It is
an instrument towards duty neutralisation of incidence of basic customs duty ----------------------
on the import content as per Standard Input-Output norms (SIONs) for the
products that are exported. It operates as passbook scheme of Bank. ----------------------
• xport Oriented Units (EOUs) – Units undertaking to export their entire
E ----------------------
production of goods and services are known as EOUs. These units are
exempted from payment of direct and indirect taxes. They are allowed to ----------------------
bring in 1000% foreign equity, thereby providing access to foreign capital.
----------------------
• Merchant Exporter – Is a person engaged in trading activity and exporting
or intending to export goods. ----------------------
• SWIFT – This acronym stands for Society for World Wide Interbank ----------------------
Financial Telecommunications. It is non-profit making co-operative society
created under Belgian Law and owned by member financial institutions. It ----------------------
enables member banks to send funds and statements to each other efficiently.
----------------------
•
Special Economic Zones (SEZs) -SEZ is a concept borrowed from China.
These zones are treated as a foreign country within the country and are ----------------------

Notes subjected to minimum restrictions. They are subjected to minimum NFE
(Net foreign exchange) conditions. 100% foreign equity is permitted other
---------------------- than for trading.
---------------------- •
Off-shore Banking Unit – Banking for non-residents is termed as offshore
banking. It is a foreign bank branch operating in the host country. The main
---------------------- attraction of an offshore banking centre is the liberal official regulation
including taxation and control. There are two kinds of offshore banking units
---------------------- –functional centres and paper centres. Functional centres are those where
actual transactions take place like London, New York, Singapore. Paper
---------------------- centres are locations where the transactions are booked legally but the actual
---------------------- business takes place elsewhere like Bahamas, Cayman Island, and Isle of
Man are such examples. Banks opened in special Economic Zones will also
---------------------- be called as Offshore Banking Units. OBUs can be functional centres and
paper centres.
----------------------
• alance of Payments (BOP) – It is a systematic record of international
B
---------------------- transactions between a country and the rest of the world in a period of time
(usually for a period of one year). It can be negative or positive. In other
---------------------- words, if the inflow of foreign currency is more than the outflow, it is called
as a surplus or favourable position. If the inflow is less than the outflow,
---------------------- it is called as adverse or unfavourable position. Adverse position leads to
---------------------- decrease in foreign exchange reserves.
• alance of Trade -It is a part of Balance of payments. It is the difference
B
---------------------- between total exports and the total imports during a period of time i.e. one
---------------------- year.
• ill of Lading -It is an acknowledgement that the carrier (shipping company)
B
---------------------- receives for the goods to be delivered to the importer. It is an evidence of a
---------------------- contract between the carrier (transporter) and the exporter to deliver the goods
to a designated party (the importer or named consignee). It is a document of
---------------------- title of the goods.
---------------------- • ertificate of Origin of Goods (COO) - A document in international trade

C
that establishes the origin of goods imported into a country. Broadly, there are
---------------------- two types of COOs. A preferential COO extends tariff concessions; whereas
a non-preferential COO merely provides evidence of origin. It is also a part
---------------------- of document of title of the goods.
---------------------- • oreign Direct Investment (FDI) –FDI refers to the ownership and/or
F
control of foreign enterprises, with the intent of developing a long lasting
---------------------- interest in them. It usually takes the form of equity alliances.
---------------------- •
Overnight limit – It is the ceiling set by a bank on an open position in foreign
currency at the end of every business day, as a part of its risk management
---------------------- practices.
----------------------
----------------------
----------------------

Notes
----------------------
1. Under FEMA, Exchange Earner’s Foreign currency account can be
----------------------
opened by an Indian __________.
2. LIBOR means ____________. ----------------------
3. In international trade, the origin of goods is established on the basis ----------------------
on of a COO, i.e., ______________.
----------------------
----------------------
Activity 3
----------------------
Visit a branch of a commercial bank conducting NRI banking business
----------------------
and ascertain various formalities for NRE and FCNR accounts.
----------------------
Summary ----------------------
• The different definitions have been given in the Income tax Act and the Foreign ----------------------
Exchange Management Act. When we speak of a provision applicable to an
NRI, we must find out the definition under the provision of that Act. FEMA ----------------------
has given three categories of NRIs:
----------------------
I. Non-Resident Indian National i.e. Non-resident Indian holding Indian
Passport. Non-resident holding Indian Passport would fall under the ----------------------
following categories.
----------------------
a. a person who has gone out of India or who stays outside India for
employment or for carrying on any business or vocation or for any other ----------------------
purpose in circumstances indicating an indefinite period of stay outside
----------------------
India.
b. Indian citizens working abroad on assignments with foreign Governments, ----------------------
Government agencies or international/multinational agencies like United
----------------------
Nations Organisations, International Monetary Fund, World Bank etc.
Official of Central and State Governments and Public Sector undertakings ----------------------
deputed abroad on assignments with foreign Government/agencies/
organisations or posted to their own offices (including Indian Diplomatic ----------------------
Missions) abroad.
----------------------
II. Non-residents holding foreign passports i.e. “Persons of Indian Origin”
means a citizen of any country other than Bangladesh or Pakistan. If (i) he, ----------------------
at any time, held an Indian Passport, or (ii) he or either of this parents or ----------------------
any of his grandparents was a citizen of India by virtue of the Constitution
of India or Citizenship Act, 1955 (57 of 1955) or (iii) the person is a ----------------------
spouse of an Indian citizen or a person referred to in sub-clause (i) or
----------------------

Notes III. OCBs are a company, partnership firm, society and other corporate body
owned, directly or indirectly, to the extent of at least 60% by Non-Resident
---------------------- Indian and include overseas trust in which not less than sixty per cent
beneficial interest is held by Non-Resident Indian directly or indirectly
---------------------- but irrevocably.
---------------------- • The NRIs/PIOs can maintain deposit accounts under following scheme:
---------------------- a) Non- Resident Ordinary Rupee account (NRO) a/c.

b) Non- Resident (External) Rupee account.
----------------------
c) Foreign Currency (Non-Resident) Account (Bank’s) Scheme (FCNR (B)
---------------------- account) with the commercial banks (ADs).
---------------------- d) Under Resident Foreign Currency (RFC) account Scheme, NRIs who are
returning NRIs can open, maintain RFC account out of foreign exchange
---------------------- acquired by him in designated foreign currency.
---------------------- • While NRE/NRO accounts can be in the form of Savings, Current or
Fixed Deposit, FCNR accounts can be maintained only in term deposits
---------------------- in designated currencies. NRO accounts can be held jointly with residents.
However, NRE and FCNR accounts cannot be held jointly with residents.
----------------------
The funds held in NRO accounts would generally be from a local source,
---------------------- hence cannot be repatriated outside India, except interest, dividend, rent can
be remitted outside India. NRIs can raise loans/ advances against the time
---------------------- deposits. The credits in NRE and FCNR accounts should be by way of inward
remittance/s through ADs, hence these funds are eligible for repatriation.
----------------------
• NRIs/PIOs can freely invest in moveable and immovable properties with
---------------------- certain guidelines/restrictions stipulated by R B I.
----------------------
Keywords
----------------------
• ADs: A Bank authorised to buy and sell foreign currency.
----------------------
• FCNR (B) Scheme: Foreign Currency (Non- Resident) Bank’s scheme for
---------------------- NRIs
---------------------- • RFC Account: Resident Foreign Currency account scheme for returning
NRIs
---------------------- • EEFC Account: Exchange Earner’s Foreign Currency account for Resident
Indians
----------------------
---------------------- Self-Assessment Questions

----------------------
1. What is the definition of Non-Resident Indian?
---------------------- 2.
State the importance of NRIs to India. What are the basic criteria for NRIs/
PIOs under FEMA, 1999?
----------------------
3. What facilities do banks (ADs) offer to NRIs?
----------------------
4. State the types of Investment opportunities for NRIs.
5. Write short notes on: Notes
a. NR (E) Rupee account scheme
----------------------
b. Portfolio Investment scheme for NRIs
----------------------
c. RFC account scheme for returning NRIs
6. What are the salient features of EEFC account scheme? ----------------------
----------------------
----------------------
----------------------
1. False ----------------------
2. True ----------------------
3. True ----------------------
----------------------
Fill in the blanks.
----------------------
1. The beneficial ownership share of Indian nationals in Overseas Corporate
Bodies (OCBs) should not be less than 60 %. ----------------------
2. Under Income Tax Act, for the accounting year ending 31st March 2001, ----------------------
the assessment year would be 2001−2002.
3. A person from India, who has gone abroad for starting a business, shall be ----------------------
deemed a Non-Resident Indian, if his stay in India during the preceding ----------------------
financial year was less than 182 days.
----------------------
1. Under Section of 10 of Foreign Exchange Management Act (FEMA), a ----------------------
bank needs to obtain a licence from RBI to deal in foreign exchange and
such banks are called authorised dealer. ----------------------
2. Non-Resident (external) deposit account cannot be held jointly with ----------------------
resident.
----------------------
3. FCNR(B) account is a term deposit account and can be opened only in
designated foreign currencies. ----------------------
Check your Progress 4 ----------------------
Fill in the blanks.
----------------------
1. Under FEMA, Exchange Earner’s Foreign Currency Account can be
opened by an Indian resident. ----------------------
2. LIBOR means London Inter Bank Offered Rate. ----------------------
3. In International Trade, the origin of goods is established on the basis on ----------------------
of a COO, i.e., Certificate of Origin of Goods.

Notes
Suggested Reading
----------------------
1. Abhyankar, Dr. Hemant and Shri S. V. Hajeri. Foreign Trade & Foreign
---------------------- Policy.
2. Iyengar, Mr. Vijayragavan. Introduction to Banking.
----------------------
----------------------
----------------------
----------------------
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Financial Regulations
UNIT
2
Structure:
2.1 Introduction
2.2 International Organisations for Trade & Development
2.3 RBI - Banking Sector Reforms
2.4 RBI - Exchange Control Authority
2.5 Exchange Control related to Import of Goods and Services
2.6 Exchange Control related to Export of Goods and Services
2.7 Highlights of Foreign Trade Policy 2015 -2020
Summary
Key Words
Suggested Reading
Financial Regulations 25
Notes
Objectives
----------------------
----------------------
• Explain the reforms in the banking sector
----------------------
• Describe the role of RBI as the Exchange Control Authority
---------------------- • Distinguish between the role of RBI in terms of imports and exports
---------------------- • Appraise the Export Import Policy of the Government of India
---------------------- • Identify the provisions of Foreign Trade (Development &

Regulations) Act, 1992
----------------------
2.1 INTRODUCTION
----------------------
In order to cope up with the increasing volume of international trade,
----------------------
many international organisations have been set up at different times in history
---------------------- to promote international trade. Most of these organisations play distinct
roles in international trade. The roles played by them are supplementary and
---------------------- complementary to the roles played by the other organisations. Hence, it is
important to know the functioning of these organisations in brief.
----------------------
---------------------- 2.2 INTERNATIONAL ORGANISATIONS FOR TRADE &

----------------------
DEVELOPMENT
---------------------- General Agreement on Tariffs and Trade (GATT): The Bretton Woods
Conference of 1944, which recommended the establishment of the IMF and the
---------------------- World Bank, had also recommended the establishment of an International Trade
Organisation (ITO). Although the IMF and World Bank were established in
---------------------- 1946, the proposal for ITO did not materialise, instead GATT, a less ambitious
---------------------- organisation, was formed in 1948. The international trading system since then
was, at least in principle, guided by the rules and procedures agreed to by the
---------------------- signatories of GATT.
---------------------- World Trade Organisation (WTO): A new world trade body under the
fold of GATT was started in January 1995. India was one the Founder signatories
---------------------- of the new body- WTO. The new pact was negotiated for over 7 years under the
GATT Umbrella covering more than 150 countries. The WTO serves as single
---------------------- institutional framework encompassing GATT and all the results of the Uruguay
---------------------- Round. The WTO is directed by a Ministerial Conference that meets at least
once every two years and a General Council oversees its regular business.
----------------------
WTO and Developing Countries: Nearly 80% of the members of
---------------------- WTO are developing countries. The developing countries enjoy certain special
privileges and concessions under the GATT system.
----------------------
International Monetary Fund (IMF): The International Monetary Fund (IMF)
---------------------- was founded in 1946. It is an organisation of countries that seeks to promote

international monetary co operation, facilitate the expansion of trade and thus Notes
contribute towards increased employment and improved economic conditions
in all member countries. The membership of the Fund is a prerequisite for ----------------------
membership in the World Bank (IBRD) and a close working relationship between
the two organisations as well as between IMF and the WTO and the Bank for ----------------------
International Settlements (BIS). The fund is a specialised agency within the ----------------------
United Nations system, co-operating with the UN on matters of mutual interest.
----------------------
World Bank: The International Bank for Reconstruction and Development
(IBRD) or the World Bank, one of the Bretton Woods Twins, was established in ----------------------
1945. The IBRD has two affiliates –the International Development Association
(IDA) established in1960 and the International Finance Corporation (IFC) in ----------------------
1956.
----------------------
The IBRD whose capital is subscribed by its member countries,
finances its lending operations primarily from its own borrowings in the world ----------------------
capital markets. The objective of the Bank is to assist the member countries
----------------------
in reconstruction and development. It facilitates the investments of capital
for productive purposes. It promotes private foreign investment by means ----------------------
of guarantees or participation in loans and other investment made by private
investors. IBRD promotes the long range balanced growth of international trade ----------------------
and the maintenance of equilibrium in the balance of payments of member
----------------------
countries.
International Finance Corporation (IFC): IFC, an affiliate of the ----------------------
World Bank, was established in 1956. It assists the less developed countries for
----------------------
their economic development by promoting growth in the private sector of their
economies and helps mobilize domestic and foreign capital for this purpose. ----------------------
IFC is acts as a catalyst in bringing together entrepreneurship, investment
capital and production. ----------------------
Asian Development Bank (ADB): The Asian Development Bank ----------------------
(ADB) was set up in December 1966 under the auspices of the United Nations
Economics Commission for Asia and Far East (ECAFE), to foster economic ----------------------
development of Asian countries, with its headquarters at Manila. ----------------------
Developed countries as Japan, USA, Canada, West Germany, Australia
etc., contribute to the funds of the ADB. The main objectives of the ADB are ----------------------
to promote investment in the ESCAP region of public and private capital for ----------------------
development and to utilise the available resources for financing development,
giving priority to those regional, sub-regional as well as national projects and ----------------------
programmes that contribute more effectively to the harmonious economic
growth of the region as a whole. ----------------------
----------------------
----------------------
----------------------
----------------------
Notes
----------------------
---------------------- Fill in the blanks.

1. IBRD, also known as World Bank, has two affiliates, International
----------------------
Finance Corporation and _______________.
---------------------- 2. As per the recommendations of the Bretton Woods Conference of
1944, two institutions, i.e. International Monetary Fund (IMF) and
----------------------
_____________ was established in 1946.
---------------------- 3. Asian Development Bank (ADB) was established to foster economic
---------------------- development of the __________ countries.
----------------------
2.3 RBI – BANKING SECTOR REFORMS
----------------------
Commercial banks (A Ds) are one of the most crucial participants in the
---------------------- foreign exchange market either as intermediaries or counter parties to a foreign
---------------------- exchange contract. They trade foreign exchange either on behalf of their clients
or on their own behalf. They are active in international financial markets. RBI
---------------------- regulates and monitors the country’s foreign exchange reserves as well as the
inflow and outflow of foreign exchange. The global banking system consists of
---------------------- the Bank for International Settlements (BIS), Central banks i.e. Reserve Bank of
---------------------- India and the commercial banks. The BIS oversees central banks. Each central
bank regulates and supervises all commercial banks within its jurisdiction.
----------------------
The Govt. of India set up the Narsimham Committee (1991) (phase I)
---------------------- to examine all aspects related to structure, organisation and the functions of
the Indian banking system. The recommendations of the committee aimed
---------------------- at creating a competitive and efficient banking system. Measures like capital
adequacy, income recognition and assets classification, norms for investments,
----------------------
entry of private sector banks, gradual reduction of SLR and CRR were introduced
---------------------- by RBI so as to strengthen the banking system. The recommendations of the
Banking Sector Reforms 1998 (Narsimham II) have also been implemented by
---------------------- RBI.
---------------------- Basel Norms
Background
----------------------
The Basel Committee was formed in response to the messy liquidation of
---------------------- a Cologne based Bank in the year 1974. On 26th June 1974, a number of banks
---------------------- had released Deutschmark to the Bank Herstatt in exchange for dollar payments
deliverable in New York. On account of differences in the time zones, there
---------------------- was a lag in the dollar payment to the counter-party banks, and during this gap,
before the dollar payments could be effected in New York; the Bank Herstatt
---------------------- was liquidated by German regulators.
----------------------

This incident prompted the G10 nations to form the Basel Committee on Notes
Banking Supervision (BCBS) under BIS.
----------------------
BCBS has published three Accords Basel I (1988), Basel II (2005) and Basel
III (2010). ----------------------
Basel I Accord primarily focused on credit risk. Assets of banks were
----------------------
classified and grouped in five categories according to credit risk. The Accord
introduced the concept of capital adequacy wherein banks with international ----------------------
presence are required to hold capital equal to 8% of risk-weighted assets. Most
of the countries have adopted these norms including India. However, it was ----------------------
criticized as being inflexible due to its focus primarily on credit risk. It treated all
----------------------
types of borrowers under one risk category regardless of their credit worthiness.
The Basel II Accord placed greater emphasis on market risk and operating ----------------------
risk, while providing new methods for the measurement of risk. It identifies ----------------------
three ‘pillars’.
Pillar1 Minimum Capital Requirements: It specifies new standards for ----------------------
minimum capital requirements along with the methodology of assigning risk ----------------------
weights on the basis of credit risk and market risk.
•
The credit risk can be calculated in three ways namely standardised approach,
----------------------
Foundation IRB and Advanced IRB (Internal Rating –Based approach) ----------------------
• For
operational risk, there are three different approaches – Basic Indicator
----------------------

Approach (BIA), Standardised Approach (STA) and Advanced
Measurement Approach (AMA). ----------------------
• For market risk, the preferred approach is Var (value at risk) IRB approach that
----------------------
allows banks to use its internal estimates of the borrower’s creditworthiness
to assess credit risk in the portfolio subject to strict methodological and ----------------------
disclosure standards. Basel II assigns capital charge for operational risk.
As per R B I guidelines, banks are required to progress in phased manner ----------------------
from Standardised to Advanced Approaches for management of Credit and ----------------------
Operational risks.
Pillar II Supervisory review Process: It diversifies the role of banking ----------------------
supervisors and gives them power to review the banks’ risk management ----------------------
systems. It demands the following -
• A bank should have a process for assessing its overall capital adequacy in ----------------------
relation to its risk profile and a strategy for maintaining its capital levels.
----------------------
•
Supervisors should review and evaluate a bank’s internal capital adequacy
assessment and strategy so as to ensure regulatory compliance of capital ratios. ----------------------
Pillar II requires that a comprehensive assessment of risks be carried out ----------------------

by both, the banks internally and the supervisor externally.
----------------------
A Board for Financial Supervision has been set up with an Advisory
Council to strengthen the supervisory system of banks and an independent ----------------------
Department of Banking Supervision has been set up in the RBI to assist the
board. ----------------------
Notes Pillar III: Market Discipline: It defines the standards and requirements
for higher disclosure by banks on capital adequacy, asset quality and other risk
---------------------- management processes. The new framework puts up disclosure requirements
in several areas, including the way in which banks calculate their capital
----------------------
adequacy and their risk assessment methods. The transparency and disclosure
---------------------- standards recommended in the International Accounting Standards have been
implemented in a phased manner.
----------------------
Banks are now required to ensure that there are no qualifications by the
---------------------- Statutory Auditors in their financial statements.
---------------------- Summary of Important Measures taken by RBI for implementation of

Basel II
---------------------- •
RBI has implemented Basel II with a view to reach the global best standards
---------------------- in a phased manner, by adopting a consultative approach. Banks are required
to maintain unimpaired minimum capital equivalent to the prescribed ratio
---------------------- on the aggregate of the risk-weighted assets and other exposures. The R B I
has stipulated a capital adequacy ratio of 9% for all banks. For the purpose of
---------------------- Capital Adequacy norm, capital is divided into two tiers Tier I (Core Capital)
and Tier II (Supplementary Capital). Tier I capital should be at least 50%
---------------------- of the total capital. The capital base of most of the Indian banks has been
---------------------- relatively low. Most of the banks including Public Sector Banks raised a large
amount of funds to meet the regulatory capital requirements. The Banks have
---------------------- now migrated to Basel II norms.
---------------------- • Banks have brought the state-of the –art technology into banking system.
The growth in banking technology and automation of banking processes
---------------------- has extension of reach and low costs of transactions.
---------------------- •
RBI has issued detailed guidelines for risk management system in banks
in October, 1999 which encompasses credit, market and operational risks.
---------------------- These guidelines require banks to have in place Loan Policies approved by
---------------------- their board of directors. The Loan Policy document is of vital importance
to each and every bank and it covers the methodologies for measurement,
---------------------- monitoring and control of credit risk. The guidelines require banks to evaluate
their portfolios on an ongoing basis and not only at time of finalisation of its
---------------------- Balance Sheet. Most of the banks have put in place, their on Loan Policy and
procedures approved by their respective Boards, which is being reviewed
---------------------- at periodical intervals. The important tools of Credit Risks Management
---------------------- initiated by the banks are as follows-
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds. The aim of
---------------------- prudential measures is to better/improve the risk management and avoid
---------------------- concentration of credit risk. Exposure ceiling limit for single borrower
would be 15% of capital funds, and 40% in case of borrower group.
---------------------- Similar credit exposure ceilings are fixed industry wise and sector wise.
Besides this, the banks are also required to observe certain statutory and
---------------------- regulatory exposure limits in respect of advances against / investments in
---------------------- shares.

b) Review/Renewal: Multi-tier Credit Approving Authority i.e. Credit Notes
Committees constituted at Regional Office/Zonal Office/Circle/Bank
level and constitution wise delegation of powers are formulated. Higher ----------------------
delegated powers are given for better-rated customers; discriminatory
----------------------
time schedule for review/renewal. Hurdle rates and Bench marks for
fresh exposures and periodicity for renewal, based on risk rating, etc. are ----------------------
formulated.
----------------------
c) Credit Rating or Risk Rating Model: Credit Rating is the assessment of
a borrower’s credit (quality) repute. Credit Ratings are based on an in- ----------------------
depth study of the Borrower/Corporate client and an evaluation of the
strengths and weakness of the company. The analytical model for rating ----------------------
consists of the four broad areas: ----------------------
• business analysis
----------------------
• financial analysis based on the borrower’s audited Balance Sheets for the last
three years ----------------------
• management evaluation ----------------------
• fundamental analysis
----------------------
In other words, credit rating performs the function of credit risk evaluation
reflecting the borrower’s expected capability to repay the debt as per terms of ----------------------
issue. Banks set up comprehensive risk scoring system on a six to nine point
----------------------
scale for fund based and non fund based facilities granted to the borrower.
Banks define rating threshold and review the ratings periodically preferably at ----------------------
half yearly intervals. Banks have made provision in the Credit Rating exercise
to the effect that if the borrowers got rated from the External Credit Rating ----------------------
Agencies like CARE, CRISIL, FITCH etc, then that rating can be incorporated
----------------------
in Bank’s Internal rating exercise.
d) Risk based scientific pricing (Interest rate on loans/advances): Banks to ----------------------
link loan pricing to expected loss. High-risk category borrowers are to be ----------------------
priced high.
e)
Portfolio Management: The need for credit portfolio management ----------------------
emanates from the necessity to optimize the benefits associated with ----------------------
diversification and to reduce the potential adverse impact of concentration
of exposures to a particular borrower, sector or industry. Stipulate ----------------------
quantitative ceiling on aggregate exposure on specific rating categories,
distribution of borrowers in various industries, business groups and ----------------------
conduct rapid portfolio reviews. ----------------------
• Market
risks arise from adverse movements in interest rates and exchange
rates. To safeguard bank’s investment portfolio against the adverse ----------------------
movements in interest rate risk, RBI has directed banks to build up an ----------------------
Investment Fluctuation Reserve of a minimum of five percent of the eligible
investments categories. ----------------------
•
Liquidity Risk emanates from maturity disparity/mismatch of assets and ----------------------
liabilities of banks. RBI has advised banks to put in place an ALM system
Notes and set up Internal Assets Liability Management Committees at the top
management level to oversee its implementation.
---------------------- •
The recommendations of Working Group to review the system of On-site
---------------------- supervision over Banks (S Padmanabhan Feb 1995) have already been
implemented and periodical ‘On-site examinations’ supplemented by in
---------------------- house ‘Offsite monitoring system and linked exercises in between two
statutory audits has been introduced. An On-site Inspection system focuses
---------------------- on statutory mandated areas of solvency, liquidity and assets classification
and income recognition norms (IRAC) of the banks. It is stated that a periodic
---------------------- and full-scope statutory examination should concentrate on core areas of
---------------------- assessment; viz:
• financial condition and performance;
----------------------
• management and operating condition; and
----------------------
• compliance and summary assessment
---------------------- This should fall in line with the internationally adopted bank-rating system
where bank supervisory authorities rate institutions according to six factors:
----------------------
For Indian Banks: CAMELS (Capital adequacy, Asset quality,
---------------------- Management, Earnings, Liquidity and Systems)
---------------------- For Foreign Banks CALCS (Capital adequacy, Asset Quality, Compliance,
Systems and Controls)
----------------------
The above system helps the supervisory authority to identify the banks that
---------------------- are in need of attention. The Off-site Monitoring and Surveillance (OSMOS)
system was brought into operation as part of crisis management framework
---------------------- for early warning system and as a trigger for on-site inspections of vulnerable
---------------------- institutions. The primary objective of the offsite surveillance is to monitor the
financial health of banks between two on-site inspections, identifying banks,
---------------------- which show financial deterioration and would be a source for supervisory
concerns. This acts as a trigger for timely remedial action.
----------------------
Basel III
----------------------
The existing guidelines were found to be unsuitable to ensure adequate
---------------------- bank liquidity during the Credit Crunch conditions, especially after 2008
when more than 1200 banks went bankrupt in USA. There were a number of
---------------------- weaknesses exacerbated by the credit crunch including-
---------------------- •
excessive leverage in the banking and financial system and inadequate high
quality capital to absorb losses;
----------------------
•
excessive credit growth based on weak underwriting standards and under
---------------------- pricing of liquidity and credit risk;
•
insufficient liquidity buffers and overly aggressive maturity transformation,
----------------------
both direct and indirect;
---------------------- •
inadequate risk governance and poor incentives to manage risks towards
prudent long term outcomes, including through poorly designed compensation
----------------------
systems;

•
inadequate cushions in banks to mitigate the inherent pro-cyclicality of Notes
financial markets and its participants
----------------------
The cause of the financial crisis was triggered by excess global liquidity,
too much leverage, too little capital of insufficient quality and inadequate ----------------------
liquidity buffers. A number of other factors also played a major role which
included major shortcomings in risk management, corporate governance, market ----------------------
transparency, compensation practices and the quality of supervision. Basel
----------------------
III is part of the BCBS’s continuous effect to enhance the banking regulatory
framework. Basel III is a comprehensive set of reform measures to strengthen ----------------------
the regulation, supervision and risk management of the banking sector. These
measures aim ----------------------
•
to raise quality and quantity of capital with a much greater focus on common ----------------------
equity to absorb losses.
----------------------
•
to improve the banking sector’s ability to absorb shocks arising from financial
and economic stress, whatever the source ----------------------
•
to improve risk management and governance especially related to capital ----------------------
market activities
•
to strengthen bank’s transparency and disclosures besides these micro ----------------------
prudential measures
----------------------
The reforms target:
----------------------
•
Bank-level, or micro prudential regulation, which will help raise the resilience
of individual banking institutions to periods of stress. ----------------------
•
Macro prudential, system wide risks that can build up across the banking ----------------------
sector as well as the pro-cyclical amplification of these risks over time.
These two approaches to supervision are complementary as greater ----------------------
resilience at the individual bank level reduces the risk of system wide shocks. ----------------------
The Basel III requirements begin to take effect from the beginning of 2013
and will be progressively phased in by 2019. Basel III is the core regulatory ----------------------
response to problems revealed by the financial crisis but new rules and standards
are not enough. The next critical task at hand relates to better and more intrusive ----------------------
supervision at the global level. ----------------------
Basel III requirements begin to take effect from the beginning of 2013 and will
----------------------
be progressively phased in by 2019. The summary of Basel III recommendations
are as under: ----------------------
A key element is the greater focus on what is called common equity, i.e.
----------------------
the highest-quality component of a bank’s capital. Under current standards, the
banks have to hold at least half of their regulatory capital as Tier 1 capital. ----------------------
The remainder i.e. Tier II is made up of other items of lower loss-absorbing
capacity. The Tier I capital requirement which includes common equity and ----------------------
other qualifying financial instruments based on stricter criteria will increase
----------------------
from 4% to 6%. By strengthening the quality of capital, Basel III will lead
to a substantial improvement in the loss absorbing capacity of banks. Higher ----------------------
Notes capital will be required for trading, derivatives and securitisation activities. The
new rules mean that, everything being equal, banks will need to increase their
---------------------- common equity capital to meet minimum requirements. The new strengthened
definition of capital will be phased in over five years: the requirements will
---------------------- be introduced in 2013 and fully implemented by the end of 2017. In addition,
---------------------- existing public sector capital injections will be grandfathered until the end of
2017. Capital instruments that no longer qualify as non-common equity, Tier 1
---------------------- capital or Tier 2 capital will be phased out over 10 years beginning 1 January
2013.
----------------------
Tier I Capital: To meet minimum capital requirements, the higher minimums
---------------------- for common equity and Tier 1 capital and Capital Conservation Buffer, the
Counter Cyclical Buffer will be phased in beginning of 2013 to 2019.
----------------------
Minimum Liquidity Another important aspect of Basel III is introduction
---------------------- of new global minimum liquidity standards. The standard aims to ensure that
a bank maintains an adequate level of unencumbered, high quality liquidity
---------------------- needs for a 30 calendar day time horizon under a significantly severe liquidity
---------------------- stress scenario specified by supervisors. At the minimum, the stock of liquid
assets should enable the bank to survive until day 30 of the stress scenario, by
---------------------- which time it is assumed that appropriate corrective actions can be taken by
management/supervisors.
----------------------
Leverage Ratio: One of the underlying features of the crisis was the buildup of
---------------------- excessive on and off balance sheet leverage in banking system. The Committee
proposed to introduce a simple, transparent, non-risk based leverage ratio that
----------------------
is calibrated to act as a credible supplementary measure to the risk based capital
---------------------- requirements.
Counter Cyclical Capital Buffer: One of the most de-stabilising elements of
----------------------
the crisis has been pro-cyclical amplification of the financial shocks throughout
---------------------- the banking system, financial markets and broader economy. A counter-cyclical
buffer within a range of 0% to 2.5% of common equity or other fully loss
---------------------- absorbing capital will be implemented as per requirements.
---------------------- Capital Conservation Buffer: An essential element of the new regulatory
capital framework is the buildup of buffer in good times that can be drawn
---------------------- down in period of stress. Banks will be required to hold a capital conservation
buffer comprising common equity of 2.5%. This framework will reinforce the
----------------------
objective of sound supervision and governance.
---------------------- How different Basel III is from Basel II
---------------------- Basel II Basel III
1. Tier I Capital Tier I capital ratio = 4% Tier I Capital Ratio = 6%
---------------------- Core Tier I Capital = 2% Core Tier I capital = 4.5%
(Common equity after deductions).
----------------------
Before 2013 = 2%
---------------------- 01.01.2013 = 3.5%
01.01.2014 = 4%
---------------------- 01.01.2015 = 4.5%

Difference between the total capital requirement of 8% and Tier I capital requirement Notes
can be met with Tier II capital
2. Capital No capital 2.5% on top of Tier I capital ----------------------
Conservation conservation buffer Before 2016 = 0.625%
Buffer 01.01.2017 = 1.25% ----------------------
01.01.2018 =1.875% ----------------------
01.01.2019 = 2.5% 3
3. Counter No counter 0% to 2.5% Cyclical cyclical buffer ----------------------
Before 2016 = 0%
Buffer 01.01.2016 = 0.625%; ----------------------
01.01.2017 = 1.25%.
01.01.2018 = 1.875% ----------------------
01.01.2019 = 2.5% ----------------------
4. Capital for None Total Regulatory Capital =
Systemically Tier I capital ratio + ----------------------
Important Capital Conservation Buffer +
Financial Countercyclical Buffer ----------------------
+ Institutions Capital for
Systemically Imp Banks ----------------------
----------------------
In a nutshell, a focus of Basel III is to foster greater resilience at the individual
bank level in order to reduce the risk of system wide shocks. ----------------------
Deposit Insurance & Credit Guarantee Corporation (DICGC) ----------------------
DICGC is wholly owned subsidiary of Reserve Bank of India. DICGC ----------------------
is governed by the provisions of ‘The Deposit Insurance and Credit Guarantee
Corporation Act, 1961’ (DICGC Act) and ‘The Deposit Insurance and Credit ----------------------
Guarantee Corporation General Regulations, 1961’ framed by the Reserve
Bank of India in exercising the powers conferred by the Act. ----------------------
The preamble of the Deposit Insurance and Credit Guarantee Corporation ----------------------
Act, 1961 states that it is an Act to provide for the establishment of a Corporation
for the purpose of insurance of deposits and guaranteeing of credit facilities and ----------------------
for other matters connected therewith or incidental thereto. ----------------------
Since 1978, DICGC used to provide guarantee cover to the credit given
by commercial banks to small borrowers belonging to weaker sections of ----------------------
society. However, the Corporation has discontinued these schemes and it is now ----------------------
exclusively providing deposit insurance cover to banks.
----------------------
The DICGC insures all deposits, demand and time deposits; such as
savings, fixed, current, recurring, etc., deposits of all commercial banks and ----------------------
Co operative Banks, including branches of foreign banks functioning in India,
local area banks and regional rural banks. However, the deposits pertaining ----------------------
to Foreign Governments, deposits of Central & State Governments interbank
----------------------
deposits, etc are excluded.
The deposit insurance scheme is compulsory and no bank can withdraw ----------------------
from it. Each depositor in a bank is insured up to a maximum of Rs.1, 00, 000
----------------------
(Rupees One lakh) for both principal and interest amount held by him in the
Notes same right and same capacity. The deposits kept in different branches of a bank
are aggregated for the purpose of insurance cover and a maximum amount up
---------------------- to Rupees one lakh is paid. The DICGC insures principal and interest up to a
maximum amount of Rs. one lakh. For example, if an individual had an account
---------------------- with a principal amount of Rs.96,000 plus accrued interest of Rs.3,000 the total
---------------------- amount insured by the DICGC would be Rs.99,000. If, however, the principal
amount in that account was Rs. One lakh, the accrued interest would not be
---------------------- insured, not because it was interest but because that was the amount over the
insurance limit. If a depositor has deposit accounts with more than one bank,
---------------------- deposit insurance coverage limit is applied separately to the deposits in each
---------------------- bank. Deposit insurance premium is borne entirely by the insured bank if a bank
goes into liquidation. The DICGC is liable to pay to each depositor through the
---------------------- liquidator, the amount of his deposit up to Rupees one lakh within two months
from the date of receipt of claim list from the liquidator.
----------------------
If a bank is reconstructed or amalgamated / merged with another bank:
---------------------- The DICGC pays the bank concerned, the difference between the full amount
of deposit or the limit of insurance cover in force at the time, whichever is less.
----------------------
Payment of Insurance Premium to DICGC: Each bank has to bear
---------------------- the cost of insurance premium payable to the Corporation. The DICGC has
settled the claims for large amounts due to the failure of banks, particularly in
----------------------
the Co-operative Sector which resulted into a drain on the Deposit Insurance
---------------------- Fund (DIF). Though there is sufficient corpus in Deposit Insurance Fund for
the present, it is necessary to build a sound DIF in the long term to protect the
---------------------- interests of the banking system. The Corporation is continuously reviewing the
DIF and is revising the premium further from time to time with the objective of
----------------------
maintaining a strong DIF.
---------------------- Value at Risk
---------------------- ‘Value at Risk’ has developed as a risk assessment tool at banks and other
financial service firms in the last decade. Its usage in these firms has been driven
---------------------- by the failure of the risk tracking systems used until the early 1990s to detect
dangerous risk taking on the part of traders. It offered a key benefit as well- a
----------------------
measure of capital at risk under extreme conditions in trading portfolios that
---------------------- could be updated on a regular basis.
---------------------- What is Value at Risk?

On the myriad balance-sheet risks that banks face today, credit and interest
---------------------- rate risks mostly account for their business risks. These and other risks expose
---------------------- a bank’s business to certain potential losses. These losses are of three types, a)
expected loss, b) unexpected loss and c) stress loss.
----------------------
The expected loss is always insurable by the myriad hedges and therefore,
---------------------- forms part of banks’ cost of operation.
There is the unexpected loss under adverse conditions. This unexpected
----------------------
loss is defined as value at risk (VaR).
----------------------

Then there is also a third type of loss the bank may be prepared to face Notes
under extreme conditions which is rare though. It is called stress loss.
Value at risk technically is defined as the “Loss amount, accumulated ----------------------
over a certain period that has not exceeded in more than a certain percentage of ----------------------
all time”. For example,
----------------------
‘VaR (99%, 1 week) is equal to the loss amount, accumulated over one
week that has not exceeded in more than one percent of all time. In other words, ----------------------
the notion of Value at Risk is simple- the maximum amount that you can lose on
an investment over a particular period with a specified probability. ----------------------
There are three broad approaches of Value at Risk, the Asset Managers ----------------------
use. They are as follows:
----------------------
a) Correlation Aggregation: In this approach, we assume that the returns
generated by exposure to multiple market risks are normally distributed. ----------------------
We use a variance-covariance matrix of all standardized instruments
representing various market risks to estimate the standard deviation ----------------------
in portfolio returns and compute the Value at Risk from this standard
----------------------
deviation.
b) Historical Simulation: In the second approach, we run a portfolio through ----------------------
historical data – a historical simulation – and estimate the probability that ----------------------
the losses exceed specified values.
c) Monte Carlo Simulation: In the third approach, we assume return ----------------------
distributions for each of the individual market risks and run Monte Carlo ----------------------
simulations to arrive at the Value at Risk.
----------------------
Each measure comes with its own (pluses and minuses) pros and cons:
the Variance-covariance approach is simple to implement but the normality ----------------------
assumption can be tough to sustain, historical simulations assume that the
previous time periods used are the representatives of the future and Monte ----------------------
Carlo simulations are time and computation intensive. All three yield Value at
----------------------
Risk measures that are estimates and subject to judgment.
Case study ----------------------
In 1959, Saiwa Bank became one of the top financial institutions in Japan. ----------------------
It was engaged in commercial banking, trustee business as well as and foreign
exchange business. Recognizing the need felt, Saiwa diversified in pension trust ----------------------
business in 1968. In the next couple of decades, the bank gained ground and
----------------------
became a leader in the corporate pension business. In 1993, Saiwa Bank also
acquired a majority stake in one of the leading security companies in Japan, ----------------------
Saiwa Bank’s Washington Branch gradually increased trading in Govt. Debt
Market. ----------------------
Mr. B. Lee was in charge of back office work. Over a period, in addition ----------------------
to this, he was promoted to the Post of Trader. In his few initial deals, Mr. Lee
lost 3.00 lakh US $ in one of the Govt. Bond deals. To cover up this small loss ----------------------
he sold some securities. Whenever the Trust Banker, an Investment Banker sent ----------------------
a statement of the sales, Mr. Lee used to forge the statement. This continued for
Notes more than ten years and ultimately when Mr. Lee was transferred, his successor
found out a loss of 1.02 billion $. This resulted in great financial crisis to the
---------------------- Bank. Analyse the case and find out the reasons for this debacle.
---------------------- Answer
---------------------- It is a clear case of utter failure on the part of bank’s Internal Supervision and
Controls and over dependence on a few Officials. The fact that Mr. Lee was able
---------------------- to conceal the losses for a period of 10 years showed that there was inadequate
control and supervision of Lee’s trading activities. The Internal Audit and the
---------------------- Supervisor failed to get an independent confirmation from the Investment
---------------------- banker for such long period.
No basic control was in place like –
----------------------
a) Periodic rotation of duty,
----------------------
b) Separation of important duties like front office and back office. Overlapping
---------------------- of front office and back office duties were allowed to continue,
c) Verification of reconciliation of statements. This led to manipulation of
----------------------
facts by Mr. Lee for a considerably long period of time,
---------------------- d) The key Officers such as Branch Head, System In charge who handled
---------------------- back office system were not asked to avail leave at regular intervals.
---------------------- 2.4 RBI - EXCHANGE CONTROL AUTHORITY

---------------------- Background
---------------------- India had a perpetual shortage of foreign exchange resources and reserves
since pre-independence time and hence, since 1939, we had Exchange Control
---------------------- Regulations in India. A system of Exchange Control Regulation was introduced
---------------------- in India for the first time by the then British Government at the outbreak of
World War II in the month of September,1939 for the purpose of conserving
---------------------- and directing to the best uses, the limited resources of foreign exchange
available. This control was made effective through a series of rules made under
---------------------- the Defence of India Act 1939. At that time, the control was meant to be a
---------------------- temporary measure. However, it was put on the statute book in its permanent
form by enacting the Foreign Exchange Regulation Act, 1947 (FERA 1949) and
---------------------- later on with effect from1stJanuary,1974 an amended version viz. FERA,1973
was enacted. Subsequently, FERA, 1973 repealed and with effect from 1st June,
---------------------- 2000, a new Act viz Foreign Exchange Management Act, 1999 (FEMA, 1999)
---------------------- was made applicable.
Secondly, the Govt. has also laid down the statutory rules and regulations
---------------------- to govern the foreign trade by means of EXIM Policy, Handbook on Import &
---------------------- Export Procedure, Exchange Control Manual, FEMA, etc. which is subject to
change. As a student of Global Banking & Finance, one should be well aware
---------------------- and ensure to comply with the statutory provision of foreign trade.
----------------------

Due to liberalization of the economy, and with FEMA in place, India has Notes
moved from a regulatory mechanism to a management mechanism with respect
to foreign exchange. ----------------------
Reserve Bank of India – Exchange Control Authority ----------------------
One of the important central banking functions of the RBI is the ----------------------
maintenance of the external value of the rupee. As such, RBI has been entrusted
the custody of foreign exchange reserves and sole agency for administration ----------------------
of exchange controls in India. The main objectives of Exchange Control are
conservation of foreign exchange resources and proper utilisation thereof in ----------------------
the interest of economic development of the country. Hence Exchange Control ----------------------
directives of RBI have been the subject of frequent review and modifications.
As a result, efforts have been made constantly to simplify the procedures, ----------------------
soften the rigorous controls, decentralise its administrations and improve the
quality of customer service. An era of liberalization has been heralded and since ----------------------
1st March, 1993, all foreign exchange transactions are being put through by ----------------------
Authorised Dealers at market determined rates. In order to give further boost to
improve foreign trade, Government of India has announced Trade Policy for a ----------------------
period of five years i.e. from 2009 to 2014.
----------------------
All receipts and payments in and out of India require general or special
permission of the RBI. The Authorised Dealers are essentially banks, authorised ----------------------
by RBI, which in turn, carries the administration of exchange controls.
----------------------
In terms of clause (a) of sub section (1), sub section (3) of section 7 and
sub section 47 of FEMA, Act1999, Reserve Bank of India has issued important ----------------------
guidelines/ regulations.
----------------------
The foreign exchange transactions that have international financial implications
are controlled by the RBI and Government. This includes the following ----------------------
important items. Many of them are liberalized and some of them are withdrawn
----------------------
since the 1991 economic reforms.
•
Realisation of proceeds of exports of goods and services ----------------------
•
Payments to non-residents or to their accounts in India for imports and others ----------------------
•
Transfer of securities as between residents and Non- Residents and acquisition ----------------------
and holding of foreign securities
•
Export and import of currency, cheques, drafts, traveller’s cheques and other
----------------------
financial instruments, securities, gold, jewellery etc. ----------------------
•
Trading, commercial and industrial activities in India of foreign firms and
companies (including branches of foreign firms and companies) and foreign ----------------------
nationals as well as acquisition of business undertakings or the holding of ----------------------
shares in Indian companies by such firms, corporate and persons.
•
Appointment of Non- Residents and foreign nationals and companies as ----------------------
agents or as technical and management advisers in India. ----------------------
• Employment, profession etc. undertaken in India by foreign nationals.
----------------------
Notes •
Acquisition, holding and disposal of immovable property in India by foreign
nationals and corporates.
----------------------
Besides this, RBI has taken series of measures and further relaxation on current
---------------------- account transactions as well as further delegation of powers to A D has been
announced.
----------------------
A brief summary of these measures is as under:
---------------------- • ADs
have been permitted to allow remittances for various purposes like
travel, studies, medical treatment, gifts and services to the extent specified
----------------------
by RBI.
---------------------- •
The exporters can retain a portion of the export earnings in foreign currency
account opened with A Ds in India. Certain exporters with good track record
----------------------
and minimum exporter performance (i.e. Status Holder exporters, Export
---------------------- Oriented Units (EOUs), units in Export Processing Zones (EPZs) Software
Technology Parks (TPs)) are allowed to maintain foreign currency accounts
---------------------- with certain designated branches of A Ds or in a bank abroad for crediting
export proceeds. These accounts are known as Exchange Earners Foreign
---------------------- Currency account (EEFC a/cs).
---------------------- • An
Indian entity has been permitted to open, hold and maintain in the name
of its office/branch set up outside India, a foreign currency account for the
---------------------- purpose of normal business operations.
---------------------- • A unit
located in a Special Economic Zone (SEZ) may be allowed to open,
hold and maintain a Foreign Currency account with an AD in India.
----------------------
• Indian
corporates who have set up offices abroad have been permitted to
---------------------- acquire immovable property outside India for their business as also for staff
residential purposes with prior approval of R B I.
----------------------
•
ADs should obtain prior approval of the RBI for issuing guarantees for
---------------------- caution-listed exporters.
---------------------- •
Exporters intending to export goods on elongated credit terms may submit
their proposals giving full particulars through their banks for consideration
---------------------- to the RBI.
---------------------- •
Units in SEZs are permitted to undertake job work abroad and export goods
from that country itself.
---------------------- •
In the case of export of books on consignment basis, A Ds may approve such
---------------------- proposals allowing for realisation of export proceeds up to 360 days from
date of shipment. The exporters may be allowed to abandon the books which
---------------------- remain unsold at the expiry of the period of the sale contract. Accordingly,
the exporters may show the value of the unsold books as deduction from the
---------------------- export proceeds in the account sales.
---------------------- •
Counter trade proposals involving adjustment of value of goods imported into
India against value of goods exported from India in terms of an arrangement
---------------------- voluntarily entered into between the Indian party and the overseas party
through an Escrow account opened in India in U.S.$ will be considered by
---------------------- RBI.

•
Participants in International exhibition/trade fair have been granted general Notes
permission for opening a temporary foreign currency account abroad.
Exporters may deposit the sale proceeds received in foreign currency at the ----------------------
international exhibition/trade fair and operate the account during their stay
outside India provided that the balance in the account is repatriated to India ----------------------
within a period of one month from the date of closure of the exhibition/trade
----------------------
fair and full details are submitted to the A Ds concerned.
• Allowing Commercial Banks (ADs) and EXIM Bank to undertake forfeiting
----------------------
business for financing of export receivables
----------------------
----------------------
----------------------
1.
The global banking system consists of Bank for International
Settlement, RBI and commercial banks. ----------------------
2. The Basel Committee was formed due to messy liquidation of
----------------------
Lehman Brothers of United States of America in 1974.
3. For issuing guarantees for caution listed exporters, the Authorised ----------------------
Dealers need to obtain RBI approval in advance. ----------------------
4. The Basel Committee on Banking Supervision (BCBS) has published
three Accords, Basel I (1988), Basel II (2005) and Basel III (2010). ----------------------
----------------------
2.5 EXCHANGE CONTROL RELATED TO IMPORT OF ----------------------
GOODS AND SERVICES
----------------------
Under FEMA, Capital account transactions include
----------------------
a) Any transaction which will create any asset or liability in foreign exchange
either in India or abroad for a resident. ----------------------
b) Any transaction which will create any asset or liability in India for a Non- ----------------------
Resident.
----------------------
These transactions require either general permission or specific approval from
Government of India or RBI. All other transactions are treated as current ----------------------
account transaction under the FEMA, i.e. trade, travel, freight transfers, gift
remittances, interest and dividend payments, services are current account ----------------------
transactions. Imports and Exports are considered current account transactions.
----------------------
The important provisions in respect of imports into India are as follows:
a) For Exchange Control Purposes, the Rupee accounts of Bhutanese and ----------------------
Nepalese Nationals and firms, maintained with any Indian Banks are
----------------------
treated as resident accounts and any trade settlements can be freely
made through these accounts without any restrictions. However, these ----------------------
settlements cannot be made out of foreign exchange remittances.
----------------------
Notes b) Whenever under the trade policy, the import of any item is subjected to
an import license; Banks should ensure that the importer submits original
---------------------- Exchange Control copy for opening of Letter of Credit as well as for
initiating any remittance. Import Licenses are for the CIF value and cannot
---------------------- be utilised to the full amount to cover the FOB value of import. Special
---------------------- conditions if any stated in the license are also to be strictly adhered to.
c) The purchaser of the exchange has to ensure that the exchange is utilised
----------------------
for the purpose for which it was purchased from the A.D. Where the
---------------------- exchange is purchased for payment of import, the evidence of import in
the form of Bill of entry is required to be submitted to the A.D.
----------------------
d) Payment for import bills, whether under LCs or on collection basis must
---------------------- be made by a debit to the account of importer maintained with the AD.
The payment in Cash cannot be accepted by AD.
----------------------
e) An advance remittance in favour of the supplier may be affected by AD
---------------------- against EC copy of a valid import license for the eligible items of import.
In case the amount remittance is over USD 25000 or its equivalent, a
---------------------- guarantee of bank of international repute should be obtained. Physical
import must be made within a period of 3 months from the date of
----------------------
remittance. The importer should undertake to submit such evidence at the
---------------------- time of remittance. In case actual import does not take place, the remitting
bank would need to ensure that the advance remittance is repatriated
----------------------
f) Remittance against imports should be completed within 6 months from
---------------------- the date of import.
---------------------- g) The goods imported without authority but later cleared by the customs
under penalty, the invoice value of the same can be remitted against EC
---------------------- copy of Bill of entry.
----------------------
2.6 EXCHANGE CONTROL RELATED TO EXPORT OF
---------------------- GOODS AND SERVICES
---------------------- A) The exports are treated as the current account transactions and remittance
can be brought in India with any restrictions. Sec.7 of FEMA authorises
----------------------
the RBI to make such regulations so as to monitor the exports from India.
---------------------- B) Declaration of exports - Every export from India has to be declared on
form/s prescribed by the RBI for the purpose, except
----------------------
• Trade samples of goods & publicity material supplied free of payment.
----------------------
• Personal effects of the traveller
---------------------- • Goods exported as free gift, value not exceeding Rs1 lakh.
---------------------- •
Goods or software not exceeding Rs.25,000, provided the declaration from
the exporter is accompanied with.
----------------------
• Goods previously imported on free of payment on re-export basis.
----------------------

• Goods being sent for testing subject to re-import. Notes
• Goods being sent abroad for repair and re-import.
----------------------
• Goods exported for export promotion up to 2% of the average annual exports

of the applicant during the preceding three years subject to a ceiling of ----------------------
Rs.5lakhs. For status holder exporters, higher limits are prescribed under
Foreign Trade Policy. ----------------------
C) Formats prescribed for declarations of exports and disposal thereof. GR ----------------------

forms to be completed in duplicate - For physical exports PP Forms: to
----------------------
be completed in duplicate - For physical exports through post SOFTEX
forms: To be completed - For export of software otherwise in triplicate ----------------------
than physical mode SDF forms: To be completed in triplicate - For physical
exports from se (SDF-Statutory Declaration Form is to be selected for ----------------------
ports/airports. Used when documents are filed electronically) The GR,
----------------------
PP and SOFTEX forms bear specific identification numbers that need to
be quoted in all correspondence with RBI. The SDF Form will bear the ----------------------
port code and the Shipping Bill Number. GR and SDF in duplicate are
to be submitted to the Commissioner of Customs. After duly verifying ----------------------
and authenticating, the customs will forward the original of the GR/SDF
----------------------
forms to RBI and handover the duplicate to the exporter. The exporter
will submit to the Bank- ----------------------
A) The duplicate of the GR/SDF form.
----------------------
B) Shipping documents.
----------------------
C) The requisite documents for claiming payment from the buyer.
The Bank has to report the receipt of the GR/SDF forms in its periodical ----------------------
returns to RBI. The Bank will continue to hold the GR/SDF forms till the full ----------------------
proceeds of the export covered by those forms are realised and then it will certify
on the back of GR/SDF form about realisation of the bill and forward the same ----------------------
to RBI. The duplicate copies of GR/SDF/PP forms and shipping documents,
once submitted to the A Ds for negotiation, collection etc., should not ordinarily ----------------------
be returned to exporter, except for rectification of errors and re-submission. ----------------------
The PP forms are to be submitted to the AD. The AD (i.e. the Bank) will
countersign the forms and return the original to the exporter for submission ----------------------
to the postal authorities. After dispatch of the goods, the Postal Authorities ----------------------
forward the original PP form to the nearest office of RBI. Exporter will submit
the export bill to the bank that had certified the PP form. On receipt of the ----------------------
bill, the Bank will report the transaction to R B I in its periodical returns. The
duplicate copy of the PP form will be endorsed on realisation of the proceeds ----------------------
and reported to RBI. ----------------------
The SOFTEX form in triplicate will be submitted to the designated
----------------------
officer at the Software Technological Part (STP) or at the Export Processing
Zone (EPZ) or Special Economic Zone (SEZ). After certifying the form, the ----------------------
designated officer will retain the third copy and send the original directly to
RBI, the duplicate will be returned to the exporter. ----------------------
The exporter will submit the duplicate of SOFTEX form and other
Notes
documents to the Bank. The treatment of SOFTEX duplicate is the same as that
---------------------- of GR/ SDF at the Bank.
D) The export bill should normally be realised according to the method of
----------------------
payment prescribed for country of destination.
---------------------- For all other countries, either the payment should be in any convertible
---------------------- currency or by debit to Rupee accounts maintained in India, in the name
of a Bank situated in the buyer’s country.
---------------------- E) Exporter may receive payment for export through approved banking
---------------------- channel by means of bank drafts, pay order, personal cheques etc.
F) The proceeds of export must be realised through an AD within 6 months
---------------------- from the date of export. However, the Status Holder Exporters and units
---------------------- in Special Economic Zones are permitted to repatriate the export proceeds
with in a period of 12 months from the date of export.
----------------------
G) Reduction in Invoice value
---------------------- •
Reduction in value on account of cash discount for pre-payment can be
allowed by the bank for usance bill, provided it commensurate with the
----------------------
proportionate interest on unexpired usance at the contracted rate of interest.
---------------------- If the contract does not specify any rate of interest, then this reduction will
be calculated at the Prime/LIBOR rate of the currency concerned.
----------------------
• Reduction in value in other cases may be considered by the bank-
---------------------- • Provided it should be up to 10% of the invoice value.
---------------------- • The exporter is not in the Exporter’s Caution List of R B I.
---------------------- • The item of export is not subject to floor price restrictions.

•
The exporter is advised to surrender the proportional export incentives
---------------------- availed of, if any.
---------------------- The ceiling of 10% is not applicable to the exporters who have been in the
trade for over 3 years and whose export outstanding is not more than 5%
---------------------- of their average annual export realisations over the past 3 years.
---------------------- H) Write off of an unrealised export bill: If after taking all the efforts, the
export bill is not realised, the exporter can request his banker (AD) to
---------------------- write off the bill with supporting documentary evidences on certain
---------------------- conditions.
I) When the goods have been exported on consignment basis, ADs, while
----------------------
forwarding shipping documents to his overseas branch/correspondent
---------------------- Banker, should instruct the latter to deliver them only against trust
receipt/undertaking to deliver sale proceeds by a specified date within the
---------------------- period prescribed for realisation of proceeds of the export. The agents/
consignees may remit the net proceeds to the exporter after deducting
----------------------
reasonable incidental charges incurred by him.
----------------------

Foreign Trade (Development and Regulation) Act, 1992 Notes
Background:
----------------------
This Act which replaced the Imports and Exports (Control) Act, 1947,
came into force in June1992. This was the first important Act enacted by the ----------------------
Parliament after economic reforms process which started in the year 1991.
----------------------
The objective of the Act is to provide for the development and regulation
of foreign trade by facilitating imports into and augmenting exports from India ----------------------
and for matters connected therewith. The Act empowers the Central Govt. ----------------------
•
To make provision for the development and regulations of foreign trade by
facilitating imports and increasing exports. ----------------------
•
To make provisions for prohibiting, restricting or otherwise regulating the ----------------------
import or export of goods as and when required.
----------------------
•
Authorise the Govt. to formulate and announce the export and import policy.
It provides for the appointment of a Director General of Foreign Trade by ----------------------
the Central Government. DGFT which functions under the Ministry of
Commerce and Industries, Department of Commerce, Government of India. ----------------------
The name of the policy has been changed from ‘Export and Import (EXIM) ----------------------
Policy to ‘Foreign Trade Policy’ on 31st August, 2004.
----------------------
2.7 HIGHLIGHTS OF FOREIGN TRADE POLICY 2015-2020 ----------------------
A. SIMPLIFICATION & MERGER OF REWARD SCHEMES ----------------------
Export from India Schemes: ----------------------
Merchandise Exports from India Scheme (MEIS)
----------------------
Earlier there were 5 different schemes (Focus Product Scheme, Market
Linked Focus Product Scheme, Focus Market Scheme, Agri. Infrastructure ----------------------
Incentive Scrip, VKGUY) for rewarding merchandise exports with
----------------------
different kinds of duty scrips with varying conditions (sector specific or
actual user only) attached to their use. Now all these schemes have been ----------------------
merged into a single scheme, namely Merchandise Export from India
Scheme (MEIS) and there would be no conditionality attached to the ----------------------
scrips issued under the scheme.
----------------------
Rewards for export of notified goods to notified markets under
‘Merchandise Exports from India Scheme (MEIS) shall be payable as ----------------------
percentage of realized FOB value (in free foreign exchange). The debits
----------------------
towards basic customs duty in the transferable reward duty credit scrips
would also be allowed adjustment as duty drawback. At present, only the ----------------------
additional duty of customs / excise duty / service tax is allowed adjustment
as CENVAT credit or drawback, as per Department of Revenue rules. ----------------------
Service Exports from India Scheme (SEIS) ----------------------
Served From India Scheme (SFIS) has been replaced with Service Exports ----------------------
from India Scheme (SEIS). SEIS shall apply to ‘Service Providers located
Notes in India’ instead of ‘Indian Service Providers’. Thus SEIS provides for
rewards to all Service providers of notified services, who are providing
---------------------- services from India, regardless of the constitution or profile of the service
provider.
----------------------
The rate of reward under SEIS would be based on net foreign exchange
---------------------- earned. The reward issued as duty credit scrip, would no longer be with
actual user condition and will no longer be restricted to usage for specified
----------------------
types of goods but be freely transferable and usable for all types of goods
---------------------- and service tax debits on procurement of services / goods. Debits would
be eligible for CENVAT credit or drawback.
----------------------
Incentives (MEIS & SEIS) to be available for SEZs
---------------------- It is now proposed to extend Incentives (MEIS & SEIS) to units located
in SEZs also.
----------------------
Duty credit scrips to be freely transferable and usable for payment of
---------------------- custom duty, excise duty and service tax.
---------------------- All scrips issued under MEIS and SEIS and the goods imported against
these scrips would be fully transferable.Scrips issued under Exports from India
---------------------- Schemes can be used for the following:-
---------------------- (i) Payment of customs duty for import of inputs / goods including capital
goods, except items listed .
----------------------
(ii) Payment of excise duty on domestic procurement of inputs or goods,
---------------------- including capital goods as per DoR notification.
---------------------- (iii) Payment of service tax on procurement of services as per DoR notification.
---------------------- Basic Customs Duty paid in cash or through debit under Duty Credit Scrip
can be taken back as Duty Drawback as per DoR Rules, if inputs so imported
---------------------- are used for exports.
---------------------- Status Holders

Business leaders who have excelled in international trade and have
---------------------- successfully contributed to country’s foreign trade are proposed to be recognized
---------------------- as Status Holders and given special treatment and privileges to facilitate their
trade transactions, in order to reduce their transaction costs and time.
----------------------
The nomenclature of Export House, Star Export House, Trading House,
---------------------- Star Trading House, Premier Trading House certificate has been changed to
One, Two, Three, Four, Five Star Export House.
----------------------
The criteria for export performance for recognition of status holder have
---------------------- been changed from Rupees to US dollar earnings. The new criteria is as under:-
----------------------
----------------------
----------------------

Status category Export Performance Notes
FOB / FOR (as converted) Value (in US $ million)
during current and previous two years ----------------------
One Star Export House 3 ----------------------
Two Star Export House 25
Three Star Export House 100 ----------------------
Four Star Export House 500
Five Star Export House 2000 ----------------------
Approved Exporter Scheme - Self certification by Status Holders ----------------------
Manufacturers who are also Status Holders will be enabled to self-certify
----------------------
their manufactured goods as originating from India with a view to qualify for
preferential treatment under different Preferential Trading Agreements [PTAs], ----------------------
Free Trade Agreements [FTAs], Comprehensive Economic Cooperation
Agreements [CECAs] and Comprehensive Economic Partnerships Agreements ----------------------
[CEPAs] which are in operation. They shall be permitted to self-certify the
----------------------
goods as manufactured as per their Industrial Entrepreneur Memorandum
(IEM) / Industrial Licence (IL)/ Letter of Intent (LOI). ----------------------
B. BOOST TO “MAKE IN INDIA”
----------------------
Reduced Export Obligation (EO) for domestic procurement under EPCG
scheme: ----------------------
Specific Export Obligation under EPCG scheme, in case capital goods ----------------------
are procured from indigenous manufacturers, which is currently 90% of
the normal export obligation (6 times at the duty saved amount) has been ----------------------
reduced to 75%, in order to promote domestic capital goods manufacturing ----------------------
industry.
Higher level of rewards under MEIS for export items with high domestic ----------------------
content and value addition. ----------------------
It is proposed to give higher level of rewards to products with high
----------------------
domestic content and value addition, as compared to products with high
import content and less value addition. ----------------------
C. TRADE FACILITATION & EASE OF DOING BUSINESS
----------------------
Online filing of documents/ applications and Paperless trade in 24x7
environment: ----------------------
DGFT already provides facility of Online filing of various applications ----------------------
under FTP by the exporters/importers. However, certain documents like
Certificates issued by Chartered Accountants/ Company Secretary / Cost ----------------------
Accountant etc. have to be filed in physical forms only. In order to move ----------------------
further towards paperless processing of reward schemes, it has been decided
to develop an online procedure to upload digitally signed documents by ----------------------
Chartered Accountant / Company Secretary / Cost Accountant. In the
new system, it will be possible to upload online documents like annexure ----------------------
attached to ANF 3B, ANF 3C and ANF 3D, which are at present signed ----------------------
by these signatories and submitted physically.
Notes Henceforth, hardcopies of applications and specified documents would
not be required to be submitted to RA, saving paper as well as cost and time for
---------------------- the exporters. To start with, applications are being covered (which account for
nearly 70% of total applications in DGFT
----------------------
As a measure of ease of doing business, landing documents of export
---------------------- consignment as proofs for notified market can be digitally uploaded in the
---------------------- following manner:-
(i) Any exporter may upload the scanned copy of Bill of Entry under his
---------------------- digital signature.
---------------------- (ii) Status holders falling in the category of Three Star, Four Star or Five Star
Export House may upload scanned copies of documents.
----------------------
Online inter-ministerial consultations:
----------------------
It is proposed to have Online inter-ministerial consultations for approval
---------------------- of export of SCOMET items, Norms fixation, Import Authorisations, Export
Authorisation, in a phased manner, with the objective to reduce time for
---------------------- approval. As a result, there would not be any need to submit hard copies of
documents for these purposes by the exporters.
----------------------
Simplification of procedures/processes, digitisation and e-governance
----------------------
Under EPCG scheme, obtaining and submitting a certificate from an
---------------------- independent Chartered Engineer, confirming the use of spares, tools, refractory
and catalysts imported for final redemption of EPCG authorizations has been
---------------------- dispensed with.
---------------------- At present, the EPCG Authorisation holders are required to maintain
records for 3 years after redemption of Authorisations. Now the EPCG
---------------------- Authorization Holders shall be required to maintain records for a period of two
---------------------- years only. Government’s endeavour is to gradually phase out this requirement
as the relevant records such as Shipping Bills, e-BRC are likely to be available
---------------------- in electronic mode which can be archived and retrieved whenever required.
---------------------- Exporter Importer Profile: Facility has been created to upload documents
in Exporter/Importer Profile. There will be no need to submit copies of
---------------------- permanent records/ documents (e.g. IEC, Manufacturing licence, RCMC, PAN
etc.) repeatedly with each application, once uploaded.
----------------------
Communication with Exporters/Importers: Certain information, like
---------------------- mobile number, e-mail address etc. has been added as mandatory fields, in
IEC data base. This information once provided by exporters, would help in
----------------------
better communication with exporters. SMS/ email would be sent to exporters to
---------------------- inform them about issuance of authorisations or status of their applications.
Online message exchange with CBDT and MCA: It has been decided to
----------------------
have on line message exchange with CBDT for PAN data and with Ministry
---------------------- of Corporate Affairs for CIN and DIN data. This integration would obviate the
need for seeking information from IEC holders for subsequent amendments/
---------------------- updation of data in IEC data base.

Communication with Committees of DGFT: For faster and paperless Notes
communication with various committees of DGFT, dedicated e-mail addresses
have been provided to each Norms Committee, Import Committee and Pre- ----------------------
Shipment Inspection Agency for faster communication.
----------------------
Online applications for refunds: Online filing of application for refund of
TED is being introduced for which a new ANF has been created. ----------------------
New initiatives for EOUs, EHTPs and STPs ----------------------
(a) EOUs, EHTPs, STPs have been allowed to share infrastructural facilities ----------------------
among themselves. This will enable units to utilize their infrastructural
facilities in an optimum way and avoid duplication of efforts and cost to ----------------------
create separate infrastructural facilities in different units.
----------------------
(b) Inter unit transfer of goods and services have been allowed among EOUs,
EHTPs, STPs, and BTPs. This will facilitate group of those units which ----------------------
source inputs centrally in order to obtain bulk discount. This will reduce
cost of transportation, other logistic costs and result in maintaining ----------------------
effective supply chain. ----------------------
(c) EOUs have been allowed facility to set up Warehouses near the port of
export. This will help in reducing lead time for delivery of goods and will ----------------------
also address the issue of un-predictability of supply orders. ----------------------
(d) STP units, EHTP units, software EOUs have been allowed the facility to
----------------------
use all duty free equipment/goods for training purposes. This will help
these units in developing skills of their employees. ----------------------
(e) 100% EOU units have been allowed facility of supply of spares/
----------------------
components up to 2% of the value of the manufactured articles to a buyer
in domestic market for the purpose of after sale services. ----------------------
(f) At present, in a period of 5 years EOU units have to achieve Positive ----------------------
Net Foreign Exchange Earning (NEE) cumulatively. Because of adverse
market condition or any ground of genuine hardship, then such period of ----------------------
5 years for NFE completion can be extended by one year.
----------------------
(f) Time period for validity of Letter of Permission (LOP) for EOUs/
EHTP/ STPI/BTP Units has been revised for faster implementation and ----------------------
monitoring of projects. Now, LOP will have an initial validity of 2 years
to enable the unit to construct the plant and install the machinery. Further ----------------------
extension can be granted by the Development Commissioner up to one ----------------------
year. Extension beyond 3 years of the validity of LOP, can be granted,
in case unit has completed 2/3rd of activities, including the construction ----------------------
activities.
----------------------
(g) At present, EOUs/EHTP/STPI units are permitted to transfer capital
goods to other EOUs, EHTPs, STPs, SEZ units. Now a facility has been ----------------------
provided that if such transferred capital goods are rejected by the recipient,
then the same can be returned to the supplying unit, without payment of ----------------------
duty. ----------------------
Notes (h) A simplified procedure will be provided to fast track the de-bonding / exit
of the STP/ EHTP units. This will save time for these units and help in
---------------------- reduction of transaction cost.
---------------------- (i) EOUs having physical export turnover of Rs.10 crore and above, have
been allowed the facility of fast track clearances of import and domestic
---------------------- procurement. They will be allowed fast tract clearances of goods,
for export production, on the basis of pre-authenticated procurement
----------------------
certificate, issued by customs / central excise authorities. They will not
---------------------- have to seek procurement permission for every import consignment.
Facilitating & Encouraging Export of dual use items (SCOMET).
----------------------
(a)
Validity of SCOMET export authorisation has been extended from
---------------------- the present 12 months to 24 months. It will help industry to plan their
activity in an orderly manner and obviate the need to seek revalidation or
----------------------
relaxation from DGFT.
---------------------- (b) Authorisation for repeat orders will be considered on automatic basis
---------------------- subject to certain conditions.
(c) Verification of End User Certificate (EUC) is being simplified if SCOMET
---------------------- item is being exported under Defence Export Offset Policy.
---------------------- (c) Outreach programmes will be conducted at different locations to raise
awareness among various stakeholders.
----------------------
e-Commerce Exports
----------------------
(a) Goods falling in the category of handloom products, books / periodicals,
---------------------- leather footwear, toys and customized fashion garments, having FOB
value up to Rs.25000 per consignment (finalized using e-Commerce
---------------------- platform) shall be eligible for benefits under FTP. Such goods can be
exported in manual mode through Foreign Post Offices at New Delhi,
----------------------
Mumbai and Chennai.
---------------------- (b)
Export of such goods under Courier Regulations shall be allowed
manually on pilot basis through Airports at Delhi, Mumbai and Chennai
----------------------
as per appropriate amendments in regulations to be made by Department
---------------------- of Revenue. Department of Revenue shall fast track the implementation
of EDI mode at courier terminals.
----------------------
Duty Exemption
---------------------- (a) Imports against Advance Authorization shall also be eligible for exemption
---------------------- from Transitional Product Specific Safeguard Duty.
(b) In order to encourage manufacturing of capital goods in India, import
----------------------
under EPCG Authorisation Scheme shall not be eligible for exemption
---------------------- from payment of anti-dumping duty, safeguard duty and transitional
product specific safeguard duty.
----------------------
----------------------

Notes
Activity 1
----------------------
1. Visit www.rbi.org.in and find out the changes in regulations regarding ----------------------
imports and exports. List out any two changes each for imports and
exports. ----------------------
2.
Visit the web site of the Industry & Commerce Ministry and ascertain ----------------------
the details of Foreign Trade Policy 2015-2020. Find out five important
points which will give boost to our foreign trade. ----------------------
----------------------
Summary
----------------------
• In the initial years of planning, the emphasis was on “export promotion
----------------------
and import substitution. Earlier, there was a list called Open General
license (OGL) for which freedom was given to export and import. After ----------------------
the process of globalisation and liberalization, Govt. has been following
Free Trade Policy. At present, Import-Export activities are administered ----------------------
in India under the Foreign Trade (Development and Regulation) Act, 1992
and Foreign Trade (Regulation) Rules, 1993 framed there under. The ----------------------
name of the policy has been changed from “Export and Import (EXIM) ----------------------
• Policy to Foreign Trade Policy .The Government of India has taken several
measures to promote exports. The Export and Import Policy 1992, 1997 ----------------------
was a significant landmark in India’s economic history. It made for the first ----------------------
time, conscious efforts to dismantle various protectionist and regulatory
policies and accelerate the country’s transition towards a globally oriented ----------------------
economy. All goods may be freely imported and exported, save for two
negative lists- one for exports and the other for imports. All restrictions ----------------------
on the import of raw materials and capital goods have been removed.
----------------------
Attempt was made in real sense to abolish License and permit Raj.
----------------------
Keywords
----------------------
• Open General License: List of goods for which the license to import is not
required. ----------------------
• EOUs: Export Oriented Units. ----------------------
• STPs: Soft ware Technology Parks
----------------------
• Negative List: List of goods for which the import is prohibited or restricted
or canalised. ----------------------
• BCBS: Basel Committee on Banking Supervision.
----------------------
Self-Assessment Questions ----------------------
1. Explain the Foreign Trade Development & Regulation Act, 1992. ----------------------
2. Explain the main provisions related to Exports issued by RBI. ----------------------
3. Explain the provisions related to Imports issued by RBI.
Notes 4. What are the objectives of Exchange Control in India?
5. What are the types for Status Holder Exporters? Explain the benefits available.
----------------------
6. State the salient features of the Foreign Trade Policy 2015-2020.
---------------------- 7. Write short notes on:
a. Export Promotion Capital Goods Scheme
----------------------
b. Objective of EXIM Policy
---------------------- c. DGFT
---------------------- d. Export Promotion Measures.
e. Service Exports.
----------------------
f. Basel II Norms.
---------------------- g. Asian Development Bank.
---------------------- h. Deposit Insurance & Credit Guarantee Corp.
---------------------- Answers to Check your Progress

---------------------- 1. IBRD, also known as World Bank, has two affiliates, International
Finance Corporation (IFC) and International Development Association
---------------------- (IDA).
2. As per the recommendations of the Bretton Woods Conference of 1944,
----------------------
two institutions, i.e., International Monetary Fund (IMF) and World Bank
---------------------- was established in 1946.
3. Asian Development Bank (ADB) was established to foster economic
---------------------- development of the Asian countries.
---------------------- Check you Progress 2
---------------------- State True or False.
1. True
----------------------
2. False
---------------------- 3. True
---------------------- 4. True
----------------------
Suggested Reading
----------------------
1. www.rbi.org.in
----------------------
2. RBI Report on Trend & Progress of Banking in India
---------------------- 3. Abhyankar, Dr. Hemant and Shri S. V. Hajeri. Foreign Trade & Foreign Policy.
---------------------- 4. Latest document of foreign trade policy from government of India.
----------------------

Banks engaged in Business of International Banking
UNIT
3
Structure:
3.1 Introduction
3.2 Correspondent Banks
3.3 Import Finance
3.4 Export Finance
3.5 Different Stages of Export Finance
3.6 Pre-shipment Credit in Foreign Currency (PCFC)
3.7 Post Shipment Export/Finance
3.8 Risk Management in International Banking
3.9 Deemed Exports
Summary
Key Words
Suggested Reading
Banks engaged in Business of International Banking 53

Notes
Objectives
----------------------
----------------------
• Analyse the international banking functions of banks
----------------------
• Describe the procedure for availing of finance for imports and
---------------------- exports
• List the bank’s requirement for raising finance
----------------------
---------------------- 3.1 INTRODUCTION

---------------------- Owing to globalisation, liberalization and privatisation, there is tremendous
---------------------- increase in international trade. In the post-reform era, the role and nature of
activity of the financial institutions have undergone sea change. Banks play a
---------------------- vital role in international trade, by extending financial assistance to the exporters
as well as importers. International trade brings many direct and indirect benefits
---------------------- to our country and the Government of India has been encouraging international
---------------------- trade by taking series of measures. Specialised financial institutions like Export
Import Bank of India (EXIM Bank), Export Credit Guarantee Corporation have
---------------------- been set for this purpose. While EXIM bank extends finance and offers other
facilities to the exporters and importers, ECGC provides insurance cover against
---------------------- various types of risks in international trade.
---------------------- Reserve Bank of India has specifically included Export credit in Priority
Sector Lending.
----------------------
The entire system of foreign inflow and outflow is regulated/or monitored
---------------------- through a network of Authorised Dealers commonly known as commercial
banks. The legal framework for administration of foreign exchange transactions
---------------------- in India is provided by the Foreign Exchange Management Act, 1999. Under
---------------------- the Foreign Exchange Management Act, 1999 (FEMA), which came into force
with effect from June 1, 2000, foreign exchange can be purchased/sold from
---------------------- any authorised person, such as Authorised Dealer (AD). Full-Fledged Money
Changers (FFMCs) are also permitted to release exchange for business purposes.
----------------------
---------------------- 3.2 CORRESPONDENT BANKS

---------------------- Our domestic commercial banks enter into tie-up arrangements with banks/
financial institutions in other countries. Such banks are known as Correspondent
---------------------- banks. The services of correspondent banks are used by domestic commercial
---------------------- banks in order to service transactions originating in foreign countries, and act
as a domestic bank’s agent abroad. This is done because the domestic bank may
---------------------- have limited access to foreign financial markets and cannot service its client
accounts without opening up a branch in another country. For example: If a
---------------------- Brazilian bank is a correspondent bank of an Indian Bank, the Brazilian Bank
---------------------- provides banking services to the India bank’s clients in Brazil. A wide network
of correspondent banks helps domestic bank’s customers in the following ways:
a)
Domestic bank’s clients i. e .Importers can have their import LCs Notes
established through them and advised by their correspondents spread
over the globe. As domestic bank has good standing in the international ----------------------
market, the LCs established by domestic banks is accepted internationally.
Nonetheless, in case the supplier wants our LCs to be confirmed by a ----------------------
bank in his country, the correspondent banks would be pleased to add ----------------------
their confirmation to the LCs established by domestic banks.
b) Outward Remittances towards import payments and for other purposes ----------------------
will be affected with ease as per FEMA regulations. ----------------------
c) Quick collection of Export Bills and clear instruments through the world
----------------------
wide network of correspondents.
d) Adequate drawing arrangements by domestic banks with a number of our ----------------------
correspondents. Remittances by way of DD / TT / Swift can be initiated
----------------------
through any of correspondents worldwide.
e) The correspondent banks should be selected with great care to ensure that ----------------------
the local bank’s customers get the best and most reliable service in the
----------------------
foreign lands at most competitive rates.
Nostro Accounts are maintained by an Indian Bank with correspondent ----------------------
banks/ overseas banks in foreign currency to settle its foreign currency ----------------------
transactions. The Indian banks maintain Nostro accounts in 9 major currencies
i.e. US Dollar, Pound Sterling, Euro, Japanese Yen, Singapore Dollar, Swiss ----------------------
Franc, Hong Kong Dollar, Canadian Dollar and Australian dollar. With the help
of our Nostro accounts, Indian banks affect remittances in foreign currency and ----------------------
payment/settlement of other cross currency transactions. ----------------------
Vostro Account is the account of a foreign bank maintained with local
bank or branch is called as Vostro account. These accounts are maintained by ----------------------
foreign banks with India banks to settle their foreign currency transactions. ----------------------
3.3 IMPORT FINANCE ----------------------
Bank as an authorised dealer in foreign exchange in India, can issue a Letter ----------------------
of Credit or Bank Guarantee in favour of the Exporter. This is the Contingent ----------------------
liability of the Banks.
Banks in India normally open import (foreign) L/C under following ----------------------
circumstances- ----------------------
• When a resident in India is importing goods into India.
----------------------
•
When a resident merchant trader is purchasing goods from one country for
sale to another country, for the purpose of merchandising trade. ----------------------
•
When an exporter who is executing a contract abroad requires importing ----------------------
goods from a third country to the country where he is executing the contract.
Parties to the Letter of Credit Transaction ----------------------
• Applicant/Buyer/importer - on whose behalf LC is opened. ----------------------

Notes • Beneficiary/seller/exporter -on whose favour the LC is opened.
• Opening bank - which opens/establishes the LC.
----------------------
• Advising Bank - which advises the LC.
----------------------
• Confirming Bank -which confirms the LC.
---------------------- • Negotiating Bank -normally beneficiary’s bank.
---------------------- •
Reimbursing Bank - which normally maintains Nostro account of the opening
Bank and reimburses the negotiating bank.
----------------------
Regulations
----------------------
While considering requests for opening such L/C s, Bank should ensure
---------------------- compliance of
• Trade Control Requirements under EXIM Policy.
----------------------
• Exchange Control Requirements.
----------------------
• Credit Norms of R.B.I.
---------------------- • FEDAI AND UCP ICC 600 guidelines.
---------------------- • Bank’s Internal Procedures.
---------------------- The Trade Control Requirements under EXIM Policy 2009-2014 lays
down the policy and regulations related to physical movement into India. As
---------------------- a Banker, one should ensure whether the goods concerned can be physically
brought into India as per current EXIM Policy. The other important guidelines
----------------------
are:
---------------------- a) The applicant must possess an Importer-Exporter Code Number (IEC)
allotted by the Director General of Foreign Trade (DGFT), unless they
----------------------
belong to an exempted category.
---------------------- b) If import is covered under license, an importer must submit Exchange
Control copy of the same. The detail scrutiny of the License should be
----------------------
ensured by the Banker.
---------------------- The scope of exchange control is to oversee the payments and receipts by
---------------------- residents to Non- Residents and vice-versa. In Import L/C, an Indian importer
is (resident) and the overseas supplier is (non- resident).
---------------------- Hence, as a Banker it should be ensured that-
---------------------- i) The L/C applicant is the bank’s customer who is having satisfactory
dealings and is known to be participating in such trade.
----------------------
ii) L/C should not be opened for import of goods which are under restricted
---------------------- category unless the importer submits original license marked ‘For
Exchange Control Purposes’. Import Licenses are for the CIF value and
----------------------
cannot be utilised for the full amount to cover the FOB value of import.
---------------------- iii) Even though opening L/C is known as Non fund based facility to the
importer as there is no immediate outgo of funds from banks, the Banker,
----------------------

as AD will apply all precautions applicable to funds based facility while Notes
sanctioning LC Limits. This needs to be ensured as this facility has the
potential to turn to funded facility. ----------------------
iv) Authorised Dealer will effect advance payment in case of imports subject ----------------------
to the prescribed limits and conditions by RBI.
----------------------
v) Remittance against imports should be completed within 6 months from
the date of import. Payment terms involving settlements beyond 6 months ----------------------
from import date are treated as External Commercial Borrowings and
require prior approval of RBI/Govt. ----------------------
vi) The import license, the Exchange Control copy shall be endorsed by the ----------------------
Bank at the following transactions:-
----------------------
a) Opening of L C.
b) Remittance of import bill received under L C. ----------------------
c) Remittance of import bill not drawn under L C. ----------------------

d) Advance remittance. ----------------------
e) Forward Contract booked for imports covered under the License.
----------------------
f) Insurance and/or freight paid by the importer in Indian Rupees.
----------------------
When the Import License is fully utilised, AD should preserve the same
for verification by the auditors and extra care should be taken while sanctioning ----------------------
facilities on DA basis or for import of capital goods. When the import L/C is
to cover import of capital goods, banks should ensure availability of adequate ----------------------
long terms funds for value of import and customs duties thereon. Banks should ----------------------
asses and extend the facility with all the precautions that are taken for granting
of a term loan. ----------------------
After credit limits are sanctioned, banks normally obtain main security ----------------------
documents like execution of pledge/hypothecation agreements, guarantee from
borrower/sureties as per sanction terms. This documentation is in addition to ----------------------
the individual credit application-cum-agreement taken at the time of opening
the letter of credit. FEDAI has evolved a standard credit format for adoption by ----------------------
banks based on ICC standard credit application with suitable modifications to ----------------------
suit Indian situations.
----------------------
It should also be ensured that every LC is to be issued subject to provisions
of UCPDC. Credit must incorporate a clause stating that “Except as otherwise ----------------------
expressly stated” this Documentary credit is issued subject to Uniform Customs
and Practice for Documentary Credits, 1993 Revision, ICC Publication No.600. ----------------------
Based on the L/C or Bank Guarantee issued by the Bank, the exporter ships ----------------------
the goods and importer/ his banker parts with the funds only on the shipment
of the goods. Sight import bills received under L/C and drawn in conformity to ----------------------
credit terms has to be retired by the importer on or before 10 days from the date
----------------------
of receipt of the documents by the Bank.
----------------------

Notes In case of non-payment by the drawee within 10 days, the importer’s
liability on the Foreign Currency Bill shall be crystallised by converting the
---------------------- Foreign Currency amount into Rupees at the Bills selling rate on the 10th day
or the forward exchange contract rate, whichever is applicable.
----------------------
While opening LC or remitting payment for imports, authorised dealer
---------------------- should bring to the notice of importers that they should produce the Exchange
Control copy of the Bill of Entry duly approved by customs. This is required
----------------------
to ascertain that the goods have been actually imported into India. Authorised
---------------------- dealer will cross check the particulars in the Bill of Entry with the particulars of
LC opened/remittance made for imports.
----------------------
If the Bills of Entry is not submitted within six months from the date
---------------------- of remittance, the authorised dealer should remind the importer to submit the
exchange control copy to the Bill of Entry and if not received within another
---------------------- three months, AD will report the details of defaulters to RBI through half yearly
return “BEF.”
----------------------
----------------------
---------------------- 1. Vastro account is the account of foreign bank maintained with local
---------------------- Indian bank to settle their foreign currency transactions.
2. Reserve Bank of India has excluded export credit in priority sector.
----------------------
3. For imports, the importer should have an Import-Export Code Number
---------------------- allotted by the Director General of Foreign Trade.
----------------------
---------------------- 3.4 EXPORT FINANCE
---------------------- Export finance is a short term, working capital finance allowed to an exporter.
An exporter may avail financial assistance from any bank provided following
---------------------- two conditions are satisfied.
---------------------- a) Funds should be made available to the exporter at the required time,
by banks by speedy sanctioning of the export credit limits. RBI has
---------------------- stipulated to commercial that 12% of their total credit should be under
export finance.
----------------------
b) Cost of the funds should be affordable. In order to compete in the
---------------------- International market the exporter may require credit facility at the
---------------------- cheapest interest rate. Hence, the export finance is normally available at
a lower rate of interest as compared to the finance for domestic activity.
---------------------- At present R.B.I. has directed the banks to provide rupee finance at rate
of interest not exceeding 2.5% less than PLR. The assistance provided by
---------------------- commercial banks in respect of export finance can be grouped as follows:
----------------------

Commercial Banks Notes
Regulations related to Export Finance
----------------------
When a commercial bank deals in export finance, it is bound by the following
----------------------
guidelines/regulations:
i) Reserve Bank’s Guidelines -Exchange Control Regulations – FEMA, ----------------------
1999 -IECD guidelines -DBOD guidelines.
----------------------
ii) Trade Control Regulations (EXIM Policy).
----------------------
iii) International Chambers of Commerce (ICC) guidelines – UCPDC -ICC
500 and URC – ICC 522 ----------------------
iv) Export Credit Guarantee Corporation guideline ----------------------
v) FEDAI Guidelines.
----------------------
Various sources for raising finance for export are as follows:
----------------------
a) Own funds b) Friends and relatives c) Advance payment from buyer d)
Trade credits from suppliers. e) Banks and financial institutions. ----------------------
As mentioned above, the export financing is broadly divided into two types ----------------------
i.e. Pre-shipment credit and post shipment credit. There can be fund based and
non fund- based financing. The advisory services include collection of useful ----------------------
information on credit worthiness of the foreign buyer through bank’s branch
abroad or through correspondent banker. The banks issue bank certificates in ----------------------
respect of export sales value, which are useful to the exporter for claiming ----------------------
incentives.
----------------------
3.5 DIFFERENT STAGES OF EXPORT FINANCE
----------------------
A) Pre-shipment/Packing Credit ----------------------
Pre-shipment/Packing Credit means any loan or advance granted or any
other credit provided by a bank to an exporter for financing the purchase, ----------------------
processing, manufacturing or packing of goods prior to shipment, on the ----------------------
basis of irrevocable confirmed letter of credit opened in his favour or
in the favour of some other person, by an importer i.e. overseas buyer ----------------------
or a confirmed and irrevocable order for export from India. Although
initially, this finance is made available without any security, the goods ----------------------
purchased out of these funds are charged i.e. hypothecated/pledged to ----------------------
the bank and the pre shipment advance becomes a secured advance. It
should be ensured that the pre-shipment/packing advance is repaid from ----------------------
the proceeds of the export bills by purchase/discounting or negotiation of
export bill. Usually, the period of packing credit is related to the operating ----------------------
cycle, but it is normally restricted to 180 days. It is expected that within ----------------------
this period, the export will take place and the packing credit will be
liquidated from the proceeds of the export bill. ----------------------
----------------------

Notes While appraising export credit proposal, besides usual techno-economic
viability and due diligence of the prospective exporter, the Commercial banks
---------------------- should take care of following:
---------------------- •
Banks should meet the genuine credit requirements of the export sector
promptly and in full. Exporter’s credit requirements at pre and post shipment
---------------------- are to be considered in total.
---------------------- •
In addition to the normal routine appraisal by banks, bank should specifically
look into the aspect of the Product Profile, Country Profile and the Commodity
---------------------- Profile. It is advisable to look into the status report on the prospective buyer
with whom the exporter proposes to deal with. Such status report on the
---------------------- buyer can be obtained from ECGC or any international consultants like
---------------------- Dun& Bradstreet.
•
Banks should adopt any of the working capital method i.e. Projected Balance
---------------------- Sheet method, Turnover method or Cash Budget method for assessment of
---------------------- working capital requirements of the exporter, whichever is most suitable and
appropriate to their business operations.
---------------------- In case of established exporters having satisfactory track record, banks
---------------------- should consider sanctioning a ‘Line of credit’ for a longer period, say 3
years, with in-built flexibility to step-up/step down the quantum of limits
---------------------- within overall limits assessed.
---------------------- Packing credit advance can be allowed for a maximum period of 180 days
•
or till the date of submission of documents whichever is earlier. In case
---------------------- the exporter is unable to ship the consignment within 180 days, extension
of 90 days can be granted by the Authorised Dealer provided the contract
---------------------- or the letter of credit against which the packing credit was granted also
---------------------- gets extended.
•
In case of export of seasonal commodities, agro-based products etc., banks
---------------------- should sanction peak/non peak credit facilities to the exporters. The inter-
---------------------- changeability of pre-shipment and post-shipment credit limits may be
permitted.
---------------------- The quantum of finance will be fixed on the FOB (Free on Board) value
---------------------- of the contract/LC or on the domestic value of the goods whichever is lower.
Normally, insurance and freight charges need not be financed at the initial stage
---------------------- of disbursement. If the exporter wants to avail of advance against insurance and
freight charges then that can be considered at the later stage of the pre-shipment
---------------------- operations when the consignment gets ready for shipment. If the contract or the
---------------------- LC is on CIF basis, the FOB value will be arrived at by deducting around 15%
(representing freight and insurance charges) from the CIF value if the dispatch
---------------------- is through sea and around 25% if the despatch is by air.
---------------------- The banker should comply with-
a) The Exchange Control Regulation under FEMA i.e.
----------------------
i) Exporter should be a regular customer, bona fide exporter and
---------------------- should have a good position in the market.

ii) Exporter should not be under the caution list of RBI. Notes
iii)
Provisions made by RBI in Foreign Exchange Management
----------------------
(Borrowing and Lending in Foreign Exchange) Regulations, 2000.
b) Under Foreign Trade Policy (EXIM) Policy. ----------------------
i) Exporter should have an IE Code number allotted by DGFT. ----------------------
ii) Goods must be freely exportable i.e. it should not be classified as ----------------------
banned/canalised / restricted. If it is restricted there should be a
valid license allowing the export. This information will be available ----------------------
from EXIM Policy-Classification of export and imports items. If
the commodity falls under quota system, proper quota should have ----------------------
been granted. ----------------------
iii) Country with which our prospective exporter wants to trade should
not be under the list of trade barrier. ----------------------
----------------------
----------------------
Multiple Choice Multiple Response. ----------------------
1. Preshipment finance is: ----------------------
i. A loan to exporter for manufacturing goods
----------------------
ii. Repaid from proceeds of export bill
----------------------
iii. Granted normally up to 180 days
iv. Known as post-shipment finance ----------------------
2. While dealing with export finance, the Authorised Dealer is guided by: ----------------------
i. Exchange control regulations under FEMA, 1999 ----------------------
ii. Exim Policy
----------------------
iii. FEDAI Guidelines
----------------------
iv. DICGC Guidelines
v. ECGC Guidelines ----------------------
3. Sources for raising finance for exports are: ----------------------
i. Advance payment from buyer ----------------------
ii. Trade credits from suppliers
----------------------
iii. Bank’s finance
----------------------
iv. Personal loan
----------------------
----------------------
----------------------

Notes
Activity 1
----------------------
---------------------- Visit a branch of any bank and obtain detailed information in respect of the
procedure for sanctioning Packing Credit Limits. Write about three main
---------------------- observations you make during the process.
----------------------
3.6 PRE-SHIPMENT CREDIT IN FOREIGN CURRENCY (PCFC)
----------------------
---------------------- The Packing credit limits can be sanctioned in Indian Rupees. If an

exporter has to import raw material from another country, the pre-shipment/
---------------------- packing credit finance can be sanctioned in foreign currency denomination.
This is known Packing Credit Foreign Currency (PCFC).
----------------------
This facility will be an additional window available to the exporters
---------------------- along with the existing rupee packing credit. The facility will be available in all
convertible currencies.
----------------------
To enable the export to compete in the international market effectively,
---------------------- the exporters need the finance at the rates of interest prevailing in international
markets. The London Inter Bank Offer Rate (LIBOR). R.B.I. has directed the
----------------------
banks to finance exporters in foreign currency at LIBOR basis. The scheme
---------------------- envisages Authorised Dealers (ADs) extending PCFC to cover both, the domestic
as well as imported inputs, which will be used for the exports. The facility will
---------------------- generally be available for a period of 180 days on the basis of firm export order
or irrevocable L/C. PCFC can be made available to the supplier EOU (export
----------------------
oriented unit)/EPZ (export processing zone)/ SEZ (special economic zone) unit
---------------------- and the receiver EOU/EPZ/SEZ unit. PCFC can be allowed only for deemed
exports for supplies to projects financed by multilateral or bilateral agencies.
----------------------
The source of funds to ADs will be-
---------------------- a) On-shore foreign exchange funds available with them by way of balances
in Exchange Earners’ Foreign Currency Accounts (EEFC),
----------------------
b) Resident Foreign Currency Account (RFC),
----------------------
c) Foreign Currency (Non-Resident) (FCNR) Account (Banks) Scheme,
---------------------- d) The banks have also been permitted to raise lines of credit abroad without
---------------------- prior permission of Reserve Bank of India so long as the spread is within
the norms.
----------------------
The PEFC facility can be extended to ‘Running Account facility’ to
---------------------- all commodities as well. However, the banks should ensure to monitor the
production of firm order or Letter of Credit subsequently by the Exporter as
---------------------- well as end use of the funds. The rate of interest on PCFC borrowings from
banks should not exceed 50 basis points over LIBOR. The exporter can opt on
----------------------
the currency of finance based on interest rate differential (IRD) between the two
---------------------- currencies and the exchange rate differential (ERD) premium/discount between

two currencies. If the IRD > ERD, then it is advantageous to avail of Rupee Notes
finance.
----------------------
3.7 POST SHIPMENT EXPORT/FINANCE ----------------------
Post shipment finance is essentially an advance against receivables, ----------------------
which will be in the form of shipping documents. When an exporter has availed
pre-shipment finance from a bank, he has to hand over all the documents ----------------------
pertaining to an export along with Letter of Credit after shipment of goods.
The Bank negotiates the documentary bills drawn under L/C and proceeds ----------------------
are appropriated towards pre-shipment finance, pertaining to that order. Thus, ----------------------
the pre-shipment finance is liquidated out of the post shipment finance. RBI
monitors the realisation of full proceeds of individual shipments made by an ----------------------
exporter through the Banker, Authorised Dealer (AD).
----------------------
Export Letters of Credits
----------------------
Letters of Credits are the legal financial instruments most frequently used
to guarantee payment for goods and services imported and exported. They ----------------------
mitigate the financial risks of doing business in unfamiliar economies. They are
a very common form of international payment. They provide a high degree of ----------------------
protection for both the parties. L/Cs established in favour of Indian residents by
----------------------
persons resident outside India for purchase of goods and services are referred to
as Export Letters of Credit. Such L/ Cs may be received for following purposes- ----------------------
a) For physical export of goods and services from India to a foreign country.
----------------------
b)
For execution of projects (project exports) outside India by Indian
exporters by supply of goods and services from India or partly from India ----------------------
and partly from outside India (third countries).
----------------------
c) Towards deemed exports where projects financed in foreign exchange
by multilateral agencies, UN organisations or projects being executed in ----------------------
India with the aid of external agencies. ----------------------
d) For sale of goods by Indian exporters with total procurement and supply
from outside India (merchandising trade by Indian intermediary). ----------------------
In all above cases, there would be earning of foreign exchange or ----------------------

conservation of foreign exchange. Banks in India associate themselves with the
export L/C s in various capacities such as Advising Bank, Confirming Bank, ----------------------
Transferring Bank, Reimbursing Bank or as remitting bank. ----------------------
Transfer of Export LC s
----------------------
Beneficiaries of Export LCs may often approach the banks concerned for
transfer of LCs in favour of one or more beneficiaries. Hence, Banks effecting ----------------------
transfer must comply with following important UCPDC provisions (article 46
----------------------
of UCPDC) besides Exchange Control Regulations.
i) A credit can be transferred only when it is expressly designated as ----------------------
‘TRANSFERABLE’ by the issuing bank and at the request of the ----------------------
beneficiary.

Notes ii) A credit can be transferred only by the bank which is entitled to effect
settlements under the credit.
----------------------
iii) Unless otherwise stated in the credit as transferable, Credit cannot be
---------------------- transferred again at the request of the second beneficiary to whom it has
been transferred. For example, if transferable credit is opened in favour of
---------------------- “X” AND “X” has transferred the same in favour of “Y” (who is known
as Second Beneficiary), “Y” cannot further transfer the LC to another
----------------------
party. However, the credit can be re-transferred to the First Beneficiary.
---------------------- Negotiation/Discounting of documentary bills under export LCs
---------------------- Scrutiny of documents presented under a L/C is a crucial and sensitive
function of banks in entire credit operations, particularly for the Issuing Bank
---------------------- and the Confirming Bank. Decisions to make payment against the documents
presented depends solely on the result of this scrutiny. The Bank official should
----------------------
have complete and comprehensive information and knowledge of the conditions
---------------------- of the relative credit, provisions of UCPDC and their implications. Since in
credit operations the basis of dealing is ‘documents’(and not goods), a small
---------------------- omission or negligence can lead to substantial losses and embarrassment to the
bank.
----------------------
What is this Uniform Customs and Practices for Documentary Credits
---------------------- (UCPDC)? In order to enable banks in all countries to follow uniform practices
---------------------- with regard to handling of documentary credits, the International Chamber of
Commerce has standardised a set of Rules. These rules are referred to as the
---------------------- Uniform Customs and Practice (UCP) for Documentary Credit and are currently
listed in ICC Publication No. 600. These Customs and Practices are binding
---------------------- on all the parties. The obligations and responsibilities of the issuing bank,
---------------------- negotiating bank and accepting bank are also set out. Credits by their nature are
separate transactions from the sales or other contracts and credit instructions
---------------------- must be clear and separate from the sale and other contracts. The revised UCP
600 contains only 39 Articles instead of 49 Articles in UCP 500. It has come
---------------------- into effect only 1st July 2007, incorporating a number of changes from UCP
---------------------- 500 which were followed by banks for more than a decade till June 2006.
The usual documents to be enclosed for availing post shipment along
---------------------- with original Letter is as follows-
---------------------- a) Bill of Exchange: The Bill of Exchange is an important document used in
foreign trade. The bill of exchange is a negotiable instrument under Indian
---------------------- Negotiable Instruments Act, 1881. The beneficiary/exporter should draw
---------------------- it as per the tenor stipulated in the L/C. It should be drawn either on
the Issuing Bank or on the Confirming Bank or on the Nominated Bank
---------------------- as per the stipulations of the Documentary Credit. It should indicate the
LC Number and the name of the Bank. The amount should not exceed
---------------------- the LC value/Invoice value. It should be properly stamped if it is on DA
---------------------- (documents against acceptance) basis. The Clean Bills are not accompanied
by shipping documents. The documentary bills are accompanied by the
---------------------- shipping and other related documents.

b) Invoice: The Beneficiary as mentioned in the Letter of Credit should Notes
draw the invoice. It should be drawn in the name of the opener of Letter of
Credit. The description of the merchandise should be exactly in agreement ----------------------
with that mentioned in the LC. The reference number of the LC and the
bank, which has been opened, should be mentioned in the invoice. The ----------------------
Invoice value should not exceed the Letter of Credit value. The terms of ----------------------
Contract such as CIF, CFR and FOB should be clearly indicated in the
invoice as mentioned in the credit. The term CFR means the seller must ----------------------
pay the cost and the freight necessary for the goods to reach the destination
specified. However, the risks of loss or damage to the goods after the time ----------------------
of the delivery are on buyer’s account. The seller is required to clear the ----------------------
goods for exports. The CIF means Cost Insurance and freight (port of
destination). The CIF price states that it covers the cost of the goods, ----------------------
freight necessary to bring the goods to the specified port of destination
and marine insurance as well. The term FOB is the most popular term and ----------------------
is widely in use. FOB means that the seller delivers when the goods pass ----------------------
the ship’s rail at the named port of shipment. Under this term, the buyer
has to bear all costs and risk of loss of damage to the goods from that ----------------------
point. This term is used only for sea or inland waterway transport.
----------------------
The other particulars like Bill of Lading Number, shipping marks, Import
License Number (if any), Gross weight, Net weight etc. should also be ----------------------
mentioned in the invoice. The Invoice should conform to Article 37 of
----------------------
UCPDC. Under Article 35 of UCPDC partial shipments and shipments in
instalments are allowed unless prohibited in terms of LC. ----------------------
c) Bill of Lading: The Bill of Lading is an important document issued by
----------------------
a common carrier, namely, the shipping company or Airways stating that
the goods mentioned therein have been received for shipment or airlift ----------------------
and that it has undertaken to deliver the goods at a named destination. It
is a document of title of goods, transferable by an endorsement. The Bill ----------------------
of Lading should be in sets with the number of non-negotiable copies as
----------------------
stipulated in the LC. It should be marked clean and should not have any
indication to the defective conditions of package or goods etc. In the case ----------------------
of any adverse remarks such as “damaged bags” or “bill torn” or Drums
dirty or old”, such bills are called “claused” or dirty bills as against clean ----------------------
bills.
----------------------
If the bills are kept for too long with the shipper by which time, the
goods might have reached the destination port, the importer has to pay ----------------------
demurrages for non-acceptance of the goods which is due to delay in the
----------------------
receipt of shipping documents. Such delayed bills of lading are called
“Stale Bills.” ----------------------
The description of goods in Bill of Lading should be as per the Letter of ----------------------
Credit requirement and should agree with the description in the invoice.
If the LC stipulates for ‘Shipped on Board’ on Bill of Lading, then the ----------------------
Bill of Lading should evidence goods having been loaded on the vessel ----------------------
and also the date on which it is loaded. ‘Freight Prepaid or ‘Freight to be

Notes paid at Destination’ should be clearly indicated in the Bill of Lading as
per the terms of LC (Article 33 of UCPDC). It should be to the order of
---------------------- the shipper blank endorsed or in favour of the opening bank as stipulated
in the LC. The Shipping marks, if any, should be as mentioned in the LC.
---------------------- The Gross weight/Net weight etc should be as per the Invoice, Weight
---------------------- Certificate etc. The date of shipment should be within the date stipulated
in the LC.
----------------------
In the case of Air Consignment Notes, it should be properly dated, signed
---------------------- and should be in the name of the banker who opened the LC. Flight
Number and date should be indicated in the Airway Bill (Article 23 to 33
---------------------- of UCPDC deals with Transport documents).
---------------------- d) Insurance Policy: Certificate: As the banks are lending against goods in
transport, they mitigate the risks of loss and invariably insist on insurance.
---------------------- Marine insurance is done through a policy of insurance taken at a stated
premium and is quasi negotiable instrument. The insurance policy should
----------------------
be issued and signed by Insurance Company or underwriters or their
---------------------- Agents, but not by brokers and it should be as per the terms of the LC
(Article 34 (a)). The insurance policy must not be dated later than the date
---------------------- of Bill of Lading on board the vessel otherwise it might have retrospective
effect from the date of/on board/ loading/the vessel (Article 34 (e)). The
----------------------
Insurance Policy should be expressed in the same currency as that on the
---------------------- LC (Article 34 f (i)). It must cover at least 110% of the CIF value of goods
(Article 34f (ii)). The LC should indicate the particular risks to be covered
---------------------- words like ‘Usual Risks’, ‘All Risks’, should be avoided. It should be
endorsed blank. It should cover the entire voyage (i.e. warehouse to
----------------------
warehouse). The insurance policy must indicate the name of the Vessel,
---------------------- Bill of Lading, Number and Date, Shipping Marks Description of the
goods (Article 34 to 36 of UCPDC deals with insurance documents).
----------------------
The Banker has to scrutinise whether there are any added clauses on the
---------------------- policy, the amount covered, voyages, goods and risks covered and the
extent of the coverage. The “Institute Clauses” are the standard policy
---------------------- clauses that are included and attached and amplified in the policy to avoid
misunderstanding. Such clauses are accepted by the Institute of London
----------------------
Underwriters.
---------------------- e) Certificate of Origin: This should be issued by the Chamber of Commerce
---------------------- or any other authority as indicated in the LC giving information regarding
Origin of Goods, value, Shipper, Bill of Lading Number etc. The LC
---------------------- should specifically stipulate as to who should issue such document
(Article 21).
----------------------
f) Packing List/Weight List etc.: All other documents like ‘packing list’,
---------------------- ‘weight list’ etc would be as per the LC terms and should be in agreement
with other documents.
----------------------
----------------------

Some of the major exchange control regulations concerning export finance Notes
at the post shipment stage are as follows:
----------------------
a) Exporter should have IEC No and each shipment should accompany the
prescribed declaration (GR-SDF-PP-SOFTEX) forms in which the value ----------------------
of export will be declared and duly certified by the customs authority
----------------------
b) Shipping documents along with relative GR forms must be submitted
to an AD within 21 days from the date of shipment. In case where the ----------------------
exporters present documents pertaining to exports after the prescribed
period of 21 days from the date of export, the ADs may handle them ----------------------
without prior approval of the Reserve Bank of India, provided that they
----------------------
are satisfied with the reasons for the delay.
c) Precious metals i.e. Gold/Silver/Platinum by the Gem & Jewellery units ----------------------
in SEZs and EOUs is equivalent to value of jewellery exported on the
----------------------
condition that the sale contract provides for the same and the approximate
value of the precious metals is indicated in the relevant GR/SDF/PP forms. ----------------------
d) Exporters have been exempted from submission of declaration in the ----------------------
prescribed format for exports of value not exceeding US $ 25000 or its
equivalent. AD s might consider request for the grant of GR waiver from ----------------------
exporters for export of goods free of cost, for export promotion up to 2
% of the average annual exports of the applicant during the preceding ----------------------
three years subject to a ceiling of Rs 5 lakh. For status holder exporters, ----------------------
the limit is Rs10 lakh 2% of average annual export realisation during the
preceding three licensing years, whichever is higher. ----------------------
The payment should be received in an approved manner within the ----------------------
prescribed time limit but within a maximum period of six months from the date
of shipment. Status Holder Exporters and units in Special Economic Zones are ----------------------
permitted to repatriate the export proceeds within a period of 12 months from
the date of export. ----------------------
Crystallization of overdue export bills: ----------------------

If an export bill purchased/negotiated/discounted is not realised on the ----------------------
due date (in case of demand bills within Normal Transit Period and in case
of usance bills on the notional due date), exporter’s foreign exchange liability ----------------------
should be converted into Rupee liability on the 30th day from the notional due
----------------------
date at the prevailing TT Selling rate. If the 30th day falls on a non-banking
day, crystallization should be effected on next working day. In other words, ----------------------
the exchange risk, held by the bank by purchasing/negotiating/discounting the
export bill, will be transferred back to the exporter. ----------------------
However, if the exporter wants to crystallize the overdue export bill he ----------------------
may apply in writing to his banker even before the 30th day from the notional
due date. Subsequently, if the crystallized export bill realizes, the conversion ----------------------
of the foreign exchange, the exchange profit or loss will be on the part of the
----------------------
exporter.
----------------------

Notes Case Study:
M/s Parmjitsingh & Co, Pvt. Ltd., Jai Ganesh Road Panipat
----------------------
Date of incorporation: 03/07/2006
----------------------
Activity: Manufacture and exporter of woollen garment and other accessories
---------------------- SSI Registration NoPPT 2128199701 dated 05/04/2007
---------------------- IEC No 423443298 dated 23/11/2007
---------------------- PAN No AWAB 3212 MN
ISO 9001-2000: 23451 from BVQi 21/04/2008
----------------------
M/s Parmjitsingh & Co Pvt. Ltd is a reputed garment exporter to the customers in
----------------------
USA, France and Germany. Over a period, the Company has customer base of around
---------------------- 12. The company has adequate infrastructure facilities and has gained business
acumen in exports. The Company has been banking with Punjab Mumbai Bank
---------------------- Ltd. (PMC), Panipat Branch and the conduct of loan accounts has been satisfactory.
---------------------- The details of present credit facilities (Rs in lakhs)
---------------------- Particulars Sanctioned limits Balance outstanding
---------------------- Cash Credit Limit Rs. 40.00 Rs. 32.00
Pre shipment Credit Rs. 50.00 Rs. 32.00
---------------------- Export Receivables Rs. 50.00 Rs. 12.00
---------------------- Total W/C Rs. 100.00 Rs. 44.00
Total Credit Facilities Rs. 140.00 Rs. 76.00
----------------------
Brief details of operating statements, i.e Trading & Profit & Loss a/c for the
---------------------- year 31/03/2011
---------------------- Details of operating statement 31/03/2011

1 Total sales 200
---------------------- 2 Cost of goods sold 160
3 Gross Profit 40
---------------------- 4 EBDIT 15
---------------------- 5 Interest on Loans (Including interest on Export credit Rs. 5.00) 6
The total cash accruals for the year are Rs14 lacs. The Company is prompt in
---------------------- repayments of term loan liability. The projected sales during the year 2011-12
---------------------- are Rs.500 lakhs Assumptions:
a) The manufacturing cycle is 3 months.
----------------------
b) All the orders executed are against confirmed Letter of Credit favouring
---------------------- Parmjitsingh & Co. Pvt Ltd.
---------------------- c) The time lag for encashment of LC is one month.
d) The audited financials of the company reveals the satisfactory position
----------------------
and the financial ratios drawn on the basis of analysis of the latest audited
---------------------- financials by the bank are satisfactory. Calculate the requirements of
packing credit and Post shipment credit.
Answer Notes
a) The projected sales during the year 2011-2012 Rs.500 lacs
----------------------
b) The cost of production (say 80% of sales) Rs.400 lacs
----------------------
c) The manufacturing cycle 3 months
d) Packing Credit required 25% of item (B) Rs.100 lacs ----------------------
e) Post shipment credit required Rs.100 lacs ----------------------
Advance against cash incentives/Duty Drawback ----------------------

Where the domestic cost of production of certain goods is higher in relation ----------------------
to international price, Government of India grants certain cash incentives
under the Export Promotion Scheme or refunds the part of excise and customs ----------------------
duty paid by the exporter on goods exported by him which is known as Duty
----------------------
Drawback, so as to give fillip to exports. These benefits/incentives are extended
to make exports more competitive and remunerative. It is an internationally ----------------------
accepted principle that the goods to be exported out of country are relieved
of the duties borne by them at various stages of the manufacture in order to ----------------------
make them competitive in the international market. The cash incentives are
----------------------
released or duty draw back entitlements are advised after the exports are made.
By and large, there is time lag between exports and the actual receipts of these ----------------------
entitlements. In India, the Banks grant finance for this intermediate period
to help the exporters ease their liquidity position. These advances would be ----------------------
liquidated out of the settlement of claims lodged by the exporters. It should be
----------------------
ensured that the bank is authorised to receive the claim amount directly from
the concerned Government authorities. ----------------------
Rediscounting of Export Bills abroad
----------------------
Under this scheme, the banks rediscount export bills in overseas market
by making arrangements with overseas agency/banks by way of a line of credit ----------------------
or bank’s acceptance facility. This is an additional source of finance available to ----------------------
the exporters. Deferred Payment Exports
Sometimes, exports are made but payments are received in instalments at ----------------------
periodic intervals. These are Deferred Payment Exports and helpful to the buyer ----------------------
of the goods.
----------------------
Forfeiting is a mechanism of discounting deferred export receivables on
non-recourse basis up to 100%. This mechanism has been explained in detail in ----------------------
Unit 9.
----------------------
Buyer’s Credit
Under this arrangement, Credit is given to the buyers abroad to enable ----------------------
them to import goods on deferred payment basis. A Letter of Credit or a Bank
----------------------
Guarantee secures such credit facility.
Supplier’s Credit ----------------------
Under this arrangement, the finance is provided to the seller of goods, ----------------------

Notes under usance Letter of Credit on D/A basis. Under such Letter of Credit, the
seller is paid only on the maturity date. The bank upon negotiation of documents,
---------------------- purchase/discounts the bills and pays to the seller, as per his request. The
negotiating bank will be reimbursed /paid on maturity as per terms of L/C.
----------------------
---------------------- Activity 2
----------------------
Visit any bank and obtain information about the procedure in detail
---------------------- for Negotiating documentary bill drawn under Irrevocable Confirmed
Letter of Credit. Write your three main observations.
----------------------
---------------------- 3.8 RISK MANAGEMENT IN INTERNATIONAL BANKING

---------------------- Risk is inherent in any walk of life in general and in financial sectors in
---------------------- particular. In pre-reform era, due to regulated environment, banks could not
afford to take risks. But of late, banks are exposed to same competition and
---------------------- hence are compelled to encounter various types of financial and non-financial
risks. Risks and uncertainties form an integral part of banking which by
---------------------- nature entails taking risks. The banking system faces different types of risks
---------------------- such as credit risk, market risk, operational risk, liquidity risk, contingent risk
etc. Basel II Accord attempted and recommended that a bank holds capital
---------------------- reserves appropriate to the risk the bank exposes itself to, through its lending
and investment practices. If the risk to which the bank is exposed is greater,
---------------------- greater is the amount of capital the bank needs to hold to safeguard its solvency
---------------------- and overall economic stability. Basel’s New Capital Accord and role of capital
adequacy, Risk Aggregation & Capital Allocation and Risk Based Supervision
---------------------- (RBS), attempted to mitigate in managing risks in banking sector.
---------------------- There exist various risks in International banking:
i) Commercial risks:
----------------------
a) Insolvency of buyer. Failure of the buyer (importer) to make the
---------------------- payment due within a specified period, normally four months from
the due date.
----------------------
b) The buyer’s failure to accept the goods, subject to certain conditions.
---------------------- Foreign credit risk may arise from the overseas operations of a
---------------------- bank and may be due to fluctuations in exchange rates, interest rate
differentials between countries.
---------------------- ii) Political risks: It consists of different types risks
---------------------- a) Imposition of restrictions by the Government of the buyers’ country
or any Government action which may block or delay the transfer of
---------------------- payment made by the buyer.
---------------------- b) War, Civil war or civil disturbances in the buyer’s country.
---------------------- c) New import restrictions or cancellation of a valid import license.

d)
Interruption of voyage outside India resulting in payment of Notes
additional freight or insurance charges which cannot be recovered
from the buyer. ----------------------
e) Any other cause of loss occurring outside India, not normally insured ----------------------
by general insurers and beyond the control of both the exporter and
the buyer. ----------------------
iii) Insolvency and default of LC Opening bank: Failure of the LC opening ----------------------
bank o make the payment due within a specified period, normally four
months from the due date. ----------------------
iv) Exchange fluctuation risk: In order to protect the interest of exporter, ----------------------
Exchange fluctuation risk cover can be obtained for exporters of capital
goods, civil engineering contractors and consultants who have to receive ----------------------
payments quite often over a period of years for their exports of services.
----------------------
v) Off Balance sheet exposures of banks such as forward contracts, swaps
etc. ----------------------
vi) Banks are exposed to interest rate risks which arise from maturity mismatch ----------------------
of foreign currency position. The RBI has issued detailed guidelines
for risk management system in banks in October, 1999, encompassing ----------------------
credit, market and operational risks. The guidelines require banks to put ----------------------
in place loan policies approved by their Board of Directors, covering
the methodologies for measurement, monitoring and control of credit ----------------------
risk. The banks have to evaluate their portfolios on an on-going basis.
Besides Credit Risks Management techniques, foreign exchange risks ----------------------
can be managed/ monitored effectively by setting appropriate limits for ----------------------
open foreign exchange positions, stop loss limits, daylight and overnight
limits for each currency, each country exposure limits and well defined ----------------------
administrative structure of bank/s. ECGC provides insurance covers
to the banks as well as exporters so as to minimize the various risks in ----------------------
international trade. ----------------------
3.9 DEEMED EXPORTS ----------------------
Definition: “Deemed Exports” refers to those transactions in which the ----------------------

goods supplied do not leave the country. ----------------------
Categories of supply
----------------------
The following categories of supply of goods by the main/sub contractors shall
be regarded as “Deemed Exports” provided the goods are manufactured in India: ----------------------
a) Supply of goods against Advance License/DFRC under the Duty ----------------------
Exemption / Remission Scheme.’
----------------------
b) Supply of goods to Export Oriented Units (EOUs) or Units located in
Export Processing Zones (EPZs) or Special Economic Zone (SEZs) or ----------------------
Soft ware Technology Parks (STPs) or to Electronic Hardware Technology
Parks (EHTPs). ----------------------

Notes c) Supply of capital goods at holders of licenses under the Export Promotion
Capital Goods (EPCG) scheme.
----------------------
d) Supply of goods to projects financed by multilateral or bilateral agencies/
---------------------- funds as notified by the Department of Economic Affairs, Ministry of
Finance under International Competitive Bidding in accordance with the
---------------------- procedures of those agencies/funds.
---------------------- e) Supply to projects funded by UN agencies. The benefits of deemed exports
shall be available under specific terms and if the supply is made under the
---------------------- procedure of International Competitive Bidding (ICB).
---------------------- Benefits of Deemed Exports:
---------------------- Deemed exports shall be eligible for the following benefits in respect of
manufacture and supply of goods qualifying as deemed exports: a) Advance
---------------------- License for intermediate supply/deemed export b) Deemed Exports Drawbacks
c) Refund of terminal excise duty.
----------------------
Packing Credit facilities to Deemed Exporters
---------------------- Deemed Exports involving supplies to IRD/IDA/ADB or any multilateral
---------------------- funds aided projects and programs, under orders secured through global tenders
for which payment will be made in free foreign exchange are eligible for
---------------------- concessional rate of interest facility both at pre and post supply stages. Packing
credit can be extended to eligible deemed exporters, and for the restricted post
---------------------- supply credit period say 30 days.
----------------------
----------------------
---------------------- 1. The benefits of deemed exports shall be available for supply to

projects funded by ____________ agencies.
---------------------- 2. Government of India grants certain cash incentives/refund of part of
---------------------- excise and custom duty to Exporter, under Export Promotion Scheme
for goods exported. It is known as _____________.
----------------------
---------------------- Summary
---------------------- • In India, there is great potential for finance for exporter and importer. Export
---------------------- credit is reckoned as priority sector lending by R B I. In International trade it
is important to understand the financial operations in detail and these involve
---------------------- study of-
---------------------- i) Foreign Exchange Management Act (FEMA).

ii) R B I regulations regarding exports.
----------------------
iii) How banking system helps in raising finance at pre-shipment and
---------------------- post shipment stage.

•
In import finance, the banks sanction the loan to the importer for procurement/ Notes
import of raw material. The bank can issue a LC or a Bank Guarantee in favour
of supplier/exporter. This is known as non-fund based facility to importer. ----------------------
The importer has to honour the LC commitment on due date. For executing
export orders, the banks provide financial assistance at concessional rates to ----------------------
exporters. The terms Export Finance consists of:
----------------------
• Pre-shipment finance.
----------------------
• Post- shipment finance.
• Advance against Duty Drawback/cash incentives. ----------------------
• Deferred payment exports. ----------------------
• Forfeiting.
----------------------
• Buyer’s Credit.
• Suppliers Credit ----------------------
• Rediscounting of Bills: If an exporter intends to import raw material from ----------------------
another country, the bank can sanction pre-shipment finance denominated in
foreign currency for a period of six months. This facility is known as Packing ----------------------
Credit Foreign Currency (PCFC).
----------------------
Keywords ----------------------
• Authorised Dealer: Commercial banks authorised by R B I. ----------------------

• Nostro A/C: Accounts opened by Indian Bank at foreign centres in foreign ----------------------
currency.
----------------------
• Supplier’s Credit: Means financing the seller of goods.
• Deferred Payment: Payment in instalments at future dates ----------------------
• Buyer’s Credit: Credit extended to the buyers. ----------------------
----------------------
----------------------
1. Write a short note on Deemed Exports.
----------------------
2. What are the various types of Export Finance?
3. What is the difference between Buyer’s Credit and Suppliers Credit? ----------------------
4.
What do you understand by Import Finance? State the procedure of financing ----------------------
imports.
----------------------
5.
What are the important regulations the banker should observe in Lending to
an exporter? ----------------------
6. Write short notes on: ----------------------
a. Documentary Letter of Credit
----------------------
b. Difference between Letter of Credit and Bank Guarantee
----------------------
c. Negotiation of Export documents under L/C

Notes Answers to Check your Progress
---------------------- 1. True
2. False
----------------------
3. True
----------------------
---------------------- Multiple Choice Multiple Response.
---------------------- 1. Preshipment finance is:
---------------------- i. Loan to exporter for manufacturing of goods
ii. Repaid from proceeds of export bill
----------------------
iii. Granted normally up to 180 days
----------------------
2. While dealing with export finance, the Authorised Dealer is guided by:
---------------------- i. Exchange control regulations under FEMA, 1999
---------------------- ii. Exim Policy
---------------------- iii. FEDAI Guidelines
v. ECGC Guidelines
----------------------
3. Sources for raising finance for exports are:
----------------------
i. Advance payment from buyer
---------------------- ii. Trade credits from suppliers
---------------------- iii. Bank’s finance
Fill in the blanks.
----------------------
1. The benefits of deemed exports shall be available for supply to projects
---------------------- funded by United Nations’ agencies.
---------------------- 2. Government of India grants certain cash incentives/refund of part of
excise and custom duty to exporter under Export Promotion Scheme for
---------------------- goods exported. It is known as duty drawback.
----------------------
Suggested Reading
----------------------
1. Foreign Trade Policy by Exim Management Institute.
----------------------
2. International Marketing by Exim Management Institute.
----------------------
----------------------

Exchange Rate Mechanism
UNIT
4
Structure:
4.1 Introduction
4.2 Exchange Rate Theories
4.3 Fixed Versus Flexible Exchange Rate System
4.4 Factors Influencing Exchange Rates
4.5 Exchange Regimes in Practice
Summary
Keywords
Suggested Reading
Annexure
Exchange Rate Mechanism 75

Notes
Objectives
----------------------
----------------------
• Identify the importance of exchange rates
----------------------
• Compare the different theories of exchange rates
---------------------- • Analyse the merits and demerits of fixed versus flexible exchange
rates
----------------------
• Examine the various factors influencing the exchange rate
----------------------
• Evaluate the exchange regimes in practice
----------------------
4.1 INTRODUCTION
----------------------
An exchange rate represents the number of units of one currency needed
---------------------- to acquire another currency. In other words, it is the rate at which one currency
---------------------- is exchanged for another. It is the price of one currency in terms of another
currency. The exchange rate (ER) between the dollar and the rupee refers to the
---------------------- number of rupees required to purchase a dollar. Thus the exchange rate between
the dollar and the rupee is expressed as say, $1 = Rs. 45.35.
----------------------
Although this definition seems simple, it is important that you understand
---------------------- how governments set an exchange rate and what causes the rate to change.
Such understanding can help you anticipate exchange-rate changes and make
----------------------
decisions about business factors that are sensitive to those changes, such as the
---------------------- sourcing of raw materials and components, the placement of manufacturing and
assembly, and the choice of final markets.
----------------------
----------------------
4.2 EXCHANGE RATE THEORIES
---------------------- In this section we examine the operation of the monetary system under:
1. Mint Parity Theory – The Gold Standard – 1880 Onwards.
----------------------
2. The Bretton Woods System - The Gold-Exchange Standard (1947-1971).
----------------------
3. Purchasing Power Parity Theory (PPP).
---------------------- 4. Balance of Payments Theory (BOP).
---------------------- 1. Mint Parity Theory – also known as The Gold Standard:
---------------------- The gold standard operated from about 1880 to the outbreak of World
War I in 1914. An attempt was made to re-establish the gold standard after
---------------------- the war, but it failed in 1931 during the Great Depression. It is highly unlikely
that the gold standard will be re-established in the near future. Nevertheless,
---------------------- it is important to understand the advantages and disadvantages inherent in the
---------------------- operation of the gold standard, not only for its own sake, but also because those
were (to some extent) also true for the fixed exchange rate system (the Bretton
---------------------- Woods system, or gold-exchange standard) that operated from the World War II
until it collapsed in 1971.
Under the gold standard, the currency in use was convertible into gold at a fixed Notes
rate. Each nation defines the gold content of its currency and passively stands
ready to buy or sell any amount of gold at that price. Since the gold content in ----------------------
one unit of each currency is fixed, exchange rates are also fixed.
----------------------
For example, let’s assume a £1gold coin in the United Kingdom contained
113.0016 grains of pure gold, while a $1 gold coin in the United States contained ----------------------
23.22 grains. This implied that the dollar price of the pound, or the exchange
rate, was £/$ = 113.0016/ 23.22=4.87. This is called the mint parity. ----------------------
Thus, the rate at which the standard money of the country was convertible into ----------------------
gold was called the mint price of the gold.
Since the cost of shipping £1 worth of gold between New York and London was ----------------------
about 3 cents, the exchange rate between the dollar and the pound could never ----------------------
fluctuate by more than 3 cents above or below the mint parity (i.e., the exchange
rate could not rise above 4.90 or fall below 4.84). The reason is that no one ----------------------
would pay more than $4.90 for £1, since he could purchase $4.87 worth of
gold at the US Treasury (the Federal Reserve Bank of New York – established ----------------------
in 1913), ship it to London at 3 cents, and exchange it for £1 at the Bank of
England (the UK central bank). Thus, the US supply curve of pounds became ----------------------
infinitely elastic (horizontal) at the exchange rate of R= $4.90/£1. This was the ----------------------
gold export point of the US.
On the other hand, the exchange rate between the dollar and the pound could ----------------------
not fall below $4.84.The reason for this is that no one would accept less than
----------------------
$4.84 for each pound he wanted to convert into dollars because he could always
purchase £1 worth of gold in London, ship it to New York at a cost of 3 cents, ----------------------
and exchange it for $4.87 (thus receiving $4.84 net). As a result, the US demand
curve of pounds became infinitely elastic (horizontal) at the exchange rate of ----------------------
R= $4.84/£1. This was the gold import point of the US.
----------------------
The exchange rate between the dollar and the pound was determined at the
intersection of the US demand and supply of pounds between the gold point ----------------------
and was prevented from moving outside the gold point by the US gold sales or
purchases. (Refer to Fig. 4.1) ----------------------
----------------------
D Gold Export Point
4.90 S1
----------------------
Mint Parity
4.87
(Dollar Price of Pound)
----------------------
R E
Exchange Rate
----------------------
4.82 D1 ----------------------
S Gold Import Point
----------------------
----------------------
O ----------------------
Q Pounds
Quantity of Foreign Exchange
----------------------
Fig. 4.1 Exchange Rate (Gold Standard)

Notes (Fig. 4.1 shows the determination of the exchange rate under the gold standard.
The exchange rate OR is set up at point E where the demand and supply curves
---------------------- DD1 and SS1 intersect. The exchange rate need not be at the mint parity. It can
be anywhere between the gold points depending on the shape of the demand
---------------------- and supply curves).
---------------------- Thus, the tendency of the dollar to depreciate, or the exchange rate to rise
above R = $4.90/£1, was countered by gold shipments from the US. These
----------------------
gold outflows measured the size of the US BOP deficit. On the other hand,
---------------------- the tendency of the dollar to appreciate, or the exchange rate to fall below R
= $4.84/£1, was countered by gold shipments to the US. These gold inflows
---------------------- measured the size of surplus in the US BOP.
---------------------- Assumptions of the Mint Party Theory:
• The price of gold is fixed by a country in terms of its currency.
----------------------
• It buys and sells gold in any amount at that price.
----------------------
• Its supply of money consists of gold or paper currency which is backed by
---------------------- gold.
---------------------- • Their price level varies directly with its money supply.
• There is movement of gold between countries.
----------------------
• Capital is mobile within countries.
----------------------
• The adjustment mechanism is automatic.
---------------------- Criticisms:
---------------------- Some of the criticisms leveled against the mint parity theory are as follows:
---------------------- • The international Gold standard does not exist now ever since it broke
down after the depression of the 1930’s. Therefore this theory does not
---------------------- hold good.
---------------------- • The theory is based on the assumption of free buying and selling of gold
and its movements between countries. But governments do not allow
---------------------- such sales, purchases and movements.
---------------------- • The theory fails to explain the determination of ER as most countries are
on inconvertible paper standard.
----------------------
• This theory assumes flexibility of internal price. But, modern governments
---------------------- follow independent domestic price policy unrelated to fluctuations in
exchange rate.
----------------------
Since the mint parity theory has long been discarded ever since the gold standard
---------------------- broke down, this theory only holds academic interest.
---------------------- 2. The Bretton Woods System: The Gold-Exchange Standard (1947-1971)
In 1944, representatives of the United States, the United Kingdom and
----------------------
42 other nations met at Bretton Woods, New Hampshire to decide on the basis
---------------------- of establishing the international monetary system after the war. The system

devised at Bretton Woods called for the establishment of the International Notes
Monetary Fund (IMF) for the purpose of (1) overseeing that nations followed
a set of agreed upon rules of conduct in international trade and finance and (2) ----------------------
providing borrowing facilities for nations in temporary balance-of-payments
difficulties. ----------------------
• The Bretton Woods system was a gold-exchange standard. ----------------------

• The United States was to maintain the price of gold fixed at $35 per ounce ----------------------
and be ready to exchange on demand, dollars for gold at that price without
restrictions or limitations. ----------------------
• Others nations were to fix the price of their currency in terms of dollar ----------------------
(and thus implicitly in terms of gold) and intervene in foreign exchange
markets to keep the exchange from moving by more than 1 percent above ----------------------
or below the par value. The exchange rate was determined by the forces
----------------------
of demand and supply within the allowed band of fluctuations.
• The US Government made a commitment to maintain the convertibility ----------------------
of the Dollar and gold whereas the other countries made a commitment to ----------------------
maintain the convertibility of their currencies with the US.
• A nation would have to draw down its dollar reserves to purchase its own ----------------------
currency in order to prevent it from depreciating by more than 1 percent ----------------------
from the agreed par value, or the nation would have to purchase its own
currency (adding to its international reserves) to prevent an appreciation ----------------------
of its currency by more than 1 percent from the par value.
----------------------
• Nations were to finance temporary balance-of payments deficits out of
their international reserves and by borrowing from the IMF. Only in a ----------------------
case of fundamental disequilibrium was a nation allowed, after the
approval of the Fund, to change the par value of its currency. Fundamental ----------------------
disequilibrium was nowhere clearly defined but broadly referred to large ----------------------
and persistent balance-of-payments deficits or surpluses. Exchange rate
changes of less than 10 percent were, however allowed without Fund ----------------------
approval.
----------------------
• Thus, the Bretton Woods system was in the nature of an adjustable peg
system, at least as originally conceived, combining general exchange ----------------------
rate stability with some flexibility. The stress on fixity can be best
----------------------
understood as resulting from the strong desire of nations to avoid the
chaotic conditions in international trade and finance that prevailed during ----------------------
the interwar period.
----------------------
Collapse of the Bretton Woods System:
US emerged as a major economic power post World War II. From 1945 to ----------------------
1949, US ran huge balance-of-payments surpluses. However, by 1950, the US ----------------------
balance of payments turned into deficit. These US deficits allowed European
nations and Japan to build up their international reserves. All this led to a high ----------------------
demand for the dollars resulting in a dollar shortage. By 1958, US balance-of-
payments deficits increased sharply and averaged over $3 billion per year. ----------------------

Notes The causes of the US deficit were the foreign direct investments to Europe,
the high rate of inflation connected with the excessive money creation during
---------------------- the Vietnam War period.
---------------------- As the US deficits persisted and rose over time, US gold reserves declined
while foreign-held dollar reserves grew to the point where, in the early 1960s
---------------------- they began to exceed the US gold reserves. In fact, by 1970 they exceeded
total US gold reserves by a multiple of about 4. The expectation then became
----------------------
prevalent that the US would sooner or later have to devalue the dollar, in the
---------------------- face of huge balance-of-payments deficits. This led to a massive flight of
liquid capital from the US, which prompted President Nixon in August 1971 to
---------------------- suspend the convertibility of the dollar into gold, and impose a temporary 10
percent import surcharge.
----------------------
In December 1971, representatives of the Group of Ten nations met at the
---------------------- Smithsonian Institution in Washington D.C., and agreed to increase the dollar
price of gold from $35 to $38 an ounce. This implied a devaluation of the dollar
----------------------
of about 9 percent. The exchange rate would now fluctuate within a band which
---------------------- was increased from 1 percent to 2.25 percent on either side of the central rate.
Since the dollar remained inconvertible into gold, the world was now essentially
---------------------- on a dollar standard.
---------------------- However, with another huge US balance-of-payments deficit in 1972 ($9
billion), it was felt that the Smithsonian Agreement was not working and that
---------------------- another devaluation of the dollar was required. This expectation led to renewed
speculation against the dollar and became self-fulfilling in February 1973, when
----------------------
the United States was once again forced to devalue the dollar, this time by about
---------------------- 10 percent – i.e., by increasing the official price of gold to $42.22 an ounce. At
the same time the dollar remained inconvertible into gold. In
----------------------
March 1972, the original six member nations of the European Common
---------------------- Market decided to let their currencies float against the dollar with a total band
of fluctuations of only 2.25 percent instead of the 4.5 percent agreed on in
---------------------- December 1971. This was named the European snake or the snake in the tunnel
---------------------- and lasted until March 1973.
When speculation against the dollar flared up again in March 1973,
---------------------- monetary authorities in the major industrial nations decided to let their currencies
---------------------- float either independently (the US dollar, the British pound, the Japanese yen,
the Italian lira, the Canadian dollar, and the Swiss franc) or jointly (the German
---------------------- mark, the French franc, and the currencies of six other central and northern
European nations- the snake with the maximum total spread of 2.25 percent
---------------------- between the strongest and the weakest currency with respect to the dollar).
---------------------- Thus, the present managed floating exchange rate system was born.
Under the managed floating exchange rate system, a nation’s monetary
---------------------- authorities are entrusted with the responsibility to intervene in foreign exchange
---------------------- markets to smooth out short-run fluctuations in exchange rates without
attempting to affect long-run trends. As we can see in Case Study 4.1, at the end
---------------------- of 2001, half of the 186 nations that were members of the IMF had opted for
some form of exchange rate flexibility.
3. Purchasing Power Parity Theory (PPP): Notes
The purchasing-power parity (PPP) theory was elaborated and brought
----------------------
back into the use by the Swedish economist Gustav Cassel in order to estimate
the equilibrium exchange rates at which nations could return to the gold ----------------------
standard after the disruption of international trade and the large changes in
relative commodity prices in the various nations caused by World War I. There ----------------------
is an absolute and a relative version of the PPP theory.
----------------------
a) Absolute Purchasing-Power Parity Theory:
----------------------
The absolute version states that the equilibrium exchange rate between
two currencies is equal to the ratio of the price levels indexes in the two ----------------------
countries.
----------------------
R=P /P Equation (1)
A B
Where R = Exchange Rate between the countries A & B (Spot rate) ----------------------
P & P refer to the price index of the respective countries. ----------------------

A B
For example, if the price of one bushel of wheat is $1 in US and Rs. 45 in ----------------------
India, then the exchange rate between the dollar and the rupee should be
R=$1/Rs.45=1. ----------------------
However, if the price of one bushel of wheat in US was $0.50, and in ----------------------
India it was Rs. 60, firms would purchase wheat in the US and resell it
in India, at a profit. This commodity arbitrage would cause the price of ----------------------
wheat to fall in India and rise in US until the prices were back to $1 per
----------------------
bushel in US and Rs.45 in India.
Commodity arbitrage thus operates just as does currency arbitrage in ----------------------
equalizing commodity prices throughout the market.
----------------------
 The exchange rate under this theory is determined only on the basis
of goods and services traded. It completely ignores the capital ----------------------
account of the balance of payment statement. ----------------------
 The PPP theory also ignores many non-traded goods and services.
Non-traded goods include products, such as cement and bricks, ----------------------
for which the cost of transportation is too high for them to enter ----------------------
international trade. This theory therefore ignores transport cost and
non-traded goods and services. Hence, the absolute version of the ----------------------
PPP theory can be very misleading.
----------------------
b) Relative Purchasing-Power Parity Theory:
----------------------
The relative version of the PPP Theory is the more refined version. The
theory postulates that the rate of exchange over a period of time should ----------------------
be proportional to the relative change in the price levels in the two
nations over the same period. Specifically, if we let the subscript 0, refer ----------------------
to the base period and 1 to a subsequent period, the relative PPP theory
----------------------
postulates that
----------------------

Notes R1 = P1/P0. R0 Equation (2)
P*1/P*0
----------------------
Where R1 and R0 is the exchange rate in period 1 and in the base period
---------------------- respectively
---------------------- For example: If the general price level does not change in the foreign nations
from the base period to period 1 (i.e., P*1/P*0 =1), while the general price
---------------------- level in the home nation increases by 50 percent, the relative PPP theory
postulates that the exchange rate (defined as the home-currency price of
----------------------
a unit of the foreign nation’s currency) should be 50 percent higher (i.e.,
---------------------- the home nation’s currency should depreciate by 50 percent) in period 1 as
compared to the base period.
----------------------
We can explain equation 2 with an example: Before the change in the
---------------------- price level, the exchange rate was Rs. 45 = $1. Suppose the domestic
(Indian) price index rises to 300 and the foreign price index (US) rises to
---------------------- 200, the new equilibrium exchange rate will be:
---------------------- R = $1 × 300/200 = $1.5 or Rs.45 = $1.5
---------------------- This will be the purchasing power parity between the two countries.
I n reality, the parity will be modified by the cost of transporting goods including
---------------------- duties, insurance, banking and other charges. These costs of transporting goods
---------------------- from one country to another are, in fact, the limits within which the exchange rate
can fluctuate depending upon the demand and supply of a country’s currency.
---------------------- There is the upper limit called the commodity export point; and the lower limit,
known as the commodity import point (these limits are not as definite as the
---------------------- gold points under the mint parity theory).
---------------------- ccording to the theory, the ER between two countries is determined at a point,
A
which expresses the equality between the respective purchasing power of the
---------------------- currencies. This is the purchasing power rarely which is a moving per and not
---------------------- fixed par (as under the gold standard). Thus with every change in price level,
ER also changes. To calculate the equilibriums ER$, the following formula is
---------------------- used.
---------------------- ote that if the absolute PPP is held, the relative PPP would also hold, but when
N
the relative PPP holds, the absolute PPP need not hold. For example, while the
---------------------- very existence of capital flows, transportation costs, other obstructions to the
free flow of international trade, and government intervention policies leads to
----------------------
the rejection of the absolute PPP, only a change in these would lead the relative
---------------------- PPP theory astray.
he general price index includes the price of both traded and non-traded goods
T
----------------------
and services, and price of the latter are not equalized by international trade
---------------------- but are relatively higher in developed nations. The relative PPP theory will
extend to predict overvalued exchange rates for developing nations, when,
---------------------- with distortions being larger, the greater will be the differences in the level of
development.
----------------------

n interesting illustration of the PPP theory for estimating exchange rates is
A Notes
the “Big Mac” index of currencies used by the Economist each year. Since
1986, the Economist has used the price of a Big Mac (McDonald’s popular ----------------------
big hamburger) to estimate the exchange rate between the dollar and another
currency (refer Table 4.1). The Economist’s Big Mac index is based on one ----------------------
of the oldest concepts in international economics: the theory of purchasing ----------------------
power parity (PPP), which argues that in the long run, exchange should move
towards levels that equalize the prices of identical baskets of goods and services ----------------------
in any two countries. Because the Big Mac is sold in over 120 countries, it is
easy to compare its prices. PPP would suggest that the exchange should leave ----------------------
hamburgers costing the same in the United States as anywhere else. However, ----------------------
sometimes the Big Mac costs more, and sometimes less, demonstrating how far
currencies are under or overvalued against the dollar. ----------------------
I n Table 4.1 the first column gives the local currency price of Big Mac. The ----------------------
second column gives the dollar price of the Big Mac in the various economies,
at the actual exchange rate given in the fourth column of the table. From the ----------------------
second column of the table, we see that the cheapest Big Mac is in China
----------------------
costing 10.5 Yuan, against an average price in US cities of $3.10, and the most
expensive is $3.77 in the Euro area. ----------------------
he third column of the table measures the implied PPP of the dollar obtained
T
----------------------
by dividing the local-currency price of a Big Mac by the price of a Big Mac in
the United States. For example, dividing the Big Mac price of 1.94 pounds in ----------------------
Britain by the price of $3.1for a Big Mac in the US gives the implied PPP of
the dollar of 1.6. This tells us what the exchange rate should be for the price of ----------------------
a Big Mac to be the same in terms of dollars in both countries (i.e., $3.1/£1.94=
----------------------
1.6). Since the dollar price of the Big Mac is $3.1 in US and is $3.64 in dollar
terms in UK, it is obvious that the pound is overvalued in UK vis-a vis the ----------------------
dollar i.e., 3.1-3.65/3.1 ×100 = 18 percent.
----------------------
imilarly, if we take the case of China – the dollar value of the Big Mac in
S
China is 1.31 and therefore the currency is undervalued by 58 percent. ----------------------
xtent of overvaluation / devaluation = Dollar price of Big Mac in US – Dollar
E ----------------------
price of Big Mac in Domestic Country ÷ Dollar price of Big Mac in US ×100
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Fig. 4.1

---------------------- The index was never intended to be a precise predictor of currency movements,
but was simply a takeaway guide to whether currencies are at their “correct”
---------------------- long-run level. Curiously, however, burgernomics has an impressive record in
predicting exchange rates: currencies that show up as overvalued often tend to
----------------------
weaken in later years.
---------------------- However, some of the limitations to the PPP theory are as follows:
----------------------  The theory of PPP falsely assumes that there are no barriers to trade and
that transportation costs are zero.
----------------------

 Prices of the Big Mac in different countries are distorted by taxes. Notes
European countries with high value-added taxes are more likely to have
higher prices than countries with low taxes. ----------------------
 The Big Mac is not just a basket of commodities; its price also includes ----------------------
non-traded costs such as rent, insurance, and so on.
 Profit margins vary by the strength of competition. The higher the ----------------------
competition, the lower the profit margins and therefore the price. ----------------------
4. Balance of Payment Theory:
----------------------
It is also referred to as the demand supply theory of exchange. The theory
stresses that the exchange rate basically relates to the position of balance of ----------------------
payments of the country concerned. A favorable balance of payments leads to
an appreciation in the external value of the currency of the country, while an ----------------------
unfavorable balance of payments causes a depreciation of the external value.
----------------------
The BOP theory of exchange rate holds that the price of foreign money
in terms of domestic money is determined by the free forces of demand & ----------------------
supply in the foreign exchange market. According to the theory, a deficit in the
----------------------
balance of payment leads to a fall or depreciation in the rate of exchange, while
a surplus in the balance of payment strengthens the exchange reserves, causing ----------------------
an appreciation in the price of home currency in terms of foreign currency.
A deficit balance of payments of a country implies that demand for foreign ----------------------
exchange exceeds its supply. As a result the price of foreign money in terms
----------------------
of domestic currency must rise. The exchange rate of domestic currency must
fall. On the other hand, a surplus in the balance of payment of a country implies ----------------------
a greater demand for home currency in a foreign country than the available
supply. As a result, the price of home currency in terms of foreign money rises ----------------------
i.e. the rate of exchange improves.
----------------------
The determination of exchange rate under the balance of payment theory
is explained in Fig. 4.2. ----------------------
D S ----------------------
A B
R1 ----------------------
----------------------
Exchange Rate
R E
----------------------
G ----------------------
R2 H
----------------------
S
D ----------------------
O Q ----------------------
Quantity of Foreign Exchange ----------------------
Fig. 4.2: Exchange Rate Determination under the Balance of Payment ----------------------
Theory
Notes DD is the demand curve for foreign currency ($) it slopes downward to
the left because when the rate exchange rises, the demand for foreign currency
---------------------- falls and when the exchange rate falls the demand for $ increases. On the other
hand, SS is the supply curve of foreign exchange which slopes upward from
---------------------- left to right. This is because when the exchange rate falls, the amount of foreign
---------------------- currency offered for the sale will be less and vice versa. The two curves intersect
at E, which determines the equilibrium rate of exchange.
----------------------
Suppose the exchange rate rises to OR1, the demand for foreign exchange
---------------------- at R1A is less than supply curve at R1B. In this case, the demand for foreign
exchange and the supply of foreign exchange will adjust and be at equilibrium
---------------------- point E. Ultimately, equilibrium rate OR is restored. Similarly, if the exchange
rate is OR2 the demand for foreign exchange R2H is greater than the supply
----------------------
of foreign exchange R2G by GH. Again the demand and supply of foreign
---------------------- exchange will adjust and equilibrium exchange rate OR at E is restored.
The factors determining demand for foreign currency feature on the debit
----------------------
side of the BOP. For example, import demand, Indians traveling abroad, when
---------------------- FIIs sell in the stock market, etc.
While items featuring on the credit side of the BOP determine the supply
----------------------
of foreign exchange. For example, exports, foreign tourists coming into India,
---------------------- capital inflows, FIIs buying stocks in the Indian stock market, etc.
---------------------- We can therefore state that, the exchange rate R == f (Demand for foreign
exchange and Supply of foreign exchange).
---------------------- Criticisms:
---------------------- The BOP theory has been criticized by economists on the following counts:
----------------------  The theory states that balance of payments is independent of the exchange
rate. In other words, the theory states that the balance of payments
---------------------- determines the exchange rate. But this is partly true because it is the
changes in the exchange rate that bring about equilibrium in the balance
----------------------
of payments.
----------------------  The theory neglects the role of the price level in influencing the balance
of payments of a country and hence its exchange rate. But the fact is that
----------------------
price changes do affect the balance of payments and the exchange rates
---------------------- between countries.
 The theory is based on the assumption of free trade and perfect competition.
----------------------
This is unrealistic because international trade can hardly be said to be free
---------------------- in the true sense of the word. Government imposes a number of restrictions
to reduce imports and adopt measures to encourage exports. In this way,
---------------------- nations try to correct disequilibrium in the balance of payments.
---------------------- Despite the criticisms leveled against the BOP theory, it is considered to be a
superior theory and gives the most satisfactory explanation of the determination
---------------------- of exchange rate.
----------------------

Notes
----------------------
State True or False. ----------------------
1. Under the Mint Parity Theory, the rate at which the standard money
----------------------
of the country was convertible into gold was called the mint price of
gold. ----------------------
2. In terms of Gold Exchange Standard, i.e., the Bretton Woods System,
----------------------
the US dollar was tied up to a certain quantity of gold and the
currencies of other countries were tied up to the US dollar. ----------------------
3. One of the criticisms levelled against Balance of Payment Theory ----------------------
is that this theory is not based on the assumption of free trade and
perfect competition. ----------------------
----------------------
4.3 FIXED VERSUS FLEXIBLE EXCHANGE RATE SYSTEM
----------------------
If we study the history of economics, we will find that three different
----------------------
exchange rate systems have been prevailing in the world economy. The first
exchange rate system, more popularly known as the Gold Standard prevailed ----------------------
over the period 1879-1934, with the exception of the period of World War I.
Under the gold standard, the value of each country’s currency was fixed in ----------------------
terms of a certain quantity of gold. With this the exchange rate between different
----------------------
countries got automatically fixed. Thus, the gold standard represented the fixed
exchange rate system. From the end of World War II to 1971, another fixed ----------------------
exchange rate system prevailed. This system was better known as the Bretton
Woods System. Under this system, the US dollar was tied to a certain quantity of ----------------------
gold and the currencies of other countries were tied to the US dollar. However,
----------------------
in 1971 due to a large and persistent deficit in the balance of payments of the
United States, the Bretton Woods System collapsed. Since then, the flexible or ----------------------
what is also called the floating exchange rate system has been in practice.
----------------------
A) Fixed Exchange Rates
Under fixed or pegged exchange rates all exchange transactions take place at ----------------------
an exchange rate that is determined by the monetary authority. It may fix the ----------------------
exchange rate by legislation or intervention in currency markets. It may buy
or sell currencies according to the needs of the country or may take policy ----------------------
decision to appreciate or depreciate the national currency. The monetary
authority (central bank) holds foreign currency reserves in order to intervene in ----------------------
the foreign exchange market, when the demand and supply of foreign exchange ----------------------
are not equal at the fixed rate.
Merits of Fixed Exchange Rate System ----------------------
1. Based on Common Currency ----------------------

A country that has a common currency with a fixed value facilitates trade, ----------------------

Notes increases production and leads to faster growth of the economy. A country
will also benefit if it has a fixed currency in relation to other countries.
---------------------- In such a case fixed exchange rates will encourage international trade by
making the prices of goods more predictable. This promotes economic
---------------------- integration.
---------------------- 2. No Uncertainty
---------------------- A fixed exchange rate avoids the wild day-to-day fluctuations that are
likely to occur under flexible rates and that discourage specialization in
---------------------- production and the flow of international trade and investments. In fact,
with flexible exchange rates, day-to-day shifts in a nation’s demand for
----------------------
and supply of foreign exchange would lead to very frequent changes in
---------------------- exchange rates.
3. Encourages Long Term Capital Flow
----------------------
A system of fixed exchange rates encourages long-term capital flow in a
---------------------- smooth and orderly manner. Such a system does not involve much risk
---------------------- or uncertainty. It promotes the development of international money and
capital markets and also helps the flow of capital among countries.
---------------------- 4. No Currency Fluctuations
---------------------- In a system of fixed exchange rates there is no fear of the currency
appreciating or depreciating. This, therefore, creates confidence in the
---------------------- strength of the domestic currency. This system encourages multilateral
---------------------- trade globally among countries because countries have no fear of wide
fluctuations in exchange rates.
----------------------
5. Prevents Speculation in Foreign Exchange Market
---------------------- According to the advocates of fixed exchange rates, speculation is more
likely to be destabilizing under a flexible than under a fixed exchange
----------------------
rate system. With destabilizing speculation, speculators purchase a
---------------------- foreign currency when the exchange rate will rise even more, and sell
the foreign currency when the exchange rate is falling, in the expectation
---------------------- that the exchange rate will fall even more. Hence, the fixed exchange
rate system does away with speculation in the foreign exchange market.
----------------------
All speculative activities are controlled and prevented by the monetary
---------------------- authorities under a regime of fixed exchange rates.
---------------------- 6. Less Inflationary

Another advantage of the fixed exchange rate system is that it serves as
---------------------- an anchor and imposes a discipline on monetary authorities to follow
---------------------- responsible financial policies. Further, once the exchange rate is fixed,
there is no fear of prices of imports and exports rising due to fluctuations
---------------------- in exchange rate.
---------------------- 7. Suitable for Small Countries

Fixed exchange rates favours the ‘banana republics’ – small countries like
----------------------
UK, France, Denmark, Ireland, etc. which are dependent on foreign trade.

It is also suitable for common currency areas such as Euro, Dollar, etc. Notes
where fixed exchange rates promote growth of world trade.
----------------------
Demerits of Fixed Exchange Rate System
1. Transmission of Disturbances: ----------------------
In this system, the unexpected disturbances in the domestic economy ----------------------
are transmitted abroad. For example, if the inflation rate in the domestic
economy is rising, it will transmit this inflation abroad through the ----------------------
exchange rate mechanism. Therefore, inflation in one economy impacts
----------------------
another.
2. Heavy Burden: ----------------------
Under this system, large reserves of foreign currencies are required to be ----------------------
maintained. Countries that have balance of payments deficit are required
to have large reserves if they want to prevent devaluation. This imposes a ----------------------
heavy burden on the monetary authorities for managing foreign exchange ----------------------
reserves. Also, a country must have adequate international liquidity to
expand its trade. To maintain a fixed exchange rate, the country must have ----------------------
sufficient reserves of foreign currencies to avoid balance of payments
disequilibrium. ----------------------
3. Misallocation of Resources: ----------------------

This system requires complicated exchange control measures and this can ----------------------
frequently lead to the misallocation of an economy’s resources.
----------------------
4. Dependence on International Institutions:
Since under fixed exchange rates nations have to keep their currencies ----------------------
pegged, they have to depend mostly on international institutions for the ----------------------
borrowing and lending of foreign currencies.
5. The Principle of Comparative Cost Advantage Sacrificed: ----------------------
Once a nation adopts the fixed exchange rate system, it is the exchange ----------------------
rate that determines the price of traded goods to a certain extent. As a
result, the comparative cost principle is not clear and a country may ----------------------
export commodities in which it has no comparative cost advantage. ----------------------
6. Fixed Exchange Rates are not always possible:
----------------------
The stability of the exchange rate poses another problem under this
system. The exchange rate of a country vis-à-vis another cannot remain ----------------------
fixed over a long period of time. Problems in the balance of payments
----------------------
and fluctuations in the international commodities prices often bring about
inevitable changes in the exchange rates. ----------------------
In view of the above given drawbacks and problems, the fixed exchange
----------------------
rate system has been abandoned since 1971. However certain nations do
adopt some form of fixed exchange rates as highlighted in Case Study 4.1. ----------------------
----------------------

Notes B) Flexible Exchange Rates
Currencies that float freely respond to supply and demand conditions free
----------------------
from government intervention. The exchange rate will automatically seek the
---------------------- correct level according to the laws of supply and demand. Flexible, floating
or fluctuating exchange rates are determined by market forces. The monetary
---------------------- authority does not intervene for the purpose of influencing the exchange rate.
---------------------- For example, if there is an excess supply of dollars in the Indian foreign
exchange market, the rupee (domestic currency) will appreciate and the dollar
---------------------- (or the foreign currency) will depreciate. However, if the demand for the dollar
increases on account of heavy selling by Foreign Institutional Investors in
----------------------
the Indian stock market, it will lead to the rupee depreciating and the dollar
---------------------- appreciating in the foreign exchange market.
Merits of Flexible Exchange Rates
----------------------
1. Simple Operation
----------------------
The system of flexible exchange rates operates in a very simple manner.
---------------------- The exchange rate moves automatically and freely to equate demand and
supply. According to advocates of flexible exchange rates, they point out
---------------------- that destabilizing speculation is less likely to occur when exchange rates
---------------------- adjust continuously than when they are prevented from doing so under
fixed exchange rate systems. It does not allow a deficit or surplus to build
---------------------- up and eliminates the problem of scarcity or surplus of a currency.
---------------------- 2. Continuous Adjustments

The adjustments in this system are continuous, smoother and painless.
----------------------
This is because the adjustments are automatic. Flexible exchange rates
---------------------- avoid the pressures on the balance of payments and the periodic crises that
follow disequilibrium in the balance of payments under a fixed exchange
---------------------- rate regime.
---------------------- 3. No Need for Foreign Exchange Reserves
In a system where exchange rates are moving freely, there is no need
----------------------
for foreign exchange reserves. A country with a deficit will just allow
---------------------- its currency to depreciate in relation to the foreign currency instead of
supplying foreign exchange to the other country to maintain a stable
---------------------- exchange rate.
---------------------- 4. Removes the problem of International Liquidity
---------------------- Under the flexible exchange rate system, since the exchange rate adjusts
automatically, it reduces the demand for international liquidity which is
---------------------- required under pegged regimes. As a result this system of exchange rate
determination does not put pressure on international financial institutions
---------------------- for borrowing and lending short-term funds to overcome either an
---------------------- exchange rate problem or a problem of disequilibrium in balance of
payments.
----------------------

5. Insulates the Domestic Economy Notes
Flexible exchange rates insulate the domestic economy from external
----------------------
shocks (such as an exogenous change in the nation’s exports) much more
than fixed exchange rates. Thus, disturbances in the international market ----------------------
are not transmitted to the domestic economy and vice-versa.
----------------------
6. Economical
The flexible exchange rates system is much more economical as it does ----------------------
not require a country to hold foreign exchange currencies which usually
----------------------
are sitting idle. Rather, a country can use its foreign exchange reserves to
meet its immediate requirements. ----------------------
7. Promotes International Trade ----------------------
Under the system of flexible exchange rates there is no fear of over-
valuation or under-valuation of a country’s exchange rate. Since the ----------------------
exchange rate finds its own level, this itself promotes international trade ----------------------
and the principle of comparative cost advantage is not sacrificed.
8. The Domestic Economy’s Monetary Policy is Effective ----------------------
The system of flexible exchange rates reinforces the effectiveness of ----------------------

monetary policy. If a country wants to increase its output and level of
----------------------
effective demand, it needs to lower its interest rate. This will lead to a
capital outflow, which in turn will increase the demand for the foreign ----------------------
currency. This leads to a depreciation of the domestic currency and an
appreciation of the foreign currency – which in turn would encourage ----------------------
exports and discourage imports. The increased exports will tend to
----------------------
raise the domestic income. Hence, the expansionary monetary policy is
effective. Further, a country can adopt a contractionary monetary policy ----------------------
to combat inflation.
----------------------
9. Complicated Trade Restrictions Not Required
Under a flexible exchange rate system a country does not require the ----------------------
introduction of complicated and expensive trade restrictions and exchange
----------------------
controls. Thus, the high cost of foreign exchange restrictions is removed.
10. No Need to form Customs Union and Currency Areas: ----------------------
Under the flexible exchange rate system, nations do not feel the need ----------------------
to form customs unions and currency areas which conflict with the very
principle of multilateral trade. ----------------------
Demerits of Flexible Exchange Rates ----------------------

1. Market Mechanism May Fail To Bring About An Appropriate Exchange Rate ----------------------
Critics of flexible exchange rates point out that the market mechanism
----------------------
may fail to bring about an appropriate exchange rate. The equilibrium
exchange rates in the foreign exchange market at a point of time my ----------------------
give the wrong signal to concerned countries. This may lead to wrong
decisions being made and a misallocation of resources. ----------------------

Notes 2. Creates a Situation of Instability and Uncertainty
Too frequent fluctuations in exchanges rates create uncertainty about the
----------------------
exact amount of receipts and payments in foreign exchange transactions.
---------------------- This instability hampers foreign trade and capital movements between
countries.
----------------------
3. Widespread Speculation
---------------------- Under this system, widespread speculation prevails in the foreign
exchange market. This has a large destabilising effect on the exchange
----------------------
rates.
---------------------- 4. Provides an Inflationary Bias to an Economy
---------------------- Flexible exchange rates have an inflationary impact on the economy. Due
to a deficit in the balance of payments of a country, the demand for foreign
---------------------- currency increases, as a result the currency depreciates and the prices of
---------------------- imports go up. The higher price of imported commodities raises the prices
of industrial products and thus generates cost-push inflation.
---------------------- 5. Official Intervention Prevails Even Under Flexible Exchange Rate
---------------------- It is not possible to have an exchange rate where there is absolutely
no official intervention. Government may not intervene directly in the
----------------------
foreign exchange market, but domestic and monetary and fiscal measures
---------------------- do influence foreign exchange rates.
6. Creates Chaos in the World Market
----------------------
There is enough evidence to show that the flexible exchange rate system
---------------------- has encouraged capital flows. This has resulted in currency crises in
Mexico (December 1994), also the much talked about South East Asian
----------------------
Crises (July 1997) and in Argentina (2002).
---------------------- To conclude, the flexible exchange rate system has its share of both merits
---------------------- and demerits. Whether a flexible exchange rate system suits an economy
or not depends on circumstances. It depends on the characteristics of
---------------------- the economy which adopts the system. It should be noted that since the
collapse of the Bretton Woods system in 1971, it is not a perfectly free
---------------------- flexible exchange rate system that has existed. The hybrid exchange rate
---------------------- regimes that have evolved are highlighted in Section 4.5 of this unit.
---------------------- 4.4 FACTORS INFLUENCING EXCHANGE RATES

---------------------- The exchange rate between countries changes due to changes in demand
or supply in the foreign exchange market. The factors which cause changes in
----------------------
the demand supply are discussed as under:
---------------------- 1. Changes in Prices (Rate of Inflation)
---------------------- It is changes in the relative price levels that cause changes in the exchange
rate. Suppose the price level in Britain rises relative to the US price level.
---------------------- This will lead to the rise in the prices of British goods in terms of pound.

British goods will become dearer in the US. So the supply of dollars to Notes
Britain will decrease. On the other hand, the American goods become
cheaper in Britain and their imports into Britain increase. Hence, the ----------------------
demand for dollars will increase. Thus the supply curve for dollars will
shift to the left so that the exchange rate is established at a higher level ----------------------
from the point of view of the US. It implies appreciation of the value of ----------------------
the dollar and depreciation of the value of the pound.
----------------------
2. Changes in Interest Rates
Changes in the interest rates also lead to changes in the exchange rate. If ----------------------
interest rates rise in the home country, there is a large inflow of capital
----------------------
from foreign countries. As a result, the exchange rate of the domestic
currency will appreciate, relative to the foreign currency. The opposite ----------------------
will be the case, if interest rates fall in the home country.
----------------------
3. Changes in Exports and Imports
The demand and supply of foreign exchange is also influenced by changes ----------------------
in exports and imports. If exports of the country are more than the imports, ----------------------
the demand for its currency increases so that the rate of exchange moves
in its favour. Conversely, if imports are more than exports, the demand for ----------------------
the foreign currency increases and the rate of exchange will move against
the country. ----------------------
4. Capital Movements ----------------------

Short-term or long-term capital movements also influence the exchange ----------------------
rate. Capital-flows tend to appreciate the value of the currency of the
capital-importing country and depreciate the value of the currency of the ----------------------
capital-exporting country. The exchange rate will move in favour of the
capital-importing country and against the capital-exporting country. (For ----------------------
example the large inflows on account of FIIs in India led to the appreciation ----------------------
of the rupee. However, the FIIs becoming net sellers in the stock market
after the second week of May, has led to a depreciation of the rupee). The ----------------------
demand for the currency of the capital-importing country will rise and its
demand curve will shift upward to the right and the exchange rate will ----------------------
be determined at a higher level, given the supply curve of the foreign ----------------------
exchange.
----------------------
5. Influence of Banks
Banks also affect the exchange rate through their operations. They include ----------------------
the purchase and sale of bank drafts, letters of credit, arbitrage, dealing
----------------------
in bills of exchange, etc. These banking operations influence the demand
for and supply of foreign exchange. If the commercial banks issue a large ----------------------
number of drafts and letter of credit on foreign currency the demand for
the foreign currency rises. ----------------------
6. Changes in Bank Rate ----------------------
The bank rate also influences the exchange rate. If the bank rate rises ----------------------
relative to other countries, more funds will flow into the country from

Notes abroad to earn high interest rate. It will tend to raise the demand for
the domestic currency and the exchange rate will move in favour of the
---------------------- country. The opposite will be true when the bank rate falls.
---------------------- 7. Influence of Speculation
The growth of speculative activities also influences the exchange
----------------------
rate. Speculation causes short-run fluctuations in the exchange rate.
---------------------- Uncertainty in the international money market encourages speculation in
foreign exchange. If the spectators expect a fall in the value of currency
---------------------- in the near future, they will sell that currency and start buying the other
currency they expect to appreciate in value. Consequently, the supply of
----------------------
the former currency will increase and its exchange rate will fall. While the
---------------------- demand for the other currency will rise and its exchange rate will go up.
8. Stock Exchange Influences
----------------------
Stock exchange operations in foreign securities, debentures, stocks and
---------------------- shares, etc. exert significant influence on the exchange rate. If the stock
---------------------- markets are very active and there is a high demand for Indian securities,
debentures, shares, etc. by the foreign investors, this will result in
---------------------- an inflow of the foreign currency and the domestic exchange rate will
appreciate. The opposite will be the case if the foreign investors take a
---------------------- selling position in the market for Indian securities, debentures, shares,
---------------------- etc.
9. Structural Influences
----------------------
Structural change is another important factor which influences the exchange
---------------------- rate of a country. Structural changes are those which bring changes in the
consumer demand for commodities. They include technological changes,
---------------------- innovations, etc. which positively influences the cost structure (reduced
---------------------- costs) and increases the export demand for the products.
10. Political Conditions
----------------------
Stable political, industrial conditions and peace and security in the country
---------------------- have a significant influence on the exchange rate. If there is political
stability and the government is stable, strong and efficient, foreigners will
----------------------
have the tendency to invest their funds into the country. However, when
---------------------- the political conditions are precarious like the War of Iraq or sanctions
being imposed on Iran, it tends to influence the rate of exchange in the
---------------------- foreign exchange market.
---------------------- 11. Policies of Exchange Control and Protection
---------------------- Policies of exchange control and protection discourage imports and lead
to a fall in the demand for foreign currency. As a result, the exchange rate
---------------------- of the home country appreciates in relation to the foreign country.
---------------------- 12. Nature of Economy

If a country is developing, it needs to import large quantities of raw
----------------------
materials, and capital goods for its development along with capital. But

its capacity to export is low. Therefore, its demand for foreign exchange Notes
is more which leads to the depreciation of its exchange rate vis-à-vis a
developed country whose exchange rate appreciates. ----------------------
----------------------
----------------------
Multiple Choice Multiple Response.
----------------------
1. Merits of fixed exchange rate system are:
----------------------
i. Avoids wild day-to-day fluctuations
ii. Encourages long-term capital flow ----------------------
iii. Prevents speculation in foreign exchange market ----------------------

iv. Comparative cost system sacrifice ----------------------
2. Flexible exchange rate means:
----------------------
i. Exchange rate responds to laws of supply and demand conditions
----------------------
ii. Avoid day-to-day fluctuations in exchange rate
----------------------
iii. Exchange rate automatically seeks correct level
iv. Exchange rate is free from Government intervention ----------------------
3. Demerits of flexible exchange rate system are: ----------------------
i. It creates a situation of instability and uncertainty ----------------------
ii. It provides an inflationary bias to an economy
----------------------
iii. It creates widespread stability
----------------------
iv. It has large destabilising effect on exchange rate
----------------------
4.5 EXCHANGE REGIMES IN PRACTICE ----------------------
Besides the fixed and flexible exchange rates, over the years especially ----------------------
after the collapse of the Bretton Woods System (1971), a number of hybrid or
intermediate exchange rate systems have come about, that lie in between the ----------------------
two extremes. In this section, we examine the advantages and disadvantages of ----------------------
hybrid exchange rate systems that combine some of the characteristics of fixed
and flexible exchange rates in various degrees. Some of the important hybrid or ----------------------
intermediate exchange rate systems are:
----------------------
1. Exchange Rate Bands
Most fixed exchange rate systems usually allow the exchange rate to ----------------------
fluctuate within narrowly defined limits. That is, nations decide on the ----------------------
exchange rate, or par value, of their currencies and then allow a narrow
band of fluctuations above and below the par value. For example, under ----------------------
the Bretton Woods system (1944-1971), the actual exchange rate was
determined by the forces of demand and supply; but it was allowed ----------------------

Notes to fluctuate within the 1 percent above and below the par value. It is
prevented from moving outside this band by official intervention. Hence,
---------------------- the monetary authorities will not have to intervene constantly in foreign
exchange markets to maintain the established par value, but only to
---------------------- prevent the exchange rate from moving outside the allowed limits of
---------------------- fluctuations. (Refer to Fig.4.3A).
2. Adjustable Peg System
----------------------
This system requires defining the par value and the allowed band of
---------------------- fluctuation with the stipulation that the par value will be changed
periodically and the currency devalued to correct a balance-of-payments
----------------------
deficit or revalued to correct a surplus. A nation could thus take advantage
---------------------- of the flexibility provided by the system and change their par values
without waiting for the pressure for such a change to become unbearable.
---------------------- Thus, under this system, exchange rate flexibility as well as exchange rate
stability is maintained. (Refer to Fig 4.3B). Note: Some objective rules
----------------------
would have to be agreed upon and enforced to determine when the nation
---------------------- must change its par value. Any such rule would be arbitrary and would be
known to speculators, who could then predict a change in the par value
---------------------- and profitably engage in destabilizing speculation.
---------------------- 3. Crawling Peg System
---------------------- It is to avoid the disadvantage of relatively large changes in par values
and possibly destabilizing speculation that the crawling peg system or
---------------------- system of “sliding or gliding parities” was devised. Under this system,
par values are changed by small pre-announced amounts or percentages
---------------------- at frequent and clearly specified intervals; say every month, until the
---------------------- equilibrium exchange rate is reached. (Refer to Fig 4.3C). In other words,
the monetary authority adjusts the exchange rate gradually. It adjusts the
---------------------- exchange rate peg frequently at regular time intervals by small amounts,
instead of making large devaluations or revaluations when the exchange
---------------------- rate changes. This system is better than the adjustable peg system because
---------------------- the country resorts to small doses of inflation rather than large devaluation.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

4. Managed Floating Notes
Under a managed floating exchange rate system, the nation’s monetary
----------------------
authorities are entrusted with the responsibility of intervening in foreign
exchange markets to smooth out these short-run fluctuations without ----------------------
attempting to affect the long-run trend in exchange rates. To the extent
that they are successful, the nation receives most of the benefits that result ----------------------
from fixed exchange rates while at the same time retains flexibility in
----------------------
adjusting balance-of-payments disequilibria.
One possible difficulty is that monetary authorities may be in no better ----------------------
position than professional speculators, investors, and traders to know
----------------------
what the long-run trend in exchange rate is. Fortunately, knowledge of the
long-run trend is not needed to stabilise short-run fluctuations in exchange ----------------------
rates if the nation adopts a policy of leaning against the wind. This
requires the nation’s monetary authorities to supply, out of international ----------------------
reserves, apportion of any short-run excess demand for foreign exchange
----------------------
in the market (thus moderating the tendency of the nation’s currency to
depreciate) and absorb a portion of any short-run excess supply of foreign ----------------------
exchange in the market (thus moderating the tendency of the nation’s
currency to appreciate). This reduces short-run fluctuations without ----------------------
affecting the long-run trend in exchange rates.
----------------------
Note that under a managed float there is still a need for international
reserves, whereas under a freely floating exchange rate system, balance- ----------------------
of –payments disequilibria are immediately and automatically corrected
----------------------
by exchange rate changes – without any official intervention and need
for reserves. However, the freely floating exchange rate system will ----------------------
experience exchange rate fluctuations, that the managed float attempts to
moderate. ----------------------
When a nation is tempted to keep the exchange rate high (i.e., its currency at ----------------------
a depreciated level) to stimulate its exports, this type of floating is referred
to as the dirty float system. The exchange rate is basically determined by ----------------------
the forces of demand and supply, but the monetary authorities intervene ----------------------
from time to time to control excessive market fluctuations.
Since 1973, the world has had a floating exchange rate system of sorts. ----------------------
However, the US did experience the large appreciation of the dollar ----------------------
from 1980 until February 1985 and the equally large depreciation from
February 1985 to the end of 1987clearly indicating that large exchange ----------------------
rate disequilibria can arise and persist over several years under the present
managed floating exchange rate system. The present system does exhibit ----------------------
a large degree of flexibility and more or less allows each nation to choose ----------------------
the exchange rate regime that best suits its preferences and circumstances.
(Refer to Case Study 4.1) ----------------------
5. Optimum Currency Areas ----------------------
The theory of optimum currency areas was developed by Mundell and
----------------------
McKinnon during the 1960s. We are particularly interested in this theory

Notes for the light it can shed on the conflict over fixed versus flexible exchange
rates. An optimum currency area or bloc refers to a group of nations whose
---------------------- national currencies are linked through permanently fixed exchange rates
and the conditions that would make such an area optimum. The currencies
---------------------- of member nations could then float jointly with respect to the currencies
---------------------- of non-member nations.
The formation of an optimum currency area has the following
---------------------- advantages:
----------------------  It eliminates uncertainty in exchange rate fluctuations.
----------------------  It stimulates specialization in production and the flow of trade and
investments among member regions or nations.
----------------------
 It encourages producers to view the entire area as a single market
---------------------- and to benefit from greater economies of scale in production.
 Since the exchange rates are permanently fixed, the countries will
----------------------
experience greater price stability.
----------------------  It also saves the cost of official intervention in foreign exchange
---------------------- markets involving the currencies of member nations, the cost of
hedging, and the cost exchanging one currency for another to pay
---------------------- for imports of goods and services and also when citizens travel
between member nations (if the optimum currency area also adopts
---------------------- a common currency).
---------------------- The formation of an optimum currency area will also entail certain
limitations. It leads to differences among member nations. The
----------------------
economically advanced members may dominate in policy matters over
---------------------- backward member nations.
Further, each member nation cannot pursue its own independent
----------------------
stabilization and growth policy attuned to its particular preferences and
---------------------- circumstances. For example, a depressed nation that needs to adopt
an expansionary fiscal and monetary policy to reduce an excessive
---------------------- unemployment rate, while the more prosperous nation might require
contractionary policies to curb inflationary pressures. Hence, member
----------------------
nations have to sacrifice their independent monetary and fiscal policy. To
---------------------- some extent, these costs of an optimum currency area are reduced by the
greater flow (arbitrage) of capital and labour from regions and nations
---------------------- of excess supply (where returns and earning tend to be low) to regions
and nations of excess demand (where returns and earnings are higher).
----------------------
However, though helpful, this is not likely to eliminate inter-regional and
---------------------- international differences within the optimum currency area, as proved by
the persistent relative poverty in depressed regions of the same nation.
----------------------
Finally, the formation of an optimum currency area is more likely to be
---------------------- beneficial on balance under the following conditions: (1) the greater is
the mobility of resources among various member nations, (2) the greater
---------------------- are their structural similarities, and (3) the more willing they are, to

closely coordinate their fiscal, monetary, and other policies. An optimum Notes
currency area should aim at maximizing the benefits from permanently
fixed exchange rates and minimizing the costs. However, it is extremely ----------------------
difficult to actually measure the net benefits accruing to each member
nation from forming an optimum currency area. ----------------------
6. Currency Board or Dollarization ----------------------
Currency board arrangements (CBAs) are the more extreme form of ----------------------
exchange rate peg, short of adopting a common currency or dollarizing
(i.e., adopting the dollar as the nation’s currency). Under CBAs, the ----------------------
nation rigidly fixes (often by law) the exchange rate of its currency to
a foreign currency, SDR, or composite, and its central bank ceases to ----------------------
operate as such. CBAs are similar to the gold standard and in that they ----------------------
require 100 percent international reserve backing of the nation’s money
supply. Thus, the nation gives up control over its money supply, and its ----------------------
central bank abdicates its function of conducting an independent monetary
policy. With a CBA the nation’s money supply increases or decreases, ----------------------
respectively, only in response to a balance-of payments surplus and inflow ----------------------
of international reserves or to a balance-of-payments deficit and outflow
of international reserves. As a result, the nation’s inflation and interest ----------------------
rates are determined, for most part, by conditions in the country against
whose currency the nation pegged or fixed its currency. ----------------------
A nation usually makes this extreme arrangement when it is in deep ----------------------

financial crisis and as a way to effectively combat inflation. CBAs
----------------------
have been in operation in several countries or economies, such as Hong
Kong (since 1983), Argentina (from 1991 to the end of 2001), Estonia ----------------------
(since 1992), Lithuania (since 1994), Bulgaria (since 1997), Bosnia and
Herzogovina (since 1997). The key conditions for the successful operation ----------------------
of CBAs (besides those generally required for the operation of a fixed
----------------------
exchange rate system) are a sound banking system (since the central bank
cannot be a “lender of last resort” or extend credit to banks experiencing ----------------------
difficulties) and a prudent fiscal policy (since the central bank cannot lend
to the government). ----------------------
The main advantage of CBAs is the credibility of the economic policy ----------------------
regime (since the nation is committed politically and often by law to stick
with it), which results in lower interest rates and lower inflation in the ----------------------
nation. The cost of CBAs is the inability of the nation’s central bank to
----------------------
(1) conduct its own monetary policy, (2) act as a lender of last resort, and
(3) collect seignorage* from independently issuing its own currency. ----------------------
(*Seignorage: The benefit accruing to a nation from issuing the currency
----------------------
or when its currency is used as an international currency and reserve)
Some nations even go further than making CBAs by adopting another ----------------------
nation’s currency as its own legal tender even though the nation can adopt ----------------------
the currency of any other nation. The process is usually referred to as
dollarization. ----------------------

Notes The benefits and costs of dollarization are similar to those arising from
adopting a CBA, but they are more pronounced because dollarization
---------------------- involves an even more complete renunciation of the nation’s monetary
sovereignty since the nation gives us its “exit option” to abandon the
---------------------- system even more than under a CBA. The benefits of dollarization arise
---------------------- from the nation (1) avoiding the cost of exchanging the domestic currency
for dollars and the need to hedge foreign exchange risks, (2) facing a rate
---------------------- of inflation similar to that of the United States and interest rates tending to
fall to the US level as result of commodity arbitrage, and interest rate; and
---------------------- (3) avoiding foreign exchange crises and the need for foreign exchange
---------------------- and trade controls, fostering budgetary discipline and encouraging more
rapid and full international financial integration.
----------------------
Dollarization also imposes some costs on the dollarizing country: (1) the
---------------------- cost of replacing the domestic currency with the dollar(estimated to be
about 4 to 5 percent of GDP for the average Latin American country);
---------------------- (2) the loss of independence of monetary and exchange rate policies
(the country will face the same monetary policy of the United States,
----------------------
regardless of its cyclical situation); and (3) the loss of its central bank
---------------------- as a lender of last resort to bail out domestic banks and other financial
institutions facing a crises.
----------------------
Good candidates for dollarization are small open economies for which the
---------------------- United States is the dominant economic partner and which have a history
of poor monetary performance, and hence very little economic-policy
---------------------- credibility. Most of the small countries of Latin America, especially those in
Central America, as well as the Caribbean nations, fit this description well.
----------------------
Case Study 4.1: Exchange Rate Arrangements of IMF Members in 2001:
----------------------
The distribution of exchange rate arrangements of the 186 member
---------------------- countries of the International Monetary Fund at the end of 2001 is discussed in
this case study. The table shows that exactly half of the countries operated under
---------------------- a fixed exchange rate system of some type, while the other half operated under
---------------------- some kind of exchange rate flexibility. The countries that had fixed exchange
rates included those that adopted the currency of another country (such as
---------------------- Ecuador, El Salvador, and Panama), those that had a common currency (such
as the members of European Monetary Union), those that adopted currency
---------------------- board arrangements (such as Argentina until the end of 2001, Bulgaria, Hong
---------------------- Kong, Estonia, and Lithuania), and those that adopted conventional pegged
arrangements (such as mainland China) or pegged exchange rates within
---------------------- horizontal pegs (such as Denmark and Hungary) of the countries that operated
with some exchange rate flexibility, 4 had crawling pegs (including Bolivia,
---------------------- Costa Rica, and Romania), 42 had managed floating (such as Indonesia,
---------------------- Thailand, and the Russian Federation), and the remaining 41 countries were
independently floating their currency (the United States, Japan, the United
---------------------- Kingdom, and Canada, among the developed countries, and Brazil Korea and
Mexico among the developed countries). Thus, we see that a wide variety of
---------------------- exchange rate arrangements existed at the end of 2001.

Table : Summary Features of Exchange Arrangements and Regulatory Notes
Frameworks for Current and Capital Transactions in IMF Member
Countries ----------------------
Exchange Rate Arrangements Total number ----------------------
of member
countries with ----------------------
these features
Currency board 11 ----------------------
No separate legal tender 13 ----------------------
Conventional peg 42
Stabilized arrangement 21 ----------------------
Crawling peg 2
Crawl-like arrangement 15 ----------------------
Pegged exchange rate within 1
----------------------
horizontal bands
Other managed arrangement 18 ----------------------
Floating 36
Free floating 29 ----------------------
Exchange rate structure 16
Dual exchange rates ----------------------
Multiple exchange rates 6 ----------------------
Arrangements for Payments 66
and Receipts Bilateral payments arrangements ----------------------
Payments arrears 28
Controls on payments for invisible transactions and current 100 ----------------------
transfers
Proceeds from exports and/or invisible transactions 86 ----------------------
Repatriation requirements ----------------------
Surrender requirements 60
Capital Transactions 151 ----------------------
Controls on: Capital market securities
Money market instruments 127 ----------------------
Collective investment securities 127
----------------------
Derivatives and other instruments 101
Commercial credits 85 ----------------------
Financial credits 115
Guarantees, sureties, and financial backup facilities 78 ----------------------
Direct investment 151
Liquidation of direct investment 42 ----------------------
Real estate transactions 144 ----------------------
Personal capital transactions 94
Provisions specific to: 170 ----------------------
Commercial banks and other credit institutions
Institutional investors 143 ----------------------
Source: Annual report on exchange rate arrangement and exchange restrictions ----------------------
2014 https://www.imf.org/external/pubs/nft/2014/areaers/ar2014.pdf
----------------------

Notes
----------------------

1. One of the hybrid exchange rates systems is exchange rate bands
----------------------
under which exchange rates do not fluctuate within narrowly defined
---------------------- bands/limits.
2. Under crawling peg system, the country’s monetary authority adjusts
----------------------
the exchange rate gradually at regular intervals instead of making
---------------------- large devaluations or revaluations in exchange rate.
---------------------- 3. According to the Balance of Payment Theory, the exchange rate of a

country depends upon the forces of demand for and supply of foreign
---------------------- exchange.
----------------------
Activity 1
----------------------
---------------------- Visit different websites of financial newspapers and find out the reasons for
volatility in Indian rupee in terms of US dollar.
----------------------
----------------------
Summary
----------------------
 An exchange rate represents the number of units of one currency needed
---------------------- to acquire another currency.
 The gold standard operated from about 1880. Under the gold standard,
----------------------
the currency in use was convertible into gold at a fixed rate. Each nation
---------------------- defines the gold content of its currency and passively stands ready to buy
or sell any amount of gold at that price. Since the gold content in one unit
---------------------- of each currency is fixed, exchange rates are also fixed.
----------------------  In 1944, representatives of the United States, the United Kingdom, and
42 other nations met at Bretton Woods, New Hampshire to decide on
---------------------- what international monetary system to establish after the war. The Bretton
---------------------- Woods system was a gold-exchange standard. The United States was to
maintain the price of gold fixed at $35 per ounce and be ready to exchange
---------------------- on demand dollars for gold at that price without restrictions or limitations.
Others nations were to fix the price of their currency in terms of dollar
---------------------- (and thus implicitly in terms of gold) and intervene in foreign exchange
---------------------- markets to keep the exchange from moving by more than 1 percent above
or below the par value.
----------------------  The Swedish economist Gustav Cassel developed the Purchasing Power
---------------------- Parity Theory in 1920 to determine the exchange rate between countries
on inconvertible paper currencies. There are two versions of the PPP
---------------------- theory: the absolute and the relative.

 The absolute version states that the equilibrium exchange rate between Notes
two currencies is equal to the ratio of the price levels indexes in the two
countries. ----------------------
R = PA/PB ----------------------
 The relative version of the PPP Theory is the more refined version. The
----------------------
theory postulates that the rate of exchange over a period of time should
be proportional to the relative change in the price levels in the two nations ----------------------
over the same period. Specifically, if we let the subscript 0 refer to the base
period and 1 to a subsequent period, the relative PPP theory postulates ----------------------
that-
----------------------
R1 = P1/P0. R0
----------------------
P1*1/P0*
 According to the Balance of Payments Theory, under free exchange rates, ----------------------
the exchange rate of the currency of a country depends upon its balance ----------------------
of payments. A favourable balance of payments raises the exchange rate
and an unfavorable balance of payment reduces the exchange rate. Thus, ----------------------
the exchange rate is determined by the forces of demand for and supply
of foreign exchange. ----------------------
 Under the fixed or pegged exchange rates, all exchange transactions take ----------------------
place at an exchange rate that is determined by the monetary authority.
It may fix the exchange rate by legislation or intervention in currency ----------------------
markets. It may buy or sell currencies according to the needs of the ----------------------
country or may take policy decision to appreciate or depreciate the
national currency. ----------------------
 Flexible, floating or fluctuating exchange rates are determined by market ----------------------
forces. The monetary authority does not intervene for the purpose of
influencing the exchange rate. ----------------------
 Both the fixed and floating exchange rates have certain advantages and ----------------------
disadvantages.
----------------------
 The exchange rate between countries changes due to changes in various
factors: To name a few- ----------------------
 Change in Prices.

----------------------
 Changes in interest rate.
----------------------
 Changes in basket of traded goods and services.
----------------------
 Nature of stock market operations.
 Structural changes in the economy. ----------------------
 Political conditions prevailing. ----------------------
 Besides the fixed and flexible exchange rates, over the years especially ----------------------
after the collapse of the Bretton Woods System (1971) a number of
hybrid or intermediate exchange rate systems have come about, that lie in ----------------------

Notes between the two extremes that have emerged. They are:
 Exchange Rate Bands.
----------------------
 Adjustable Peg System.
----------------------
 Crawling Pegs.
----------------------  Managed Floating –Dirty Float – to name a few.
----------------------  The theory of optimum currency areas was developed by Mundell and
McKinnon during the 1960s. An optimum currency area or bloc refers
---------------------- to a group of nations whose national currencies are linked through
---------------------- permanently fixed exchange rates and the conditions that would make
such an area optimum. The currencies of member nations could then float
---------------------- jointly with respect to the currencies of non-member nations.
----------------------  Currency board arrangements (CBAs) are the more extreme form of
exchange rate peg, short of adopting a common currency or dollarizing
---------------------- (i.e., adopting the dollar as the nation’s currency). Under CBAs, the nation
rigidly fixes (often by law) the exchange rate of its currency to a foreign
---------------------- currency, SDR, or composite, and its central bank ceases to operate as
---------------------- such.
 Some nations even go further than making CBAs by adopting another
----------------------
nation’s currency as its own legal tender even though the nation can adopt
---------------------- the currency of any other nation; the process is usually referred to as
dollarization.
----------------------
---------------------- Keywords
---------------------- • Exchange rate: It represents the number of units of currency needed to
acquire another currency.
----------------------
• Balance of Payment (BOP): A favourable BOP raises the exchange rate
---------------------- and unfavourable BOP reduces the exchange rate.
---------------------- • Currency Board Arrangements: These are the more extreme form of
exchange rate peg, short of adopting a common currency or dollarising,
---------------------- i.e., adopting the dollar as the nation’s currency.
----------------------
----------------------
1. How is the exchange rate determined under the Gold Standard?
----------------------
2. Critically examine ‘The Purchasing Power Parity Theory’ of exchange
---------------------- rates.
3. What is meant by the ‘Bretton Woods System’? How were exchange rates
----------------------
determined under the Bretton Woods system?
---------------------- 4. Examine the factors influencing exchange rates.
---------------------- 5. Examine how the equilibrium exchange rate is determined by forces of
demand and supply.
6. Analyse the various hybrid exchange rate arrangements existing. Notes
7. What are the merits and demerits of a fixed exchange rate system?
----------------------
8. Examine the arguments for and against the flexible exchange rate system.
----------------------
9. Write short notes on:
a. Optimum currency area ----------------------
b. Currency Board Arrangements ----------------------

c. Dollarization ----------------------
Answers to Check your Progress ----------------------

1. True ----------------------
2. True
----------------------
3. False
----------------------
1. Merits of fixed exchange rate system are: ----------------------

i. Avoids wild day-to-day fluctuations ----------------------
ii. Encourages long-term capital flow
----------------------
iii. Prevents speculation in foreign exchange market
----------------------
2. Flexible exchange rate means:
i. Exchange rate respond to laws of supply and demand conditions ----------------------
iii. Exchange rate automatically seeks correct level ----------------------

iv. Exchange rate is free from Government intervention ----------------------
3. Demerits of flexible exchange rate system are: ----------------------
i. It creates a situation of instability and uncertainty
----------------------
ii. It provides an inflationary bias to an economy
----------------------
iv. It has large destabilising effect on exchange rate
1. False ----------------------
2. True
----------------------
3. True
----------------------

Notes
Suggested Reading
----------------------
1. RBI Report on Trend & Progress of Banking in India.
---------------------- 2. Various Issues Export Finance, Banking and Exchange Regulations by Exim
Management Institute.
----------------------
----------------------
----------------------
ANNEXURE
----------------------
Exchange Rate Systems in India
----------------------
1 Till 1947 : India followed the Sterling Exchange Standard
----------------------
2 1947-1975 : India followed Fixed Exchange Rate System
---------------------- (a) 1947-1966: The Rupee was pegged to Gold and Sterling
---------------------- (b) 1966-1971: The Rupee was pegged to Gold and Dollar
---------------------- (c) 1971-1975: The Rupee was again pegged to Sterling

1 1975-1992: The Rupee was pegged to the Basket Peg System (viz; the
---------------------- Pound, US dollar, Yen, and Deutsche Mark).
---------------------- 2 March 1992-Feb 1993: Dual Exchange Rate System Liberalized Exchange
Rate Management System (LERMS).
----------------------
3 February 1993: Market Determined Floating Rate System Unified
---------------------- Exchange Rate System (UERS).
----------------------  March 1993: Rupee Fully Convertible on Trade Account.
----------------------  August 1994: Rupee Fully Convertible on Current account.

 1966 To March 1992: The Sterling was the Intervention Currency.
----------------------
 Since March 1992: The Dollar became the Intervention Currency.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Developmental Financial Institutions & International
Banking (Specialised Institutions in International UNIT
Banking)
Structure:
5
5.1 Introduction
5.2 Export Credit Guarantee Corporation of India (ECGC)
5.3 ECGC – Types of Credit Insurance Policies
5.4 Types of Guarantees to Banks
5.5 Export Import Bank of India (EXIM Bank)
5.6 Functions of EXIM Bank
5.7 EXIM Bank Programmes
5.8 Foreign Exchange Dealers Association of India (FEDAI)
5.9 Directorate General of Foreign Trade (DGFT)
Summary
Key Words
Suggested Reading
Developmental Financial Institutions & International Banking

(Specialised Institutions in International Banking) 107
Notes
Objectives
----------------------
----------------------
• Describe the role of ECGC in international finance
----------------------
• Explain the insurance schemes of ECGC
---------------------- • Compare the schemes of Exim Bank
---------------------- • Discuss the role of Directorate General of Foreign Trade (DGFT)
and FEDAI
----------------------
---------------------- 5.1 INTRODUCTION

---------------------- India is diverse country spread over a wide geographical area. It will not
be practical to have a single institute to deal with every aspect of international
---------------------- finance. The needs of the exporters and importers are different and there are
different institutes involved to perform the specialised functions in one or two
----------------------
areas. In this Unit, we will study about Export Credit Guarantee Corporation
---------------------- of India (ECGC), Export Import Bank of India (EXIM Bank) and the Director
General of Foreign Trade (DGFT) and Foreign Exchange Dealers Association
---------------------- of India (FEDAI)
----------------------
5.2 EXPORT CREDIT GUARANTEE CORPORATION OF
---------------------- INDIA (ECGC)
---------------------- In 1957, Export Risk Insurance Corporation (ERIC) was established by
---------------------- the Government of India to strengthen the export promotion drive by covering
the risk of exporting on credit. The Corporation’s name was changed to Export
---------------------- Credit Guarantee Corporation Ltd., in 1983.
---------------------- ECGC, being an export promotion organisation, it functions under the

administrative control of the Ministry of Commerce, Government of India. It is
---------------------- managed by Board of Directors representing Government, Banking, Insurance,
Trade and Industry etc.
----------------------
Why is Insurance necessary for Export Credit?
----------------------
All export transactions carry heavy risk – commercial and political – those
---------------------- related to buyer, buyer’s country and unforeseen contingencies even at the best
of times. The risks have assumed large proportions today due to the far reaching
---------------------- political and economic changes that are sweeping the world. An outbreak of
war or civil-war like Jasmine revolution in Tunisia, Egypt; may block or delay
----------------------
payment for goods export. A coup or an insurrection may also bring about the
---------------------- same result. Economic Difficulties or Balance of Payment problems may lead a
country to impose restrictions
----------------------
on either import of certain goods or on transfer of payments for the goods
---------------------- imported. In addition, the exporters have to face commercial risks of insolvency

or the protracted default of buyers. The commercial risks of a foreign buyer going Notes
bankrupt or losing his capacity to pay are aggravated due to the political and
economic uncertainties. Export credit insurance is designed to protect exporters ----------------------
from the consequences of the payment risks, both political and commercial and
----------------------
to enable them to expand their overseas business without fear of loss.
ECGC ----------------------
•
Has a major role in insuring against inherent credit risks of non- payment or ----------------------
loss of export of goods and services.
----------------------
•
Offers guarantees to banks and financial institutions to enable exporters to
obtain better facilities from them. ----------------------
•
Provides Overseas Investment Insurance to Indian companies investing in ----------------------
joint ventures abroad in the form of equity or loan.
• Offers insurance protection to exporters against payment risks. ----------------------
• Provides guidance in export-related activities. ----------------------

•
Makes available information on different countries with its own credit ----------------------
ratings.
----------------------
• Makes it easy to obtain export finance from banks/financial institutions.
• Assists exporters in recovering bad debts. ----------------------
• Provides information on credit-worthiness of overseas buyers. ----------------------
5.3 ECGC – TYPES OF CREDIT INSURANCE POLICIES ----------------------
----------------------
1) Shipment Comprehensive Risk (SCR) Policy: This policy is also known
as Standard Policy. This policy is ideally suited to cover risks in respect of ----------------------
all shipments on short-terms credit of exporters with anticipated annual
turnover of more than 50 lakhs. ----------------------
Two types of risks from the date of shipment are covered in this policy. ----------------------
The Commercial Risks includes: ----------------------
• Insolvency of the buyer.
----------------------
•
Failure of the buyer to make the payment due within a specified period,
normally four months from the due date. ----------------------
• Buyer's failure to accept the goods subject to certain conditions ----------------------
The Political Risks includes
----------------------
•
Imposition of restriction by the Government of the buyer’s country or any
Government action, which may block or delay the transfer of payment made ----------------------
by the buyer.
----------------------
• War, civil war, revolution or civil disturbances in the buyer’s country.
New import restrictions or cancellation of a valid import license in the ----------------------
buyer’s country.
----------------------
•
Interruption or diversion of voyage outside India resulting in payment of
Notes
additional freight or insurance charges which cannot be recovered from the
---------------------- buyer.
•
Any other cause of loss occurring outside India, not normally insured by
----------------------
general insurers, and beyond the control of both the exporter and the buyer.
---------------------- Under this policy
---------------------- •
the exporter has to get a credit limit approved from ECGC in respect of each
foreign buyer to whom he would like to make shipments on DP/DA terms of
---------------------- payments. Such limits are of revolving nature for a period of 12 months. The
Credit limit is a limit on ECGC’s exposure on the buyer for commercial risks
---------------------- and not a limit on the value of shipment that may be made to him. In case
---------------------- the losses are due to political risks, ECGC’s exposure is not restricted by the
credit limit.
---------------------- •
the exporter has to submit on or before the 15th of every month, the details of
---------------------- shipments in a prescribed form, all shipments made by him in the preceding
calendar month.
---------------------- • A
n exporter can file his claim under the policy any time after the loss is
---------------------- ascertained but within one year from the due date of payment for the shipment
claim.
---------------------- • E
CGC normally pays 90% of the loss, whether it is due to commercial
risks or political risks. The remaining 10% has to be borne by the exporter
----------------------
himself. However, ECGC reserves the right to offer a lower percentage of
---------------------- cover in certain cases. Although the exporter’s claim is honoured, ECGC
does not relieve an exporter of his responsibility for taking recovery action
---------------------- and realizing whatever amount can be recovered. The exporter should
therefore, consult ECGC and take prompt and effective steps for recovery of
---------------------- the debts. For its part, ECGC will help the exporter by providing the name of
---------------------- the reliable lawyer and/or debt collecting agency and by enlisting the help
of India’s commercial representative in the buyer’s country. All amounts
---------------------- recovered, net of recovery expenses should be shared with ECGC in the
ratio in which the loss was originally shared.
----------------------
2) Turnover Policy: It is a variation of Shipment Comprehensive Risk (SCR)
---------------------- policy with additional discounts and incentives available to exporters who
pay a premium of not less than Rs.10 lacs per year.
----------------------
Under this scheme/product, the estimated export turnover of the exporter
---------------------- for a year is ascertained and based on that the premium payable is
determined, subject to adjustment at the end of year based on actual. The
----------------------
policy provides additional discount in premium with an added incentive
---------------------- for increasing the exports beyond the projected turnover and also offers
simplified procedure for premium remittance and filing of shipment
---------------------- information.
---------------------- Small Exporters Policy: Similar to Shipment Comprehensive Risk
3)
(SCR), but for exporters with an anticipated annual turnover of Rs.50
---------------------- lacs or less.

4) Services Policy: Under this policy once the Company based in India Notes
finalized the arrangements with foreign principals for providing them
with technical or professional services, payments due under the contracts ----------------------
are open to risks similar to those under supply contracts. Under this policy
risks is covered of such exporters of services only. ----------------------
Broadly, there are two types of Service policies, the details of which are ----------------------
as under:
----------------------
Specific Service Contract Policy
----------------------
----------------------
----------------------
Comprehensive Risks Policy Political Risks Policy
----------------------
----------------------
Whole turnover Services Policy
----------------------
----------------------
----------------------
Comprehensive Risks Policy Political Risks Policy
----------------------
Specific Service Contract Policy
----------------------
Specific Services Policy is issued to cover a single specified contract
of large value and it is extended for a relatively long period. Whole-turnover ----------------------
services policies are appropriate for exporters who provide services to a set
of principles on a repetitive basis and where the period of each contract is ----------------------
relatively short. Such policies are issued to cover all services contracts that may
----------------------
be concluded by the exporter over a period of 24 months ahead.
Under this policy- ----------------------
•
The exporter should submit the declaration of shipments at quarterly intervals ----------------------
and also the details of all payments remaining overdue by more than 60 days
from the due date. ----------------------
•
ECGC will pay claims to the extent of 95% where the loss is due to commercial ----------------------
risks and 100% by any of the political risks.
----------------------
5) Specific Shipment Policy (Short term) -SSP-ST: To cover risks in
respect of a specific shipment or shipments against a specific contract of ----------------------
short-term period.
----------------------
Under this policy, the cover is provided to Indian exporters against
commercial and political risks involved in export of goods on short-term ----------------------
credit not exceeding 180 days. Exporters can take cover under these
policies for either a shipment or a few shipments to a buyer under a ----------------------
contract.
----------------------
Notes Types of Specific Shipment Policy (Short term)
• Specific shipments (commercial and political risks) Policy short term.
----------------------
• Specific shipments (political risks) Policy short term.
----------------------
•
Specific shipments (insolvency & default of L/C opening bank and political
---------------------- risks) Policy short term.
---------------------- The risks covered under Specific Shipment Policy (ST)

• Commercial risks:
----------------------
– Insolvency of the buyer.
----------------------
–Failure of the buyer to make the payment due within a specified period,
---------------------- normally four months from the due date.
– Buyer’s failure to accept the goods, subject to certain conditions.
----------------------
• Political risks:
----------------------
•
Imposition of restrictions by the Government of the buyer’s country or any
---------------------- Government action which may block or delay the transfer of payment made
by the buyer.
----------------------
• War, civil war, revolution or civil disturbances in the buyer’s country.
---------------------- • New import restrictions or cancellations of a valid import license.
---------------------- •
Interruption of voyage outside India resulting in payment of additional
freight or insurance charges which cannot be recovered from the buyer.
----------------------
•
Any other cause of loss occurring outside India, not normally insured by
---------------------- general insurers and beyond the control of both the exporter and the buyer.
---------------------- • I
nsolvency & default of LC opening bank
– Insolvency of the LC opening bank.
----------------------
– Failure of the LC opening bank to make the payment due within a
---------------------- specified period normally four months from the due date. The percentage
of cover normally available under the policy would be 80% of the gross
----------------------
invoice value of the shipments covered, in respect of countries in open
---------------------- cover. The Exporter is required to submit-
A statement of shipments effected on 15th of every month during the
----------------------
previous month along with statement, detailing the payments against the
---------------------- shipments which have remained overdue for more than thirty days from the due
date, under the contract. The exporter can file a claim under the policy any time
---------------------- after the loss is ascertained but, within one year from the due date of payment
for the shipment under claim.
----------------------
However, following risks are not covered under Specific shipment Policy (ST):
----------------------
• Commercial disputes including quality disputes raised by the buyer.
----------------------
• Causes inherent in the nature of goods.
----------------------

•
Buyer’s failure to obtain necessary import or exchange authorization from Notes
authorities in his country.
•
Insolvency or default of any agent of the exporter or of the collecting bank. ----------------------
• Loss or damage to goods. ----------------------

• Exchange rate fluctuation. ----------------------
•
Failure of the exporter to fulfill the terms of the export contract or negligence
----------------------
on his part.
•
Non payment under a LC due to any discrepancy pointed out by the LC ----------------------
opening bank.
----------------------
6) Maturity Factoring Scheme: Factoring is the purchase of accounts
receivables. ----------------------
The Factor provides financing, by way of pre-payment of receivables and ----------------------

sales ledger administration and collection. Under this type of factoring,
the Factor does not make any prepayment against export bills initially, but ----------------------
the Factor undertakes to pay the amount due only on maturity of the credit ----------------------
period.
----------------------
Under the scheme, ECGC provides following services-
• 100% Credit guarantee protection against bad debts. ----------------------
• Sales register maintenance in respect of factored transactions. ----------------------
•
Regular monitoring of outstanding credits, facilitating collection of ----------------------
receivables on due date, recovery at its own cost, of all recoverable bad debts.
•
ECGC would facilitate easier availability of bank finance to its factoring ----------------------
clients. ----------------------
• B
etter security than even Letters of Credit. Exporter can offer more friendly
Delivery terms, like direct delivery to the customer (as against DP/DA) ----------------------
without any risk. ----------------------
• F
or the bank, which advances funds on ECGC factored export receivables, it
would be a win-win situation all the way. Advances given against the scheme ----------------------
could become the most preferred export advance portfolio for a bank, even ----------------------
better than the advances granted under an irrevocable letter of credit.
7) Insurance cover for Buyers Credit and Line of Credit: Buyers credit ----------------------
is a credit extended by a bank in India to an Overseas Buyer enabling ----------------------
the buyer to pay for machinery and equipment that he may be importing
from India or a specific project. Line of Credit is credit extended by ----------------------
bank in India to an overseas bank, institution or Govt. for the purpose of
facilitating import of a variety of listed goods from India into overseas ----------------------
country. A number of importers in the overseas country may be importing ----------------------
the goods under the Line of Credit.
----------------------
The salient feature of this policy is to insure against the risks pertaining
to credit provided by a Bank in India to an overseas buyer for paying for ----------------------
Notes machinery and equipments to be imported from India or credit extended
by a bank in India to an overseas institution for facilitating imports from
---------------------- India.
---------------------- Cover can be granted either for political risks or for comprehensive risks.
In comprehensive risk cover, the risk of protracted default of the borrower
---------------------- to pay the amounts due under the loan agreement and insolvency of the
borrower will be covered in addition to the political risks.
----------------------
8) ECGC provides cover against risks in Construction Contracts which is
---------------------- known as “Construction Works Policy”. This policy provides cover to an
Indian contractor who executes a civil construction job abroad.
----------------------
The distinguishing features of a constructions contract are that-
----------------------
•
The contractor keeps raising bills periodically throughout the contract period
---------------------- for the value of work done between one billing period to another.
---------------------- • To be eligible for payment, the bills have to be certified by a consultant or
supervisor engaged by the employer.
---------------------- • It covers risks up to 85% of the losses that may be sustained by the
---------------------- exporter due to following risks.
•
Insolvency of the employer.
----------------------
•
Failure to pay the bills on due dates.
----------------------
•
Restrictions on transfer of payments from the employer as a country to India
---------------------- after the employer has made the payments in local currency
•
Outbreak of War, civil war, rebellion
----------------------
•
Interruption or diversion of voyage outside India, resulting in additional
---------------------- transport or insurance charges for goods, materials exported from India,
which cannot be recovered from the employer.
----------------------
9) Overseas Investment Insurance
----------------------
Under the scheme, the protection is provided for Indian investments
---------------------- abroad. Any investment made by way of equity capital or untied loan for
the purpose of setting up or expansion of overseas projects are eligible
---------------------- for cover under Investment insurance. The risks of war, expropriation
---------------------- or restriction on remittances are covered under the scheme. For such
type of insurance cover, there should be a bilateral agreement protecting
---------------------- investment of one country in the other.
---------------------- 10) Specific Policies for Supply Contracts: The Standard Policy is a whole
turnover policy designed to provide a continuing insurance for the regular
---------------------- flow of an exporter’s shipments for which, credit period does not exceed
180 days. Contracts for export of capital goods or turnkey projects or
---------------------- construction works or rendering services abroad are not of a repetitive
---------------------- nature and they involve medium/ long-term credits. Such transactions are
insured by ECGC on a case to case basis under specific policies.
----------------------

All contracts for export on deferred payment terms and contracts for Notes
turnkey projects and construction works abroad require prior clearance
of Authorised Dealers, EXIM Bank or the Working Group in terms of ----------------------
powers delegated to them as per exchange control regulations.
----------------------
There are different types of specific contract policies for supply contracts
covered under the Standard Policy for shipments. ----------------------
Specific Shipment Policy ----------------------
----------------------
----------------------
Specific Shipment Specific Shipment ----------------------
(Comprehensive Risks Policy) (Political) Policy
----------------------
Specific Contract Policy ----------------------
----------------------
----------------------
Specific Contract Specific Contract ----------------------
(Comprehensive Risks Policy) (Political) Policy
----------------------
Specific Shipments (Comprehensive Risks) Policy provides cover against

all risks covered under the Standard Policy for shipments. Where the ----------------------
Commercial risks are absent, e.g. where the payments are guaranteed by a
bank or by the Government of the overseas country, the exporter may opt for
----------------------
the Specific Shipments (Political Risks) Policy. ----------------------
Specific Contract Policy (which can also be comprehensive or political risks)
differs from Shipments Policy. The former provides the exporter not only ----------------------
with the post shipment cover like the later, but also with some pre-shipment ----------------------
cover from the date of contract. In case shipments could not be made due
to any of the risks covered or due to restriction on export of the goods from ----------------------
India, the loss in respect of unshipped goods will also be covered under
Contract Policies. ----------------------
11) Exchange Fluctuation Risk Cover ----------------------
The purpose of the Exchange Fluctuation risk cover is intended to provide ----------------------
a measure of protection to exporters of capital goods, civil engineering
contractors and consultants who often receive payments over a period of ----------------------
years for their exports or services. This cover is available for payments
scheduled over a period of 12 months or more, up to a maximum of 15 ----------------------
years. At the stage of bidding, an exporter/contractor can obtain Exchange ----------------------
Fluctuation Risk (Bid) cover. The basis for cover will be a reference
rate agreed upon. Most of the convertible currencies are covered under ----------------------
Exchange Fluctuation Risk cover. Contracts coming under Buyer’s credit
and Line of Credit are also eligible for cover under the schemes. ----------------------
Notes
----------------------

1. The Indian institutes involved in cross-border export/import
----------------------
transactions are:
---------------------- i. ECGC
---------------------- ii. Exim bank
---------------------- iii. Chit funds

iv. FEDAI
----------------------
2. ECGC:
----------------------
i. Offers guarantees to FIs on behalf of exporters for better credit
---------------------- facilities
ii. Assists exporters in recovery of bad debts
----------------------
iii. Provides information on creditworthiness of overseas buyers
----------------------
iv. Insures credit risk of non-payment by importer
---------------------- v. Offers domestic credit facilities to SMEs
---------------------- 3. ECGC’s Shipment Comprehensive Risk (SCR) policy:
---------------------- i. Provides risk cover against insolvency of buyer
---------------------- ii. Covers political risk such as civil disturbances in the buyer’s
countries
---------------------- iii. Provides normally 80% of the loss
---------------------- iv. Covers failure of the importer to make payment due within
specified period, up to say 4 months from the date
----------------------
----------------------
5.4 TYPES OF GUARANTEES TO BANKS
----------------------
1. Packing Credit Guarantee: To enable banks to provide pre-shipment
---------------------- advances to exporters for the manufacture, processing, purchasing or
packing of goods meant for export against a firm order. The Guarantee
----------------------
assures the banks that, in the event of an exporter failing to discharge his
---------------------- liabilities to the bank, ECGC would make good a major portion of the
banks loss i.e. up to two third of its loss ,if entire amount due from the
---------------------- exporter is not recovered within a period of four months from the due
date. The bank is required to be co insurer to the extent of the remaining
----------------------
loss.
---------------------- The ECGC also issues Whole turnover Packing Credit Guarantee WTPCG
to Banks which undertakes to obtain cover for packing credit advances
----------------------
granted to all of its customers on all India basis.
2. Post Shipment Credit Guarantee: This Guarantee enables banks to Notes
extend post shipment finance to exporters through purchase, negotiation
or discount of export bills or advances against such bills. It is necessary, ----------------------
however, that the exporter concerned should hold suitable policy of
ECGC to cover the overseas credit risks. Individual Post shipment credit ----------------------
guarantee can also be obtained for finance granted against LC bills, where ----------------------
an exporter does not hold an ECGC policy, provided that the exporter
makes shipments solely against LC. ----------------------
3. Transfer Guarantee: When bank in India adds its confirmation to a ----------------------
foreign LC, it binds itself to honour the drafts drawn by the beneficiary of
LC without any recourse to him, provided such drafts are drawn strictly ----------------------
in accordance with terms of the LC. The confirming bank will suffer a
----------------------
loss if the foreign bank fails to reimburse it with the amount paid to the
exporter. This may happen due to insolvency or default of the opening ----------------------
bank or due to certain political risks such as war, transfer delay to prevent
the transfer of funds to the bank in India. The Transfer Guarantee seeks to ----------------------
safeguard banks in India against losses arising out of such risks. Loss due
----------------------
to political risks is covered upto 90% and loss due to commercial risks up
to 75%. ----------------------
4. Export Production Finance Guarantee: The purpose of this Guarantee
----------------------
is to enable banks to sanction advances at the pre shipment stage to the
full extent of cost of production when it exceeds the f.o.b. value of the ----------------------
contract or order, the differences representing incentive or duty drawback
receivable. ----------------------
5. Export Performance Guarantee: ECGC provides counter guarantee to ----------------------
protect a bank against losses that it may suffer on account of guarantees
given by it on behalf of exporters. The Indian banks issue such bank ----------------------
guarantees at various stages of execution of export order i.e. bid bond at the
----------------------
time of tendering, performance guarantee to foreign buyers, guarantees to
the Customs, Central Excise authorities, to Export Promotion Councils, ----------------------
Commodity Boards, State Trading Corporations etc. This protection is
intended to encourage banks to give guarantees on a liberal basis for ----------------------
export purposes. Normally under Export Performance Guarantee, cover
----------------------
is extended up to 75% of loss.
Export Finance Guarantee: This guarantee covers post shipment
6. ----------------------
advances granted by banks to exporters against export incentives ----------------------
receivable in the form of cash assistance, duty drawback etc.
----------------------
5.5 EXPORT IMPORT BANK OF INDIA (EXIM BANK)
----------------------
Introduction
----------------------
In 1981, the Export & Import Bank of India was established by an Act of
Parliament. ----------------------
----------------------
Notes EXIM Bank is a Government-owned financial institution set up for the
purpose of financing, facilitating and promoting India’s foreign trade. EXIM
---------------------- Bank commenced its operations in March, 1982.
---------------------- EXIM Bank’s mission is to help globalisation of Indian business. Its
mission is to develop commercially viable relationship with externally oriented
---------------------- companies by supporting their internationalization efforts, through a diverse
range of products and services.
----------------------
The Export-Import Bank of India – Its objectives are “for providing
---------------------- financial assistance to exporters and importers, and for functioning as the
principal institution for coordinating the working of institutions engaged in
----------------------
financing export and import of goods and services with a view to promote the
---------------------- country’s international trade.”
EXIM Bank is managed by a Board of Directors consisting of
----------------------
representatives from the Government, RBI, Export Credit Guarantee Corporation
---------------------- of India, financial institutions, public sector banks and the representatives of
business community.
----------------------
EXIM bank is set up to serve the exporters and importers by way of
---------------------- providing financial assistance solely or jointly with commercial banks, advisory
services, market intelligence, credit information services, etc. EXIM bank
---------------------- extends financial assistance for export of turnkey projects, joint ventures and
---------------------- civil construction projects. The bank grants fund based as well as non fund
based facilities. The fund based facilities include pre-shipment credit to EOUs
---------------------- (Export Oriented units), Supplier’s credit etc.
---------------------- EXIM bank also provides lines of credit, buyer’s credit, refinance of
export credit bulk import finance, bridge loans, production equipment finance,
---------------------- finance for leasing, etc.
----------------------
----------------------
----------------------
1. ECGC issues Whole Turnover Packing Credit Guarantee (WTPCG) to
---------------------- banks, which undertakes to obtain cover for packing credit advances
granted to all its customers on all India basis.
----------------------
2. Exchange fluctuation risk cover is intended to provide continuing
---------------------- insurance under whole turnover policy for the regular flow of an
---------------------- exporter’s shipment.
3. Exim Bank was set up for the sole purpose of financing. facilitating
---------------------- and promoting India’s foreign trade.
----------------------
----------------------
----------------------

5.6 FUNCTIONS OF EXIM BANK Notes
•
Granting loans and advances in India solely or jointly with commercial banks ----------------------
to exporters or potential exporters from India, goods including export of
turnkey projects, civil construction contracts or other contracts and services ----------------------
including consultancy services.
----------------------
•
Granting loans and advances solely or jointly with commercial banks to persons
outside India for import from India of goods including turnkey projects, civil ----------------------
constructions contracts or other contracts and services including consultancy
services. ----------------------
• G
ranting lines of credit to Governments, financial institutions and other ----------------------
suitable organisations in foreign countries to enable persons outside India
to import from India, goods including turnkey projects, services, including ----------------------
consultancy services. ----------------------
•
Handling transactions where a mix of government- to- government credit
and commercial credit for exports is involved. ----------------------
•
Issuing bid bonds or guarantees and other similar facilities in India or abroad ----------------------
solely or jointly with commercial banks on behalf of persons exporting
or intending to export from India goods including turnkey projects, ----------------------
consultancy etc. ----------------------
• Purchasing, discounting and negotiating export bills etc.
----------------------
Incidental functions
----------------------
•
Maintaining of foreign currency accounts with banks and correspondents
abroad for purposes connected with the business of the EXIM Bank. ----------------------
•
Buying and selling currencies or foreign exchange and undertaking such ----------------------
other functions of authorised dealers as may be necessary for the discharge
of its functions. ----------------------
•
Undertaking and financing of research surveys, studies etc., in connection to
----------------------
promotion and development of international markets.
• Providing technical, administrative and financial assistance to any ----------------------
exporter in India or any other person who intends to export goods from ----------------------
India for promotion, management and expansion of any industry with a view
of promoting international trade ----------------------
• Planning, promoting, developing and financing export-oriented industries.
----------------------
• Forming or conducting subsidiaries for carrying out its functions.
----------------------
• Acting as an agent of the Central and State Governments, the RBI, IDBI etc.
----------------------
----------------------
----------------------
----------------------
Notes 5.7 EXIM BANK PROGRAMMES
---------------------- The EXIM bank’s funded facilities may be set out under the following
programmes:
----------------------
•
Pre-shipment Credit beyond six months: While pre-shipment credit up
---------------------- to six months is provided by bank, beyond six months is given by EXIM
Bank jointly with other banks to facilitate the provision of rupee funds for
---------------------- expenses in constructions exports and turnkey project exports enabling them
to buy raw materials and other inputs.
----------------------
•
Direct Financial Assistance to Exporters: EXIM bank provides funds on
---------------------- deferred payment basis to Indian exporters of eligible goods and services,
which enable the Indian exporter to extend deferred payment credit to the
----------------------
overseas buyers. Commercial Banks can participate in this directly or under
---------------------- Risk Syndication Facilities, when the risk of non- payment by the supplier is
shared by banks with the EXIM Bank.
----------------------
Consultancy and Technology Services: Indian companies can avail themselves
---------------------- of the EXIM Bank’s financial facility against deferred credit extended to
overseas buyers of Indian consultancy, technology and other services.
----------------------
• acilities for Export-oriented Units: There are two categories of exporting
F
---------------------- units-
•
100% export oriented units which get green cards for securing easy access to
----------------------
their inputs and
---------------------- •
Units set up in the Free Trade Zones such as Kandla, Santacruz, Madras,
Cochin and Noida(UP). The EXIM Bank provides term loans or deferred
----------------------
payments guarantees for them to acquire Indian plant and machinery or
---------------------- foreign capital goods.
•
Overseas Investment Facility: The Bank provides funds to Indian promoters
----------------------
of joint ventures overseas for equity participation over a period of one to ten
---------------------- years to set up projects abroad or in third world countries.
•
Export Bills Rediscounting by MEMEs: This facility is designed to help
---------------------- MSMEs (Small Scale Industries) to have easier access to commercial banks
---------------------- credit for export purposes. Under the scheme, the Authorised Dealers can
rediscount with the EXIM bank, the export bills of MSMEs arising out of
---------------------- post shipment export credit granted to them.
---------------------- •
Export Vendors Development Finance: Under this scheme, the focus is
to help exporters develop strategic vendor development plans and enhance
---------------------- the export capabilities through the creation and strengthening of backward
linkages with vendors.
----------------------
•
Export Marketing Finance to export marketing activities both, as loans
---------------------- and grants for strategic marketing in industrialized country by Indian
manufacturing companies.
----------------------
• The bank has signed MoU with Ministry of Food Processing Industries
----------------------

Export Credit Notes
----------------------
----------------------
Projects Products Services
----------------------
Suppliers/Buyer’s Credit Lines of Credit Supplier’s Credit ----------------------
----------------------
----------------------
Pre-shipment Credit Pre-shipment Credit Buyer’s Credit
----------------------
----------------------
Guarantees/LCs Post-Shipment Credit Guarantees & LCs ----------------------

----------------------
----------------------
Equipment Finance Guarantees & LCs
----------------------
Fig. 5.1: EXIM Bank’s Major Programmes
----------------------
Oriented Units and Value Added Services working capital, Indian exporters
of capital goods, engineering goods, turnkey projects, construction projects and ----------------------
consultancy services are eligible for term finance, both, funded and non funded
----------------------
assistance from the EXIM Bank. High value proposals are scrutinized by an inter-
institutional working group, consisting of the EXIM bank as the leader, the R.B.I. ----------------------
and the ECGC as members. Exports on deferred payment credits are eligible for
finance and refinance from the EXIM bank for periods beyond six months and ----------------------
up to 100 per cent of finance required and granted by commercial banks so that
short-term exports are not affected by the lack of finance. The pricing i.e. interest ----------------------
rates and margins for various schemes vary from time to time. Normally periods
----------------------
of credit vary from 1 to 10 years and margins from 10 to 20 per cent. Finance in
rupees as well as in foreign currencies, depending on the needs is made available ----------------------
by the EXIM bank.
----------------------
In addition, the following activities are covered under Export Capability
Creation Programme: ----------------------
• Lending Programme for Export Oriented Units.
----------------------
• Production Equipment finance Programme.
----------------------
• Technology Upgradation Fund Scheme for Textile and Jute Industries.
• Overseas Investment Finance Programme. ----------------------
• Equity Investment in Indian Ventures Abroad. ----------------------

• Asian Countries Investment Partners Programme. ----------------------
Notes • Export Marketing Finance Programme.
• Export Product Development Programme.
----------------------
• Finance for Research & Development for Export Oriented Units.
----------------------
• Export Vendor Development Programme.
---------------------- • Programme for Export Facilitation.
---------------------- • Port Development.
---------------------- • Software Training Institutes.
---------------------- 5.8 FOREIGN EXCHANGE DEALERS ASSOCIATION OF

---------------------- INDIA (FEDAI)
---------------------- Foreign Exchange Dealers’ Association of India was formed in August
1958, with the approval of Reserve Bank of India, to take over certain functions
---------------------- then undertaken by the Exchange Bank’s Association (foreign Banks).
---------------------- Earlier, financing of foreign trade and foreign exchange was confined
to foreign banks, which were as a group, designated as Exchange Banks. The
---------------------- Exchange Banks’s Association of which these foreign banks were members at
Bombay, Calcutta, Delhi, Madras and Amirtsar were laying down terms and
----------------------
conditions for foreign exchange business between banks and customers.
---------------------- With the growth of India’s foreign trade, RBI permitted several scheduled
---------------------- commercial banks to undertake foreign exchange business and it was considered
desirable to form an association comprising of all Authorised Dealers in foreign
---------------------- exchange as its members. Accordingly, with the approval of R B I, the Foreign
Exchange Dealers’ Association of India (FEDAI), was established and an
---------------------- undertaking was given by each ADs to RBI to abide by the exchange rates
---------------------- and other terms and conditions prescribed by this Association for transacting
foreign business.
---------------------- FEDAI is a non-profit making body and its expenses are shared by all
---------------------- its members on an annual basis. The main objectives of the Association is to
further the interests and regulate the dealings of and between authorised dealers
---------------------- in Foreign Exchange both inter se and with the public, brokers, RBI and other
bodies. For the information of trade and other allied organisations, FEDAI has
---------------------- subscribed to the
---------------------- a) Uniform Customs and Practice for Documentary Credits and
---------------------- b) Uniform Rules for Collection.
As regards project exports covered by Export Credit Guarantee Corporation
----------------------
of India Ltd (ECGC) under their policies and guarantees, ADs are required to
---------------------- recover premium on such policies/guarantees issued to project exporters. These
premiums have also been incorporated in FEDAI Rules.
----------------------
----------------------

FEDAI has been playing a multifarious role by formulating uniform Rules Notes
and Guidelines for ADs, ensuring a level playing field for the participants and
harmonizing the interest of ADs and Customers. FEDAI has been articulating ----------------------
effectively India’s viewpoint in the various revisions in the ground rules
pertaining to Documentary Credits, Collections etc; by associating itself with ----------------------
International Chamber of Commerce (ICC), Paris. ----------------------
These Uniform Rules have been drawn up recognising the obligations of
----------------------
the exporters,
Importer and Ads under foreign exchange/import/export trade control ----------------------
regulations and have been approved RBI. However, these rules do not cover
transactions between the ADs such as those pertaining to inter-bank market ----------------------
operations, business done through foreign exchange brokers and the sharing of ----------------------
charges between members.
Uniform Customs and Practices for Documentary Credit (UCPDC) ----------------------
Uniform Customs and Practices for Documentary Credit 600 is prepared ----------------------
by International Chamber of Commerce, defining the responsibility of the
buyer’s bank, Negotiating bank, Confirming bank, Advising bank and all ----------------------
international LCs bear an endorsement that they are subject of UCPDC 600. As ----------------------
a representative of Export House or a Banker, one has to get acquainted with the
UCP 600 set of guidelines. The aim of the Uniform Customs and Practices for ----------------------
Documentary Credit is to frame a set of contractual rules that would establish
uniformity to conflicting national regulations. ----------------------
----------------------
5.9 DIRECTORATE GENERAL OF FOREIGN TRADE (DGFT)
----------------------
Export trade is regulated by the Directorate General of Foreign Trade
(DGFT), which functions under the Ministry of Commerce and Industries, ----------------------
Department of Commerce, Government of India.
----------------------
As per the provisions of Foreign Trade Development & Regulation Act,
1992, the policies and the procedures required to be followed for exports from ----------------------
India are announced by the DGFT. The Authorised Dealers (ADs) have to conduct
----------------------
export transactions in conformity with the Foreign Trade Policy in vogue and
the Rules framed by the Government of India. The Director General of foreign ----------------------
Trade is an officer of the Central Government. DGFT has headquarters at New
Delhi and 33 offices all over the country. They issue Import Export code (IEC) ----------------------
to the people engaged in International trade. Issuance of Importer-Exporter
----------------------
Code Number: The application process for issuance of the IEC number has
been simplified since 2006. The applicants can file an on-line application at the ----------------------
DGFT web-site http://dgft.gov.in. The applicant has to submit scanned copies
of PAN and bank certificate along with his application. All applications for ----------------------
Advance License, Advance License for Annual Requirement, EPCG License
----------------------
and DEPB License (for EDI shipping bills from notified EDI Ports), Duty Free
Import Authorisation scheme will have to be submitted with digital signature on ----------------------
the DGFT web site and the payment of license fee will have to be made through
the EFT payment gateway of the DGFT designated banks. ----------------------
Notes Guidelines for maintaining the denied entities list (DEL)
The Denied Entities List (earlier called ‘Black List’) is drawn under the
----------------------
provision of Rule 7 of Foreign Trade (Regulation) Rules 1993. There are 14
---------------------- conditions, which have been described for invocation under this rule, before
a firm can be refused for a license. These conditions cover a vast variety of
---------------------- offences/contraventions leading to refusal of license to an entity.
---------------------- Although the conditions prescribed under Rule 7 of the Rules are
comprehensive and will constitute the basis of any denial of license, a brief
---------------------- description of most common instances are mentioned below-
---------------------- • Generally,
most common instance of action leading to refusal of license
occurs when the firms default in Export Obligation i.e. failure to fulfill
---------------------- the commitment under various export promotion schemes. The licensing
authorities in such cases will place the firm in DEL after serving a demand
---------------------- notice to the entity to submit evidence of export obligation fulfillment within
---------------------- a reasonable time. This demand notice shall indicate that the firm’s inability
to submit documents within prescribed duration will lead to refusal to license
---------------------- under Rule 7 of the Rules and the firm’s name will be placed in the DEL.
Subsequently, the enforcement division of DGFT will take suitable action
---------------------- after investigation/adjudications.
---------------------- • Instances to be noticed when the external agencies such as DRI, CBI, ED etc.

request for information in connection with some investigations or sometimes
---------------------- recommend licensing authorities to withhold further licensing facilities to
the firms under investigation. If external agencies have supplied evidence
---------------------- to the satisfaction of the licensing authority, the firm shall be placed in DEL
---------------------- after issuing a speaking order against the erring firm without disclosing the
source of information in the denial order.
---------------------- •
The sub-rule 7(1) (c) of the Rules deals with cases of fraud and mis-
---------------------- declaration. Whenever, it comes to the notice of the licensing authority that
a license has been obtained by fraud, forgery, mis-declaration, etc, the firm
---------------------- shall immediately be placed in the DEL, by issuing an order and licensing
authority shall also suspend the IE Code of the firm.
----------------------
The procedure and policy leading to suspension and cancellation of
---------------------- licenses shall be governed by Section 9 of the Act read with Rule 9 (suspension)
and Rule 10 (cancellation) of the Rules.
----------------------
The DEL maintained by the port offices will contain full details of the
---------------------- firm along with the IEC Code of the firm. Licensing benefits will not only be
denied to the firm as legal entities but also to the individuals/persons owning/
---------------------- controlling these entities.
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. UCPDC 600 defines the responsibilities of:
----------------------
i. Buyer’s bank
----------------------
ii. Negotiating bank
iii. Central bank of the country ----------------------
iv. Confirming bank ----------------------

2. Exim bank provides value added services, such as: ----------------------
i. Export marketing services
----------------------
ii. Multilateral funding projects
----------------------
iii. Joint venture facilitation
iv. Solvency certificates ----------------------
3. DGFT: ----------------------
i. Regulates export/import trade ----------------------
ii. Issues Import Export Code number to concerned parties
----------------------
iii. Provides reinsurance cover
----------------------
iv. Maintains denied entities’ list
----------------------
Activity 1 ----------------------
----------------------
1. Visit www.eximbank.com and list the performance of exports and
import finance of the bank for the year ending 31st March, 2012 under ----------------------
various activities.
----------------------
2.
Visit the website www.dgft.gov.in and write below the gist of couple of
recent communications. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes Summary
---------------------- • There are various specialised institutions doing specific functions in
International trade/finance.
----------------------
• Besides RBI, EXIM Bank was established by an Act of Parliament. EXIM
---------------------- Bank is a Government-owned financial institution set up for the purpose of
financing/facilitating and promoting foreign trade. The activities of EXIM
---------------------- Bank can be categorized as fund based and Non fund based.
---------------------- • The fund based activities consist of Lines of credit, Supplier’s Credit,
Overseas Buyer’s Credit, Loans under Rupee Expenditure for Project Export
---------------------- Contracts, Pre-Shipment Rupee credit/foreign currency credit, Refinance of
Export Loans, Forfeiting etc.
----------------------
• Non-fund based activities covers Bid Bond, Advance Payment Guarantee,
---------------------- Performance Guarantee, Guarantee for Release of Retention Money,
Guarantee for raising Borrowings Overseas, Confirmation of Letters of
---------------------- Credits.
----------------------
Keywords
----------------------
• EXIM Bank: Export Import Bank of India is a public sector financial institution.
---------------------- • DEL: Denied Entities List maintained by DGFT (Director General of Foreign
---------------------- Trade).
• Transfer Guarantee: Confirmation to LC by Indian Bank which is opened
---------------------- by foreign Bank
----------------------
----------------------
1. What is the role of Export Import Bank of India in International finance?
----------------------
2.
State the role of Export Credit Guarantee Corporation in International
---------------------- Finance.
---------------------- 3.
What are the insurance schemes of the Export Credit Guarantee
Corporation?
----------------------
----------------------
a. Role of EXIM Bank in export promotion.
---------------------- b. Specific shipment short term Policy of ECGC
---------------------- c. FEDAI.
---------------------- d. Maturity Factoring Scheme of ECGC.

e. Transfer Guarantee Scheme of ECGC.
----------------------
6. State the role of Director General of Foreign Trade (DGFT).
----------------------
7. State the schemes of the Export Import Bank of India.
---------------------- 8. State the schemes of ECGC in respect of Guarantees to Banks.

Answers to Check your Progress Notes
1. The Indian institutes involved in cross-border export/import transactions
are: ----------------------
i. ECGC ----------------------
ii. Exim bank ----------------------
iv. FEDAI
----------------------
2. ECGC:
----------------------
i. Offers guarantees to FIs on behalf of exporters for better credit
facilities ----------------------
ii. Assists exporters in recovery of bad debts ----------------------
iii. Provides information on creditworthiness of overseas buyers
----------------------
iv. Insures credit risk of non-payment by importer
----------------------
3. ECGC’s Shipment Comprehensive Risk (SCR) policy:
i. Provides commercial risk cover against insolvency of buyer ----------------------
ii.
Covers political risk such as civil disturbances in the buyer’s ----------------------
countries
----------------------
iii. Covers failure of the importer to make payment due within specified
period, up to say 4 months from the date ----------------------
----------------------
1. True
----------------------
2. False
3. True ----------------------

1. UCPDC 600 defines the responsibilities of :
----------------------
i. Buyer’s bank
----------------------
ii. Negotiating bank
iv. Confirming bank ----------------------
----------------------
----------------------
----------------------
Notes 2. Exim bank provides value added services, such as:
i. Export marketing services
----------------------
ii. Multilateral funding projects
---------------------- iii. Joint venture facilitation
---------------------- 3. DGFT:
---------------------- i. Regulates export/import trade
ii. Issues Import Export Code number to concerned parties
----------------------
iii. Maintains denied entities’ list
----------------------
---------------------- Suggested Reading

---------------------- 1. http://www.irda.gov.in
---------------------- 2. http://www.fincen.gov/
3. Khan, M Y. Financial Services.
----------------------
4. Pathak, Bharti V. Commercial Banking, Volume II. , Indian Institute of
---------------------- Bankers The Indian Financial System – Market Institutions and Services.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

New Financial Instruments Objectives
UNIT
6
Structure:
6.1 Introduction
6.2 Classification of Financial Instruments
6.3 Traditional Financial Instruments
6.4 Emergence of Complex Financial Instruments
6.5 Meaning of Derivatives
6.6 Derivative Markets/Contracts
6.7 Various Types of Derivatives
6.8 Permissible Derivative Instruments in India
6.9 Reasons for Popularity of Derivatives
Summary
Key Words
Suggested Reading
New Financial Instruments Objectives 129

Notes
Objectives
----------------------
----------------------
• Understand the emergence of various Financial Instruments.
----------------------
• Explain the features of various Financial Instruments.
---------------------- • Discuss the various Derivative Products.
---------------------- • Compare the benefits of using Derivatives.
---------------------- • Evaluate the reasons for popularity of Derivatives.
---------------------- 6.1 INTRODUCTION

---------------------- A Financial Instrument can be defined as a real or virtual document
representing a legal agreement involving some sort of monetary value. Financial
----------------------
instruments can be classified generally as equity based, representing ownership
---------------------- of the asset, or debt based representing a loan made by an investor to the owner
of the asset. A Financial Instrument is a tradable asset of any kind, either cash;
---------------------- evidence of an ownership interest in an entity; or a contractual right to receive,
or deliver cash or another financial instrument. It may be defined as ‘any contract
----------------------
that gives rise to a financial asset of one entity and a financial liability or equity
---------------------- instrument of another entity’. There are various types of documents that are
properly identified as a ‘financial instrument’. The financial instruments can
---------------------- broadly be classified as ‘cash instruments’ or ‘derivative instruments’. Foreign
exchange instruments comprise a third, unique type of instrument.
----------------------
---------------------- 6.2 CLASSIFICATION OF FINANCIAL INSTRUMENTS

---------------------- Financial instruments can be categorized on the basis of their form depending
on whether they are cash instruments or derivative instruments:
----------------------
(a) Cash instruments are financial instruments whose value is determined
---------------------- directly by markets. Cash instruments are simply those documents that are
recognized as cash that can be utilized for various transactions. Currency
----------------------
is the most easily identified instruments of all cash instruments although
---------------------- documents such as cheques or fund transfers from bank accounts would
also be considered as a financial instrument of this type.
----------------------
The cash instruments can be divided into securities, which are readily
---------------------- transferable, and other cash instruments such as loans and deposits, where
both, borrowers and lenders have to agree on a transfer.
----------------------
(b) Derivative Instruments are financial Instruments which derive their value
---------------------- from the value and characteristics of one or more underlying entities
such as an asset, index or interest rate. They can be further classified as
---------------------- exchange-traded derivatives and over the counter (OTC) derivatives.
---------------------- The financial Instruments can also be classified by “asset class” depending

on whether they are equity based (reflecting ownership of the issuing Notes
entity) or debt based (reflecting a loan the investor has made to the issuing
entity). If it is debt, it can be further categorized into short term (less than ----------------------
one year) or long term.
----------------------
(c)
Foreign Exchange Instruments and transactions are neither debt nor
equity based and belong in their own category. ----------------------
Different types of ‘Financial Instruments’ can be broadly classified as under: ----------------------
----------------------
----------------------
1. Financial instruments means:
----------------------
i. Tradable assets
ii. Government securities ----------------------
iii. Stressed assets ----------------------
iv. Derivate instruments ----------------------
2. Cash instrument means:
----------------------
i. Currency notes
----------------------
ii. Counterfeit currency
iii. Readily transferable securities ----------------------
iv. Loans and advances ----------------------
3. Financial instruments can be: ----------------------
i. Equity based
----------------------
ii. Debt based
----------------------
iii. Short-term debt
iv. Chit fund ----------------------
v. Long-term debt ----------------------
----------------------
6.3 TRADITIONAL FINANCIAL INSTRUMENTS
----------------------
Several financial instruments are available in the Indian Financial System.
These are government securities, or G-sec, preference shares, commercial ----------------------
papers, equity shares, certificate of deposits, call money market and industrial ----------------------
securities. Some of these are discussed in brief as under:
----------------------
----------------------
----------------------

Notes Asset Class Instrument Type
Securities Other Cash Exchange OTC
---------------------- Traded Derivatives
Derivatives
----------------------
Debt (long Bonds Loans Bond Futures Interest rate
---------------------- term) > Options on Swaps Interest
1year Bond Futures rate caps and
---------------------- floors Interest
rate options
----------------------
Debt (short T- Bills, Deposits, Short Term Forward Rate
---------------------- term) Commercial Certificate Interest Rate Agreements
<=1year Paper (CP) of Deposits Futures
---------------------- (COD)
Equity Stock - Stock Options Stock options
----------------------
Equity
---------------------- Futures
Foreign - Spot Foreign Currency Foreign options
---------------------- Exchange Exchange Futures Outright
Forwards
---------------------- Foreign
---------------------- exchange Swaps
Currency Swaps
---------------------- Government Securities: For the purpose of borrowing money, the
---------------------- government makes use of different types of instruments with maturities
ranging from 10 days to more than 30 years. To meet the temporary receipt and
---------------------- expenditure mismatch, it obtains overdraft from Reserve Bank of India under
Ways and Means Advances (WMA). To meet the short term liquidity situations,
---------------------- it issues cash management bills; treasury bills (T-Bills) of 91 days, 182 days, and
---------------------- 364 days maturity. For long-term needs, it makes use of dated securities in the
form of bonds and long term loans. In India, mainly the institutional investors
---------------------- buy the government securities. The government, both State and Central, and
the government authorities, for example, state electricity boards, municipalities
---------------------- etc issue it. Commercial banks are the biggest investors who buy the G-sec.
---------------------- The government collects money through the G-sec to finance its several new
infrastructure development projects or to meet its present needs.
----------------------
Bonds: A bond is a negotiable certificate evidencing indebtedness. A
---------------------- bond investor lends money to the issuer and in exchange, the issuer promises to
repay the loan amount on a specified maturity date. The issuer usually pays the
---------------------- bondholder periodic interest payments over the life of the loan. In order to raise
long term funds Government and corporates issue bonds and long term loans.
----------------------
Bonds are generally issued in the form of promissory notes and thus they entail
---------------------- a promise to pay. Since bonds are issued in the form of promissory notes, the
provisions of Negotiable Instruments Act 1881 are applicable to them and they
---------------------- can be conveniently transferred by endorsement and delivery, without incurring
any stamp duty for the transfer.
----------------------

The various types of bonds are (a) Zero Coupon Bonds, issued at a Notes
discount and repaid at the face value (b) Convertible Bond, which gives the
investor the option to convert the bond into equity at a fixed conversion price ----------------------
(c), Security Receipt, issued by a securitisation company or reconstruction
company evidencing the purchase or acquisition of an undivided right, title or ----------------------
interest in the financial asset involved in securitisation. ----------------------
Debentures: An instrument issued by a company bearing a fixed
----------------------
rate of interest usually payable half-yearly on specific dates and principal
amount repayable on the date of redemption. A debenture therefore is an ----------------------
acknowledgement from the company that it has to repay a certain amount
of money on a specified date. A debenture has (a) an ‘issuer’, i.e. the party ----------------------
that has issued the security (b) a ‘maturity date’ on which the security will be
----------------------
redeemed by the issuer, (c) a maturity amount that is repayable by the issuer
on redemption and (d) an arrangement for payment of interest, either on a fixed ----------------------
rate or on floating rate basis. This again can be non-cumulative or cumulative.
Debentures are normally secured and charged against the asset of the company ----------------------
in favour of debenture holder.
----------------------
Non-Convertible Debentures: NCD is a debt instrument issued by
a corporate (including NBFC) by way of private placement. The maturity of ----------------------
NCD ranges from minimum 90 days to maximum one year.
----------------------
Commercial Papers (CP): Commercial Paper (CP) introduced during
1990, is a short term money market instrument (7days to one year) issued as a ----------------------
Usance promissory note (unsecured). It is privately placed. The objective is to
----------------------
enable highly rated corporate borrowers and primary dealers to diversify their
sources of short term borrowings. CPs are issued mainly by the corporates to ----------------------
fund their working capital needs. Commercial Papers are issued generally for
short-term maturities. Commercial papers are not secure and subject to market ----------------------
risks, as such, corporate bodies that have a good tangible net worth, high credit
----------------------
rating and a good credit history will only be able to use this financial instrument.
Equity Shares: The equity capital of a company is divided into shares. ----------------------
Equity share is the basic unit of ownership in a company. Ownership of a ----------------------
share entitles the holder to a proportionate share of the profit distributed by the
company in the form of dividends. The holder of an equity share can earn a ----------------------
capital gain on the sale of the shares. Equity shares don’t have any fixed return
rate and thereby, no period of maturity. The equity shareholders, as fractional ----------------------
owners, undertake the maximum entrepreneurial risk associated with a business ----------------------
venture. The holders of equity shares are members of the company and have
voting rights. A company may issue such shares with differential rights as to ----------------------
voting, payment of dividend, etc.
----------------------
Preference Shares: Preference Share holders are entitled to a fixed
dividend calculated at a fixed rate to be paid regularly before dividend can be paid ----------------------
in respect of equity shares. They also enjoy priority over the equity shareholders
in payment of surplus. But, in the event of liquidation, their claims rank below ----------------------
the claims of the company’s creditors, bond holders/debenture holders. Thus, ----------------------

Notes preference shares carry a fixed dividend rate and a special right to dividends
over the private equity holders. A type of preference share on which dividend
---------------------- accumulates if it remains unpaid is known as ‘Cumulative Preference Shares’.
All arrears of preference dividend have to be paid out before paying dividend
---------------------- on equity shares. In case of ‘Cumulative Convertible Preference Shares’ the
---------------------- dividend payable accumulates, if not paid. After a specified date, these shares
will be converted into equity capital of the company.
----------------------
Deposits: Deposits are another avenue for investors to earn a fixed return.
---------------------- Like debentures, the investor in a fixed deposit earns interest that may be
calculated on fixed rate or floating rate basis. The principal amount is repayable
---------------------- on maturity. Unlike debentures, a fixed deposit receipt cannot be traded in the
market as it is not a security.
----------------------
Certificate of Deposits (CD): COD was introduced in July 1989, to enable
---------------------- the banking system to mobilize bulk deposits from the market, which they can
attract at competitive rates of interest. All Scheduled commercial banks (other
----------------------
than RRBs) and all India Financial Institutions within their ‘Umbrella limits’
---------------------- can issue CoDs. CoDs are issued in the form of Usance Promissory notes and
are issued in the dematerialization form only. Individuals (other than minors)
---------------------- Corporations, Companies, Trusts, Funds, Associations etc can invest. The
CODs can be issued for maturities ranging from minimum 7 days to maximum
----------------------
12 months (In case of FIs minimum 1 year and maximum 3 years). Minimum
---------------------- amount of CD should be Rs. 1lakh, beyond which it can be in multiples of Rs.
1 lakh. The interest rate on CoDs can be fixed or floating but, is market related.
----------------------
Call Money Market: Under the call money market, funds are transacted
---------------------- on overnight basis and under notice money market, funds are transacted for the
period between 2 days and 14 days. Participants in call/notice money market
---------------------- currently include banks and Primary dealers, both as borrowers and lenders.
The participants are free to decide on interest rates in call/notice money market.
----------------------
Industrial Securities: Refers to the market of shares and debentures of
---------------------- old as well as new companies. This market is further divided as primary market
---------------------- and secondary market.
---------------------- 6.4 EMERGENCE OF COMPLEX FINANCIAL

---------------------- INSTRUMENTS
---------------------- In recent years complex financial products like asset-backed securities,

derivatives, credit-default swaps and collateralized debt obligations have
---------------------- emerged. These instruments have become highly popular with banks and
financial institutions as they allow them to hedge their risks and manage their
---------------------- regulatory and economic capital more effectively.
---------------------- The emergence of the market for derivative products, particularly
forwards, futures and options can be traced back to the willingness of risk-
----------------------
averse economic agents to guard themselves against uncertainties arising out
---------------------- of fluctuations in asset prices. The financial markets, by their very nature are
subject to a high degree of volatility.
Through the use of derivative products, it is possible to partially or fully Notes
transfer price risks by locking-in asset prices. The derivatives thus emerged
as hedging devices against fluctuations in commodity prices and commodity- ----------------------
linked derivatives remained the sole form of such products for a long time. The
financial derivatives came into spotlight in the seventies due to the growing ----------------------
instability in the financial markets. In the recent years, the market for financial ----------------------
derivatives has grown tremendously both in terms of variety of instruments
available and their complexity. ----------------------
----------------------
----------------------
----------------------
1. All scheduled commercial banks and financial institutions including
Regional Rural Banks (RRBs), within their umbrella limits can issue ----------------------
Certificate of Deposits. ----------------------
2. Commercial Papers (CPs) are unsecured promissory notes issued by
highly rated corporate to fund their working capital requirements. ----------------------
3. To meet long-term mismatches in receipt and expenditure, Central ----------------------

and State Governments obtain overdraft from Reserve Bank of India
under Ways and Means Advances (WMAs). ----------------------
----------------------
6.5 MEANING OF DERIVATIVES ----------------------
As per Reserve Bank of India, derivative means a financial instrument to ----------------------
be settled at a future date, whose value is derived from change in some other
variable such as interest rate, foreign exchange rate, market index, credit index, ----------------------
price of securities or goods, index of prices etc.(called underlying). In other
----------------------
words, derivatives are financial instruments/contracts whose value depends
upon the value of an underlying. ----------------------
The term derivative indicates that it has no independent value, i.e. its value ----------------------
is entirely derived from the value of the underlying asset. The term ‘derivative’
means a forward, future, option or any other hybrid contract of pre-determined ----------------------
fixed duration, linked for the purpose of contract fulfillment to the value of
a specified real or financial asset of an index of securities. Similarly, in the ----------------------
financial sense, a derivative is a financial product, which has been derived from ----------------------
a market for another product.
The International Monetary Fund (IMF) defines derivatives as ‘financial ----------------------
instruments that are linked to a specific financial instrument or indicator or ----------------------
commodity and through which specific financial risks can be traded in financial
markets in their own right. The value of a financial derivative derives from the ----------------------
price of an underlying item, such as an asset or index.
----------------------
Derivatives instruments are defined by the Indian Securities Contracts
(Regulation) Act, 1956 to include: ----------------------

Notes (1) A security derived from a debt instrument, share, secured/unsecured loan,
risk instrument or contract for differences or any other form of security
---------------------- and
---------------------- (2) A contract that derives its value from the prices/index of prices of
underlying securities.
----------------------
---------------------- 6.6 DERIVATIVE MARKETS/CONTRACTS
---------------------- There are two distinct groups of contracts:

Over-the-counter (OTC) derivatives: Traded directly between two
(a)
----------------------
eligible parties, with/without use of an intermediary and without going
---------------------- through an exchange.
(b) Exchange traded derivatives: Derivative products that are traded on an
----------------------
exchange.
----------------------
6.7 VARIOUS TYPES OF DERIVATIVES
----------------------
The most common types of derivative contracts are as under:
----------------------
Forward Contracts: A forward contract is a customized contract between
---------------------- two entities, where settlement takes place on a specified future date at today’s
pre-agreed price. A forward contract is an agreement to buy or sell an asset on
----------------------
a specified date for specified price. One of the parties to the contract assumes a
---------------------- long position and agrees to buy the underlying asset on a certain specified future
date, for a certain specified price. The other party assumes a short position and
---------------------- agrees to sell the asset on the same date for the same price. Other contract details
like delivery date, price and quantity are negotiated bilaterally by the parties to
----------------------
the contract. Forward contracts are normally traded outside stock exchanges.
---------------------- They are popular on the Over the Counter (OTC) market.
Some of the salient features of forward contracts are as follows:
----------------------
(1) They are bilateral contracts and hence exposed to counter party risk.
----------------------
(2) Each contract is customer designed, and hence unique in terms of contract
---------------------- size, expiration date and the asset type and quantity.
---------------------- (3) The contract price is generally not available in public domain.
(4) On the expiry date, the contract has to be settled by delivery for the asset.
----------------------
A typical hedging application of the forward contract may pertain to an
---------------------- exporter who expects to receive payment in US dollars, three months later.
He is exposed to the risk of exchange rate fluctuations. By using the currency
----------------------
forward market to sell dollars forward, he can lock-on a rate today and reduce
---------------------- his uncertainty. Similarly, an importer who is required to make payment of US
dollars forward can reduce his exposure to exchange rate fluctuations by buying
---------------------- dollars forward.
----------------------

FUTURES: A futures is a standard contract based on an agreement to Notes
buy or sell an asset at a certain price at a certain time in future. It is an obligation
on the buyer to purchase the underlying instrument and the seller to sell it. The ----------------------
delivery under a futures contract is not a must. The buyers and sellers can set-
off the contract by packing the different amount at the current rate/price of the ----------------------
underlying. ----------------------
As stated above, a future contract is an agreement between two parties to
----------------------
buy or sell an asset at a certain time in future, at a certain price. However, unlike
forward contracts, future contracts are standardised and stock exchange-traded. ----------------------
To facilitate
----------------------
Liquidity in the future contracts, the exchange specifies certain standard
features for the contract. It is a standardised contract with a standard underlying ----------------------
instrument. The standardised items in a future contract are (a) Quality and
Quantity of the underlying (b) date/month of delivery (c) Units of price quotation ----------------------
and minimum price change (d) Location of settlement.
----------------------
OPTIONS: It is a contract that provides a right but does not impose
any obligation to buy or sell a financial instrument (say a share or a security). ----------------------
Options are fundamentally different from forward and future contracts. An
----------------------
‘Option’ gives the holder the right to do something. The holder does not have
to necessarily exercise this right. In contrast, in a forward or future contract, the ----------------------
two parties commit themselves to do something. While it costs nothing (except
margin requirements) to enter into a future contract, the purchase of an option ----------------------
requires an upfront payment. The person who buys the option from option seller
----------------------
by making payment of option premium is known as the owner or buyer of the
option. His obligation under the option is up to the payment of premium on ----------------------
option. The person who sells the option to the option buyer by charging the
option premium is known as the writer or seller of the option. ----------------------
There are two variants of options (a) European option where the holder ----------------------
can exercise the right, on the expiry date and (b) American option where the
holder can exercise the right anytime between purchase date and the expiry ----------------------
date. ----------------------
Options have two components i.e. (a) Call Option wherein the owner
(buyer) has the right to purchase and the seller has the obligation to sell (b) ----------------------
Put Option where the owner or buyer has the right to sell and the seller has the ----------------------
obligation to buy.
The cost of the option charged upfront, from the buyer of the option is ----------------------
called a premium. In other words, it is the fee paid for the option contract. ----------------------
SWAP: A SWAP is a contract that binds two counterparties to exchange
----------------------
the different streams of payments over the specified period at specified rate. In
the context of foreign exchange, it means simultaneous sale and purchase of ----------------------
one currency to another. In the context of financial derivatives, the swap means
the exchange of two streams of cash flows, over a definite period of time. ----------------------
----------------------

Notes Currency swap: When pre-determined streams of payments in different
currencies are exchanged on a pre-fixed period at pre-fixed rate.
----------------------
Interest Rate swap: It is exchange of different streams of interest structures
---------------------- (and not the principal amount).
---------------------- 6.8 PERMISSIBLE DERIVATIVE INSTRUMENTS IN INDIA

---------------------- Presently the following types of derivative instruments are permitted by
---------------------- RBI.
Interest Rate Derivatives: Interest Rate Swap (IRS), Forward Rate
----------------------
Agreement (FRA) and Interest Rate Future (IRF).
---------------------- (a) Interest Rate Swap: It is a financial contract between two parties
exchanging or swapping a stream of interest payments for a ‘notional
----------------------
principal’ amount on multiple occasions during a specified period. Such
---------------------- contracts generally involve exchange of ‘fixed to floating ’or ‘floating
to floating’ rates of interest. On each payment date occurring during the
---------------------- swap period, cash payments based on fixed/ floating and floating rates, are
made by the parties to one another.
----------------------
(b) Forward Rate Agreement: A Forward Rate Agreement is a financial
---------------------- contract between two parties to exchange interest payments for a ‘notional
principal’ amount on settlement date, for a specified period from start
----------------------
date to maturity date. Accordingly, on the settlement date, cash payments
---------------------- based on contract (fixed) and the settlement rates are made by the parties
to one another.
----------------------
(c) Interest Rate Future: It is a standardised, exchange-traded contract with
---------------------- an actual or notional interest bearing instrument as the underlying asset.
RBI introduced IRF on a notional coupon bearing 10-year Government
---------------------- of India Security and issued a direction dated August 28, 2009. The
---------------------- standardised IRF contract has the following features:
•
The contract shall be on 10-year notional coupon bearing Government of
---------------------- India Security.
---------------------- • The notional coupon shall be 7% per annum with semi-annual compounding.
---------------------- The contract shall be settled by physical delivery of deliverable grade

securities using the electronic book entry system of the Depositories, NSDL or
---------------------- CDSIL and Public Debt Office of RBI.
---------------------- – Deliverable grade securities shall comprise GOI securities maturing at
least 7.5 years but not more than 15 years from the first day of the delivery
---------------------- month with a minimum total outstanding stock of Rs 10,000 crores.
---------------------- Foreign Currency Derivatives: Foreign Currency Forward, Currency Swap and
Currency Option.
----------------------
(a)
Foreign Exchange Forward: It is an over-the-counter contract under
---------------------- which a purchaser agrees to buy from the seller, and the seller agrees

to sell to the purchaser, a specified amount of a specified currency on a Notes
specified date in the future- beyond the spot settlement date- at a known
price denominated in another currency (known as the forward price) that ----------------------
is specified at the time the contract is entered into.
----------------------
(b) Currency Swap: It is an interest rate swap where the two legs to the
swap are denominated in different currencies. Additionally, the parties ----------------------
may agree to exchange the two currencies normally at the prevailing spot
----------------------
exchange rate with an agreement to reverse the exchange of currencies, at
the same spot exchange rate, at a fixed date in the future, generally at the ----------------------
maturity of the swap.
----------------------
(c) Currency Options: It is a contract where the purchaser of the option has
the right but not the obligation to either purchase (call option) or sell (put ----------------------
option) and the seller of the option agrees to sell (call option) or purchase
(put option) an agreed amount of a specified currency at a price agreed in ----------------------
advance and denominated in another currency (known as the strike price)
----------------------
on a specified date (European option) or by an agreed date (American
option) in the future. ----------------------
(d) Currency Futures: It is a standardised foreign exchange derivative contract
----------------------
traded on a recognised stock exchange to buy or sell one currency against
another, on a specified future date; at a price specified on the date of ----------------------
contract (it excludes a forward contract). The currency futures market
in India functions subject to the directions issued by RBI and SEBI. The ----------------------
Currency Futures (Reserve Bank) Directions, 2008 came into force with
----------------------
effect from August 6, 2008 and amended on Jan 19, 2010.
----------------------
6.9 REASONS FOR POPULARITY OF DERIVATIVES
----------------------
Derivatives are means of managing risks. They enable transfer of various
----------------------
financial risks to entities who are more willing or better suited to take or manage
them. The users can undertake derivative transactions to reduce or extinguish an ----------------------
existing identified risk or for transformation of risk exposure. Market-makers
undertake transactions to act as counterparties in derivative transactions with ----------------------
users and also amongst themselves.
----------------------
The parties managing risks in the market are known as hedgers. Some people
organizations are in the business of taking risks to earn profits. Such entities ----------------------
represent the speculators. Third types of players in the market are known as the
----------------------
arbitragers who take advantage of the market mistakes.
During the recent years, derivatives have become increasingly important for the ----------------------
following reasons: ----------------------
(1) Increased volatility in asset prices in financial markets.
----------------------
(2) Increased integration of national financial markets with the international
markets. ----------------------
----------------------

Notes (3) Marked improvement in communication facilities and sharp decline in
their costs.
----------------------
(4) Development of more sophisticated risk management tools, providing
---------------------- economic agents a wider choice of risk management strategies.
(5) Innovations in the derivatives markets, which optimally combine the
----------------------
risks and returns over a large number of financial assets, leading to
---------------------- higher returns, reduced risks as well as transaction costs as compared to
individual financial assets.
----------------------
(6) So far as the equity derivatives are concerned, futures and options on
---------------------- stock indices have gained more popularity than on individual stocks,
especially among institutional investors, who are major users of index-
---------------------- linked derivatives. The lower costs associated with index derivatives vis-
à-vis derivative product based on individual securities is another reason
----------------------
for their growing use.
----------------------
----------------------
---------------------- 1. Derivative instrument is defined by the Indian Securities Contracts

(Regulation) Act, 1956 and it includes a security derived from a
---------------------- _____ instrument like share, bonds, etc.
---------------------- 2. A bond is a negotiable certificate and zero coupon bonds are issued at
a ____ and repaid at the face value.
---------------------- 3. Derivate contracts are of mainly two types: Over-the-Counter (OTC)
---------------------- derivates and _______ traded derivates.
----------------------
Activity 1
----------------------
---------------------- 1.
List out at least three reasons for the popularity of Derivatives.
2.
List out the various Foreign Exchange Instruments and prepare a
----------------------
comparative chart giving the salient features of each of them
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Summary Notes
• A Financial Instrument can be defined as a real or virtual document ----------------------

representing a legal agreement involving some sort of monetary value.
----------------------
• In recent years, complex financial products like asset-backed securities,
derivatives, credit-default swaps and collateralized debt obligations have ----------------------
emerged. These instruments have become highly popular with banks and
----------------------
financial institutions as they allow them to hedge their risks and manage their
regulatory and economic capital more effectively. ----------------------
• As per RBI, derivative means a financial instrument to be settled at a future
date whose value is derived from change in some other variable such as interest ----------------------
rate, foreign exchange rate, market index, credit index, price of securities or ----------------------
goods, index of prices etc. (called underlying). The term derivative indicates
that it has no independent value, i.e. its value is entirely derived from the ----------------------
value of the underlying asset. There are two distinct groups of derivative
contracts: (a) traded directly between two eligible parties, with/without use ----------------------
of an intermediary and without going through an exchange known as OTC
----------------------
products and (b) products that are traded on an exchange.
----------------------
Keywords
----------------------
• Financial Instrument: A real or virtual document representing a legal
----------------------
agreement involving some sort of monetary value.
• Bond: A bond is a negotiable certificate evidencing indebtedness. ----------------------
• Zero Coupon Bonds: Bonds issued at a discount and repaid at the face value. ----------------------
• Convertible Bond: A Bond which gives the investor the option to convert ----------------------
the bond into equity at a fixed conversion price.
• Security Receipt: A receipt issued by a securitization company or ----------------------
reconstruction company evidencing the purchase or acquisition of an ----------------------
undivided right, title or interest in the financial asset involved in securitization.
• Debentures: An instrument issued by a company bearing a fixed rate ----------------------
of interest usually payable half yearly on specific dates and principal ----------------------
amount repayable on the date of redemption. A debenture therefore is an
acknowledgement from the company that it has to repay a certain amount of ----------------------
money on a specified date.
----------------------
• Non-Convertible Debentures: NCD is a debt instrument issued by a
corporate (including NBFC) by way of private placement. ----------------------
• Commercial Paper: CP is a short term money market instrument issued as ----------------------
a Usance promissory note (unsecured).
• Equity Share: It is the basic unit of ownership in a company, the holders ----------------------
of which are entitled to a proportionate share of the profit distributed by the ----------------------
company in the form of dividends.
----------------------

Notes • Preference Share: The holders of which are entitled to a fixed dividend
calculated at a fixed rate to be paid regularly before dividend can be paid in
---------------------- respect of equity shares.
---------------------- • Certificate of Deposits (CD): COD are issued in the form of Usance
Promissory notes in the dematerialization form only by all scheduled
---------------------- commercial banks (other than RRBs) and all India Financial Institutions
within their ‘Umbrella limits’ with a view to raise bulk deposits.
----------------------
• Derivative: Means a financial instrument to be settled at a future date,
---------------------- whose value is derived from change in some other variable such as interest
rate, foreign exchange rate, market index, credit index, price of securities or
---------------------- goods, index prices etc.
---------------------- • Over-The-Counter (OTC) Derivatives: Derivatives traded directly between
two eligible parties, with/without use of an intermediary and without going
---------------------- through an exchange.
---------------------- • Exchange Traded Derivatives: Derivative products that are traded on an
exchange.
----------------------
• Forward Contract: A customized contract between two entities, where
---------------------- settlement takes place on a specified future date at today’s pre-agreed price. It
is an agreement to buy or sell an asset on a specified date for specified price.
----------------------
• Futures: A standard contract based on an agreement to buy or sell an asset
---------------------- at a certain price at a certain time in future. It is an obligation on the buyer to
purchase the underlying instrument and the seller to sell it.
----------------------
• Options: A contract that provides a right but does not impose any obligation
---------------------- to buy or sell a financial instrument.
• European Option: An option contract where the holder can exercise the
----------------------
right, on the expiry date.
---------------------- • American Option: An option where the holder can exercise the right anytime
between purchase date and the expiry date.
----------------------
• Call Option: An option wherein the owner (buyer) has the right to purchase
---------------------- and the seller has the obligation to sell.
---------------------- • Put Option: An option where the owner or buyer has the right to sell and the
seller has the obligation to buy.
----------------------
• Swap: A contract that binds two counterparties to exchange the different
---------------------- streams of payments over the specified period at specified rate.
---------------------- • Currency Swap: When pre-determined streams of payments in different

currencies are exchanged on a pre-fixed period at pre-fixed rate.
---------------------- • Interest Rate Swap: It is exchange of different streams of interest structures
(and not the principal amount).
----------------------
----------------------
----------------------

Notes
----------------------
1. What are Financial Instruments? How are they classified in different
categories? ----------------------
2. What are Derivatives? List out the benefits of using derivatives.
----------------------
----------------------
a. Forward Contracts
b. Commercial Paper (CP) ----------------------
c. Certificate of Deposit (COD) ----------------------

d. Currency Futures ----------------------
----------------------
1. Financial instruments means: ----------------------
i. Tradable assets ----------------------
ii. Government securities
----------------------
iv. Derivate instruments
----------------------
2. Cash instrument means:
i. Currency notes ----------------------
iii. Readily transferable securities ----------------------
iv. Loans and advances ----------------------
3. Financial instruments can be:
----------------------
i. Equity based
----------------------
ii. Debt based
iii. Short-term debt ----------------------
v. Long-term debt ----------------------
----------------------
1. False
----------------------
2. True
3. False ----------------------
----------------------
----------------------

Notes Check your Progress 3
Fill in the blanks.
----------------------
1. Derivative instrument is defined by Indian Securities Contracts
---------------------- (Regulation) Act, 1956 and it includes a security derived from a debt
instrument like share, bond, etc.
----------------------
2. A bond is a negotiable certificate and zero coupon bonds are issued at a
---------------------- discount and repaid at the face value.
---------------------- 3. Derivate contracts are of mainly two types: Over-the counter (OTC)
derivates and exchange traded derivates.
----------------------

---------------------- 1. Bhole, L. M. Financial Institutions and Markets: Structure, Growth and
Innovations, 4e.
----------------------
2. Machiraju, H.R. Indian Financial System, 3E.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Derivatives
UNIT
7
Structure:
7.1 Introduction to Derivatives

7.2 Uses of Derivatives
7.3 Types of Derivatives
7.4 Types of Derivative Contracts
7.5 Classes of Underlying Assets
7.6 Foreign Exchange Risk Management-Process and Necessity
7.7 The Forward Contract
7.8 Futures Contracts
7.9 Swaps
7.10 Options
Summary
Key Words
Suggested Reading
Derivatives 145
Notes
Objectives
----------------------
----------------------
• Determine the meaning of derivatives.
----------------------
• Analyse different uses of derivatives.
---------------------- • Review types of derivatives.
---------------------- • Compare types of derivative contracts.
---------------------- Examine process and techniques of foreign exchange risk

•
management.
---------------------- • Explain functioning of forward contracts.
---------------------- • Describe characteristics and trading of futures.
---------------------- • Interpret meaning, types and termination of swaps.
• Interpret meaning, types and trading of option contracts.
----------------------
---------------------- 7.1 INTRODUCTION TO DERIVATIVES

---------------------- In layman’s language, a derivative is an agreement between a future buyer
and a future seller which specifies a future price at which some item, commonly
----------------------
known as Underlying Asset must be sold. It specifies a future date on or before
---------------------- which the transaction must occur.
The term “Derivative” indicates that its value is derived from the value of
----------------------
an underlying asset and it has no independent value of its own. The underlying
---------------------- asset can be securities, commodities, bullion, currency, live stock or anything
else.
----------------------
Common elements of all derivatives:
---------------------- • Buyer
---------------------- • Seller
---------------------- • Underlying Asset

• Future Price
----------------------
• Future Date
----------------------
---------------------- 7.2 USES OF DERIVATIVES
---------------------- Some of the most common uses of derivatives are:

A. Hedging: Hedgers use derivatives to reduce the financial risk, or the
----------------------
prospect that the price of things might move against them. The risk arising
---------------------- from the change in the value of underlying asset is transferred from one
party to another with the use of derivatives.
----------------------

For example, a rice farmer and a miller sign a futures contract to exchange Notes
a specified amount of cash for a specified quantity of rice in the future.
Both parties reduce a risk on one hand and acquire a risk on the other ----------------------
hand when they sign a futures contract. The farmer reduces the risk that
----------------------
the price of rice will fall below the price specified in the contract but at the
same time acquires the risk of price rising above the price mentioned in ----------------------
the contract, thereby losing the additional income he could have earned.
----------------------
The miller, on the other hand, acquires the risk that the price of rice will
fallbelow the price specified in the contract (thereby paying more in the ----------------------
future than he otherwise would have) and reduces the risk that the price
of wheat will rise above the price specified in the contract. ----------------------
B. Speculation: Speculators use derivatives not to reduce risk (as hedgers) ----------------------
but to earn profit from it. Speculators can enter into derivative transactions
in the following manner: ----------------------
•
Buy an asset in the future at a low price according to a derivative ----------------------
contract when the future market price is high.
----------------------
•
Sell an asset in the future at a high price according to a derivative
contract when the future market price is low. ----------------------
C. Arbitrage: Arbitrageurs avoid taking risks. In common language, ----------------------
arbitrage is the process of taking benefit of price difference between
two or more markets, striking a deal simultaneously in both the markets ----------------------
and making a profit from the price difference. For example if a security
is trading at Rs. 454 in one market and Rs. 457 in another market an ----------------------
arbitrageur can simultaneously buy at Rs. 454 and sell at Rs. 457 thereby ----------------------
making a profit without any risk.
----------------------
7.3 TYPES OF DERIVATIVES
----------------------
Derivatives are broadly distinguished into two groups based on the way they ----------------------
are traded in the market.
A. Over The Counter (OTC) Derivatives ----------------------
OTC contracts are traded or negotiated in private directly between ----------------------

two parties, without going through a specialized exchange or other
intermediary. Since the contracts are mutually negotiated they are mostly ----------------------
highly unregulated in terms of disclosure of information between parties. ----------------------
OTC derivative market is the largest market for derivatives.
----------------------
B. Exchange Traded Derivatives (ETD)
ETD’s are those derivative instruments that are traded via specialized ----------------------
derivative exchanges or other exchanges. A derivatives exchange acts as
----------------------
an intermediary to all related transactions, and takes Initial margin from
both sides of the trade to act as a guarantee. ----------------------
----------------------
Derivatives 147
Notes 7.4 TYPES OF DERIVATIVE CONTRACTS
---------------------- In a Forward Contract, one party agrees to buy, and the counterparty
agrees to sell, a physical asset or a security at a specific price on a specific date
---------------------- in the future. If the future price of the asset increases, the buyer gains and the
seller loses.
----------------------
A Futures Contract is a forwards contract that is standardised and
---------------------- exchange traded. The main difference with forwards are that futures are traded
---------------------- in an active secondary market, these markets are regulated, backed by a clearing
house, and require a daily settlement of gains and losses.
---------------------- A Swap contract is an agreement to exchange future cash flows. Typically
---------------------- one cash flow is based on a variable or floating price and the other on a fixed
price.
---------------------- An Option Contract grants its holder the right but not the obligation, to
---------------------- buy or sell something at a specified price, on or before a specified future date.
Most of the option contracts are executed on an exchange.
----------------------
----------------------

---------------------- 1. Broadly, there are four types of derivative contracts: forward contract,
future contract, option and _____ contract.
----------------------
2. The common elements of all derivatives are buyer, seller, underlying
---------------------- ________, future price and future date.
---------------------- 3. OTC contracts are traded in private directly between ____ parties,
without going through a specialised exchange or other intermediary.
----------------------
---------------------- 7.5 CLASSES OF UNDERLYING ASSETS

---------------------- The overall derivatives market has five major classes of underlying asset:
---------------------- 1. Interest rate derivatives: An interest rate derivative is a derivative where
the underlying asset is the right to pay or receive a notional amount of
---------------------- money at a given interest rate. In other words, the parties to the contract
---------------------- accept an agreement to exchange interest payments. These are the most
largely used derivatives and are usually traded over the counter.
----------------------
2. Foreign exchange derivatives: A Foreign exchange derivative is a financial
---------------------- derivative. These instruments are used either for currency speculation and
arbitration or for hedging foreign exchange risk.
----------------------
3. Credit derivatives: A credit derivative is a securitized derivative whose
---------------------- value is derived from the credit risk on an underlying bond, loan or any
other financial asset. It enables the users to manage their exposure to
---------------------- credit risk by transferring the risk to another party. For example, if a bank

is anticipating that one of its customers will default in repayment of loan Notes
then it can transfer the credit risk to some other party thereby safeguarding
itself against the loss. ----------------------
4. Equity derivatives: Equity derivatives are those derivatives where the ----------------------
underlying asset is an equity security. The value of such derivatives changes
with the change in the value of one or more underlying equity security. ----------------------
Options and futures are by far the most common equity derivatives.
----------------------
5. Commodity derivatives: A commodity derivative is a derivative where
the underlying asset is a commodity and the contracts are based on the ----------------------
variation in the price of the commodity.
----------------------
7.6 FOREIGN EXCHANGE RISK MANAGEMENT ----------------------
-PROCESS & NECESSITY
----------------------
Firms dealing in multiple currencies face a risk (an unanticipated gain/ ----------------------
loss) on account of sudden/unanticipated changes in exchange rates, quantified in
terms of exposures. Exposure is defined as a contracted, projected or contingent ----------------------
cash flow whose magnitude is not certain at the moment and depends on the
value of the foreign exchange rates. The process of identifying risks faced by ----------------------
the firm and implementing the process of protection from these risks by financial ----------------------
or operational hedging is defined as foreign exchange risk management.
Kinds of Foreign Exchange Exposure ----------------------
The techniques for FOREX risk management vary with the type of ----------------------
exposure and the tenure of the same. Foreign exchange exposures are broadly
classified as Accounting exposure and Economic Exposure. Accounting ----------------------
exposure, also called as translation exposure, is the result of restatement of the ----------------------
financial statements of the foreign subsidiaries into the reporting currency of
the parent. As a result of restatement the figure of net income changes with the ----------------------
variation in the exchange rate between a foreign subsidiary and its parent.
----------------------
Economic exposure is the term given to the change in the firm’s market
value, in any particular currency, as a result of any unexpected change in the ----------------------
exchange rate of a foreign currency. Currency fluctuations have an impact on
----------------------
the firm’s operating cash flows, profitability, and competitive position, hence
market share and stock price. Currency fluctuations also impact the firm’s ----------------------
balance sheet by changing the value of assets and liabilities, debtors, creditors,
stock, FOREX loans, investments in foreign banks; this type of economic ----------------------
exposure is called balance sheet exposure. Transaction Exposure is a form of
----------------------
short-term economic exposure due to fixed price contracting in an atmosphere
of exchange-rate volatility. ----------------------
Foreign Exchange Risk Management Framework
----------------------
Once the exposure is identified, the next step is to deploy resources in
order to manage it well. Some commonly used tools for managing foreign ----------------------
exchange exposure are listed as under:
----------------------
Derivatives 149
Notes Forecasts: After assessing its exposure, the first step is to develop
a forecast on the future trends in the foreign exchange rates. The forecast is
---------------------- usually done for a period of 6 months but can vary from firm to firm. The
forecast should be based on valid assumptions. Along with forecasting trends,
---------------------- an analysis should also be done of the probability of the forecast coming true
---------------------- and how much the change would be.
Risk Estimation: Once the forecast is done, the next step is to measure the
----------------------
value at risk. This is the amount of actual profit or loss resulting from a change in
---------------------- exchange rate according to the forecast. The probability of this risk should also
be ascertained. Various other risks that need to be taken into account include:
----------------------
• Risk of a transaction failing due to market-specific problems.
---------------------- •
The Systems Risk arising due to inadequacies such as reporting gaps and
implementation gaps.
----------------------
Benchmarking: With the exposures and the risk estimates prepared, the
---------------------- firm is now required to set its limits for handling foreign exchange exposure.
The decision required at this stage is whether the exposure will be managed on
----------------------
a cost centre or profit centre basis. Under the cost centre approach, the main aim
---------------------- is to secure cash flows by ensuring that they are not adversely impacted beyond
a certain limit. The cost centre approach is defensive in nature. On the other
---------------------- hand the profit centre approach follows an aggressive pattern where the firm
decides to generate profits from its exposures over a period of time.
----------------------
Hedging: Hedging strategy is decided by the firm on the basis of limits
---------------------- benchmarked for managing the exposure. Amongst the various financial
---------------------- instruments available for hedging, futures, forwards, options, swaps and issue
of foreign debt are the most common ones. Different hedging strategies are
---------------------- explored around these options.
---------------------- Stop Loss: The entire risk management framework is based on forecast of
exchange rates which are estimates of unpredictable trends. If the forecast turns
---------------------- out to be wrong, then there should be some arrangement to rescue the firm. Stop
loss sets up the maximum limit of absorbing the loss in case of adverse currency
---------------------- rate movements.
---------------------- It requires continuous monitoring of the currency rate movements so that
appropriate steps can be taken as soon as a critical change takes place.
----------------------
Reporting and Review: Reporting and review of risk management policies
---------------------- should be done on a periodic basis. The main reports reviewed are:
---------------------- • Profit/ loss status on open contracts after marking to market.
---------------------- • The actual exchange/ interest rate achieved on each exposure.

•
Profitability vis-à-vis the benchmark and the expected changes in overall
---------------------- exposure due to forecasted exchange/ interest rate movements.
---------------------- The review analyses whether the benchmarks set are valid and effective
in controlling the exposures, what the market trends are and finally whether the
---------------------- overall strategy is working or needs change.

Notes
----------------------
1. In interest rate derivative, underlying asset is the right to pay or
----------------------
receive a notional amount of money at a given interest rate.
2. The common tools used for managing foreign exchange exposure ----------------------
are forecasting risk estimation, benchmarking, hedging, stop loss,
----------------------
reporting and review.
3. A commodity derivative is a derivative where the underlying asset is ----------------------
equity security and the contracts are based on the variation in prices ----------------------
and underlying equity security.
----------------------
7.7 THE FORWARD CONTRACT ----------------------
The forward contract is the simplest of all derivatives. It is a bilateral ----------------------

contract which obligates one party to buy and the other to sell a specific quantity ----------------------
of an asset, at a set price, on a specific date in the future. Typically, no party to
the contract pays anything to get into the contract. If the expected future price ----------------------
of the asset increases over the life of the contract, the right to buy at the contract
price will have positive value, and the obligation to sell will have an equal ----------------------
negative value. If the future price of the asset falls below the contract price, the ----------------------
result is the opposite and the right to sell will have a positive value. The key
benefit of a forward contract is the mitigation of uncertainty; both buyer and ----------------------
seller lock in a price that does not change.
----------------------
The party to the forward contract that agrees to buy the financial or physical
asset has a long forward position and is called the long. The party to the forward ----------------------
contract that agrees to sell or deliver the asset has a short forward position and
is called the short. There are two pay off functions for any derivative, one for ----------------------
the long party and other for the short party, as one party’s gain is equal to other ----------------------
party’s loss. The payoff functions for a forward contract are:
PFwd, Long = S – K ----------------------
PFwd, Short = S – K ----------------------

PFwd, Long = Payoff for the long party ----------------------
PFwd, Short = Payoff for the short party
----------------------
S = Spot Price
----------------------
K = Delivery Price
----------------------
----------------------
----------------------
Derivatives 151
Notes
Payoff
---------------------- Long Forward
---------------------- P
K S
----------------------
----------------------
----------------------
Fig. 7.1 – Long Forward Payoff Diagram
----------------------
The payoff table clearly illustrates why some payoffs are positive and some are
---------------------- negative. The long party is obligated to buy at the delivery price K. If on the
---------------------- delivery date the spot price S is greater than the delivery price, they will buy
something for less than the market price and therefore make a gain of positive
---------------------- pay off. If spot is below delivery price, they will be buying something for more
than the market price and therefore have a negative payoff. Long party payoff
---------------------- is spot minus delivery price, if the difference is positive they gain, if negative
---------------------- they lose. Figure 7.1 clearly indicates that long forward payoff increases with
the increase in spot rate and becomes negative if the spot rate comes below the
---------------------- delivery rate.
----------------------
Payoff
---------------------- Short Forward
---------------------- P
K S
----------------------
----------------------
----------------------
Fig. 7.2 – Short Forward Payoff Diagram
----------------------
The short party is obligated to sell at the delivery price K. If on the delivery
---------------------- date the spot price S is greater than the delivery price, they will sell something
for less than the market price and therefore make a loss or negative pay off. If
---------------------- spot is below delivery price, they will be selling something for more than the
market price and therefore have a positive payoff. Short party payoff is delivery
----------------------
minus spot price, if the difference is positive they gain, if it is negative, they
---------------------- lose. Figure 7.2 clearly indicates that short forward payoff decreases with the
increase in spot rate and is positive only when the spot rate comes below the
---------------------- delivery rate.
---------------------- We will illustrate the mechanics of basic forward contract with the help of an
example based on the purchase and sale of a treasury bill. Consider a contract
---------------------- under which party X agrees to pay Rs. 50,000 face value, 90 day Treasury bill
---------------------- from party Y 30 days from now at a price of Rs. 48,000. Party X is the long and
party Y is the short.
Both parties have removed the uncertainty about the price they will buy / Notes
sell the T-bill at the future date. If 30 days from now the T-bill is trading at Rs.
49,000, the short must deliver the T-bill to the long in exchange of Rs. 48,000 ----------------------
payment. If the T-bill is trading at Rs. 47,500 on the future date, the long must
purchase the T-bill for the short at Rs. 48,000, the contract price. This is an ----------------------
example of deliverable forward contract. ----------------------
Another settlement method is cash settlement. Under this method, the
----------------------
party that has a position with negative value is obligated to pay that amount to
the other party. In the previous example if the price of the T-bill were Rs. 49,000 ----------------------
on the settlement date, the short will satisfy the contract by paying Rs. 1,000 to
long. If the t-bill is priced at Rs. 47,500 on settlement date, the long will make ----------------------
a payment of Rs. 500 to short. This method yields the same results as delivery
----------------------
of asset as the net proceeds remains the same.
----------------------
7.8 FUTURE CONTRACTS
----------------------
A future contract is a highly standardised forward contract executed at an
exchange. Under the futures contract, there is an agreement to buy or sell the ----------------------
underlying security on a future date and it is legally bound by an agreement. ----------------------
The contracts are standardised contracts in terms of quantity, quality (in case
of commodities), delivery time and place for settlement on any date in future. ----------------------
Every contract has an expiry date, which is predecided and the contract expires
on that date. Future contracts are settled by delivery of the underlying asset or ----------------------
cash. Cash settlement enables the settlement of obligations arising out of the ----------------------
future/option contract in cash. Future contracts differ from forward contracts in
the following ways: ----------------------
Future Contracts Forward Contracts ----------------------
l Trade on organized Exchanges l Private contracts and do not trade
----------------------
l Highly standardized l Customised contracts which satisfy
the needs of parties involved ----------------------
l Single clearing house is the l Contracts with originating
counterparty to all future counterparty ----------------------
contracts ----------------------
l Government regulates them l Not regulated
----------------------
The contracts are traded on a futures exchange. The party to the contract,
which agrees to buy the underlying asset in the future, is termed as “long”, and ----------------------
the party, which agrees to sell the asset in the future, the “seller” of the contract,
is termed as “short”. The expectations of the buyer and the seller are reflected ----------------------
in the terms “long” and “short” - the buyer expects the asset price to increase,
----------------------
while the seller expects the price to decrease.
For financial futures, the underlying asset or item can be currencies, ----------------------
securities or financial instruments and intangible assets or referenced items ----------------------
such as stock indexes and interest rates.
----------------------
Derivatives 153
Notes While the futures contract specifies a trade taking place in the future,
the purpose of the futures exchange institution is to act as intermediary and
---------------------- minimize the risk of default by either party. Thus, the exchange requires both
parties to put up an initial amount of cash, i.e; the margin. Additionally, since the
---------------------- futures price will generally change daily, the difference in the prior agreed-upon
---------------------- price and the daily futures price is settled daily as well. The exchange will draw
money out of one party’s margin account and put it into the others so that each
---------------------- party has the appropriate daily loss or profit. If the margin account goes below a
certain value, then a margin call is made and the account owner must replenish
---------------------- the margin account. This process is known as marking to market. Thus on the
---------------------- delivery date, the amount exchanged is not the specified price on the contract
but the spot value (since any gain or loss has already been previously settled by
---------------------- marking to market).
---------------------- Characteristics of Future Contracts:
A. Standardization: Futures contracts ensure their liquidity by being highly
----------------------
standardized, usually by specifying:
---------------------- • The underlying asset or instrument.
---------------------- • Quality and quantity of goods to be delivered.
---------------------- • Settlement type - cash v/s physical settlement.

• Manner of delivery.
----------------------
• Time of delivery.
----------------------
• Minimum permissible price fluctuation.
---------------------- • The currency in which the contract is quoted.
---------------------- • Trading time for contract
---------------------- •
The grade of the deliverable- In the case of bonds, this specifies which
bonds can be delivered. In the case of physical commodities, this
---------------------- specifies not only the quality of the underlying goods but also the
manner and location of delivery and the month of delivery.
----------------------
• The last trading date
----------------------
B. Margin: To minimize credit risk to the exchange, traders must post a
---------------------- margin or a performance bond, typically 5%-15% of the contract’s value.
C. Initial margin is the equity required to initiate a futures position. This
----------------------
is a type of performance bond. The maximum exposure is not limited to
---------------------- the amount of the initial margin; however the initial margin requirement
is calculated based on the maximum estimated change in contract value
---------------------- within a trading day. Initial margin is set by the exchange.
---------------------- D. Maintenance margin A set minimum margin per outstanding futures
contract states that a customer must maintain in his margin account. If the
---------------------- margin balance in an account falls below the maintenance margin due to
a change in the contract price for the underlying asset, additional funds
----------------------
must be deposited to bring the margin balance back to the required level.
Variation margin is the fund that must be deposited in the account to bring Notes
it back to the initial margin amount.
----------------------
E. Clearing house: Each exchange has a clearing house. The clearing
house guarantees that the traders in the futures market will honour their ----------------------
obligations. It does this by splitting each trade once it is made and acting
as the opposite side of each position. Clearing house acts as a buyer to ----------------------
every seller and seller to every buyer. This allows traders to enter the
----------------------
market knowing that they will be able to reverse their position and they
need not worry about counterpart defaulting since the counterparty is now ----------------------
a clearing house.
----------------------
F. Settlement Price: Settlement price is analogous to the closing price for
a stock but is not simply the price of the last trade. It is an average of the ----------------------
prices of the trades during the last period of trading, called the closing
period, which is set by the exchange. This prevents price manipulation by ----------------------
traders and is used to make margin calculations at the end of the day.
----------------------
Trading in Futures
----------------------
In contrast to forward contracts in which a bank or brokerage is usually the
counterparty to the contract, there is a buyer and seller on each side of a futures ----------------------
trade. The futures exchange selects the contract that will trade. The assets, the
amount of the asset, and the settlement / Delivery date are standardized in this ----------------------
manner. Each ime there is a trade, the delivery price for that contract is the ----------------------
equilibrium price at that point of time, which depends on supply (by those who
wish to short) and demand (by those who wish to be long). The mechanism ----------------------
by which demand and supply determine this equilibrium is open outcry at a
particular location on the exchange floor called a “Pit”. Each trade is reported ----------------------
to the exchange so that the equilibrium price, at any point of time, is known to ----------------------
all traders. Many futures contracts have price limits, which are the exchange
imposed limits on the variation in the contract price from the previous day’s ----------------------
settlement price. Exchange members are prohibited from executing trades at
prices outside these limits. If the equilibrium price at which traders would ----------------------
willingly trade is above the upper limit or below the lower limit, trades cannot ----------------------
take place. Marking to market is the process of adjusting the margin balance
in a futures account each day for the change in the value of the contract assets ----------------------
from the previous trading day, based on the new settlement price.
----------------------
Termination of Futures contract prior to expiry
There are four ways to terminate a futures contract: ----------------------
1
A short can terminate the contract by delivering the goods, and a long can ----------------------
terminate the contract by accepting delivery and paying the contract price to
the short. This is called delivery. The location of delivery, terms of delivery, ----------------------
and details of exactly what is to be delivered are all mentioned in the contract. ----------------------
2
In a cash settlement contract delivery is not an option. The futures account is
marked to market, based on the settlement price on the last day of trading. ----------------------
----------------------
Derivatives 155
Notes 3. Reverse Trade or offsetting trade is the third technique of termination
of futures contract. In futures, the other side of your position is held by
---------------------- the clearing house. If you make an exactly opposite trade to your current
position, the clearing house will net your position out leaving you with a
---------------------- zero balance. The contract price can differ between the two contracts. E.g.
---------------------- Initially you have a contract to buy 100 kg. of wheat for Rs. 20 per kg and
subsequently you sell (take short position) an identical quantity of wheat
---------------------- contract when the price is Rs. 18 per kg. In this situation Rs. 200 (2 times
100 kg.) will be deducted from the margin deposit in your account. The
---------------------- sale of the futures contract ends the exposure to future price fluctuations
---------------------- on the first contract. Your position has been reversed or closed out by a
closing trade.
----------------------
4. A position may also be settled through an exchange of physicals. Here,
---------------------- you find a rader with an opposite position to your own and deliver the
goods and settle up between yourselves i.e. off the floor of the exchange
---------------------- (called an Ex-pit transaction). You must then contact the clearing house
and tell them about the same.
----------------------
---------------------- 7.9 SWAPS

---------------------- Swaps are agreements to exchange a series of cash flows on periodic
settlement dates over a certain time period. In the simplest type of swap one
---------------------- party makes fixed rate interest payments on the notional principal specified
---------------------- in the swap in return for floating rate payments from the other party. At each
settlement date, the two payments are netted so that only one payment is made.
---------------------- The party with the greater liability makes a payment to the other party. The
length of the swap is termed as the tenor of the swap and the contract ends
---------------------- on the termination date. A swap can be decomposed into a series of forward
---------------------- contracts that expire on the settlement dates. The streams of cash flows which
are exchanged in a swap agreement are called the legs of the swap. The swap
---------------------- agreement defines the dates when the cash flows are to be paid and the way
they are calculated. At the time of initiation of the swap agreement at least one
---------------------- of these series of cash flows is determined by a random or uncertain variable
---------------------- such as interest rate, foreign exchange rate, equity price or commodity price.
The cash flows are calculated over a notional principal amount, which is usually
---------------------- not exchanged between counterparties. Consequently, swaps can be in cash or
collateral.
----------------------
Swaps can be used to hedge certain risks such as interest rate risk, or to
---------------------- speculate on changes in the expected direction of underlying prices.
---------------------- In many respects, swaps are similar to forwards:
• Swaps require no payment by either party at initiation.
----------------------
• Swaps are custom instruments.
----------------------
• Swaps are not traded on any exchange.
---------------------- • Swaps are largely unregulated.

• Default risk is an important aspect of the contracts. Notes
• Most participants in the swap market are large institutions.
----------------------
Swap Markets
----------------------
Most swaps are traded over-the-counter (OTC), “tailor-made” for the
counterparties. ----------------------
Some types of swaps are also exchanged on futures markets. ----------------------
Types of Swaps
----------------------
The five generic types of swaps, in order of their quantitative importance are:
----------------------
• Interest rate swaps,
• Currency swaps, ----------------------
• Credit swaps, ----------------------
• Commodity swaps, ----------------------
• Equity swaps.
----------------------
The most common type of swap is a “plain Vanilla” interest rate swap.
It involves trading fixed interest rate payments for floating rate payments. The ----------------------
party who wants floating rate interest payments agrees to pay fixed rate interest
----------------------
and has the pay-fixed side of the swap. The counterparty, which receives the
fixed payments and agrees to pay variable rate interest has the pay-floating side ----------------------
of the swap and is called the floating rate payer. The life of the swap can range
from 2 years to over 15 years. The reason for this exchange is to take benefit ----------------------
from comparative advantage. Some companies may find fixed rate markets
----------------------
more beneficial while others may find floating rate markets more beneficial.
Initially at the time of borrowing the cheapest source of funds is given highest ----------------------
priority, which may result in a company borrowing fixed when it wants floating
or borrowing floating when it wants fixed. This is where a swap comes in. A ----------------------
swap has the effect of transforming a fixed rate loan into a floating rate loan
----------------------
or vice versa. For example, party B makes periodic interest payments to A is
currently paying floating rate of interest but wants to pay fixed rate, whereas B is ----------------------
currently paying fixed rate but wants to pay floating rate. By entering into an interest
rate swap, the net result is that each party can ‘swap’ their existing obligation for ----------------------
their desired obligation. The payments are not swapped directly but each party
enters into a separate swap with an intermediary like a bank. In return for matching ----------------------
the two parties together, the bank takes a spread from the swap payments.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Derivatives 157
Notes 8.65%
8.50%
---------------------- A Bank B
PLR + 0.55% PLR + 0.70%
---------------------- PLR +
1.50% 8.5%
----------------------
----------------------
Floang Fixed
----------------------
Net 9.6% PLR + 0.70%
----------------------
Fig. 7.3 Interest Rate Swap
----------------------
Currency Swaps
---------------------- In currency swap, one party makes payments denominated in one currency,
while the payments from the other party are made in another currency. Typically,
----------------------
the notional amounts of the contract, expressed in both currencies at the current
---------------------- exchange rate, are exchanged at contract initiation and returned at the contract
termination date in the same amounts. Just like interest rate swaps, the currency
---------------------- swaps also are motivated by comparative advantage. Both principal and interest
portion are swapped between the parties and the cash flows are in different
----------------------
currencies.
---------------------- SWAP INITIATION
Swaps AUD for USD
---------------------- The Australian firm wants USD The U.S. firm wants AUD
Has or can borrow AUD Has or can borrow USD
---------------------- Swaps USD for AUD
---------------------- SWAP INTEREST PAYMENTS

Australian pays USD interest
The Australian firm has use of The U.S. firm has use of the
----------------------
the USD AUD
U.S. firm pays AUD interest
----------------------
SWAP TERMINATION
---------------------- USD returned
The Australian firm returns The U.S. firm returns the AUD
---------------------- the USD borrowed borrowed
AUD returned
----------------------
Fig. 7.4 Currency Swap
----------------------
Commodity Swaps
----------------------
A commodity swap is an agreement whereby the exchanged cash flows
---------------------- are dependent on the price of the underlying commodity. These swaps are used
to hedge against the price of the commodity. The most common underlying
---------------------- asset in commodity swap is crude oil.
---------------------- Equity Swap
In an equity swap, the return on a stock, a portfolio, or a stock index is
----------------------
paid each period by one party in return for a fixed rate or floating rate payments.
The return can be the capital appreciation or the total return including dividends Notes
on the stock, portfolio or index.
----------------------
Credit Default Swaps
A credit default swap (CDS) is a swap contract in which the buyer of the ----------------------
CDS receives credit protection whereas the seller of the swap guarantees the
----------------------
credit worthiness of the product. In other words, the risk of default is transferred
to the seller of the swap from the holder of the security. Few examples of credit ----------------------
events which lead to entering into credit default swaps include restructuring,
bankruptcy and credit rating downgraded. ----------------------
Valuation of Swaps ----------------------
The value of a swap is the net present value (NPV) of all estimated future ----------------------
cash flows. A swap is worth zero when it is first initiated, however after this
time its value may become positive or negative. There are two ways to value ----------------------
swaps: in terms of bond prices, or as a portfolio of forward contracts.
----------------------
Termination of Swaps
There are four ways of terminating a swap prior to its original termination date. ----------------------
Mutual Termination: A cash payment can be made by one party which is ----------------------
acceptable by other party. If the party that has been disadvantaged by the market
----------------------
movement is willing to make a payment of the swap’s value to the counterparty,
and the counterparty is willing to accept it, they can mutually terminate the ----------------------
swap.
----------------------
Offsetting Contract: If the terms of the original counterparty offers for
early termination are unacceptable, the alternative is to enter an offsetting swap. ----------------------
Exiting a swap by offsetting may involve taking a loss. Consider a case where
we receive 3% fixed on our original 5 year pay floating swap, but must pay ----------------------
4% fixed on the offsetting swap. We have locked in a swap because we must
----------------------
pay 1% higher rate on the offsetting swap than we receive on the swap we
are offsetting. Exiting a swap through an offsetting swap with other than the ----------------------
original counterparty will also expose the investor to default risk.
----------------------
Resale: It is possible to sell the swap to another party, with the permission
of the counterparty to the swap. This would be unusual as there is not a ----------------------
functioning secondary market.
----------------------
Swaption: A swaption is an offer to enter into a swap. The option to
enter into an offsetting swap provides an option to terminate an existing swap. ----------------------
Consider in the case of previous 5 year floating swap, we purchased a 3 year
call option on a 2 year pay fixed swap at 3%. Exercising this swap would give ----------------------
us the offsetting swap to exit our original swap. The cost of such protection is ----------------------
the swaption premium.
----------------------
7.10 OPTIONS
----------------------
An option contract gives its owner the right, but not the legal obligation, ----------------------
Derivatives 159
Notes to conduct a transaction involving an underlying asset at a predetermined
future date and at a pre-determined price. The pre-determined date is called the
---------------------- exercise date and the pre-determined price is called the exercise / strike price.
Option gives the option buyer the right to decide whether the trade will actually
---------------------- take place. The seller of the option has the obligation to perform if the buyer
---------------------- exercises the option.
•
The owner of a call option has the right to purchase the underlying asset at a
---------------------- specific price for a specified time period.
---------------------- •
The owner of a put option has the right to sell the underlying asset at a
specific price for a specified time period.
----------------------
The price of an option is derived from the difference between the
---------------------- reference price and the value of the underlying asset (commonly a stock, a
bond, a currency or a futures contract) and a premium amount calculated on the
----------------------
basis of the time remaining for the expiration of the option is also added to the
---------------------- price.
The option is said to be exercised when it is activated and the underlying
----------------------
asset is traded at the agreed price. Generally, all options contracts come with
---------------------- an expiry date and become void if the option is not exercised by the expiration
date.
----------------------
For every owner of an option there must be a seller. The seller of the option
---------------------- is also called the option writer. The owner of the option is the one who decides
whether to exercise the option or not. If the option has value, the buyer may
---------------------- either exercise the option or sell the option to another buyer in the secondary
---------------------- options market. There are four possible option positions:
Long Call: Buyer of a call option has the right to buy an underlying asset.
---------------------- If a trader anticipates an increase in the price of a security then he can buy the
---------------------- right to purchase the security (a call option) rather than purchasing the security
itself. In such a situation, he will have just the right to buy the security until
---------------------- the expiration date and not the obligation. He will make a profit if, on the date
of expiry, the difference between price of the security and the exercise price is
---------------------- more than the premium (price) paid. If, on the other hand, the security price is
---------------------- lower than the exercise price on the expiry date, he will not exercise the option
to buy the security and lose only the amount of the premium. Buying option
---------------------- instead of shares enables the trader to leverage on a much larger number of
shares.
----------------------
Short Call: The seller of a call option has the obligation to sell the
---------------------- underlying asset. If a trader anticipates a decrease in the price of a security then
he can sell the stock short. The trader who sells a call option has an obligation
---------------------- to sell the stock to call buyer at the buyer’s option. If the price of the security
---------------------- decreases, the short call position will make a profit in the amount of the premium.
If the stock price increases over the exercise price by more than the amount of
---------------------- the premium, the short will lose money, with the potential loss unlimited.
---------------------- Long Put: The buyer of the put option has the right to sell the underlying

asset. If a trader anticipates decrease in the price of a security he can buy the Notes
right to sell the security at a fixed price (a put option). Under this contract he
will have the right to sell the security at any time before the expiry date but ----------------------
he will not be bound by any obligation. He will make a profit if the difference
between the security price on the expiry date and the strike price is more than ----------------------
the premium paid. If, on the other hand, the security price is higher than the ----------------------
exercise price on the expiry date, he will not exercise the option to sell the
security and lose only the amount of the premium. ----------------------
Short Put: The seller of the put option has the obligation to buy the ----------------------
underlying asset. A trader who believes that a stock price will increase can
buy the stock or instead sell, or “write”, a put. The trader selling a put has an ----------------------
obligation to buy the stock from the put buyer at the put buyer’s option. If, on
----------------------
the expiry date, the price of the security is above the exercise price, the short
put position will make a profit equivalent to the amount by which the price ----------------------
difference exceeds the premium amount. If, on the other hand, the price of the
security at expiration is below the exercise price by more than the amount of ----------------------
the premium, the trader will lose money. The amount of loss can extend up to
----------------------
the face value of the security. To acquire these rights, owners of options must
buy them by paying a price called the option premium to the seller of the option. ----------------------
Option premium is just the price of the option and is different from strike price
which is the price at which the underlying asset would be bought / sold if the ----------------------
option is exercised.
----------------------
Trading
----------------------
Just like futures, there are standardised contracts for trading options which
are listed on various exchanges. The trader can track the listing and prices with ----------------------
the help of ticker symbol. The live option prices are continuously published on
the exchange which enables the traders to execute transactions. The exchange ----------------------
acts as an intermediary to both the parties to the transaction and offers the
----------------------
following benefits:
•
Contract fulfillment is backed by the credit of the exchange, which has the ----------------------
highest rating (AAA),
----------------------
• Counterparties remain anonymous,
----------------------
• Well regulated contracts ensure fairness and transparency, and
• Proper order is maintained during fast trading conditions.
----------------------
Over-the-counter options contracts are traded between two independent parties ----------------------
without involvement of exchange. Ordinarily, at least one of the counterparties
----------------------
is a well-capitalized institution. Since the exchange is not involved, there is
no requirement of a standardised contract and OTC options provide the ease ----------------------
of customizing the terms of contract as per the convenience and business
requirements of the parties involved. In addition, such transactions are ----------------------
not required to be advertised to the market and face little or no regulatory
----------------------
requirements. However, it is advisable that the OTC counterparties must
establish credit lines with each other, and confirm the procedures related to ----------------------
clearing and settlement.
Derivatives 161
Notes Contract Specifications
Every financial option is regulated by a contract between the two
----------------------
counterparties and the terms and conditions are clearly specified. The term
---------------------- sheet has all the information about the conditions governing the contract.
Option contracts can be quite complicated, but the minimum specifications are
---------------------- as under:
---------------------- • Whether it is a call option (right to buy) or a put option (right to sell).
• The details of the underlying asset in terms of quantity and class.
----------------------
•
The strike price / exercise price, which is the price at which the option will
---------------------- be executed.
---------------------- • The expiry date, which is the last date for exercising the option.
---------------------- • The settlement terms - physical delivery.

• The terms for calculation of premium amount.
----------------------
Types of options in terms of underlying instruments
----------------------
There are three types of options in terms of underlying instruments:
---------------------- 1. Financial Options,
---------------------- 2. Options on Futures,
---------------------- 3. Commodity Options.

Financial Options include equity options and other options based on
----------------------
stock indices, treasury bonds, interest rates and currencies. The strike price for
---------------------- financial options can be in terms of yield to maturity on bonds, an index level
or an exchange rate for foreign currency options.
----------------------
Options on futures give the holder the right to buy or sell a specified
---------------------- futures contract on or before a given date at a given futures price, the strike
price.
----------------------
Commodity Option gives the holder the right to either buy or sell a fixed
---------------------- quantity of some physical asset at a fixed (strike) price.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. In credit default swap, the credit events which lead to entering in
----------------------
credit default swaps include:
i. Restructuring ----------------------
ii. Bankruptcy ----------------------
iii. Credit rating downgraded
----------------------
iv. Creditworthiness
----------------------
2. Future contracts are:
i. Trade on organised exchanges ----------------------
ii. Highly standardised ----------------------
iii. Regulated by Government ----------------------
iv. Private contracts
----------------------
Activity 1 ----------------------
----------------------
Visit RBI website and find out the recent instructions pertaining to
derivatives. ----------------------
----------------------
Summary ----------------------
• Derivative
is an agreement between a future buyer and a future seller which ----------------------
specifies a future price at which some item, commonly known as Underlying
Asset, must be sold. ----------------------
•
The most common uses of derivatives are hedging, speculation and arbitrage. ----------------------
Hedgers use derivatives to reduce the financial risk, or the prospect that
the price of things might move against them. ----------------------
• Speculators use derivatives not to reduce risk (as hedgers) but to earn ----------------------
profit from it.
• Arbitrageurs
avoid taking risks. Arbitrage is the process of taking benefit of
----------------------
price difference between two or more markets, striking a deal simultaneously ----------------------
in both the markets and making a profit from the price difference.
• Derivatives
are broadly classified into Over The Counter Derivatives, traded ----------------------
directly between parties without going through exchange, and Exchange
----------------------
Traded Derivatives, traded on an exchange.
•
There are four types of derivative contracts:- Forwards, Futures, Swaps and ----------------------
Options.
----------------------
• Major classes of underlying assets are Interest rate, Foreign Exchange.
Derivatives 163
Notes Commodity, Credit and Equity
•
The process of identifying risks faced by the firm and implementing the
---------------------- process of protection from these risks by financial or operational hedging is
---------------------- defined as foreign exchange risk management.
• Foreign
exchange exposures are broadly classified as accounting exposure,
---------------------- resulting from need to restate financial statements, and economic exposure,
---------------------- resulting from unexpected change in foreign currency rates.
•
Foreign exchange risk management framework includes forecasting the
---------------------- change in foreign currency rates, estimating the risk, benchmarking the
limits for handling foreign exchange exposure, hedging the risk, stop loss
----------------------
arrangements and reporting and reviewing the exposure.
---------------------- Forward contract is a bilateral contract which obligates one party to buy
and the other to sell a specific quantity of an asset, at a set price, on a
----------------------
specific date in the future.
---------------------- •
Long forward payoff increases with the increase in spot rate and becomes
negative if the spot rate comes below the delivery rate.
----------------------
•
Short forward payoff decreases with the increase in spot rate and is positive
---------------------- only when the spot rate comes below the delivery rate.
---------------------- •
Futures Contract means a legally binding agreement to buy or sell the
underlying security on a future date.
---------------------- •
The party to the contract which agrees to buy the underlying asset in the
future is termed as “long”, and the party which agrees to sell the asset in the
----------------------
future, the “seller” of the contract, is termed as “short”.
---------------------- •
Futures contracts are highly standardized, buyer and seller need to deposit
margin money with the exchange, each exchange has a clearing house and
---------------------- each trade has a settlement price.
---------------------- •
The futures trade can be terminated before expiry by delivery, cash settlement,
reverse trade and exchange of physicals.
----------------------
Swaps are agreements to exchange a series of cash flows on periodic
---------------------- settlement dates over a certain time period.
---------------------- • The five types of swaps, in order of their quantitative importance are:
•
Interest rate swaps, Currency swaps, Credit swaps, Commodity swaps and
---------------------- Equity swaps
---------------------- •
Swaps can be terminated by mutual termination, offsetting contract, resale
and swaption.
----------------------
• An
option contract gives its owner the right, but not the legal obligation, to
---------------------- conduct a transaction involving an underlying asset at a predetermined future
date and at a pre determined price.
---------------------- •
The owner of a call option has the right to purchase the underlying asset and
---------------------- the owner of a put option has the right to sell the underlying asset at a specific
price for a specified time period.
---------------------- • Four possible option positions are:

• Long call – buyer of a call option has the right to buy an underlying Notes
asset.
----------------------
• Short call – the seller of a call option has the obligation to sell the
underlying asset. ----------------------
• Long put – the buyer of the put option has the right to sell the
----------------------
underlying asset.
• Short put – the seller of the put option has the obligation to buy the ----------------------
underlying asset.
----------------------
•
The most common way to trade options is via standardized options contracts
that are listed by various futures and options exchanges. Listings and prices ----------------------
are tracked and can be looked up by ticker symbol.
----------------------
•
There are three types of options in terms of underlying instruments - Financial
Options, Options on Futures and Commodity Options. ----------------------
----------------------
Keywords
----------------------
• Derivatives: Agreement between a future buyer and a future seller which
specifies a future price at which some item must be sold. ----------------------
• Underlying Assets: The financial instrument (e.g., stock, futures, commodity, ----------------------
currency, index) on which a derivative’s price is based.
----------------------
• Hedging: Use of derivatives too reduce financial risk
----------------------
• Speculation: Use of derivatives to earn profit from it
• Arbitrage: Practice of taking advantage of price difference between two or ----------------------
more markets, striking a deal simultaneously in both the markets and making
----------------------
a profit from the price difference.
• Over The Counter (OTC) Derivatives: Contracts that are traded (and ----------------------
privately negotiated) directly between two parties, without going through an
----------------------
exchange or other intermediary.
• Exchange Traded Derivatives (ETD): Those derivative instruments that ----------------------
are traded via specialized derivative exchanges.
----------------------
• Forward Rate Agreement (FRA): An over-the-counter contract between
parties that determines the rate of interest, or the currency exchange rate, to ----------------------
be paid or received on an obligation beginning at a future start date.
----------------------
• Long Call: Buyer of a call option has the right to buy an underlying asset.
----------------------
• Short Call: The seller of a call option has the obligation to sell the underlying
asset. ----------------------
• Long Put: The buyer of the put option has the right to sell the underlying
----------------------
asset.
• Short Put: The seller of the put option has the obligation to buy the underlying ----------------------
asset.
----------------------
Derivatives 165
Notes • Call Option: An option which conveys the right to buy something.
• Put Option: An option which conveys the right to sell.
----------------------
• Clearing House: A financial institution that provides clearing and settlement
---------------------- services for financial and commodities derivatives and securities transactions.
---------------------- • Netting: Allow a positive value and a negative value to set-off and partially
or entirely cancel each other out.
----------------------
• Margin: Collateral that the holder of a financial instrument has to deposit to
---------------------- cover some or all of the credit risk of their counterparty.
----------------------
----------------------
1. Describe the term Derivatives. What are the common elements in all
---------------------- derivatives?
---------------------- 2. What are the different uses of Derivatives?
3.
What do you mean by Futures Contacts? How are they different from
----------------------
Forwards?
---------------------- 4. Explain the different types of foreign exchange exposures.
---------------------- 5.
What do you mean by the term ‘Options’? What are the various possible
option positions?
----------------------
6. What are the key characteristics of Futures Contracts?
---------------------- 7.
Can swaps be terminated prior to its original date? If yes, then what are the
---------------------- possible ways of termination of swaps?
8. What do you mean by Swaps? What are the most commonly used SWAPS?
----------------------
9. Elaborate the process of calculating payoff under Forward Contracts.
----------------------
----------------------

Fill in the blanks.
----------------------
1. Broadly, there are four types of derivative contracts: forward contract,
---------------------- future contract, option and swap contract.
---------------------- 2. The common elements of all derivatives are buyer, seller, underlying
asset, future price and future date.
----------------------
3. OTC contracts are traded in private directly between two parties, without
---------------------- going through a specialised exchange or other intermediary.
----------------------
----------------------
----------------------

Check your Progress 2 Notes
----------------------
1. True
----------------------
2. True
3. False ----------------------
1. In credit default swap, the credit events which lead to entering in Credit
----------------------
default swaps include:
i. Restructuring ----------------------
ii. Bankruptcy ----------------------
iii. Credit rating downgraded ----------------------
2. Future contracts are:
----------------------
i. Trade on organised exchanges
----------------------
ii. Highly standardised
iii. Regulated by Government ----------------------
----------------------
Suggested Reading
----------------------
1. Gomez, Clifford. Financial Markets, Institutions, and Financial Services.
----------------------
2. Gurusamy. Indian Financial System, 2E.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Derivatives 167
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Credit Rating
UNIT
8
Structure:
8.1 Introduction and Need of Credit Rating

8.2 Credit Rating
8.3 Factors that contributed to the Growth of Credit Rating
8.4 Factors considered by Credit Rating Agencies while Rating an Instrument
8.5 Flow Chart of Rating Process
8.6 CRISIL’s Long-Term Rating Symbols
8.7 Recent Developments
Summary
Key Words
Suggested Reading
Credit Rating 169

Notes
Objectives
----------------------
----------------------
• Recognise the need for credit rating for different constituents in the
---------------------- market
---------------------- • Describe credit rating
• Identify the factors that contributed to the growth of credit rating
----------------------
• Analyse the exercise of assigning credit rating to corporate
----------------------
• Explain the long-term credit symbols used by CRISIL
----------------------
8.1 INTRODUCTION AND NEED OF CREDIT RATING
----------------------
---------------------- The system of rating got institutionalized following the Great Depression
in 1933, when the US Controller of Currency enacted a rule that banks could
---------------------- only purchase securities, which have minimum investment rating.
---------------------- The need for credit rating is different for different parties depending on
the benefits it offers to the various parties utilising these services viz. Investors,
---------------------- issuers, intermediaries and the regulatory authority.
---------------------- Investors
• Rating supplements the investors’ credit evaluation process.
----------------------
• It facilitates comparison of relative value between competing securities.
----------------------
• It helps in recognising the risk involved in the investment.
---------------------- Issuers
---------------------- • A company with highly rated instrument has the opportunity to reduce the
cost of borrowing by quoting less interest rates.
----------------------
• A company with rating can approach a wider section of investors for
---------------------- resource mobilisation.
---------------------- • Companies with rated instruments can avail of the rating as a marketing
tool to create better image in dealing with its customers, lenders and
---------------------- creditors.
---------------------- • Rating encourages the companies to come out with more disclosures about
their accounting system, financial reporting and management pattern.
----------------------
• Smaller and not so well known companies can access markets.
---------------------- • Encourages financial discipline as borrowers attempt to obtain ratings by
---------------------- improving financial structures, reducing operating risks.
Financial Intermediaries
----------------------
• The ratings help them in pricing the debt.
----------------------

• It shifts the burden of establishing credit quality from intermediary to a Notes
rating agency thereby easing the due diligence requirement.
----------------------
•
With high credit rated instruments, the brokers can convince their clients
to select a particular investment proposal. This saves their time, cost and ----------------------
manpower in convincing their clients.
----------------------
Regulatory Authority
•
By identifying the risks, rating helps in channeling savings into productive ----------------------
investments.
----------------------
• Credit rating serves the objective of protecting the investors.
----------------------
8.2 CREDIT RATING ----------------------
•
Rating reflects the borrower’s accountability, expected capability and ----------------------
inclination to pay interest and principal in a timely manner.
----------------------
•
Rating is an isolated function of a credit risk evaluation.
•
Rating is useful in differentiating credit quality. ----------------------
•
Rating will involve issue-specific evaluation. ----------------------
What Credit Rating is not about? ----------------------
•
Rating is not a general purpose evaluation of the issuer.
----------------------
• It is not a recommendation to buy/sell/hold a security.
----------------------
• Rating is not an extensive audit of the issuing company.
•
Rating is not a one-time assessment of creditworthiness valid over the future ----------------------
life of the security.
----------------------
----------------------
----------------------
1. Credit rating is a one-time assessment of creditworthiness valid over
the future life of the security. ----------------------
2. The regulatory authority ensures to protect the interest of investors by
----------------------
carrying out credit rating exercise as well as channelises savings into
productive investments. ----------------------
----------------------
8.3 FACTORS THAT CONTRIBUTED TO THE GROWTH
OF CREDIT RATING ----------------------
• High level of defaults in U.S. capital markets in 1970.

----------------------
• Regulators stipulation for mandatory ratings. ----------------------

• Investor’s awareness of ratings for risk assessment and risk management. ----------------------
Credit Rating 171

Notes • It helps intermediaries for pricing and placement of financial instruments.
• The increasing role of capital and money markets.
----------------------
• Globalisation of credit markets.
----------------------
• The continuing growth of information technology.
---------------------- • The growth of confidence in the efficiency of the market mechanism.
---------------------- • The withdrawal of government safety nets and the trend towards privatisation.
----------------------
8.4 FACTORS CONSIDERED BY CREDIT RATING
---------------------- AGENCIES WHILE RATING AN INSTRUMENT
---------------------- Rating is a search for long term fundamentals and the probabilities for
changes in the fundamentals.
----------------------
The analytical framework for rating methodology is divided into two
---------------------- independent segments. The first deals with operational characteristics and
the second with financial characteristics. Besides quantitative and objective
----------------------
factors, qualitative aspects like assessment of management capabilities play
---------------------- a very important role in arriving at the rating for an instrument. The relative
importance of qualitative and quantitative components of analysis varies with
---------------------- the type of issuer.
---------------------- Credit rating is an opinion on the relative ability and willingness of an
issuer to make timely payments on specific debt or related obligations over
---------------------- the life of the instrument. Credit rating thus provides a relative ranking of the
instrument of the credit quality of debt instruments.
----------------------
Credit rating is expressed in terms of rating symbols. This is required for
---------------------- following reasons:
---------------------- A) They (the credit ratings) are easily comprehensible to lay investors.
---------------------- B) There are distinct symbols for different instruments.
C)
This differentiation is based on the degree of safety which shows
----------------------
investment grades and non-investment grades.
---------------------- D) Securities with same rating are of similar but NOT identical investment
quality.
----------------------
Following are some of the key factors generally considered by the rating
---------------------- agencies for the purpose of ratings:
---------------------- A) Business Analysis
---------------------- Industry risk Industry Structure, Industry size and importance to Economy
Determinates of revenue growth Entry barriers.
----------------------
B) Market position of the Company
---------------------- Nature and basis of competition, Threat from imports and substitutes,
Presence of unorganized sector, Market share,
----------------------

Competitive advantages like Brand Equity and Pricing Flexibility, Product Notes
and customer diversity like proportion of exports and nature and type of
customer diversity. ----------------------
C) Operating Advantages of the Company ----------------------
Cost Structure, Manufacturing Efficiency, Production Flexibility,
----------------------
Technology Risk, Raw Material Sourcing, Location Factors.
D) Financial Risk Analysis ----------------------
Income recognition, Expense capitalisation, Depreciation and inventory ----------------------
valuation policies, Off-balance sheet and contingent liabilities. Non-
operating income, Profitability measures, Interest coverage, Capital ----------------------
structure, Debt service coverage, Working capital indicators, Return on ----------------------
capital employed, Adequacy of cash flows, Debt servicing requirements
Sustainability of funds from operations, Ability to raise equity and debt ----------------------
funds, Alternatives available in times of stress, Liquid assets available. ----------------------
E) Project Risk
----------------------
Project size in relation to existing operations, Means of financing, Funding
tie-up, Extent of completion, Adherence to implementation schedules. ----------------------
F) Management Evaluation ----------------------
Strength of linkage to parent/group-operational, financial, managerial ----------------------
support. Systems and track record, Project implementation record,
Management talent and succession. ----------------------
Legal position -Whether the company has complied with all the legal ----------------------
requirements that they need to follow. If the company fails to follow the
legal requirements, then it can get into trouble in the future and thus the ----------------------
credit rating assigned could prove to be incorrect.
----------------------
Financial Analysis
----------------------
• Accounting quality.
• Financial Ratios. ----------------------
• Adequacy of cash flows. ----------------------
• Financial flexibility. ----------------------
Management Evaluation
----------------------
• Track record of management.
----------------------
• Crisis management.
• Goal, philosophy and strategic. ----------------------
Regulatory and Competitive Environment ----------------------
• Structure and regulatory framework of the financial system. ----------------------
• Trends in regulation / deregulation and their impact on company.
----------------------
Credit Rating 173

Notes • Fundamental Analysis.
• Capital adequacy.
----------------------
• Liquidity management.
----------------------
• Financial position.
---------------------- • Interest and tax sensitivity.
---------------------- • From the above points it is very clear that the rating agencies go into
the minute details of the companies working before assigning any credit
---------------------- rating to its instruments.
---------------------- One of the most important aspects that need to be given a great deal of
importance is the track record of the issuer. Many a times we observe that
---------------------- even a relatively new company’s instruments also get a very high rating
---------------------- simply because the company is promoted by an established business
house with a solid track record.
----------------------
----------------------

---------------------- 1. The key factors considered by the rating agencies for making business
analysis include:
----------------------
i. Industry risk
----------------------
ii. Industry structure
---------------------- iii. Industry size and importance to economy
---------------------- iv. Number of employees
---------------------- v. Entry barriers

2. The reasons for expressing credit ratings by rating symbols are:
----------------------
i. The rating symbols are easily comprehensible to lay investors
----------------------
ii. Distinct symbols for different instruments
---------------------- iii. Differentiation is based on degree of safety
---------------------- iv. Securities with same rating are identical investment quality
analysis include:
---------------------- i. Track record of management
---------------------- ii. Its goal, philosophy and strategies
---------------------- iii. Ability to raise loans
iv. Crisis management
----------------------
----------------------

8.5 FLOW CHART OF RATING PROCESS Notes
1. Mandate Activity 1 & 2 Initial stage. ----------------------
2. Assign rating team. ----------------------
3. Receive initial information Activity 1 to 5 Fact finding & analysis conduct
basic research. ----------------------
4. Meeting and visits. ----------------------

5. Analysis and preparation of report. ----------------------
6. Preview meeting Rating finalisation.
----------------------
7. Rating meeting Fresh inputs.
----------------------
8. Assign rating.
9. Communicate rating and the rationale Request for review. ----------------------
10. Acceptance Non-acceptance. ----------------------

11. Surveillance. ----------------------
In today’s market driven economy, there is a genuine need for authentic
----------------------
investment information characterised by authenticity, quality analysis and good
presentation, and specifically designed to facilitate the decision-making process ----------------------
of investors and other participants in the financial services world.
----------------------
Types of Instruments Rated
Credit rating is used extensively for evaluating debt instruments. These ----------------------
include long term instruments like bonds and debentures as well as short-term ----------------------
instruments like commercial paper. In addition, fixed deposits, certificates of
deposits, structured obligations including the non-convertible portion of PCDs ----------------------
and preference shares are rated. Equity shares are not rated.
----------------------
8.6 CRISIL’S LONG TERM RATING SYMBOLS ----------------------
AAA : Highest safety ----------------------
AA : High safety ----------------------
A : Adequate safety (Change in circumstances can adversely affect such
----------------------
issues.)
BBB : Moderate safety (Change in circumstances is more likely to lead to ----------------------
weakened capacity.)
----------------------
BB : Inadequate safety (Uncertainty could lead to inadequate capacity)
----------------------
B : High risk. (Currently obligations being met but adverse conditions
could lead to lack of ability.) ----------------------
C : Substantial risk (Payment possible only if favourable circumstances ----------------------
continue.)
D : Default ----------------------
Credit Rating 175

Notes It should be noted that each credit rating company has its own symbols and
they may use different symbols for rating different instruments. For example,
---------------------- the symbols used for Commercial paper and Fixed deposits will be different. In
India, there are presently four companies, in the business of Credit Rating, they
---------------------- are CRISIL, ICRA, CARE and Fitsch. The last one is an international credit rating
---------------------- company.
It is important to emphasize the limitations of credit ratings. They are
---------------------- not recommendations to invest. They do not take into account various aspects,
---------------------- which influence an investment decision. They do not, for example evaluate
the reasonableness of the issue price, possibilities for capital gains or take into
---------------------- account the risk of prepayment by issuer, or interest or exchange risks. Although
these are often related to credit risk, the rating essentially is an opinion on the
---------------------- relative quality of the credit risk.
----------------------
8.7 RECENT DEVELOPMENTS
----------------------
There have been discussions for a long time now as to whether the IPOs
---------------------- should be brought under compulsory rating process. In the past, we have seen that
---------------------- especially during the Bull Run in the stock markets, many dubious companies
come out with IPOs and the gullible investors fall pray to such issues as they
---------------------- believe that all IPOs will give them a profit after listing. It has been argued that
all issues are either appraised by the merchant bankers to the issue or by the lead
---------------------- bankers who are taking exposure by way of funding to the project for which
---------------------- the issue has been brought out. However, the counter argument is that the retail
investors are not in a position to understand all this. It may be useful therefore,
---------------------- that the IPO is assigned credit rating related to the risk profile of the project on
the whole.
----------------------
Some new and the existing credit rating agencies have approached SEBI
---------------------- for allowing them to rate the IPOs. We are likely to see some developments in
this direction shortly.
----------------------
Some rating agencies have also started rating the companies as a whole on
---------------------- its overall performance. This rating obviously is much wider in nature than the
issue related rating. We have also seen that some rating agencies have started
----------------------
rating the corporate governance practices. This is a welcome development as
---------------------- investors will come to know as to which companies are practicing corporate
governance in the way it needs to be done.
----------------------
We have also seen some innovation in the ratings for the different schemes
---------------------- of various mutual fund schemes. This is also a good development. The experts
have always maintained that before making any investments in a mutual fund
---------------------- scheme, its past performance needs to be evaluated. The credit rating may make
this decision making easier for the investors.
----------------------
We have seen the emergence of Securitization as a financial instrument in
---------------------- the market. This is gaining popularity and many players have started using this
---------------------- instrument very effectively. The pay-through and pass through instruments that
are issued in this process are presently being rated by the rating agencies.
In future, the retail investors will be able to invest money in these Notes
instruments. The credit rating for these will greatly help the retail investors to
make the investment decision in these instruments. ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. In India, the credit rating agencies includes CRISIL, ICRA, Fitch and
__________. ----------------------
2. The long-term rating symbol of CRISIL for highest safety is _____. ----------------------
3. Credit rating is used extensively for evaluating debt instruments, ----------------------
fixed deposits, CPs, CDs, PCDs, preference shares but not _________
shares. ----------------------
----------------------
Activity 1
----------------------
List out the items one will look at as an investor, while making ----------------------
investment decision other than the credit rating assigned to an
----------------------
instrument.
----------------------
Summary ----------------------
• We have studied the development of rating and reasons for it. We have ----------------------
seen the usefulness of rating to various constituents in the markets and
what exactly credit rating is. ----------------------
• We have seen the process of credit rating and the factors that are considered ----------------------
by the rating agencies while assigning the rating along with the flow chart
of the rating process. ----------------------
• We have also read the rating symbols for the long term investment ----------------------
instruments as given by the rating agency CRISIL. The current scenario
regarding the future of credit rating has also been highlighted in this unit. ----------------------
----------------------
Keywords
----------------------
• Issuer: The company that issues an instrument.
----------------------
• Management analysis: Quality of management of the company that is
seeking rating. ----------------------
• Rating symbol: Alfa numerical code given by the credit rating agencies. ----------------------
• Rating agency: The entity that undertakes the rating.
----------------------
• Turn around companies: Companies that are not doing well at present but
those who can do better in future. ----------------------
Credit Rating 177

Notes
----------------------
1. What is meant by Credit Rating?
---------------------- 2. What factors need to be considered while rating the companies?
---------------------- 3. What is the importance of rating to issuers, investors and marketing
companies?
----------------------
4. What is meant by business analysis? 5. Why is management quality
---------------------- analysis important for rating process?
---------------------- 6. According to you, which products that are not under rating, should be
brought under rating?
----------------------
7.
Should an investor depend solely on rating agencies while making
---------------------- investment decisions?
8. Explain the various symbols used in rating and their significance.
----------------------
---------------------- Answers to Check your Progress
---------------------- 1. False
2. True
----------------------
----------------------
analysis include:
----------------------
i. Industry risk
----------------------
ii. Industry structure
---------------------- iii. Industry size and importance to economy
---------------------- v. Entry barriers
---------------------- 2. The reasons for expressing credit ratings by rating symbols are:
i. The rating symbols are easily comprehensible to lay investors
----------------------
ii. Distinct symbols for different instruments
----------------------
iii. Differentiation is based on degree of safety
---------------------- analysis include:
i. Track record of management
----------------------
ii. Its goal, philosophy and strategies
----------------------
iv. Crisis management
Check your Progress 3 Notes
Fill in the blanks.
----------------------
1. In India, the credit rating agencies includes CRISIL, ICRA, Fitch and
CARE. ----------------------
2. The long-term rating symbol of CRISIL for highest safety is AAA. ----------------------
3. Credit rating is used extensively for evaluating debt instruments, fixed ----------------------
deposits, CPs, CDs, PCDs, preference shares but not equity shares.
----------------------
Suggested Reading ----------------------
1. Bhole, L. M. Financial Institutions and Markets: Structure, Growth and ----------------------
Innovations, 4e.
----------------------
2. Khan, M Y. Financial Services.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Credit Rating 179

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Factoring & Forfeiting
UNIT
9
Structure:
9.1 Introduction
9.2 Factoring
9.3 Functions of Factor
9.4 Factoring Mechanism
9.5 Legal Aspects involved in Factoring
9.6 Types of Factoring
9.7 Advantages of Factoring
9.8 International Factoring
9.9 Factoring in India
9.10 Factors Inhibiting the Growth of Factoring in India
9.11 Forfeiting
9.12 Mechanism of Forfeiting Transaction
9.13 Difference between Forfeiting and Factoring
Summary
Key Words
Suggested Reading
Factoring & Forfeiting 181

Notes
Objectives
----------------------
----------------------
• Describe the meaning and scope of factoring and forfaiting
----------------------
• Explain the various operations in respect to factoring and forfaiting
---------------------- services
• Differentiate between factoring and forfaiting services
----------------------
• Summarise the developments of factoring services introduced in
---------------------- India
----------------------
9.1 INTRODUCTION
----------------------
---------------------- With the advent of globalisation and liberalization, competition has

gone up considerably among business establishments, and corporates both at
---------------------- domestic and international level. Globally, mergers and acquisitions are common
phenomena. The environmental and technological changes are very rapid and
---------------------- the corporate has a challenge to keep pace with these changes on continuing
---------------------- basis. All over the world, the financial markets are facing turbulent weather.
In view of this, the efficient management of working capital requirements and
---------------------- more particularly cash and receivables is of utmost importance to corporate/
firms. We have been witnessing the collapse of many business units for want of
---------------------- liquidity. The success of the enterprise lies in converting credit sales into cash
---------------------- within a short period of time. In the present, we will be discussing in detail two
major services used for financing credit sales i.e. factoring and forfeiting.
---------------------- Factoring services started in the United States of America in the 1920s.
---------------------- Factoring as financing against receivables, got boost in 1930 and were introduced
to the other parts of the world in the 1960s. Today there are more than 250
---------------------- companies offering factoring services in more than 60 countries. Factoring
services have become quite popular all over the world.
----------------------
---------------------- 9.2 FACTORING

---------------------- “Factoring is a service of financial nature involving the conversion of
credit Invoices/ bills into cash.” Factoring is an ongoing arrangement between
---------------------- Financial intermediary known as factor and business establishment (Client).
---------------------- Under the factoring arrangement, the factor purchases the Client’s
receivables/book debts either with or without recourse to the Client.
----------------------
As the factor gets title to the receivables on account of the factoring contract,
---------------------- he becomes responsible for all credit control, sales ledger administration and
debt collection from the customers.
----------------------
Parties to the Factoring Contract - There are three parties involved
---------------------- generally in a factoring contract, viz:

1)
Seller of goods or services (i.e. client) who has supplied goods or provided Notes
services to the customers on credit terms.
----------------------
2) Buyer of goods or services (i.e. customer) who has purchased goods or
services on credit and as such has to pay for the same once the credit ----------------------
period gets over.
3) ‘Factor’ who purchase the invoices (receivable) from seller of goods and ----------------------
collect the money from the customers of his clients. ----------------------
9.3 FUNCTIONS OF FACTOR ----------------------
The functions of the factor include: ----------------------

a) To provide finance against book debts, say upto 80/90 per cent of the ----------------------
invoice value. The client gets funds immediately for his working capital.
----------------------
b) To collect cash against receivables on due date from the customers of the
clients and furnish reports to the client. ----------------------
c) To undertake sales ledger maintenance (i.e. accounting work) for the ----------------------
client in respect of client’s transactions with its customers.
d) Under the non-recourse factoring arrangement, if the customer becomes ----------------------
financially insolvent and cannot honour the commitment on due date. The ----------------------
Factor provides protection to the client against bad debts on all approved
invoices. Thus, the Factor provides credit protection facility to the client ----------------------
against possible losses arising from insolvency or bankruptcy of the customer.
----------------------
e) Factor also provides other information such as sales analysis and overdue
invoice analysis which enables the client to run the business more ----------------------
effectively. Besides, the Factor also provides relevant expertise in the
areas of marketing, finance, etc. to the client. ----------------------
Factoring contract is like any other loan sanctioning arrangement/ ----------------------
agreement regulated under the law of contract. The terms and conditions on
which factor agrees to purchase the debts from seller are mutually settled ----------------------
keeping in view the business connections and customs and practices.
----------------------
9.4 FACTORING MECHANISM ----------------------
A factor provides finance to his client up to a certain percentage of the ----------------------

unpaid invoices which represent the sales of goods or services to approved
customers. The mechanism of the factoring scheme is explained with the ----------------------
following example: ----------------------
M/s Nitin Auto Ltd (NAL-Client) has factoring facility with Canbank Factors
for the auto spares sold to Bajaj Auto Ltd.(BAL-Customer) ----------------------
a) BAL, customer places an order with the NAL, client, for goods on 90 ----------------------
days credit basis. NAL delivers the goods and sends invoice to BAL
----------------------
b) NAL assigns the invoice to factor c) Factor makes prepayment up to 80%
and sends periodical statements d) Monthly statement of accounts to BAL ----------------------
customer and follow up. e) BAL customer makes payment after 90days to
Notes CANBANK Factor. f) Factor makes balance 20% payment on realisation
to the NAL.
----------------------
The flow chart of Factoring Transaction
---------------------- Factoring Charges
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Fig. 9.1: Factoring Transaction

---------------------- • Like a Banker, Factors charge finance charge and service charges (fees).
• Factoring charge is similar to Interest charge levied on Cash Credit facility
---------------------- in a bank. It is computed on the basis of prime lending rate of Factor
---------------------- plus premium for credit risk. It is levied on the advances effected i.e.
prepayments outstanding in the Clients account at monthly intervals.
---------------------- • Service charge is levied to cover the cost of services involved in collection,
administering the sales ledger management, periodical MIS reports. The
---------------------- service charge is based on criteria such as the gross annual sales, the number
---------------------- of customers, the number of invoices and credit notes, the degree of risk
represented by the customers. The service charge is nominal for domestic
---------------------- factoring and it ranges from 0.30% to 0.75%.
----------------------
----------------------
Fill in the blanks.
----------------------
1. Under factoring arrangement, the factor purchases the _____ (Seller”s)
---------------------- receivables/book debts either with or without recourse facility
---------------------- 2. Under without recourse factoring arrangement, the factor provides
credit protection facility against possible losses arising from default/
---------------------- insolvency of the __________ (Buyer).
3. Factoring charge is similar to ______ charge levied on cash credit
----------------------
facility by a banker.
9.5 LEGAL ASPECTS INVOLVED IN FACTORING Notes
After entering into a factoring arrangement- ----------------------
a) The Client agrees to serve a notice of assignment in the format prescribed ----------------------
by the Factor to all Customers, whose receivables have been factored.
b)
The Client agrees to provide all copies of invoices along with the ----------------------
receipted delivery challans evidencing delivery of goods, obtained from ----------------------
the Customers. The Clients also agrees to remit any payment received if
any against the factored invoices. ----------------------
c) Power of Attorney from the Client to the factor for the assignment of ----------------------
invoices factored.
----------------------
d) In case the Client has cash credit facilities simultaneously with the
Factoring facility i.e. multiple finance, then the Factor requires Letter of ----------------------
Disclaimer (LOD).
----------------------
e) In India, the factoring transactions attract stamp duty to assign all debts.
----------------------
9.6 TYPES OF FACTORING
----------------------
a) Recourse Factoring: In recourse factoring the factor provides all types of
----------------------
factoring services such as collection and maintenance of sales ledgers.
However, if there is default or non-payment by the Customer, the Factor ----------------------
will recover full amount of invoices with charges from the Client. The
recourse factoring does not include bad debt protection. ----------------------
b) Non-recourse Factoring: Under this type of factoring, the Factor offers ----------------------
the client protection against bad debts. In case of default by the Customer
on due date the Factor bears the loss arising out of non-payment. Hence, ----------------------
the factoring charges are on high side in such factoring facility. The Non-
----------------------
recourse factoring arrangement is found in developed countries, where
reliable credit rating services are available. ----------------------
c) Maturity Factoring: Under Maturity factoring, no advance payment is ----------------------
made by the Factor but payment is made only on maturity date. The Factor
provides all other services to the Client as agreed. Maturity factoring is ----------------------
also known as collection factoring.
----------------------
d)
Invoice Factoring: It is a variant of factoring. The Factor provides
finance once the Letter of Credit Opening Banker confirms the due date ----------------------
of payment. The Factor does not offer any other services in respect of
receivables. ----------------------
e) Full Servicing Factoring: This is also known as Old Line Factoring as ----------------------
it provides comprehensive factoring arrangement to the Client i.e. short
term finance, collection, credit protection, sale ledger administration and ----------------------
advisory services. ----------------------
f) International Factoring: It is also known as Cross border factoring, wherein
----------------------
the factoring services are provided by Factors of both countries i.e. the

Notes exporter country’s Factor and the importer country’s Factor. In other
words, in domestic factoring, there are three parties involved, namely
---------------------- Client (Seller), Customer (Buyer) the Factor, whereas in international
factoring, there are four parties involved. i.e. exporter (Client), Importer
---------------------- (Customer), and export factor and import factor.
----------------------
9.7 ADVANTAGES OF FACTORING
----------------------
Benefits of Factoring to Clients:
----------------------
i) Factoring is universally accepted as vital to the financial needs of small
---------------------- and medium enterprises(SMEs) The Client converts his credit sales into
ready cash as the Factor makes a prepayment up to 80-90 percent of the
---------------------- factored invoices immediately and the amount on due date. This improves
---------------------- the cash flow position of the Client and thereby it enables him to manage
his working capital funds efficiently.
----------------------
ii) The Client can offer more competitive credit terms to his Customers
---------------------- (buyers), thereby increasing his sales and profitability.
iii) By availing the full services of the Factor in respect of sales ledger
----------------------
administration and collection of receivables, the Client can reduce his
---------------------- overhead expenses and improve the profitability.
iv) Under Non recourse factoring facility, the Client can eliminate the losses
----------------------
on account of bad debts; this will enable the Client to expand his business
---------------------- by booking new customers and augment his business.
---------------------- Benefits of factoring to Customers (Buyers)

• By availing the factoring facility, the customer gets adequate credit period.
----------------------
• The customers can save on bank charges and other expenses.
----------------------
•
Once the Notification letter, acknowledging the factoring arrangement is
---------------------- signed by the Customer, the Customer does not need to furnish any other
documents.
----------------------
• F
actoring does not impinge on the customer’s rights in respect of quality
---------------------- supplies and other contractual obligations by the Client.
Benefits to Banks
----------------------
Many a times, it is perceived that Factoring is threat to the Working
---------------------- Capital Banker. Factoring improves liquidity of the clients, and the proceeds
---------------------- of all such factored invoices are routed through the Cash Credit account of the
Client, which results in improving the quality of advances of banks.
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. In case the Client (Seller) has cash credit facility simultaneously with
----------------------
the factoring facility, i.e., multiple finance to meet his working capital
requirements, then the factor requires Letter of Disclaimer (LOD) ----------------------
from the banker.
----------------------
2. Under maturity factoring, advance payment is made by factor, who
provides all other services to the client (seller). ----------------------
3. Factoring facility improves liquidity of the client (seller) and the ----------------------
proceeds of factored invoices are routed through cash credit account
of the client (seller) which results in improving the quality of advances ----------------------
of banks.
----------------------
Activity 1 ----------------------
----------------------
What is the difference between factoring facility and Cash credit facility of
the Banker? Mention five points. ----------------------
----------------------
9.8 INTERNATIONAL FACTORING ----------------------
International Factoring covers both, exports as well imports where the ----------------------
seller and buyer are located in different countries. It facilitates as well as
promotes international trade. An attempt was made to define uniform laws for ----------------------
International factoring by International Institute for Unification of Private Laws ----------------------
(UNIDROIT), Canada. It was agreed by UNIDROIT that the term factoring
meant an arrangement between a factor and his client (seller) which included at ----------------------
least two of the following services-
----------------------
a. Factor financing
----------------------
b. Debt Administration (management of sales ledgers and collection of debts
and analysis) ----------------------
c. Credit Protection
----------------------
International factoring eases much of the credit and collection burden
created by cross border sales. ----------------------
Need for International Factoring ----------------------
In international trade, as seller and buyer are located in different countries, ----------------------
many sellers (exporters) usually find it difficult to evaluate creditworthiness of
potential (buyers) importers owing to lack of authenticate information and data. ----------------------
There could be a lot of reasons due to which, on maturity, an exporter finds
it difficult to recover the dues from importer (buyer). International factoring ----------------------

Notes offers credit assessment and protection, financing and collection services to
exporter on ongoing basis.
----------------------
International factoring requires neither collateral security not Letter
---------------------- of Credit, which provides guarantee by the Banker of importer (buyer). The
importer gets an access to open account credit terms. Owing to the Factors’
---------------------- professional expertise, International factoring enables the exporter to expand
the business with the existing customers as well as search for new markets for
----------------------
new business. The importer also gets the benefits as he pays the invoice amount
---------------------- to a Factor in his own country.
Mechanism of International Factoring Transaction
----------------------
There are four parties involved in International factoring i.e. exporter
---------------------- (Client), importer (Customer), export factor and import factor. International
factoring is a two factor system. The export factor provides services to the client
----------------------
in India, which includes the assessment of financial status of the exporter, while
---------------------- the import factor undertakes the credit assessment of the customer, including
the country as well as industry specific risk factors. There is no banker involved
---------------------- in International Factoring. All the requisite documentations and regulatory
formalities are complied with by the export factor who is an authorised dealer.
----------------------
The steps involved in export factoring are as follows:
---------------------- a) The exporter receives an order from the importer.
---------------------- b) The exporter provides the export factor with full details of the importer
along with the estimates of the credit requirements. The exporter forwards
---------------------- these details to correspondent import factors in the relevant country.
---------------------- c) On sanction of credit limits by the export factor, the exporter enters into a
factoring agreement with him.
----------------------
d) The exporter submits the relevant documents such as invoice, bill of
---------------------- lading/airway bill, Certificate of origin, GR forms etc to the export factor.
---------------------- e) On detail scrutiny, the export factor makes the prepayment to the exporter
on agreed terms.
----------------------
f) The export factor forwards the documents to the importer, under advice to
---------------------- the import factors.
---------------------- g) The import factor follows up with the customer (importer) and collects
payments.
---------------------- h) On collection, the import factor remits the same to the export factor.
---------------------- i) On receipt, the export factor effects the balance payment to the exporter
after adjusting the prepayments made.
----------------------
----------------------
----------------------
----------------------

International Factoring Transaction Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 9.2: International Factoring Transaction
----------------------
1. Exporter receives order ----------------------
2. Credit limit request
----------------------
3. Approval
----------------------
4. Delivery of goods
5. Submits documents ----------------------
6. Prepayments ----------------------
7. Documents ----------------------
8. Collection
----------------------
9. Payment remittance
----------------------
10. Balance payment
Factor Chain International (FCI) ----------------------
FCI is a global network of leading factoring companies, based in Amsterdam. ----------------------

FCI aims:
----------------------
i) To facilitate international trade through Export Factor and Import Factor
located in two different countries, in which, their local laws and practices ----------------------
may be different.
----------------------
ii) Provide effective communication systems to enable factors to conduct
their business in a cost effective way as well as a legal framework to ----------------------
protect exporters and importers.
----------------------
FCI has introduced standard procedures of factoring to maintain universal
quality. It is mandatory for both the Factors to follow uniform rules to operate ----------------------
in the international market. It undertakes worldwide promotion to position
----------------------
international factoring as the preferred method of trade finance. FCI has played
a major role in bringing factoring in most of the countries and at present FCI has ----------------------
a membership of 247 factoring companies operating in 66 countries.
----------------------

Notes 9.9 FACTORING IN INDIA
---------------------- In India, the factoring services have been introduced since 1991; however
factoring volume is quite low. Initially, the Vaghul Committee on Money Markets
---------------------- recommended the development of a system of factoring of open account sales
mainly for small scale industrial (SSI) units and commercial enterprises. The
----------------------
Committee suggested that both the banks and non-bank financial institutions in
---------------------- private sector should be encouraged to set up factoring companies.
---------------------- Later on, RBI formed a Kalyanasundaram committee in 1988 to examine

the need and scope of factoring organisations in India. The Committee strongly
---------------------- recommended introduction of factoring services in India. The committee
observed that banks were ideally suited for providing factoring services to the
---------------------- industries in the economy. Subsequently, R B I accepted the recommendations
---------------------- and a suitable amendment was made in the Banking Regulation Act 1949, which
enabled the banks to set up subsidiary companies for undertaking factoring
---------------------- services. RBI permitted both the State Bank of India and Canara Bank to start
factoring services through their own subsidiaries. Accordingly, in 1991, two
---------------------- factoring companies in India, i.e. SBI Factors and Commercial Services Ltd. and
---------------------- Canbank Factors Ltd; sponsored by the State Bank of India and Canara Bank
respectively, commenced operations. SBI Factors and Commercial Services
---------------------- Private Limited, is a subsidiary of SBI, promoted by SBI and its associates
jointly with SIDBI & Union Bank of India.
----------------------
Besides the above following factoring companies are operating in India-
----------------------
• Export Credit Guarantee Corporation of India Ltd,
---------------------- • The Hongkong and Shanghai Banking Corporation Ltd,
---------------------- • Citibank N.A. India,
---------------------- • Small Industries Development Bank of India.

India Factoring & Finance Solutions Pvt. Ltd (India Factoring) has
---------------------- announced the launch of its factoring business recently. It is a joint venture of
---------------------- Punjab National Bank and Malta-based Fim Bank group, Banca IFIS of Italy
and Mumbai-based Blend Financial Services.
----------------------
9.10 FACTORS INHIBITING THE GROWTH OF
----------------------
FACTORING IN INDIA
----------------------
The factoring industry has grown phenomenally extending to over 66
---------------------- countries around the world. However, the factoring volume is quite low in
India. The reasons for slow growth in factoring volumes are as follows.
----------------------
a) There is no Factoring Act in India like other developed countries. Absence
---------------------- of regulatory frame work is hindering factor.
---------------------- b) Higher stamp duty on assigning of debt increases the cost of the client
which reduces factoring arrangement.
----------------------

c) Being registered as NBFCs, factoring companies are not eligible for Notes
refinance which limits the extension of factoring facility to the exporters.
Besides this, these factoring companies are not covered by SARFEASI ----------------------
Act, thereby limits their recovery prospects of their Non Performing
Assets. ----------------------
d) Many times banks in India perceive factoring as a threat to banking. Non ----------------------
availability of permission i.e. Non-Issuance of Letter of Disclaimer to
----------------------
the factoring companies by the working capital bankers restricts their
financing capacity of Factors and thereby the growth of factoring market. ----------------------
9.11 FORFEITING ----------------------
The word ‘forfeit’ is derived from the French word ‘a forfait’ which means ----------------------
the surrender of rights. In forfeiting arrangement, the exporter relinquishes the ----------------------
right to receivables due at a future date in exchange for immediate cash payment
at an agreed discount and passes on all risks and responsibilities for collecting ----------------------
the debt to the Forfeiter. As a result, an exporter in India can convert a credit
sale into a cash sale, with no recourse to him or to his banker. Commercial banks ----------------------
usually, do not fund export credit risks beyond 180 days. Hence, for financing ----------------------
long tenor receivables, forfeiting is the only best option. In short, forfeiting is a
mechanism of financing exports- ----------------------
• By discounting export receivables. ----------------------
• Evidenced by bills of exchange or promissory notes.
----------------------
• Without recourse to the seller.
----------------------
• Carrying medium to long terms maturities.
• On a fixed rate basis (discount). ----------------------
• Up to 100 percent of the contract value. ----------------------

Forfeiting evolved in the year 1960 and it was originally developed to ----------------------
help German exports to the Eastern bloc countries. In India Exim Bank was
authorised by R.B.I. to finance exports through forfeiting. The role of EXIM ----------------------
Bank is that of a facilitator between the Indian exporter and the overseas
----------------------
forfeiting agency.
Initially, forfeiting was developed as a fixed interest rate and medium ----------------------
term i.e. to say 3 to 5 years financing. Now it can be tailor made to suit the
----------------------
requirements taking into consideration the interest rate, credit period, moratorium
and shipment schedule. Forfeiting can now be structured on a floating rate basis ----------------------
for shorter and longer periods ranging between 60 days to 10 years.
----------------------
Characteristics of a forfeiting transaction
•
In forfeiting transaction, the exporter is fully protected against the probable ----------------------
default in payment by the importer. ----------------------
• Credit period can be from 60 days to 10 years.
----------------------

Notes •
Trade receivables are usually evidenced by bill of exchange, promissory
notes or letter of credit. These receivables are denominated in US Dollar and
---------------------- euro, which are freely convertible currencies.
---------------------- •
An importer’s obligation is normally supported by a local bank guarantee or
an aval. An aval means an unconditional financial obligation. It takes in
---------------------- the form of an endorsement on a debt instrument like a promissory note
or bill of exchange. The act of giving an aval is known as avalising. It
---------------------- represents an irrevocable, unconditional and fully transferable guarantee
---------------------- given by the foreign buyer’s local bank.
• F
orfeiting helps in eliminating interest rate fluctuation as it involves upfront
----------------------
discounting. The interest cost is known to both the exporter and the importer
---------------------- and is built into the contract itself.
•
Forfeiting is suitable for high value exports such as capital goods, vehicles,
---------------------- consultancy and construction contracts, project exports and bulk commodities.
---------------------- • The pricing of a forfeiting transaction consists of four elements i.e.
---------------------- discount rate reflects cost of funds, commitment fee is calculated from the
•
date of forfeiter is committed to undertake the financing until the date of
---------------------- discounting.
---------------------- – handling fee is applicable for documentation and custom clarification.
---------------------- What benefits accrue to an exporter from Forfaiting?

• I
t converts a deferred payment export into a cash transaction, improving
---------------------- liquidity and cash flow. It is superior to the traditional discounting of export
---------------------- bills.
• F
rees the exporter from cross border political or commercial risks, interest
---------------------- risk and exchange risk associated with export receivables.
---------------------- • F
inance up to 100 percent of the export value is possible as compared to 80-
85% financing available from conventional export credit arrangements.
----------------------
• A
s forfeiting offers without recourse finance to an exporter, it does not
---------------------- impact the exporter’s existing borrowing limits. Thus, forfeiting represents
an additional source of funding contributing to improved liquidity and cash
---------------------- flow.
---------------------- •
It relieves the balance sheet of contingent liabilities and helps the exporter to
undertake more exports.
----------------------
• Exporter is freed from credit administration and collection problems.
----------------------
•
Forfeiting is transaction specific. Consequently, a long term banking
---------------------- relationship with the forfeiter is not necessary to arrange a forfeiting
transaction.
---------------------- •
Exporter saves on insurance costs as forfeiting obviates the need for export
---------------------- credit insurance.
----------------------

•
Forfeiting is also beneficial to the importer as it is an alternative form of Notes
financing capacity that increases and diversifies borrowing capacity.
Simplicity of documentation enables rapid conclusion of the forfeiting ----------------------
arrangement.
----------------------
9.12 MECHANISM OF FORFEITING TRANSACTION ----------------------
Flow chart of a forfeiting transaction is as follows- ----------------------
1) At the request of the exporter, the forfeiter provides the exporter with a ----------------------
written commitment to purchase the debt from him on a without recourse
basis. ----------------------
2) Commercial contract between exporter and importer. ----------------------
3) On execution of the forfeiting contract, EXIM bank issues a certificate to
----------------------
the exporter with a copy to the authorised dealer (AD).
4) The importer’s bank provides guarantee at the request of the importer. ----------------------
5) The guarantee is forwarded by the importer to the exporter. ----------------------
6) The exporter assigns the guarantee in favour of the forfeiter and forwards ----------------------
other documents related to forfeiting.
7) On complete scrutiny of the documents, the forfaiter makes the payment ----------------------
to the exporter on a without recourse basis. ----------------------
8) On maturity, the forfaiter presents the documents to the importer’s bank
----------------------
for payment.
9) The importer makes the payment to his guaranteeing bank. ----------------------
10) The importer’s bank guaranteeing the transactions makes the payment to ----------------------
the forfaiter on due date.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Flow Chart of a Forfeiting Transaction
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 9.3: Forfeiting Transaction
----------------------

----------------------
---------------------- 1. In forfaiting, the charges levied consist of:
---------------------- i. Discount rate
ii. Interest
----------------------
iii. Commitment fees
----------------------
iv. Handling fees
---------------------- 2. Parties involved in export factoring are:
---------------------- i. Exporter
ii. Importer
----------------------
iii. Both bankers
---------------------- iv. Import factor
---------------------- v. Export factor
3. Forfaiting includes:
----------------------
i. High value exports of merchandised goods
----------------------
ii. High value exports of capital goods
---------------------- iii. Credit period of 60 days to 10 years
---------------------- iv. The exporter is fully protected against default by the importer

Notes
Activity 2
----------------------
Visit www.factors-chain.com and find out the number of factoring ----------------------
companies in India who are members of FCI.
----------------------
9.13 DIFFERENCE BETWEEN FORFEITING AND ----------------------

FACTORING ----------------------
a) Factoring is mainly for financing and collection of receivables of short ----------------------

term maturities say up to 180 days. Forfeiting is usually for international
credit transactions of long term maturity periods ranging between 90 days ----------------------
and up to 10 years. ----------------------
b) Forfeiting is 100 per cent financing without recourse to the exporter.
Factoring can be with recourse or without recourse depending on the ----------------------
terms of transaction between the seller and the factor. ----------------------
c)
Forfeiting transaction is always considered for export transactions.
----------------------
Factoring services are offered either for domestic transaction or for export
transaction. ----------------------
d) The basic difference between factoring and forfeiting is the difference
----------------------
in risk profiles of the receivables and it has implications for the cost of
services. ----------------------
e) Factoring is carried out on the strength of sales invoices and receipted ----------------------
delivery challans, which constitutes basic documents. Forfeiting involves
availised negotiable instruments like bill of exchange or promissory note. ----------------------
f) In forfeiting, the complete sales ledger of the exporter is not handled by ----------------------
the forfeiter. In Forfeiting transaction, structuring and costing is tailor
made as per the requirements of the contract between the parties. Under ----------------------
factoring, the factor handles the entire sales ledger at a predetermined
price. Factoring requires the assignment of whole turnover with a buyer ----------------------
on a continuous basis. Factoring is on continuous and revolving facility. ----------------------
In other words, forfeiting can be done on transaction basis where as
factoring is generally on whole turnover basis. ----------------------
g) In forfeiting, the cost i.e. charges consists of three elements – discount ----------------------
rate, commitment fees and handling fees which are ultimately borne by
the importer. In respect of factoring, the cost of factoring is usually borne ----------------------
by the seller.
----------------------
----------------------
----------------------
----------------------

Notes Summary
---------------------- • Both the factoring and forfeiting are new trade financing services. Managing
the trade debts of a business establishment and converting credit sales into
----------------------
cash, is the crux of the factoring activity which also includes the collection and
---------------------- administration of sales ledger. There are three parties involved in factoring.
The different types of factoring arrangements are: recourse factoring, non
---------------------- recourse factoring, invoice discounting, maturity factoring and international
factoring.
----------------------
• Factoring is beneficial to the seller (client), the buyer (customer) and the
---------------------- banks.
---------------------- • International factoring is two factor system. There are four parties involved in
international factoring i.e. exporter (client). Importer (customer), the export
---------------------- factor and import factor. International factoring facilitates international trade.
---------------------- • International factoring is comprehensive receivable management and

financing services. The factor offers to the exporter, at least, two of the
---------------------- following services – credit management, finance up to 90% of the invoice
value of shipment to approved customers (importers), debt protection,
---------------------- collection service and professional sales ledger administration and analysis
of receivables.
----------------------
• Forfeiting is the discounting of international trade receivables on a 100%
---------------------- without recourse basis. Forfeiting is the only appropriate option for financing
long tenor export receivables.
----------------------
---------------------- Keywords
---------------------- • Factoring: Factoring is a service of financial nature involving the conversion
of credit Invoices/bills into cash.
----------------------
• Recourse Factoring: In recourse factoring, the factor provides all types of
---------------------- factoring services such as collection and maintenance of sales ledgers.
---------------------- • Non-Recourse Factoring: Under this type of factoring, the Factor offers the
client protection against bad debts.
----------------------
• Invoice Factoring: It is a variant of factoring. The Factor provides finance
---------------------- once the Letter of Credit Opening Banker confirms the due date of payment.
---------------------- • Maturity Factoring: Under Maturity factoring, no advance payment is

made by the Factor but payment is made only on maturity date.
---------------------- • International Factoring: International factoring facilitates international
---------------------- trade. It is comprehensive receivable management and financing services.
There are four parties involved in it, i.e. exporter (client) and importer
---------------------- (customer), the export factor and import factor.
---------------------- • Forfeiting: In forfeiting arrangement, the exporter relinquishes the right to

receivables due at a future date in exchange for immediate cash payment, at
---------------------- an agreed discount and passes on all risks and responsibilities for collecting
the debt to the forfeiter.
Notes
----------------------
1. What do you mean by factoring? Explain the mechanism of Factoring.
2. What are the types of factoring? ----------------------
3. What is International Factoring? How does it differ from Forfeiting? ----------------------
4. Explain the mechanism of International Factoring. ----------------------
5. Explain the concept of forfeiting. What are the benefits of forfeiting?
----------------------
6. How does factoring differ from bills discounting?
----------------------
Fill in the blanks.
----------------------
1. Under factoring arrangement, the factor purchases the Client’s (Seller’s)
receivables/book debts either with or without recourse facility. ----------------------
2. Under without recourse factoring arrangement, the factor provides credit ----------------------
protection facility against possible losses arising from default/insolvency
of the Customer (Buyer). ----------------------
3. Factoring charge is similar to interest charge levied on cash credit facility ----------------------
by a banker.
----------------------
----------------------
1. True ----------------------
2. False ----------------------
3. True ----------------------
----------------------
----------------------
1. In forfaiting, the charges levied consist of:
i. Discount rate ----------------------
iii. Commitment fees ----------------------
iv. Handling fees ----------------------
2. Parties involved in export factoring are:
----------------------
i. Exporter
----------------------
ii. Importer
iv. Import factor ----------------------
v. Export factor ----------------------

Notes 3. Forfaiting includes:
i. High value exports of capital goods
----------------------
ii. Credit period of 60 days to 10 years
----------------------
iv. The exporter is fully protected against default by the importer
----------------------
---------------------- 1. Abhyankar, Dr. Hemant and Shri S. V. Hajeri. Foreign Trade & Foreign
Policy.
----------------------
2. Banga, S. “Factoring: A Cash Flow Solution”. Fortune India. March,
---------------------- 2000
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Introduction to Insurance
UNIT
10
Structure:
10.1 Introduction
10.2 Insurance Regulatory and Development Authority (IRDA)
10.3 Types of Insurance
10.4 Life Insurance
10.5 Non - Life Insurance
10.6 Reinsurance
Summary
Key Words
Suggested Reading
Introduction to Insurance 199

Notes
Objectives
----------------------
----------------------
• State the meaning of insurance
----------------------
• Describe the role of IRDA in regulating insurance industry
---------------------- • Distinguish between the characteristics of life insurance and non-
life insurance
----------------------
• Identify the different types of non-life insurance
----------------------
• State the meaning of reinsurance
----------------------
10.1 INTRODUCTION
----------------------
---------------------- In today’s world, insurance has become the most important business
impacting all walks of life. Increasing complexities of life and trade are
---------------------- compelling individuals and businesses to manage their risk through insurance.
Therefore, it is very important to understand what insurance is and what purpose
---------------------- does it solve.
---------------------- Insurance can be defined as a technique of risk management where the
risk of a probable loss is transferred from one entity to another in exchange of
---------------------- a payment called the insurance premium. The person or the entity selling the
insurance is called the insurer and the person buying the insurance policy is
----------------------
termed as policy holder or the insured.
---------------------- Atypical insurance transaction involves the insured, paying a fee called
the insurance premium to the insurer in exchange of a promise from the insurer
----------------------
to compensate the insured in case of any financial / personal loss. The basic
---------------------- principle governing the insurance business is that the fee or the insurance
premium is collected from many insured entities whereas the risk which
---------------------- is insured will actually occur only for a few insured entities. The amount of
premium is dependent upon the type of risk covered, the probability of the risk
----------------------
actually occurring and the frequency.
---------------------- Characteristics of Insurance
---------------------- Insurance, of any type, has the following key characteristics:
Risk Sharing – Insurance is the device to share the risk of financial loss,
----------------------
which may be suffered, by an individual or a business due to happening or not
---------------------- happening of an event. For example in case of crop insurance there is a financial
guarantee given by the insurance company that if the crop does not yield the
---------------------- desired result or if the crop fails then the insurance company covers up the loss
giving a sense of security to the farmer.
----------------------
Common risk – The insurer cannot pay for all the losses suffered by insured
---------------------- from his own pocket. Insurance business runs on the concept that a large number
of people are exposed to the same risk and hence collects premium from a larger
----------------------
section of people and actual loss is incurred by only a few insured people.

Value of risk – The value of risk is a very important factor for determining the Notes
amount of insurance premium. The various parameters like probability of risk,
timing etc are considered while determining the amount of insurance premium. ----------------------
Contingent event – The payment of insurance premium is dependent on the ----------------------
occurrence or non occurrence of a certain event. If the event occurs, then only
the insured amount becomes due to the insured. ----------------------
Amount of payment – The amount of payment depends on the amount of loss ----------------------
suffered subject to the maximum sum insured.
----------------------
The key features of risk, which ensures insurability, are:
•
The risk should be common amongst a large number of people so that the ----------------------
insurer can get the benefit from the large numbers. ----------------------
•
The loss should be definite and the insurer has an idea of the probable time,
place and cause of the loss. ----------------------
•
The loss should be accidental or outside the control of insured and not ----------------------
speculative.
----------------------
•
The amount of loss should be huge as compared to the premium paid to
insure the same. ----------------------
• The amount of loss occurring from the risk insured should be calculable. ----------------------
•
The risks insured should be independent from one another and not linked to
a single event.
----------------------
A well-developed and evolved insurance sector is a boon for economic ----------------------

development as it provides long- term funds for infrastructure development at
----------------------
the same time strengthening the risk taking ability of the country.
Purpose and need of Insurance ----------------------
The key benefits derived from insurance can be listed as under: ----------------------
Indemnification of losses – Insurance helps in restoring back to the previous ----------------------
financial position as if no loss has taken place.
Reduces fear of loss – Insurance reduces the worry and fear of prospective ----------------------
impact of a loss before and after the occurrence of the same. ----------------------
Mobilization of savings – Insurance is considered as a major instrument for
----------------------
mobilization of savings of individuals thereby increasing the level of investment
leading to economic growth. ----------------------
Employable industry – the scope of insurance industry is huge and provides
----------------------
employment to a large number of people.
Enlighten individuals on loss prevention – The insurance companies ----------------------
enlighten people on the techniques of loss prevention through insurance thereby
----------------------
increasing the risk appetite of the people.
----------------------
----------------------

Notes 10.2 INSURANCE REGULATORY AND DEVELOPMENT
AUTHORITY (IRDA)
----------------------
The insurance business in India is governed by the Insurance Regulatory
---------------------- and Development Authority Act, 1999. The IRDA Act was enacted by the
---------------------- parliament in the fiftieth year of republic of India in order to ensure that there
is an established authority to protect the interests of the policy holders and to
---------------------- regulate, promote and ensure orderly growth of Insurance industry in India.
The Authority has the power to frame regulations under Section 114A of the
---------------------- Insurance Act, 1938 and has from 2000 onwards framed various regulations
---------------------- ranging from registration of companies for carrying on insurance business to
protection of policy holders’ interests.
----------------------
Up to 2018, there are 30 general insurance companies including the ECGC and
---------------------- Agriculture Insurance Corporation of India and 24 life insurance companies
operating in the country.
----------------------
IRDA Mission Statement
---------------------- • To protect the interest of and secure fair treatment to policyholders;
---------------------- •
To bring about speedy and orderly growth of the insurance industry (including
annuity and superannuation payments), for the benefit of the common man,
---------------------- and to provide long term funds for accelerating growth of the economy;
---------------------- •
To set, promote, monitor and enforce high standards of integrity, financial
soundness, fair dealing and competence of those it regulates;
----------------------
•
To ensure speedy settlement of genuine claims, to prevent insurance frauds
---------------------- and other malpractices and put in place effective grievance redressal
machinery;
----------------------
To promote fairness, transparency and orderly conduct in financial markets
---------------------- dealing with insurance and build a reliable management information
system to enforce high standards of financial soundness amongst market
---------------------- players;
---------------------- • To take action where such standards are inadequate or ineffectively enforced;
---------------------- •
To bring about optimum amount of self-regulation in day-to-day working of
the industry consistent with the requirements of prudential regulation.
---------------------- Section 14 of IRDA Act, 1999 lays down the duties, powers and functions of
---------------------- IRDA.
Subject to the provisions of this Act and any other law for the time being in
----------------------
force, the Authority shall have the duty to regulate, promote and ensure orderly
---------------------- growth of the insurance business and re-insurance business.
----------------------
----------------------
----------------------

The following are the powers and duties of IRDA: Notes
•
issue to the applicant a certificate of registration, renew, modify, withdraw,
suspend or cancel such registration; ----------------------
•
protection of the interests of the policy holders in matters concerning assigning ----------------------
of policy, nomination by policy holders, insurable interest, settlement of
insurance claim, surrender value of policy and other terms and conditions of ----------------------
contracts of insurance; specifying requisite qualifications, code of conduct ----------------------
and practical training for intermediary or insurance intermediaries and
agents ----------------------
• specifying the code of conduct for surveyors and loss assessors; ----------------------
• promoting efficiency in the conduct of insurance business;
----------------------
•
promoting and regulating professional organisations connected with the
insurance and re-insurance business; ----------------------
• levying fees and other charges for carrying out the purposes of this Act; ----------------------
•
calling for information from, undertaking inspection of, conducting enquiries ----------------------
and investigations including audit of the insurers, intermediaries, insurance
intermediaries and other organisations connected with the insurance business; ----------------------
•
control and regulation of the rates, advantages, terms and conditions that
----------------------
may be offered by insurers in respect of general insurance business not so
controlled and regulated by the Tariff Advisory Committee under section ----------------------
64U of the Insurance Act, 1938 (4 of 1938);
----------------------
•
specifying the form and manner in which books of account shall be maintained
and statement of accounts shall be rendered by insurers and other insurance ----------------------
intermediaries;
----------------------
• regulating investment of funds by insurance companies;
• regulating maintenance of margin of solvency; ----------------------
•
adjudication of disputes between insurers and intermediaries or insurance ----------------------
intermediaries;
----------------------
• supervising the functioning of the Tariff Advisory Committee;
----------------------
•
specifying the percentage of premium income of the insurer to finance
schemes for promoting and regulating professional organisations referred to ----------------------
in clause (f);
•
specifying the percentage of life insurance business and general insurance ----------------------
business to be undertaken by the insurer in the rural or social sector; and ----------------------
• exercising such other powers as may be prescribed.
----------------------
----------------------
----------------------
----------------------

Notes
----------------------

1. One of the important factors in determining the amount of insurance
----------------------
premium is ___________.
---------------------- 2. Insurance is considered as a major instrument for mobilisation of
_________ of individuals, which ultimately leads to economic
----------------------
growth.
---------------------- 3. To protect the interest and secure fair treatment to policyholders is
---------------------- one of the basic objectives of ______.
----------------------
10.3 TYPES OF INSURANCE
----------------------
Insurance can be classified on the basis of two aspects/ angles:
----------------------
From business point of view Life Insurance
---------------------- This insurance provides protection to the family at the premature death or gives
---------------------- adequate amount at the old age when earning capacities are reduced. Types-
Non Life / General Insurance
----------------------
The general insurance includes property insurance, liability insurance and other
---------------------- forms of insurance. Eg. Fire insurance, health insurance, accident insurance,
vehicle insurance etc.
----------------------
Social Insurance
----------------------
This insurance is provided to the weaker sections of the society who are unable
---------------------- to pay adequate premium. E.g. Pension plan, unemployment benefit, etc.
---------------------- From risk point of view Property Insurance

Under this insurance, the property of a person is insured against a specific risk
---------------------- which may arise from fire, accident, marine perils etc.
---------------------- Liability Insurance
---------------------- Under this insurance, the insurer is liable to compensate for the loss of personal
injury or death.
----------------------
Other forms of insurance
---------------------- Other forms include credit insurance, fiduciary insurance, privilege insurance
etc. whereby the payment is due upon happening.
----------------------
Let us cover life and non life insurance in detail.
----------------------
----------------------
----------------------

10.4 LIFE INSURANCE Notes
Life insurance is an agreement between the insurance company and the ----------------------
insured wherein, the insurer pays to the insured a predefined sum of money in
case of death , accident of serious illness. The insured pays a periodical premium ----------------------
to the insurer based on the terms as mentioned in the insurance agreement.
----------------------
Life insurance is the most common form of insurance as it provides
protection against untimely death of an individual, savings for old age when ----------------------
earnings reduce, tax benefit and social security. It also increases the credit ----------------------
worthiness of an individual as he can raise a loan keeping his life insurance
policy as security. Above all, it encourages the habit of savings amongst people. ----------------------
Principles of Life Insurance Contract ----------------------
Insurable Interest
----------------------
The person taking the insurance must have insurable interest in the life
of the person assured. Such insurable interest must be present at the time of ----------------------
entering into the insurance contract. It may or may not be present at the time of
----------------------
maturity. Different examples of insurable interest include interest in the life of
spouse, parents, kids, employer, debtor etc. ----------------------
Utmost good faith
----------------------
The contract of insurance is a contract of utmost good faith. The insured
should not hide any material information which may have an impact on the ----------------------
terms of the policy from the insurance company at the time of entering into the ----------------------
contract.
Not a contract of indemnity ----------------------
Life insurance contracts are not contracts of indemnity as a fixed amount ----------------------
is paid at the time of occurrence of death. The loss of life cannot be valued and
hence there cannot be any indemnification of loss. ----------------------
Factors determining life insurance premium ----------------------

There are various factors, which are kept in mind by the insurance ----------------------
companies while determining the amount of insurance premium on the life of
any person. The key factors are: ----------------------
a. Age of the insured – higher the age the more will be the amount of ----------------------
insurance premium
----------------------
b. Health – if the insured person is suffering from any chronic disease then it
increases the risk of the insurance company and hence they tend to charge ----------------------
more premium.
----------------------
c. Mortality rate- The mortality rate in the area in which the insurer resides is
also considered while determining the insurance premium. If the average ----------------------
age is high the amount of premium is low and vice versa.
----------------------
d. Lifestyle – If the lifestyle of a person is such that he/she is continuously
exposed to thrilling situations then the amount of insurance changes. ----------------------

Notes e. Gender – women live longer as compared to men and hence pay less
insurance premium.
----------------------
In order to get this information the insurance companies generally ask the
---------------------- insured to fill up a from before deciding the final terms of the insurance policy.
Based on the information so collected an analysis is done on the likelihood
---------------------- of the death or exposure to accidents of the insured and then the amount of
premium is decided.
----------------------
In order to get this information, the insurance companies generally ask the
---------------------- insured to fill up a form before deciding the final terms of the insurance policy.
Based on the information so collected an analysis is done on the likelihood of
----------------------
the death or exposure to accidents of the insured and then the amount of premium
---------------------- is decided.
Types of life insurance policies
----------------------
Term Assurance Plan
----------------------
Term insurance is insurance purely on the life of the insured. The benefit
---------------------- from the policy accrues only in the event of the death of the insured. Such plans
come with a fixed tenure starting with 1 year and the premium amount is also
---------------------- very low. There is no refund if the policy holder survives the term.
---------------------- Whole Life Policy
---------------------- Such policy runs for the entire life of the insured. In the event of death
of the insured, the legal heirs of the insured get the amount from the insurance
---------------------- company. The premium on such policies can be paid at periodical intervals
throughout the life or one time or for a specific period of time depending upon
----------------------
the terms of the policy.
---------------------- Endowment Life Policy
---------------------- Under this policy the insurance company agrees to pay the assured amount
to the insured or his nominees either on the death of the insured or at maturity of
---------------------- the policy whichever is earlier. The premium on such policies is usually higher
as compared to other policies and is paid till the maturity of the policy.
----------------------
Annuity Policy
----------------------
Under this policy the assured sum is paid in periodical instalments which
---------------------- may be monthly, quarterly or yearly once the insured person attains a certain
age. The amount is payable as long as the insured person lives.
----------------------
Money Back Policy
----------------------
Under this policy the money is paid to the insured in separate cash
---------------------- payments till the time the insured is alive. The term used for these periodical
payments is survival benefit. The life insurance contract can be on the life of a
---------------------- single individual or a joint life contract or a group contract.
----------------------
----------------------

Notes
----------------------
1. From business point of view, insurance can be classified as:
----------------------
i. Life insurance
----------------------
ii. Non-life insurance
iii. Marine insurance ----------------------
iv. Social insurance ----------------------

2. Principles of life insurance contract: ----------------------
i. Insurable interest
----------------------
ii. Utmost good faith
----------------------
iii. Contract of indemnity
iv. Not a contract of indemnity ----------------------
3. From risk point of view, insurance can be classified as: ----------------------

i. Property insurance ----------------------
ii. Liability insurance
----------------------
iii. Credit insurance
----------------------
iv. Reinsurance
----------------------
10.5 NON-LIFE INSURANCE ----------------------
Insurance other than ‘Life Insurance’ falls under the category of Non life ----------------------
/ General Insurance. It comprises of insurance of property against fire, burglary
----------------------
etc, personal insurance such as Accident and Health Insurance, and liability
insurance which covers legal liabilities. There are also other covers such as ----------------------
Errors and Omissions insurance for professionals, credit insurance etc.
----------------------
In other words, non-life insurance covers businesses and individuals and
provides monetary protection from any disaster that may occur which is covered ----------------------
under the terms of the policy.
----------------------
The key characteristics of non life insurance are as under:
Insurable Interest ----------------------
Insurable interest in case of general insurance means the insured should be ----------------------
the owner of the property which he intends to insure and he can insure only the
property owned by him. For example, owner of a house can get house owners ----------------------
insurance, owner of a vehicle can get vehicle insurance and so on. ----------------------
----------------------

Notes Personal Contact
Unlike life insurance, where you can take an insurance policy on the life
----------------------
of some other person, in non life insurance, there needs to be a personal contact
---------------------- between the insured and the insurance company.
Life of the contract
----------------------
Non life insurance contract is a one year renewable contract unlike a life
---------------------- insurance contract which is a contract for life time.
---------------------- Certainty
---------------------- In life insurance, there is a certainty about the death of the insured and
only the time of death is not assured. In non life insurance there is always an
---------------------- uncertainty whether the event will take place or not. For example under a fire
insurance policy it is not certain that the fire will take place or not. It may
---------------------- happen that during the entire tenure of the policy fire does not take place.
---------------------- Types of Non Life Insurance
---------------------- The different types of non life insurances along with their key features are
detailed as under:
----------------------
Fire Insurance
---------------------- A contract of fire insurance is an agreement where the insurer agrees to
indemnify the loss of property suffered by the insured as a result of fire. Loss
----------------------
of life due to fire is covered under life insurance. Fire insurance covers the loss
---------------------- due to fire only up to a specified period and up to an agreed amount.
---------------------- The fire insurance policy contains various details like the details of
property insured, period, amount of loss covered and different types of losses
---------------------- covered under the policy like loss due to actual fire, lighting, explosion, storm,
riots or any other natural disaster. Any loss incurred in an attempt to extinguish
---------------------- fire and expenses incurred to extinguish fire are also covered under the fire
---------------------- insurance policy. By paying an extra premium, the insurer can issue the standard
fire policy with add-ins like debris removal, deterioration of stock, earthquake,
---------------------- forest fire etc.
---------------------- Marine Insurance

Marine insurance is a contract wherein the insurer agrees to indemnify the
----------------------
insured, of loss or damage to vessels or cargo during transportation to the high
---------------------- seas. The amount of loss covered and the time period are clearly mentioned in
the marine insurance policy. The insured may be a cargo owner, ship owner or a
---------------------- freight receiver. Marine perils cover any accident or causality of the sea caused
without willful human interventions.
----------------------
Like all general insurance contracts, marine insurance is also a contract of
---------------------- utmost good faith and indemnity. The insurable interest must be present at the
time of loss, it may or may not be there at the time of tasking the policy.
----------------------
----------------------

Any loss occurred due to storm, collision of one ship with another or Notes
with a rock, burning or sinking of ship, mutiny, loss of cargo by sea water are
covered under the marine insurance policy. Regular wear and tear, loss to the ----------------------
cargo caused by rate or leakage in the ship due to bad maintenance are however,
not covered in marine insurance policy. ----------------------
Marine insurance can be classified into three categories: ----------------------

Hull Insurance – insurance of ocean going vessel ----------------------
Cargo Insurance – Insurance of the cargo, going in the vessel Freight
----------------------
insurance – Insurance of freight payable on receipt of goods at destination in
case there is any damage to the goods on the way ----------------------
Accordingly the policy can be for a particular voyage or a particular time period ----------------------
Health Insurance
----------------------
Health insurance is a contract between the insurer and the insured whereby
the insurer agrees to indemnify the financial loss arising due to the poor health ----------------------
of the insured. It covers reimbursement of expenses incurred due to illness or
injury. There are various clauses under the health insurance policy and can ----------------------
cover types of protection depending upon the type of policy purchased by the ----------------------
insured.
----------------------
Motor Insurance
Motor insurance policy is a contract between the insurer and the insured ----------------------
to indemnify the loss suffered by the insured on account of any damage to the
----------------------
motor vehicle which is insured.
The motor vehicles are divided into three categories under motor insurance ----------------------
which are private cars, private vehicles (two wheelers) and commercial vehicles. ----------------------
Various factors like geographical location area of use, capacity of vehicle,
value of vehicle are considered while calculating the premium on insurance. ----------------------
For commercial vehicles, the carrying capacity is considered while calculating
premium. ----------------------
The risk covered can either be the loss or damage to the vehicle insured ----------------------
or injury or death of the owner of the vehicle. Even the liability arising as a
result of loss or damage to the property of others from the vehicle insured can ----------------------
be covered under motor insurance. ----------------------
The principles of general insurance of utmost good faith, insurable
interest and indemnity apply to motor insurance as well. There is a principle ----------------------
of subrogation where if the damage to the vehicle is caused due to the fault of ----------------------
a third party then, the insurer makes good the loss suffered by the insured but
he can sue the third party for causing that damage. The indemnity provided can ----------------------
also be shared proportionately between the insurers in case of double insurance.
----------------------
Personal Accident Insurance
----------------------
The personal accident policy pays compensation to the insured in the
event of any one of the following happenings as a result of an accident, as may ----------------------
be selected by the insured at the time of taking the policy.
Notes • Death.
• Permanent total or partial disability.
----------------------
• Temporary total disability.
----------------------
However, the death or injury resulting from war, disease, suicide or some natural
---------------------- calamity is not covered under this policy.
---------------------- Fidelity Insurance

Under this type of insurance, the insurer undertakes to make good the
---------------------- loss suffered by insured as a result of misappropriation of funds, damage
---------------------- to property, fraud, burglary or dishonesty on the part of his employees. The
insurer needs to provide the details of the employees to the insurance company
---------------------- and generally such insurance is taken for strategic positions such as cashier,
accountant etc., rather than specific persons. A blanket cover can also be taken
---------------------- for all the employees.
---------------------- Burglary Insurance
---------------------- This type of insurance provides protection against theft and burglary .A
blanket cover can be taken for all the items present or it can be taken specifically
---------------------- for particular items like gold ornaments, silver articles, electronics etc.
---------------------- Credit Insurance
---------------------- Credit insurance covers the probable loss arising from bad debts or non-
payment of complete dues by the debtors. It is especially very important for
---------------------- people selling their goods on credit as they can get rid of the risk of bad debts.
---------------------- Workmen’s Compensation Insurance

Under the Workmen’s Compensation Act, the employer is liable to pay
----------------------
compensation to the employee if he acquires any injury or disability in the
---------------------- course of his work. In order to pay this compensation to the employees, the
employer can take workmen’s compensation insurance where, the insurer pays
---------------------- such compensation.
---------------------- Travel Insurance
This insurance covers all risks faced by the insured while travelling within
----------------------
or outside the country such as loss of baggage, accident while travelling, illness
---------------------- requiring hospitalization, theft while travelling etc. This form of insurance is
more common for overseas travel.
----------------------
Unemployment Insurance
---------------------- Unemployment insurance provides short term protection to employees
---------------------- who are otherwise fit to work but are currently unemployed. The protection can
be in the form of cash payment during the period on unemployment or help in
---------------------- finding a new job.
---------------------- Personal Liability Insurance

This insurance provides protection against legal liability arising from
----------------------
the personal acts of the insured person. The personal acts can include fire in

neighbours’ house due to negligence of insured, injury to some other person Notes
due to some act of the insured etc. If the matter goes to the court of law then the
insurer supports the insured there as well. ----------------------
----------------------
10.6 REINSURANCE
----------------------
Reinsurance is the term used for the practice of transfer of a portion of risk
portfolio by an insurance company to another party under a formal agreement ----------------------
and in exchange of a share on insurance premium. By doing so, the insurance
company can reduce the risk of likelihood of having to pay a large obligation ----------------------
resulting from an insurance claim and spread the risk across institutions. ----------------------
In other words, it is an insurance purchased by an insurance company
----------------------
from another insurance company as a risk mitigation measure.
The party that diversifies its insurance portfolio is known as the ceding ----------------------
party. The party that accepts a portion of the potential obligation in exchange
----------------------
for a share of the insurance premium is known as the reinsurer.
A Reinsurance contract is a contract on indemnity meaning that it becomes ----------------------
effective only when the insurance company has made payment to the original ----------------------
policy holder. Reinsurance redistributes or diversifies the risk or threat associated
with the business of issuing policies by allowing the reinsured to show more ----------------------
assets by reducing its reserve requirements. The reinsurance industry became
more popular during the late 1990s and early 2000s because natural disasters ----------------------
and mass tort litigation resulted in large payouts by insurance companies. ----------------------
Because of the large size of the payments, some insurance companies became
insolvent. ----------------------
The different parties to the reinsurance contract are the reinsurer, the ----------------------
reinsured, and the original policyholder. The reinsurer is the third party or the
company issuing the reinsurance policy. Generally, reinsurers are engaged ----------------------
exclusively in the business of issuing reinsurance policies but any company
which meets the requirements and is authorized to issue insurance may issue ----------------------
such policies. The reinsured is the insurance company that issued the first policy ----------------------
and is applying for reinsurance. The original policy holder or original insured
is the party who purchased the original policy from the reinsured. When the ----------------------
reinsurance contract is between just the two insurance companies (the reinsured
and the reinsurer), the original policy-holder usually has no rights against the ----------------------
reinsurer. ----------------------
The reinsurance policy covers the risk and liability associated with the
original policy and can cover either the entire amount of risk or part of it. The ----------------------
risk cover under reinsurance cannot exceed that of the original policy. The ----------------------
policy must be for a specific insurable interest which must exist at the time of
issue of reinsurance policy and cannot be created later. ----------------------
Under a contract of reinsurance, the reinsured is under an obligation to ----------------------
disclose all material facts to the reinsurer that might result in potential risk. The
reinsurer should be put in the same position as it would be while deciding the ----------------------

Notes risk and possibilities of coverage on the original policy. The reinsured should
provide timely notice for all claims to the reinsurer.
---------------------- Types of Reinsurance
---------------------- The two basic types of reinsurance are Facultative reinsurance and Treaty
reinsurance.
----------------------
Facultative reinsurance is issued after individual analysis of facts and
---------------------- situation of the underlying policy. It is negotiated separately for each insurance
contract and can cover all or part of the policy. Case to case analysis enables the
----------------------
reinsurer to decide whether he wants to take the risk associated with a particular
---------------------- policy. Underwriting costs are usually very high in such types of contracts.
---------------------- Treaty reinsurance covers a particular class of policies issued by the

reinsured. Examples may include all fire insurance policies or all vehicle
---------------------- insurance policies etc. The risks associated with all policies coming under a
particular class get transferred to the reinsurer. This type of reinsurance is more
---------------------- general in nature as compared to facultative, which is more specific in nature.
---------------------- Coverage of Allotment
---------------------- The coverage can be allotted between the reinsurer and the reinsured either
proportionately or non-proportionately. In case of proportional reinsurance the
---------------------- reinsurer covers only a fixed percentage of risk of the reinsured based on the
percentage of insurance premium shared between them. For example, if the
---------------------- reinsurer is getting a 35% share in premium then he is going to indemnify only
---------------------- 35% of claim to the reinsured. The reinsurance agreement does not mention and
specific amount but it only mentions the percentage.
----------------------
In case of non-proportionate reinsurance, a fixed amount of loss is covered.
---------------------- A base amount is mentioned in the policy and any loss exceeding that amount
is paid by the reinsurer. The reinsured gets reimbursement of any amount that
---------------------- exceeds the base amount as mentioned in the contract.
---------------------- Both proportionate and non proportionate coverage is applicable to
facultative as well as treaty reinsurance.
----------------------

---------------------- 1. A reinsurance contract is not a contract of indemnity.
---------------------- 2. Non-life insurance contract is a contract for lifetime, which need not
be renewed every year.
----------------------
3. In non-life insurance, there needs to be a personal contract between
---------------------- insured and insurance company.
----------------------
----------------------

Notes
Activity 1
----------------------
Visit www.irda.gov.in and find out the services being provided by banks ----------------------
under Bancassurance.
----------------------
Summary ----------------------
----------------------
• Insurance is a technique of risk management where the risk of a probable loss
is transferred from one entity to another in exchange of insurance premium. ----------------------
• The main characteristics of insurance are risk sharing, common risk, value of
----------------------
risk, contingent event and the amount of payment.
• The key features of risk are that it should be common, loss should be definite ----------------------
and accidental and amount of loss should be much more than the amount of
----------------------
premium.
• The main reasons behind taking an insurance policy include indemnification ----------------------
of loss, reduction in risk and fear and mobilization of savings.
----------------------
• The insurance business in India is governed by the Insurance Regulatory and
Development Authority Act, 1999. ----------------------
• The main purpose of establishment of IRDA is to ensure that there is an ----------------------
established authority to protect the interests of the policy holders and to
regulate, promote and ensure orderly growth of Insurance industry in India. ----------------------
•
Insurance can be classified into life and non life insurance from business ----------------------
point of view and property and liability insurance from risk point of view.
----------------------
•
Life insurance is an agreement between the insurance company and the
insured, wherein the insurer pays to insured a predefined sum of money in ----------------------
case of death, accident or serious illness.
----------------------
•
Main principles of life insurance contract are insurable interest, utmost good
faith and it is not a contract of indemnity. ----------------------
•
Various factors like geographical location, gender, nature of profession,
----------------------
lifestyle and health history are taken into consideration while deciding the
amount of life insurance premium. ----------------------
•
Life insurance policies can be term insurance plan, whole life policy,
----------------------
endowment policy or annuity policy.
• Life insurance policy can be taken jointly or for a group. ----------------------
Insurance other than ‘Life Insurance’ falls under the category of Non-life / ----------------------
General Insurance.
----------------------
• The key characteristics of general insurance are insurable interest, certainty
of event, personal contact, utmost good faith and defined life of the contract. ----------------------
----------------------

Notes •
Various types of general insurance include Fire insurance, marine
insurance, health insurance, motor insurance, credit insurance, fidelity
---------------------- insurance, burglary insurance, personal accident, travel insurance, employee
compensation insurance etc.
----------------------
•
Reinsurance is insurance purchased by an insurance company from another
---------------------- insurance company as a risk mitigation measure.
---------------------- •
Reinsurance becomes effective only when the insurance company has made
payment to the original policy holder.
---------------------- •
The different parties to the reinsurance contract are the reinsurer, the
---------------------- reinsured, and the original policyholder.
•
The reinsurance policy covers the risk and liability associated with the
---------------------- original policy and can cover either the entire amount of risk or part of it.
---------------------- •
Facultative reinsurance is issued after individual analysis of facts and
situation of the underlying policy.
----------------------
• Treaty reinsurance covers a particular class of policies issued by the reinsured.
----------------------
•
In case of proportional reinsurance, the reinsurer covers only a fixed
---------------------- percentage of risk of the reinsured, based on the percentage of insurance
premium shared between them.
----------------------
•
In case of non-proportionate reinsurance, a fixed amount of loss is covered. A
---------------------- base amount is mentioned in the policy and any loss exceeding that amount
is paid by the reinsurer.
----------------------
---------------------- Keywords
---------------------- • Insurer: He is the person selling the insurance.
---------------------- • Insured: The person buying the insurance.

• Premium: The amount paid by insured to insurer to cover the risk.
----------------------
•
Indemnity: It is the restoration of a loss to the insured by payment, repair or
---------------------- replacement.
---------------------- •
Insurable Interest: It is interest in property such that loss or destruction of
the property could cause a financial loss.
----------------------
•
Subrogation: The right of an insurer who has taken over another’s loss also
---------------------- to take over the other person’s right to pursue remedies against a third party.
---------------------- • Loss: Means being without something, which is previously possessed.
---------------------- •
Total Loss: Implies that the subject matter insured is fully destroyed and is
totally lost to its owner.
----------------------
•
Actual Loss: Subject matter is completely destroyed or so damaged that it
---------------------- ceases to be a thing of the kind insured like complete destruction of cargo by
fire.
----------------------

• onstructive Total Loss: Means that the ship or cargo insured is not
C Notes
completely destroyed but is so badly damaged that the cost of repair or
recovery would be greater than the value of the property saved. ----------------------
•
Peril: It is defined as the cause of the loss. Examples of perils include ----------------------
fires, tornadoes, heart attacks and criminal acts. Insurance policies provide
financial protection against losses caused by perils. ----------------------
•
Hazards: These are the conditions that increase either the frequency or the ----------------------
severity of losses.
•
Warranty: It is that by which, the assured undertakes that some particular ----------------------
thing shall or shall not be done, or that some conditions shall be fulfilled, or ----------------------
whereby he affirms or negates the existence of a particular state of facts.
•
Reinsurance: It is an arrangement whereby an original insurer who has ----------------------
insured a risk insures a part of that risk again with another insurer, that means ----------------------
reinsures a part of the risk in order to diminish his liability.
•
Jettison: It means voluntary throwing away of the cargo or part of a vessel’s ----------------------
equipment for relieving the ship for common safety.
----------------------
•
Underwriting: It is the process of selecting applicants for insurance and
classifying them according to their degrees of insurability so that the ----------------------
appropriate premium rates may be charged. The process includes rejection
----------------------
of unacceptable risks.
----------------------
Self-Assessment Questions ----------------------
1.
What do you mean by the term insurance? What are the key characteristics ----------------------
of insurance?
----------------------
2.
Elaborate the role of IRDA in regulating the Indian Insurance Industry and
protecting investors’ interest. ----------------------
3. What are the broad categories of insurance based on risk and business?
----------------------
4.
What are the key characteristics of life insurance? What factors are considered
while determining the amount of life insurance premium? ----------------------
5.
What are the different types of life insurance policies? Elaborate the key ----------------------
feature of each type of policy.
----------------------
6.
What do you mean by the term non life insurance? What are the different
types of non life insurance? ----------------------
7. What do you mean by the term reinsurance? What are the benefits derived
----------------------
from reinsurance?
8. What are the different types of reinsurance? What is the basis for coverage ----------------------
of allotment for the claims under reinsurance? ----------------------
----------------------
----------------------

Notes Answers to Check your Progress
1. One of the important factors in determining the amount of insurance
----------------------
premium is value at risk.
---------------------- 2. Insurance is considered as a major instrument for mobilisation of savings
---------------------- of individuals, which ultimately leads to economic growth.
3. To protect the interest and secure fair treatment to policyholders is one of
---------------------- the basic objectives of IRDA.
1. From business point of view, insurance can be classified as:
----------------------
i. Life insurance
----------------------
ii. Non-life insurance
---------------------- iv. Social insurance
---------------------- 2. Principles of life insurance contract:
---------------------- i. Insurable interest
ii. Utmost good faith
----------------------
iv. Not a contract of indemnity
----------------------
3. From risk point of view, insurance can be classified as
---------------------- i. Property insurance
---------------------- ii. Liability insurance
---------------------- iii. Credit insurance
----------------------
----------------------
1. False
----------------------
2. False
---------------------- 3. True
----------------------
Suggested Reading
----------------------
1. Cummins, David, Anthony Santomer. Changes in the Life Insurance
---------------------- Industry: Efficiency, Technology and Risk.
---------------------- 2. Dionne, Georges, Scott E. Harrington Ed. Foundations of Insurance
Economics: Readings in Economics and Finance.
----------------------

Disinvestment of PSUs
UNIT
11
Structure:
11.1 Introduction
11.2 Disinvestment Policy
11.3 Different Approaches to Disinvestments
11.4 Need for Disinvestment
11.5 National Investment Fund
11.6 Issues in the Disinvestment Process
11.7 Government Policy on Disinvestment
11.8 Conclusion
Summary
Key Words
Suggested Reading
Disinvestment of PSUs 217

Notes
Objectives
----------------------
----------------------
• Describe the meaning and objectives of disinvestment
----------------------
• Analyse the disinvestment policy and its need
---------------------- • Explain the importance of disinvestment process
----------------------
11.1 INTRODUCTION
----------------------
The Department of Disinvestment has been renamed as Department of
---------------------- Investment and Public Asset Management or ‘Dipam’, a decision aimed at proper
management of Centre’s investments in equity including its disinvestment in
---------------------- central public sector undertakings.
---------------------- Disinvestment was initiated by selling undisclosed bundles of equity
shares of selected central PSEs to public investment institutions (like the UTI),
---------------------- which were free to dispose of these shares in the booming secondary stock
---------------------- market. The process however came to an abrupt halt when the market collapsed
in the aftermath of Harshad Mehta led scam, as the asking prices plummeted
---------------------- below the reserve prices.
---------------------- A Disinvestment Commission was constituted to advise the government
on whether to disinvest in a particular enterprise, its modalities and the
---------------------- utilization of the proceeds. The commission, among other things, recommended
(Disinvestment Commission, 1997):
----------------------
• Restructuring and reorganization of PSEs before disinvestment,
----------------------
• Strengthening of the well-functioning enterprises, and
---------------------- •
To utilize the disinvestment proceeds to create a fund for restructuring of
PSEs.
----------------------
Disinvestment Policy in response to the public debate, and to the
---------------------- commission’s recommendations, some large and well-functioning PSEs were
---------------------- declared “jewels” (Navaratnas) in the government’s crown, and were granted
greater managerial and financial autonomy. However, disinvestment did not pick
---------------------- up as the share prices remained subdued because of the scandals that rocked the
financial markets. But, by the turn of the decade, there was some improvement
---------------------- mainly in response to the stock boom engineered by Ketan Parikh. Apparently,
---------------------- some PSEs stocks were part of the scandal, which this time also, involved the
UTI.
---------------------- Definition of Disinvestment At the very basic level, disinvestment can be
---------------------- explained as follows:
“Investment refers to the conversion of money or cash into securities,
---------------------- debentures, bonds or any other claims on money. Disinvestment involves the
---------------------- conversion of money claims or securities into money or cash.”

Disinvestment can also be defined as the action of an organisation (or Notes
government) selling or liquidating an asset or subsidiary. It is also referred to as
‘divestment’ or ‘divestiture.’ ----------------------
In most contexts, disinvestment typically refers to sale from the ----------------------
government, partly or fully, of a government-owned enterprise.
----------------------
A company or a government organization, will typically disinvest an asset
either as a strategic move for the company, or for raising resources to meet ----------------------
general/specific needs.
----------------------
Disinvestment was identified as an active tool to reduce the burden of
financing the PSUs. The following main objectives of disinvestment were ----------------------
outlined:
----------------------
• To reduce the financial burden on the Government.
• To improve public finances. ----------------------
• To introduce, competition and market discipline. ----------------------

• To fund growth. ----------------------
• To encourage wider share of ownership.
----------------------
• To depoliticize non-essential services.
----------------------
Importance of Disinvestment
----------------------
The importance of disinvestment lies in utilisation of funds for:
• Financing the increasing fiscal deficit. ----------------------
• Financing large-scale infrastructure development. ----------------------
• For investing in the economy to encourage spending. ----------------------
•
For retiring Government debt- Almost 40-45% of the Centre’s revenue
receipts go towards repaying public debt/interest. ----------------------
• For social programmes like health and education. ----------------------

Disinvestment also assumes significance due to the prevalence of an ----------------------
increasingly competitive environment, which makes it difficult for many PSUs
to operate profitably. This leads to a rapid erosion of value of the public assets ----------------------
making it critical to disinvest early to realize a high value.
----------------------
11.2 DISINVESTMENT POLICY ----------------------
The present disinvestment policy has been articulated in the recent ----------------------
President’s addresses to Joint Sessions of Parliament and the Finance Minister’s
recent Parliament Budget Speeches. ----------------------
The salient features of the Policy are: ----------------------

•
Citizens have every right to own part of the shares of Public Sector ----------------------
Undertakings.
----------------------

Notes •
Public Sector Undertakings are the wealth of the Nation and this wealth
should rest in the hands of the people.
---------------------- •
While pursuing disinvestment, Government has to retain majority
---------------------- shareholding, i.e. at least 51% and management control of the Public Sector
Undertakings.
---------------------- Approach for Disinvestment
---------------------- On 5th November 2009, Government approved the following action plan for
disinvestment in profit making government companies:
----------------------
Already listed profitable CPSEs (not meeting mandatory shareholding of
•
---------------------- 10%) are to be made compliant by ‘Offer for Sale’ by Government or by
the CPSEs through issue of fresh shares or a combination of both.
----------------------
Unlisted CPSEs with no accumulated losses and having earned net profit
•
---------------------- in three preceding consecutive years are to be listed.
---------------------- •
Follow-on public offers would be considered taking into consideration
the needs for capital investment of CPSE, on a case by case basis, and
---------------------- Government could simultaneously or independently offer a portion of its
equity shareholding.
----------------------
•
In all cases of disinvestment, the Government would retain at least 51%
---------------------- equity and the management control.
---------------------- • All cases of disinvestment are to be decided on a case by case basis.
---------------------- •
The Department of Disinvestment is to identify CPSEs in consultation with
respective administrative Ministries and submit proposal to Government in
---------------------- cases requiring offer for Sale of Government equity.
---------------------- 11.3 DIFFERENT APPROACHES TO DISINVESTMENTS

----------------------
There are primarily three different approaches to disinvestments (from
---------------------- the sellers’ i.e. Government’s perspective).
Minority Disinvestment is one such that, at the end of it, the government
----------------------
retains a majority stake in the company, typically greater than 51%, thus
---------------------- ensuring management control. Historically, minority stakes have been either
auctioned off to institutions (financial) or offloaded to the public by way of
---------------------- an Offer for Sale. The present government has made a policy statement that
all disinvestments would only be minority disinvestments via Public Offers.
----------------------
Examples of minority sales via auctioning to institutions go back into the early
---------------------- and mid 90s. Some of them were Andrew Yule & Co. Ltd., CMC Ltd. etc.
Examples of minority sales via Offer for Sale include recent issues of Power
---------------------- Grid Corp. of India Ltd., Rural Electrification Corp. Ltd., NTPC Ltd., NHPC
Ltd. etc.
----------------------
Majority Disinvestment is one in which the government, post
---------------------- disinvestment, retains a minority stake in the company i.e. it sells off a majority
---------------------- stake. Historically, majority disinvestments have been typically made to strategic

partners. These partners could be other CPSEs themselves, a few examples Notes
being BRPL to IOC, MRL to IOC, and KRL to BPCL. Alternatively, these can
be private entities, like the sale of Modern Foods to Hindustan Lever, BALCO ----------------------
to Sterlite, CMC to TCS etc. Again, like in the case of minority disinvestment,
the stake can also be offloaded by way of an Offer for Sale, separately or in ----------------------
conjunction with a sale to a strategic partner. ----------------------
Complete Privatisation is a form of majority disinvestment wherein 100%
----------------------
control of the company is passed on to a buyer. Examples of this include 18
hotel properties of ITDC and 3 hotel properties of HCI. Disinvestment and ----------------------
Privatisation are often loosely used interchangeably. There is, however, a vital
difference between the two. Disinvestment may or may not result in Privatisation. ----------------------
When the Government retains 26% of the shares carrying voting powers while
----------------------
selling the remaining to a strategic buyer, it would have disinvested, but would
not have ‘privatised’, because with 26%, it can still stall vital decisions for ----------------------
which generally a special resolution (three-fourths majority) is required.
----------------------
1. Disinvestment was initiated by selling disclosed bundles of equity ----------------------

shares of selected Central PSEs to public investment institutions such
as UTI, which were free to dispose of these shares in the booming ----------------------
secondary stock market. ----------------------
2.
One of the salient features of the disinvestment policy is that
Government has to retain majority shareholding of say 51% and ----------------------
management control of the Public Sector Undertakings. ----------------------
3. There are different approaches to disinvestments; one of them is
----------------------
complete privatisation wherein 100% control of the company is
passed on to a buyer. ----------------------
----------------------
11.4 NEED FOR DISINVESTMENT
----------------------
Rationale of Disinvestment - The Government of India has outlined the
following as the primary objectives of disinvestment. ----------------------
(1) Releasing large amount of public resources locked up in non-strategic ----------------------

Public sector Enterprises, for deployment in areas that are much higher
----------------------
on social priority, such as basic health, family welfare, primary education
and social and economic infrastructure. ----------------------
(2) Stemming further outflow of these scarce public resources for sustaining
----------------------
the non-viable non-strategic PSUs.
(3) Reducing the public debt that is threatening to assume unmanageable ----------------------
proportions. ----------------------

Notes (4) Transferring the commercial risk to the private sector wherever the private
sector is willing and able to step in.
----------------------
(5) Releasing other tangible and intangible resources, such as, large manpower
---------------------- currently locked up in managing PSUs and their time and energy, for
deployment in high priority social sectors that are short of such resources.
----------------------
One basis rational for privatization in the concept is that private ownership
---------------------- leads to better use of resources and their more efficient allocation. Throughout
the world, the preference for market economy received a boost after it was
---------------------- realized for privatization in the concept that private ownership leads to better
use of resources and their more efficient allocation. Throughout the world, the
----------------------
preference for market economy received a boost after it was realized that the
---------------------- State could no longer meet the growing demands of the economy and the State
share holding inevitably had to come down. The ‘State in business’ argument
---------------------- thus lost out and so did the presumption that direct and comprehensive control
over the economic life of citizen from the Central government can deliver results
----------------------
better than those of a more liberal system that directly responds according to
---------------------- the market driven forces. Another reason for adoption for privatization policy
around the globe has been the inability of the Governments to raise high taxes,
---------------------- pursue deficit / inflationary financing and the development of money markets
and private entrepreneurship. Further, technology and W.T.O. commitments
----------------------
have made the world a global village and unless industries, including PSEs do
---------------------- not quickly restructure, they would not be able to survive. Public enterprises,
because of the nature of their ownership, can restructure slowly and hence the
---------------------- logic of privatization gets stronger. Besides, techniques are now available to
control public monopolies by regulation/competition, and investment of public
----------------------
money to ensure protection of consumer interests is no longer a convincing
---------------------- argument.
Beginning of Disinvestment in India
----------------------
The new industrial policy statement 1991 based on economic reform
---------------------- measures envisaged disinvestment of a part of government holding in the case
---------------------- of select public sector enterprises to provide financial support and improve the
performance of public sector enterprises. This became necessary because of
---------------------- the withdrawal of the budgetary support of 60 percent by the government to
the loss making units. The Common Minimum Programme of the United Front
---------------------- Government, has also, emphasized that it would be a democratic disinvestment.
---------------------- Rangarajan Committee (1993)
---------------------- Rangarajan Committee of 1993 constituted by the government for
this purpose made important observations. It maintained that the units to be
---------------------- disinvested should be identified and disinvestment could be made up to any
level, except in defence and atomic energy where the government should retain
---------------------- the majority holding in equity. Further, disinvestment should be a transparent
---------------------- process duly protecting the right of the workers.
----------------------

Further, it suggested setting up of an autonomous body for the smooth Notes
functioning and monitoring of the disinvestment programme. Disinvestment
Commission was thus constituted in 1996 as an advisory body having a full ----------------------
time chairman and four part-time members. The Commission was required to
advise the government on the extent, made, timing and pricing of disinvestment. ----------------------
It suggested four modes of disinvestment: ----------------------
• Trade sale
----------------------
• Strategic sale
----------------------
• offer of shares
• Closure or sale of Assets ----------------------
In its budget speech of 2000-01, the government emphasized that more ----------------------
emphasis would now be paid on the strategic sale of public sector enterprises. Up
to November 1999, the commission had submitted 12 reports to the government ----------------------
covering 58 public sector enterprises. On 30th November 1999, the term of the ----------------------
Commission expired.
However, it was reconstituted in July 2001. Initially the Department of ----------------------
Disinvestment was constituted which was later on, upgraded as the ministry of ----------------------
disinvestment in order to streamline and speed up the process of disinvestment
including restructuring. The Disinvestment Commission also recommended ----------------------
creation of separate disinvestment fund in which the disinvestment proceeds
would be placed to be used for the purpose of financial restructuring of the ----------------------
concerned unit before disinvestment and for carrying out voluntary retirement ----------------------
schemes. It also suggested merger of National Renewal Fund with the
disinvestment fund. ----------------------
----------------------
11.5 NATIONAL INVESTMENT FUND
----------------------
The proposal for operationalisation of the NIF was approved on 3rd
November, 2005. Accordingly, the Department of Disinvestment issued ----------------------
a resolution on 23rd November, 2005 constituting ‘NIF’ with the following
objectives, structure and administrative arrangements, investment strategy and ----------------------
accounting procedure: ----------------------
Objectives
----------------------
• The proceeds from disinvestment of CPSEs will be channelised into NIF,
which is to be maintained outside the Consolidated Fund of India. ----------------------
• The corpus of NIF will be of a permanent nature. ----------------------
NIF will be professionally managed to provide sustainable returns to the ----------------------
Government without depleting the corpus. Selected Public Sector Mutual
Funds will be entrusted with the management of the corpus of NIF. ----------------------
• 75% of the annual income of NIF will be used to finance selected social ----------------------
sector schemes, which promote education, health and employment. The
residual 25% of the annual income of the Fund will be used to meet the ----------------------

Notes capital investment requirements of profitable and revivable CPSEs that
yield adequate returns, in order to enlarge their capital base to finance
---------------------- expansion/diversification.
---------------------- Structure and Administrative Arrangements -NIF will be operated by
the selected Fund Managers under the ‘discretionary mode’ of the Portfolio
---------------------- Management scheme, which is governed by SEBI guidelines. The entire work
of NIF will be supervised by Chief Executive Officer (CEO) of NIF, a senior
----------------------
officer of the Government. A part-time Advisory Board consisting of three
---------------------- eminent persons, with the requisite expertise to be appointed by the Government,
would advise the CEO on various aspects of the functioning of NIF Investment
---------------------- Strategy. The broad investment strategy is to provide sustainable returns without
depleting the corpus. The investment strategy for NIF will be formulated by the
----------------------
CEO based on the advice of the Advisory Board so as to ensure that Government
---------------------- has a hands-off relationship in terms of the actual investment to be done by the
Fund Managers.
----------------------
Only broad guidelines are to be provided under the “discretionary mode”
---------------------- to the Fund Managers within which individual investments would be made
independently by the Fund Managers. More detailed guidelines specifying
---------------------- investment instruments and limits for investment in such instruments will be
separately specified in the agreements to be entered into between the Fund
----------------------
Managers and CEO of NIF on behalf of the Government. Other operational
---------------------- details such as allocation of funds need to the selected.
Fund Managers, negotiations of management fee and charges to be paid
----------------------
to the Fund
---------------------- Managers, etc. will be also decided by CEO based on the advice of the
---------------------- Advisory Board. Appropriate mechanisms for regular review and monitoring
of the functioning of NIF, emerging market trends and future prospects will be
---------------------- instituted.
---------------------- Accounting Procedure -The receipts from disinvestment of CPSEs will

be deposited in CFI under the designated Head. Thereafter, these amounts
---------------------- would be appropriated from the CFI, with due approval, by the Department of
Disinvestment and transferred to the selected Fund Managers through CEO of
---------------------- NIF. Income from NIF similarly be deposited in CFI and would be appropriated
---------------------- from it for specific purposes as per the scheme of appropriation approved from
time to time by the Department of Expenditure.
---------------------- Fund Managers of NIF -The following Public Sector Mutual Funds
---------------------- have been appointed initially as Fund Managers to manage the funds of NIF
under the ‘discretionary mode’ of the Portfolio Management Scheme, which
---------------------- is governed by SEBI guidelines. These fund managers have been appointed
for an initial agreement for two years, which is extendable on the basis of their
---------------------- performance.
----------------------
----------------------

UTI ASSET MANAGEMENT CO.LTD. Notes
SBI FUNDS MANAGEMENT CO.PVT.LTD.
----------------------
LIC MUTUAL FUND ASSET MANAGEMENT CO.LTD.
----------------------
Launch - The launching ceremony of National Investment Fund (NIF) took
place on 6th October, 2007, and was presided over by the Finance Minister. ----------------------
This consisted of the following two activities:
----------------------
(a)
Signing of the Portfolio Management Services Agreement by JS
(Disinvestment) & Chief Executive Officer (CEO), NIF (on behalf of the ----------------------
Government) and CEO, of Selected Public Sector Fund Managers viz.
UTI Asset Management Co.Pvt. Ltd., SBI Funds Management Pvt.Ltd. ----------------------
and LIC Mutual FundAsset Management Co.Ltd. Separate Agreements ----------------------
were signed with each Fund Manager.
(b)
Handing over of cheques to the CEO of the three Asset Management ----------------------
companies. The total amount of Rs. 994.82 crore received from the sale of
----------------------
Government equity in PGCIL was handed over to the Fund Managers by the
Finance Minister as per the allocation given below: ----------------------
(Rs. Crore) ----------------------
UTI ASSET MANAGEMENT CO. LTD. 368.91
SBI FUNDS MANAGEMENT CO. PVT. LTD. 368.91 ----------------------
LIC MUTUAL FUND ASSET MANAGEMENT CO. LTD. 257.00 ----------------------
994.82
Including the proceeds from the disinvestment in REC, the corpus of NIF became Rs. ----------------------
1814.5 crore. The pay out on NIF was Rs. 84.81 crore in the first year. The payout ----------------------
received in the second year was Rs. 248.98 crore. Average income of first year and
second year was 8.47% and 10.13% respectively. Thus, the average income was ----------------------
9.36% against the hurdle rate of 9.25%.
----------------------
Restructuring of NIF -In view of the deceleration of GDP growth due to
global economic downturn coupled with unprecedented drought last summer, ----------------------
a reduced budgetary resource generation was anticipated by the Government.
The Government, thus, approved (on 5th November 2009), a one-time ----------------------
exemption permitting full utilization of disinvestment proceeds deposited in the
----------------------
NIF for meeting the capital expenditure requirements of selected social sector
programmes decided by the Planning Commission/Department of Expenditure. ----------------------
The status quo ante will be restored from April 2012.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------

1. The proceeds from disinvestment of Central Public Sector Enterprises
----------------------
are channelised through creation of fund, which is known as
---------------------- _______________.
2. The Rangarajan Committee recommended setting up of an autonomous
----------------------
body, which is known as ________________for smooth functioning
---------------------- and monitoring of the disinvestment programme.
---------------------- 3. Majority disinvestment is one in which the Government after the

disinvestment retains a ______ minority stake in the company/
---------------------- enterprise.
----------------------
11.6 ISSUES IN THE DISINVESTMENT PROCESS
----------------------
A number of problems and issues have pulled back the disinvestment process.
---------------------- Some of these impediments are as under:
---------------------- (1) The number of bidders for equity has been small not only in the case of
financially weak PSUs, but also in that of better-performing PSUs.
---------------------- (2) In many cases, disinvestment has not really changed the ownership of PSUs,
as the government has retained a majority stake in them.
----------------------
(3) There has been some apprehension that disinvestment of PSUs might result
---------------------- in the crowding out of private corporates through lowered subscription to
their shares from the primary market.
----------------------
(4)
Inadequate information about PSUs has impeded free, competitive and
---------------------- efficient bidding of shares, and a free trading of those shares.
---------------------- (5) Since the PSUs do not benefit monetarily from disinvestment, they have been
reluctant to prepare and distribute prospectuses. This has in turn, prevented
---------------------- the disinvestment process from being completely open and transparent.
---------------------- (6) In view of some, the rationale for divestment process is well-founded. The
assumption of higher efficiency, better / ethical management practices and
---------------------- better monitoring by the private shareholders in the case of the private sector
all of which supposedly underlie the disinvestment rationale, is not always
---------------------- borne out by business trends and facts.
---------------------- Critique of disinvestment:
---------------------- Various issues have been raised against the Government’s Policy of
‘disinvestment’; some of these are, as under:
----------------------
(1) The advocates of disinvestment argue that it is not the business of the
---------------------- Government to be in business. They believe that but for a small strategic
sector like defence equipment, arms and ammunitions, atomic, railways
---------------------- etc., the Government should not run any public sector enterprise in a non-

strategic area. This view has been challenged by the critics of disinvestment. Notes
They have questioned the Government whether classification of strategic
and non-strategic sectors is correct. ----------------------
(2) Is it desirable to disinvest profit-making public enterprises, while keeping ----------------------
the loss-making PSUs under state ownership?
----------------------
(3) What should be the procedure for disinvestment-public offering through
stock exchange or strategic sale to a private party? ----------------------
(4)
Should disinvestment create private monopoly in place of public
----------------------
monopoly?
(5) What should be the method of valuation of a PSU? ----------------------
(6) Should PSUs be allowed to participate in the bids for disinvestment of ----------------------
PSUs?
----------------------
(7) How should the proceeds from disinvestment be utilised?
----------------------
(8) How should the interests of workers and employees be safeguarded?
Advantages of Disinvestment ----------------------
Disinvested shares are listed, quoted and traded on the stock market. ----------------------
Indian and foreign financial institutions, banks, mutual funds, companies as well
as individuals can buy disinvested shares / bonds. Disinvestment is expected to ----------------------
achieve a greater inflow of private capital and the use of private management ----------------------
practices in PSUs, as well as enable more effective monitoring of management
discipline by the private shareholders. Such changes would lead to an increase ----------------------
in the operational efficiency and the market value of the PSUs. This in turn,
would enable the much needed revenue generation by the government and help ----------------------
reduce deficit financing. ----------------------
11.7 GOVERNMENT POLICY ON DISINVESTMENT ----------------------
The present disinvestment policy has been articulated in the recent ----------------------
President’s addresses to Joint Sessions of Parliament and the Finance Minister’s
----------------------
recent Parliament Budget Speeches.
The salient features of the Policy are: ----------------------
1. Citizens have every right to own part of the shares of Public Sector ----------------------
Undertakings
----------------------
2. Public Sector Undertakings are the wealth of the Nation and this wealth
should rest in the hands of the people ----------------------
3.
While pursuing disinvestment, Government has to retain majority ----------------------
shareholding, i.e. at least 51% and management control of the Public
Sector Undertakings ----------------------
----------------------
----------------------

Notes Arguments against Disinvestment (and Defenses)
There have been several arguments that have been raised against
----------------------
disinvestment, both specific as well as general in nature. Some of them are
---------------------- listed below, with their counter-arguments (in bold italics):
Considerable disinvestment of government’s stakes in CPSEs would
----------------------
squeeze this important source of revenue for the Government.
---------------------- Apart from generating a one-time sale amount, a lot of these stake sales
---------------------- have also resulted in higher annual revenues for the government, thus nullifying
the effect of loss of dividends. More so, while they were dividend yielding,
---------------------- there were annual outgoes associated with them, thus again nullifying the effect
of dividends. Moreover, the loss of dividends, if any, is well compensated by
---------------------- gains in capital appreciation.
---------------------- Policies implying that the real beneficiaries would not be the ordinary
retail investors but institutional investors.
----------------------
While the current equity penetration remains low, it is precisely these PSU
---------------------- IPOs themselves that present the best opportunity of widening the retail base.
To also ensure that institutional investors do not run away with the bulk of this
---------------------- sale, curbs and measures can be put in place that ensure only retail participation
---------------------- in these issues.
Using funds, made available from disinvestment to bridge the fiscal deficit
----------------------
is an unhealthy and a short term practice. It is said that it is equivalent of selling
---------------------- ‘family silver’ to meet short term monetary requirements. Borrowing, which
is the currently used practice for bridging fiscal deficit, should continue to be
---------------------- used since while borrowing, the government has to make interest payments
in the future against a one-time borrowing from the market, in the case of
----------------------
disinvestment, future streams of income from dividends are forgone against a
---------------------- one-time receipt from the sale of stakes.
Letting go of these assets is best in the long term interest of the tax payers
----------------------
as the current yield on these investments in abysmally low. Even if the funds
---------------------- from the sale are not utilised for bridging fiscal deficit, a much better utilisation
of these funds would be investments into critical sectors such as healthcare,
---------------------- education and infrastructure or for retiring government debt rather than letting
the low yielding capital remain locked in these assets.
----------------------
As mentioned above, while there will be a loss in terms of dividend and
---------------------- tax income, this shortfall would be more than adequately compensated by
revenues and capital gains. More so, the returns on capital employed for the
----------------------
entire PSU sector is very low and the government can find alternate avenues for
---------------------- deploying this capital which would yield far better returns, both monetarily and
otherwise. All the same, revisions need to be made in tax laws to ensure that all
---------------------- such loopholes currently being exploited by the corporate sector are closed.
---------------------- Profit making PSUs should not be disinvested as they are performing well.
----------------------

A good example against this criticism would be BALCO which was a Notes
profit making company that earned the Government an average dividend (over
eight years) of Rs. 5.69 cr every year on the equity sold. The Government post- ----------------------
disinvestment, however started getting Rs. 82.65 crore every year. Similarly,
----------------------
CMC was a very well managed and profitable company, yet the average
dividend was only 0.80 crore. The Government’s benefit, post-disinvestment ----------------------
however was Rs. 15.2 crore annually. Similarly, Maruti Udyog Ltd. gave
average returns to the tune of Rs. 13 crore annually to the Govt. and IPCL gave ----------------------
Rs. 16.24 crore on equity sold against Rs. 242 crore and 149 crore respectively
----------------------
post-disinvestment. There can possibly be no justification of maintaining public
sector character in such companies, especially them, being non-core sectors. ----------------------
Complete Privatisation may result in public monopolies becoming private
----------------------
monopolies, which would then exploit their position to increase costs of various
services and earn higher profits. ----------------------
It needs to be ensured that Privatisation leads to greater competition in all cases. ----------------------
Complete Privatisation results in a situation where political compulsions
make companies sell to the preferred parties, at low cost. ----------------------
The process followed for Privatisation needs to be very fair and transparent ----------------------
to ensure a situation such as this does not arise.
----------------------
A majority stake sale done to another CPSE results in no real change in
ownership, and is thus just hogwash. ----------------------
This is fair to some extent, though it must be realized that some of the ----------------------
CPSEs are very well run, competitive and profit making. Thus, a sale of a loss
making CPSE to a well performing CPSE can be a proposition well worth ----------------------
considering.
----------------------
Public Offer being the chosen approach for Disinvestments does not yield
the best realisation on the assets and is a time consuming process. Auctioning ----------------------
to financial institutions (QIBs) should be the preferred modus operandi since it
----------------------
gives the best realisation on the assets, and has minimal transaction cost.
While the realisation on assets might be higher in case of an auctioning ----------------------
process, it must be remembered that the Government is not a private enterprise ----------------------
and hence should not be looking at short-term gains. It should look at the greater
good and sell these stakes by public offers to increase retail participation in the ----------------------
capital markets as well as to increase the depth and width of the capital markets.
In any case, the loss is minimal as very small stakes are being sold. The real ----------------------
gains for the government lie in the appreciation post-listing. Let us look at the ----------------------
PSU IPOs since 2004 with a trading period of over 1 year. The value of the
government holding, courtesy the market, has gone up nearly 3 times from Rs. ----------------------
236980 crore on the issue date to Rs.399504.87 crore (as on 4 November 2011).
----------------------
As on 31 October 2011, the 50 Central Public Sector Enterprises (CPSEs)
listed on the stock exchanges contributed about 20% of the total market ----------------------
capitalization.
----------------------

Notes Company Market Capitalisation (Rs.crore)
OIL & NATURAL GAS CORP. LTD. 2,38,013.74
---------------------- COAL INDIA LTD. 2,09,955.95
---------------------- NTPC LTD. 1,47,882.40
NMDC LTD. 94,023.24
---------------------- INDIAN OIL CORP. LTD. 70,665.56
MMTC LTD. 67,310.00
----------------------
GAIL (INDIA) LTD. 53,574.14
---------------------- POWER GRID CORP. OF INDIA LTD. 48,450.08
STEEL AUTHORITY OF INDIA LTD. 46,406.45
---------------------- OIL INDIA LTD. 31,148.46
----------------------
11.8 CONCLUSION
----------------------
While public sector enterprises’ contribution to national development is
---------------------- widely acknowledged, their poor financial return has been a matter of deep
and enduring concern, especially since the mid-1980s when, for the first time,
----------------------
the central government’s current revenues were found inadequate to meet its
---------------------- current expenditure. Though firm and industry level studies of PSEs have often
highlighted gross inefficiencies and poor profitability, many of them have
---------------------- also suggested their unquantifiable (or difficult to quantify) non-economic
benefits. However, macroeconomic discourse in India has largely focused on
----------------------
the “crowding-in” effects of public investment, and the need for institutional
---------------------- structures to insulate the PSEs from political and bureaucratic interference to
improve their financial returns. Deeper analyses have sought to offer political
---------------------- economic explanations for continuation of such a state of affairs. As a means
to restore budgetary balance, after the crisis in 1991, government sold a small
----------------------
fraction of its equity shares in selected public sector enterprises to public
---------------------- investment institutions.
---------------------- Though quantitatively modest, it signaled a major departure in public

policy; it was the thin end of the wedge that led to transfer of managerial control
---------------------- in a few PSEs about a decade later. The policy shift was also significant, as it
deflected the contours of the discourse on public sector reform from institutional
---------------------- design and corporate governance to a change in ownership in favour of private
---------------------- sector as a means to overcome the inefficiencies. The shift in debate was
consistent with the changes in the discussions on economic policies worldwide.
---------------------- Quantitatively, the disinvestment and privatisation have been modest so
---------------------- far, as proportions of the targets, revenues realised, or as a proportion of the
fiscal deficit. Disinvestment did not secure much revenue, as the stock market
---------------------- was subdued during much of the 1990s on account of a series of scandals that
repeatedly rocked the financial markets. Sale of substantial chunks of equity
---------------------- with transfer of managements that took place in the last 3-4 years has yielded
---------------------- sizable revenues. But, most of these sales have been contentious with a series of
legal cases pending in the courts, and enormous adverse commentary on them
---------------------- in press and the parliament.

Should we persist with the policy of ownership reform? Realistically Notes
speaking, prospects for the D-P appear limited, as the bulk of the public
investments (in terms of capital employed) are in infrastructure and industries ----------------------
of strategic importance, where, market failures and national interests seem too
----------------------
significant to be left unattended by public policy. There is little that is credible
in economic theory that argues ownership as the principal basis for economic ----------------------
outcomes. Moreover, accumulating evidence on privatisation across the world
does not give any prospect of this policy making a genuine difference to firm ----------------------
level performance on a sustainable basis.
----------------------
----------------------
1. After the announcement of Statement on Industrial Policy in 1991, ----------------------
there has been a major shift in Government’s approach towards role ----------------------
of public sector in the national economy.
2. One of the arguments for disinvestment in Public Sector Undertakings ----------------------
is using the proceeds from such disinvestment to bridge the fiscal ----------------------
deficit is a healthy practice.
----------------------
3. The Government’s policy of disinvestment has been utilised by
advocating an argument that it is not the business of the Government ----------------------
to be in business except in few strategic sectors like defence, railways,
etc. ----------------------
----------------------
Activity 1
----------------------
Visit the website of the Ministry of Finance, GOI and list out the latest ----------------------
changes in the disinvestment policy of the Government.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Summary
---------------------- •
The structural reform measures -are long-term measures, aimed at improving
the efficiency of the economy and increasing its international competitiveness
----------------------
by removing the rigidities in various segments of the Indian economy.
---------------------- Disinvestment means selling government equity in public sector units (PSUs)
to private parties. Thus, disinvestment refers to the sale or liquidation of an
---------------------- asset or subsidiary of an organization or government. It is also known as
divestiture or divestment. In India, the process of disinvestment began since
---------------------- 1991-92. The need for disinvestment arises from the fact of poor performance
of PSUs.
----------------------
•
The major thrust for Disinvestment Policy in India came through the
---------------------- Industrial Policy Statement 1991.The policy stated that the government
would disinvest part of their equities in selected PSEs. However, it did not
----------------------
state any cap or limit on the extent of disinvestment. It also did not restrict
---------------------- disinvestment to any class of investors. The main objective was to improve
overall performance of the PSEs.
----------------------
---------------------- Keywords
---------------------- • PSE/PSU: Public Sector Enterprises/Public Sector Undertakings
•
Maharatna: The Maharatna Scheme was introduced for Central Public
----------------------
Sector Enterprises (CPSEs), with effect from 19th May, 2010, in order to
---------------------- empower mega CPSEs to expand their operations and emerge as global
giants. The objective of the scheme is to delegate enhanced powers to the
---------------------- Boards of identified large-sized Navratna CPSEs so as to facilitate expansion
of their operations, both in domestic as well as global markets.
----------------------
•
Navratna: Under this scheme, the Government has delegated higher powers
---------------------- to CPSEs having a comparative advantage and the potential to become global
players. Presently, the Navratna CPSEs are:-
----------------------
---------------------- Self-Assessment Questions

---------------------- 1. What is disinvestment? Why is it significant?
---------------------- 2. What are the different perspectives to disinvestment from the Government
standpoint?
----------------------
3. What type of problems can arise in the disinvestment process? Elaborate
---------------------- with examples.
----------------------
----------------------
----------------------
----------------------

Answers to Check your Progress Notes
1. False
----------------------
2. True
----------------------
3. True
1. The proceeds from disinvestment of Central Public Sector Enterprises ----------------------
are channelized through creation of fund which known as National
Investment Fund (NIF). ----------------------
2. The Rangarajan Committee recommended setting up of an autonomous ----------------------
body, which is known as Disinvestment Commission for smooth
functioning and monitoring of the disinvestment programme. ----------------------
3.
Majority disinvestment is one in which the Government after the ----------------------
disinvestment retains a minority stake in the company/enterprise.
----------------------
1. True ----------------------
2. False ----------------------
3. True
----------------------
Suggested Reading ----------------------
1. Jain, T.R. Business Environment. ----------------------
2. Naib, Sudhir. Disinvestment in India: Policies, Procedures, Practices. ----------------------

3. Paul, Justin. Bussiness Environment. ----------------------
----------------------
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----------------------
----------------------
----------------------
----------------------

Notes
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Prevention of Money Laundering Act (PMLA), 2002
UNIT
12
Structure:
12.1 Introduction to Money Laundering

12.2 Introduction to Financial Intelligence Unit – India (FIU-IND)
12.3 Offence of Money Laundering
12.4 Definitions
12.5 Obligations of Banks & Financial Institutions under PMLA
12.6 USA Patriot Act
12.7 Provisions for Prevention of Money Laundering under USA Patriot Act
Summary
Key Words
Suggested Reading
Prevention of Money Laundering Act (PMLA), 2002 235

Notes
Objectives
----------------------
----------------------
• Describe the Financial Intelligence Unit -India
----------------------
• Explain the concept and meaning of money laundering
---------------------- • Distinguish between the role of banks and financial institutions in
prevention of money laundering
----------------------
• Describe provisions of USA Patriot Act related to money laundering
----------------------
---------------------- 12.1 INTRODUCTION TO MONEY LAUNDERING

---------------------- The Prevention of Money Laundering Act, 2002 was enacted to prevent
---------------------- money laundering and to provide for the confiscation of property derived from,
or involved in money laundering. The banking machinery has been used by
---------------------- the persons indulging in money laundering. In order to prevent the misuse
of the banking machinery, a separate Chapter, viz., Chapter IV dealing with
---------------------- Obligations of Banking Companies, Financial Institutions and Intermediaries
---------------------- has been included in the Act. The Central Government in consultation with the
Reserve Bank of India has framed the rules, viz., The Prevention of Money
---------------------- Laundering, Maintenance of Records of the Nature and Value of Transactions
etc., Rules, 2004.
----------------------
The process of money laundering can be analyzed into three stages; First,
---------------------- the stage of ‘placement’ when the proceeds, more often in cash form, are placed
into the financial system; Second, the stage of ‘layering’ where the proceeds are
----------------------
moved, through a series of transactions to make it difficult to trace the origin
---------------------- of the funds ; and Third, the stage of ‘integration’ when the criminal resumes
control of the resources. These proceeds now appear free from any link to a
---------------------- criminal source. The process of money laundering would largely be impossible
without the network of banks and financial institutions.
----------------------
The extent of criminal activity as well as the incentive to finance such
---------------------- activity can be brought under control while attempting to curb money launderings.
Detection and control of such activity at the first stage can help identify the very
----------------------
offence that generated the proceeds and can also lead to confiscation of such
---------------------- proceeds.
Objectives of the PMLA
----------------------
• To prevent, combat and control money laundering.
----------------------
• To monitor and report suspicious transactions.
----------------------
•
To identify money laundering or terrorist financing activities and to discourage
---------------------- the same.
• To confiscate and seize the property obtained from the laundered money.
----------------------

•
To undertake periodic Due Diligence measures which are sensitive to money Notes
laundering and terrorist financing risks.
----------------------
• To comply with applicable laws as well as norms adopted internationally
with reference to money laundering. ----------------------
• To deal with any other issue connected with money laundering in India.
----------------------
• To take adequate and appropriate measures to follow the spirit of the PMLA.
----------------------
12.2 INTRODUCTION TO FINANCIAL INTELLIGENCE ----------------------
UNIT – INDIA (FIU-IND)
----------------------
FIU-IND was set by the Government of India in November 2004 as
the central national agency responsible for receiving, processing, analyzing ----------------------
and disseminating information related to the suspected financial transactions. ----------------------
FIU-IND is also responsible for coordinating and strengthening the efforts of
national and international intelligence, investigation and enforcement agencies ----------------------
in pursuing the global efforts against money laundering and related crimes. FIU-
IND is an independent body reporting directly to the Economic Intelligence ----------------------
Council (EIC) headed by the Finance Minister. ----------------------
Organization Strength of FIU-IND
----------------------
FIU-IND is a multi disciplinary body with a sanctioned strength of
74 personnel. These are being inducted from different organizations namely ----------------------
Central Board of Direct Taxes (CBDT), Central Board of Excise and Customs
----------------------
(CBEC), Reserve Bank of India (RBI), Securities Exchange Board of India
(SEBI), Department of Legal Affairs and Intelligence agencies. ----------------------
Functions of FIU-IND
----------------------
The main function of FIU-IND is to receive cash/suspicious transaction
reports, analyse them and, as appropriate, disseminate valuable financial ----------------------
information to intelligence/enforcement agencies and regulatory authorities.
----------------------
The other functions of FIU-IND are:
Collection of Information: Act as the central reception point for receiving ----------------------
Cash Transaction reports (CTRs) and Suspicious Transaction Reports (STRs) ----------------------
from various reporting entities.
Analysis of Information: Analyze received information in order to ----------------------
uncover patterns of transactions suggesting suspicion of money laundering and ----------------------
related crimes.
----------------------
Sharing of Information: Share information with national intelligence/
law enforcement agencies, national regulatory authorities and foreign Financial ----------------------
Intelligence Units.
----------------------
Act as Central Repository: Establish and maintain national data base on
cash transactions and suspicious transactions on the basis of reports received ----------------------
from reporting entities.
----------------------

Notes Co-ordination: Co-ordinate and strengthen collection and sharing of
financial intelligence through an effective national, regional and global network
---------------------- to combat money laundering and related crimes.
---------------------- Research and Analysis: Monitor and identify strategic key areas on
money laundering trends, typologies and developments.
----------------------
----------------------

---------------------- 1. FIU-IND:
---------------------- i. Financial Intelligence Unit-India

ii. Aims to prevent money laundering and related crimes
----------------------
iii. Multidisciplinary body
----------------------
iv. Controller of RBI
---------------------- 2. The process of money laundering can be analysed into:
---------------------- i. Placement
---------------------- ii. Collaboration

iii. Layering
----------------------
iv. Integration
----------------------
3. Objectives of Prevention of Money laundering Act are:
---------------------- i. To prevent money laundering
---------------------- ii. To combat and control money laundering
---------------------- iii. To monitor suspicious transactions
iv. To report suspicious transactions to CBI
----------------------
----------------------
12.3 OFFENCE OF MONEY LAUNDERING
----------------------
Offence of Money Laundering is where a person directly or indirectly
---------------------- attempts to indulge or knowingly assists or knowingly be a party or actually
involves in any process or activity connected with the proceeds of crime and
---------------------- projecting it as untainted property. Whosoever commits the offence of money
---------------------- laundering shall be punishable with rigorous imprisonment for a term which
shall not be less than three years but may extend to seven years and also be
---------------------- liable to a fine which may extend to five lakh rupees. If the offence relates to
offences under the Narcotic Drugs and Psychotropic Substances Act, 1985 the
---------------------- maximum punishment could extend to imprisonment for ten years.
----------------------
----------------------

Applicability of Prevention of Money Laundering Act Notes
The basic objective behind the enactment of PMLA 2002 is to identify and
----------------------
discourage any money laundering and terrorist financing activity. It has been
accepted at international level that financial institutions including securities ----------------------
market intermediaries should have internal control procedures to combat with
money laundering. As such the Act is applicable to the following: ----------------------
• Banking Company. ----------------------
•
Financial Institution including chit fund company, co-operative bank,
----------------------
housing finance institution and a non banking financial company.
Intermediary which includes stock broker, sub broker, share transfer ----------------------
agent, banker to an issue, trustee to a trust deed, registrar to an issue, merchant
----------------------
banker, underwriter, portfolio manager and investment adviser and any other
intermediary registered with SEBI. ----------------------
Attachment of Property involved in Money Laundering ----------------------
Where a director or any other person authorized by him has reason to
believe that a person is in possession of any proceeds of crime and such a person ----------------------
has been charged of having committed a scheduled offence and such proceeds ----------------------
are likely to be concealed or transferred, he may issue an order of attachment of
such property for a period not exceeding 90 days from the date of order. ----------------------
----------------------
12.4 DEFINITIONS
----------------------
There is no definition of money laundering in the Act. The meaning of
“Money Laundering” is assigned in Section3. It states that “whosoever, directly ----------------------
or indirectly attempts to indulge or knowingly assists or knowingly is a party or
is actually involved in any process or activity connected with the proceeds of ----------------------
crime and projecting it as untainted property shall be guilty of offence of money ----------------------
laundering”.
“Attachment” means prohibition of transfer, conversion, disposition or ----------------------
movement of property by an order issued under Chapter III. ----------------------
“Person” includes-(i) an individual, (ii) an HUF,(iii) a company, (iv) a
----------------------
firm, (v)an association of person or a body of individuals, whether incorporated
or not; (vi) every artificial juridical person not falling within any of the preceding ----------------------
sub clauses, and (vii) any agency, office or branch owned or controlled by any
of the above persons mentioned in the preceding sub-clauses. ----------------------
“Proceeds of crime” means any property derived or obtained, directly or ----------------------
indirectly, by any person as a result of criminal activity related to a scheduled
offence or the value of any such property. ----------------------
“Property” means any property or assets of every description, whether ----------------------
corporeal or incorporeal, moveable or immovable, tangible or intangible and
includes deeds and instruments evidencing title to, or interest in, such property ----------------------
or assets, wherever located.
----------------------

Notes “Records” include the records maintained in the form of books or stored
in a computer or such other form as may be prescribed.
----------------------
----------------------

---------------------- 1. The banks and FIs should meticulously follow KYC norms for
opening accounts to check on offence of money laundering.
----------------------
2. PML Act, 2002 is applicable to banking companies, FIs, NBFCs,
---------------------- excluding chit funds companies, co-operative banks and housing
finance institutions.
----------------------
3. Every banking company/FIs/Intermediary is required to maintain
---------------------- records of all cash transactions valuing more than 50 lac or its
equivalent in foreign currency.
----------------------
----------------------
Activity 1
----------------------
List the objectives behind the enactment of the Prevention of the Money
----------------------
Laundering Act, 2002 (5 points).
----------------------
---------------------- 12.5 OBLIGATIONS OF BANKS & FINANCIAL

INSTITUTIONS UNDER PMLA
----------------------
---------------------- Every banking company, financial institution and intermediary is required to-
To maintain a record of all transactions, of the nature and value specified
•
---------------------- in the rules whether such transactions comprise of a single transaction or
---------------------- a series of transactions integrally connected to each other, and where such
a series of transactions take place within a month.
---------------------- •
To furnish information of the transactions to the director within the prescribed
---------------------- time; and
• To verify and maintain records of the identity of all its clients.
----------------------
The records shall be maintained for ten years from the date of cessation of
•
---------------------- the transactions between the clients and the banking company, financial
institution or intermediary.
----------------------
The Director, appointed by the Central Government, has the right to call
---------------------- for the records and make such inquiry or cause an enquiry to be made.
---------------------- •
If he finds that the banking company, financial institution or intermediary has
not complied with the requirements, he may impose a fine on the banking
---------------------- company which shall not be less than ten thousand rupees but may extend to
one lakh rupees.
----------------------

•
The Act also specifically provides that the banking companies and their Notes
officers shall not be liable to any civil proceedings against them for furnishing
information. ----------------------
The Central Government in consultation with the Reserve Bank of India ----------------------
has framed ‘The Prevention of Money Laundering Maintenance of Records of
the Nature and Value of Transactions, the Procedure and Manner of Maintaining ----------------------
and Time for Furnishing Information and Verification and Maintenance of
Records of the Identity of the Clients of the Banking Companies, Financial ----------------------
Institutions and Intermediaries Rules, 2004’. ----------------------
Every banking company, financial institution and intermediary is required
to maintain the following records- ----------------------
•
All cash transactions of the value of more than rupees ten lakh or its equivalent ----------------------
in foreign currency;
----------------------
•
All series of cash transactions integrally connected to each other which have
been valued below rupees ten lakh or its equivalent in foreign currency where ----------------------
such series of transactions have taken place within a month;
----------------------
•
All cash transactions where, forged or counterfeit currency notes or bank
notes have been used as genuine and where any forgery of a valuable security ----------------------
has taken place;
----------------------
•
All suspicious transactions, whether or not made in cash and by way of:
----------------------
•
deposits and credits, withdrawals into or from any accounts in whatsoever
name they are referred to in any currency maintained by way of: ----------------------
– Cheques including third party cheques, pay orders, demand drafts,
----------------------
cashier’s cheques or any other instruments or payment of money including
electronic receipts or credits and electronic payments or debits; or ----------------------
– Traveller’s cheque; or ----------------------
– Transfer from one account within the same banking company, financial
institution and intermediary, as the case may be, including from or to ----------------------
Nostro and Vostro accounts; or ----------------------
– Any other mode in whatsoever name it is referred to;
----------------------
credits or debits into or from any non-monetary accounts such as a demat
•
account, security account in any currency maintained by the banking ----------------------
company, financial institution and intermediary, as the case may be;
----------------------
money transfer or remittances in favour of own clients or non-clients
•
from India or abroad and to third party beneficiaries in India or abroad ----------------------
including transactions on its own account in any currency by any of the
----------------------
following:
– payment orders, or – cashier cheques; or – demand drafts; or – telegraphic ----------------------
or wire transfer or electronic remittances or transfer; or – interest transfers;
----------------------
or – automated clearing house remittances; or – lock box driven transfers or
remittances; or – remittances for credit or loading to electronic cards; or ----------------------

Notes • any other mode of
• money transfer by whatsoever name it is called;
----------------------
loans and advances including credit or loan substitutes, investments and
•
---------------------- contingent liability by way of:
---------------------- – subscription to debt instruments such as commercial paper, certificate
of deposits preferential shares, debentures, securitized participation,
---------------------- inter-bank participation or any other investments in securities or the like
whatever form and name it is referred to; or
----------------------
– purchase and negotiation of bills, cheques and other instruments; or –
---------------------- foreign exchange contracts, currency, interest rate and commodity and
---------------------- any other derivative instrument in whatsoever name it is called; or
– letters of credit, standby letters of credit, guarantees, comfort letters,
---------------------- solvency certificates and any other instruments for settlement and/or
---------------------- credit support.
collection service in any currency by way of collection of bills, cheques,
•
---------------------- instruments or any other mode of collection in whatsoever name it is
---------------------- referred to.
Every banking company, financial institution and intermediary is required to
----------------------
maintain the following information in the records -
---------------------- • the nature of the transaction.
---------------------- • the amount of the transaction and the currency in which it was denominated.
---------------------- • the date on which the transaction was conducted; and

• the parties to the transaction.
----------------------
---------------------- maintain the information in the following manner:-
---------------------- The information as to the transactions shall be maintained in hard and soft
•
copies in accordance with the procedure and manner as may be specified
---------------------- by the RBI or SEBI.
---------------------- •
Banking company shall have to evolve a mechanism for maintaining such
information in such form and at such intervals as may be specified by the
---------------------- RBI or SEBI.
---------------------- •
It is the duty of the banking company to observe the procedure and manner
of maintaining the information as specified by the RBI or SEBI.
----------------------
•
---------------------- follow the following procedure for furnishing Information:-
The principal officer of a banking company shall furnish the information in
----------------------
respect of the transaction every month to the director by the seventh day of the
---------------------- succeeding month.
----------------------

Information has to be furnished on the transactions that relate to (a) forged
• Notes
or counterfeit currency notes or bank notes or forgery of valuable security
or (b) all suspicious transactions, whether or not made in cash shall be ----------------------
promptly furnished in writing or by way of fax or electronic mail to the
director not later than three working days from the date of occurrence of ----------------------
such transactions. ----------------------
----------------------
verify the Records of the Identity of the Clients.
•
There are rules that prescribe the type of records to be obtained or verified in ----------------------
respect of various types of clients.
----------------------
The rules mandate that every banking company shall, at the time of opening
an account or executing any transaction with it, verify and maintain the ----------------------
record of identity and current address or addresses including permanent
----------------------
address of the client, the nature of business of the client and his financial
status. ----------------------
If it is not possible to verify the identity at the time of opening the account
•
----------------------
or executing the transaction, the banking company shall verify the identity
of the client within a reasonable time after the account has been opened or ----------------------
the transaction has been executed.
----------------------
The documents required to be taken for verification of the identity of
•
clients differ from the type of client. They are listed below: ----------------------
a) An Individual ----------------------
One certified copy of an officially valid document containing details of
----------------------
his permanent address, current address including in respect of the nature
of business and financial status. ----------------------
b) Company
----------------------
• Certificate of Incorporation;
----------------------
• Memorandum and articles of association;
• Board resolution or the power of attorney; ----------------------
•
Officially valid document in respect of the person, operating the ----------------------
account.
----------------------
c) Partnership firm
----------------------
• Registration certificate;
• Partnership deed; ----------------------
•
Officially valid document in respect of the person acting in the ----------------------
transaction.
----------------------
----------------------
----------------------

Notes d) Trust
• Registration certificate;
----------------------
• Trust deed; and
----------------------
•
Officially valid document in respect of the person acting in the
---------------------- transaction.
e) Unincorporated association
----------------------
• Resolution of the managing body;
----------------------
•
Power of attorney granted to the person conducting the transaction; and
----------------------
3. Information as may be required by the banking company to establish the
---------------------- legal existence of the association or body of individuals.
The records related to the identity of the clients shall be maintained for
----------------------
a period of ten years from the date of cessation of the transactions between the
---------------------- client and the banking company.
---------------------- Activity 2
----------------------
1. Make a study of the measures taken by the Reserve Bank of India to
---------------------- tackle the problem of Fake Currency in India.
---------------------- 2. Make a study of the Know Your Customer (KYC) Guidelines of the
Reserve Bank of India. What is the significance of such guidelines?
----------------------
---------------------- 12.6 USA PATRIOT ACT

----------------------
Just like Financial Intelligence Unit which governs the PMLA 2002
---------------------- in India, the USA Patriot Act is governed by Financial Crimes Enforcement
Network (FinCEN) under the US Department of Treasury. FinCEN’s mission
---------------------- is to enhance U.S. national security, deter and detect criminal activity, and
safeguard financial systems from abuse by promoting transparency in the U.S.
----------------------
and international financial systems.
---------------------- Provisions of USA Patriot Act to prevent Money Laundering
---------------------- The USA Patriot Act contains a separate title cited as the ‘‘International
Money Laundering Abatement and Financial Anti-Terrorism Act of 2001’’. The
---------------------- definition of Money Laundering has been given a wider meaning under the Act
---------------------- and includes the following:
• Making financial transaction in US in order to commit a violent crime.
----------------------
• Bribery of public officials.
----------------------
• Fraud in dealing with public funds.
---------------------- • Smuggling or illegal export of controlled munitions.
---------------------- • Import of fire arm or ammunition not authorized by U.S. Attorney General.

The purpose of inclusion of this title in the Act can be summarized as under: Notes
•
To strengthen U.S. measures to prevent, detect and prosecute international
money laundering and financing of terrorism; ----------------------
• To subject to special scrutiny foreign jurisdictions, foreign financial ----------------------

institutions, and classes of international transactions or types of accounts
----------------------
that are susceptible to criminal abuse;
To require all appropriate elements of the financial services industry to
• ----------------------
report potential money laundering;
----------------------
To strengthen measures to prevent use of the U.S. financial system for
•
personal gain by corrupt foreign officials and facilitate repatriation of ----------------------
stolen assets to the citizens of countries to whom such assets belong.
----------------------
The rules governing money laundering are divided into following subtitles:
----------------------
• Strengthening of the international banking rules against money laundering.
----------------------
•
Improvement in communication between the law making agencies and
various financial institutions and enhancing the scope of record keeping and ----------------------
reporting.
• Currency smuggling and counterfeiting. ----------------------
The Act introduced the following measures to strengthen the international ----------------------
banking rules:
----------------------
•
Tightening of record keeping requirements by maintaining of record of
aggregate amount of transactions processed from different areas of the ----------------------
world.
----------------------
•
Identification of beneficial owners of bank accounts and details of
persons authorized to use payable through accounts. ----------------------
• Promotion of information sharing amongst financial institutions. ----------------------
Restriction on mergers of bank holding companies and banks with
----------------------
other banks that had a bad history of preventing money laundering.
•
Financial institution to investigate the identity of owners of private ----------------------
banks that have correspondent account with them.
----------------------
12.7 PROVISIONS FOR PREVENTION OF MONEY ----------------------

LAUNDERING UNDER USA PATRIOT ACT ----------------------
The different sections of USA Patriot Act related to anti money laundering ----------------------
and prevention of terrorist financing are summarized as under:
----------------------
Section 311: Special Measures for Jurisdictions, Financial Institutions, or
International Transactions of Primary Money Laundering Concern. ----------------------
This Section allows for identifying customers using correspondent
----------------------
accounts, including obtaining information comparable to information obtained
on domestic customers and prohibiting or imposing conditions on the opening ----------------------

Notes or maintaining in the U.S. of correspondent or payable-through accounts for a
foreign banking institution.
----------------------
Section 312: Special Due Diligence for Correspondent Accounts and Private
---------------------- Banking Accounts
This Section amends the Bank Secrecy Act by imposing due diligence
----------------------
& enhanced due diligence requirements on the U.S. financial institutions that
---------------------- maintain correspondent accounts for foreign financial institutions or private
banking accounts for non-U.S. persons.
----------------------
Section 313: Prohibition on U.S. Correspondent Accounts with Foreign
---------------------- Shell Banks
---------------------- This section prevents foreign shell banks, which are generally not subject
to regulation and considered to present an unreasonable risk of involvement in
---------------------- money laundering or terrorist financing, from having access to the U.S. financial
system. Banks and broker-dealers are prohibited from having correspondent
---------------------- accounts for any foreign bank that does not have a physical presence in any
---------------------- country. Additionally, they are required to take reasonable steps to ensure that
their correspondent accounts are not used to indirectly provide correspondent
---------------------- services to such banks.
---------------------- Section 314: Cooperative Efforts to Deter Money Laundering
This section helps law enforcement identify, disrupt, and prevent terrorist
----------------------
acts and money laundering activities by encouraging further cooperation among
---------------------- law enforcement regulators and financial institutions to share information
regarding those suspected of being involved in terrorism or money laundering.
----------------------
Section 319(b): Bank Records Related to Anti-Money Laundering
---------------------- Programmes
This section facilitates the government’s ability to seize illicit funds of
----------------------
individuals and entities located in foreign countries by authorizing the Attorney
---------------------- General or the Secretary of the Treasury to issue summons to any foreign bank
that maintains a correspondent account in the U.S. for records related to such
---------------------- accounts, including records outside the U.S. related to the deposit of funds into
the foreign bank. This Section also requires the U.S. banks to maintain records
----------------------
identifying an agent for service of legal process for its correspondent accounts.
---------------------- Section 325: Concentration Accounts at Financial Institutions
---------------------- This section allows the Secretary of the Treasury to issue regulations governing
maintenance of concentration accounts by financial institutions to ensure such
---------------------- accounts are not used to obscure the identity of the customer who is the direct
---------------------- or beneficial owner of the funds being moved through the account.
Section 326: Verification of Identification
----------------------
This section prescribes regulations establishing minimum standards for
---------------------- financial institutions and their customers regarding the identity of a customer
that shall apply with the opening of an account at the financial institution.
----------------------

Section 351: Amendments Relating to Reporting of Suspicious Activities Notes
This Section expands immunity from liability for reporting suspicious
----------------------
activities and expands prohibition against notification to individuals of SAR
filing. No officer or employee of federal, state, local, tribal, or territorial ----------------------
governments within the U.S., having knowledge that such report was made,
may disclose to any person involved in the transaction that, it has been reported ----------------------
except as necessary to fulfill the official duties of such officer or employee.
----------------------
Section 352: Anti-Money Laundering Programmes
----------------------
This section requires financial institutions to establish anti-money laundering
programmes, which at the minimum, must include: the development of internal ----------------------
policies, procedures and controls; designation of a compliance officer; an
ongoing employee training program; and an independent audit function to test ----------------------
programmes. ----------------------
Section 356: Reporting of Suspicious Activities by Securities Brokers and
Dealers; Investment Company Study ----------------------
This section requires the Secretary to consult with the Securities Exchange ----------------------
Commission and the Board of Governors of the Federal Reserve to publish
----------------------
proposed regulations in the Federal Register before January 1, 2002, requiring
brokers and dealers registered with the Securities Exchange Commission to ----------------------
submit suspicious activity reports under the Bank Secrecy Act.
----------------------
Section 359: Reporting of Suspicious Activities by Underground Banking
Systems ----------------------
This section amends the BSA definition of money transmitter to ensure
----------------------
that informal/ underground banking systems are defined as financial institutions
and therefore becomes subject to the BSA. ----------------------
Section 362: Establishment of Highly Secure Network ----------------------
This section requires FinCEN to establish a highly secure network
to facilitate and improve communication between FinCEN and financial ----------------------
institutions to enable financial institutions to file BSA reports electronically and ----------------------
permit FinCEN to provide financial institutions with alerts.
----------------------
----------------------
1. Proceeds of crime: As per Section 2 (1) (u) of the Act, ‘proceeds of crime’ ----------------------
means any property derived or obtained, directly or indirectly, by any
person as a result of criminal activity. This term was amended in the ----------------------
Finance Act, 2015, to enable attachment and confiscation of equivalent
asset in India where the asset located abroad cannot be forfeited.2 ----------------------
This time, the scope of the term has been enhanced to include property ----------------------
equivalent to proceeds of crime held outside the country and such property
can be proceeded against. ----------------------
----------------------

Notes 2. Bail: The conditions of bail shall now be applicable to all offences under
the Act as against the previous provision wherein bail conditions were
---------------------- applicable to offences in which the scope of imprisonment is of more than
3 years.
----------------------
3. Corporate Frauds: Section 447 of the Companies Act, 2013 deals with
---------------------- punishment for fraud for any act, omission, concealment of any fact or
abuse of position committed by any person with respect to affairs of a
---------------------- company. This section is now being included as scheduled offence under
---------------------- the Act. Therefore, such cases may now be reported by the Registrar of
Companies to the Enforcement Directorate under the Act. Therefore,
---------------------- concerned authorities under the Act now have power to deal with such
cases.
----------------------
4. Investigations: As per Section 5 (1) of the Act, concerned authorities may
---------------------- issue order to attach property of a person who he has reason to believe
to be in possession of proceeds of crime. Such order shall cease to have
----------------------
effect within 180 days from the date of its issuance unless confirmed by
---------------------- the Adjudicating Authority under the Act. The Act is now being amended
to further extend this period by 30 days to take care of delays if any in
---------------------- communication of judicial orders.
---------------------- 5. Disclosure of information: A sub-new clause has been added to the
existing clause 66 on disclosure of information wherein the Director
---------------------- appointed under the Act may furnish to any officer performing functions
under Government or under any law relating to tax or prevention of illicit
----------------------
traffic any information received or obtained by such Director.
---------------------- The new clause provides clear guidelines to share information relating to
---------------------- contraventions of other laws noticed during investigation with concerned
authorities under applicable Acts. This will facilitate exchange of
---------------------- information among agencies. This shall enable exchange of information
among agencies and enhance effectiveness
----------------------
6. Restoration of property: As per section 8(8), any property confiscated by
---------------------- the government may be restored to claimant with legitimate interest in
such property only after the trial is complete. This section is now amended
---------------------- t o consider the claims of the claimants to restore property even during
---------------------- trial in the prescribed manner.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. Uniting (and) Strengthening America (by) Providing Appropriate
----------------------
Tools Required (to) Intercept (and) Obstruct Terrorism Act of 2001
means USA PATRIOT ACT and is commonly known as __________. ----------------------
2. For verification of records of identity by banks for partnership firm, ----------------------
the banker should obtain _________ and registration certificate along
with the firm’s ----------------------
3. The rules governing money laundering under PATRIOT Act are ----------------------
divided into three subtitles, namely strengthening international
banking rules, improvement in communication between law making ----------------------
agencies and FIs and currency smuggling and _________.
----------------------
----------------------
Summary
----------------------
•
A sudden acquisition of a large sum of money especially in cash invites
suspicion that its source is some illegitimate activity. In general terms, ----------------------
money laundering is a term used to describe the manner in which the source
of money gets disguised. ----------------------
•
Money Laundering can be broadly defined as engaging in financial transactions ----------------------
involving income derived from criminal activity; the transactions are so
designed to conceal the true original source of criminality derived proceeds ----------------------
and appears to have been received through legitimate sources/origins.
----------------------
•
This is done in three phases– placement, layering and integration. The process
of money laundering would be difficult and largely impossible without the ----------------------
network of banks and financial institutions.
----------------------
•
The banks and financial institutions therefore have to follow necessary
procedures and guidelines prescribed by the authorities in order to prevent ----------------------
any such activity. The Know Your Customer (KYC) norm followed by the
banking system is one such measure to check on the offence of money ----------------------
laundering. Banks and Financial Institutions/Intermediaries have to fulfill
----------------------
the KYC requirements before allowing customers to open bank accounts or
make investments with/in the financial system. ----------------------
•
FIU-IND is responsible for receiving, processing, analyzing and disseminating
----------------------
information relating to suspect financial transactions and for coordinating and
strengthening efforts of national and international intelligence, investigation ----------------------
and enforcement agencies. It is an independent body reporting directly to the
Economic Intelligence Council (EIC) headed by the Finance Minister. The ----------------------
PMLA is enacted and governed by FIU-IND.
----------------------
----------------------

Notes •
There is a need to control the extent of criminal activity as well as the very
incentive to finance such activity; at the same time attempting to curb money
---------------------- launderings. Detection of such activity at the appropriate time and further on,
the control of such activity can help identify and trace the very offence that
---------------------- generated the proceeds thus leading to the confiscation of such proceeds.
---------------------- •
After the September 11 attacks in the USA, there was high emphasis on
national security and prevention of terrorist funding activities. As a result,
---------------------- the USA Patriot Act was enacted and contains various provisions for
strengthening the national security of USA.
----------------------
•
Prevention of money laundering and terrorist funding has been incorporated
---------------------- as a separate chapter in the Act with high emphasis on regulating the
functioning and reporting of international banks and financial institutions.
----------------------
---------------------- Keywords
---------------------- •
Money Laundering: Literal meaning ‘washing money’ free from illegal or
criminal associations.
----------------------
•
Offence of Money Laundering: Whosoever directly or indirectly attempts
---------------------- to indulge or knowingly assists or knowingly is a party or actually involved in
any process or activity connected with the proceeds of crime and projecting
----------------------
it as untainted property.
---------------------- •
Proceeds of Crime: It means any property derived or obtained, directly or
indirectly, by any person as a result of criminal activity related to a scheduled
----------------------
offence or the value of any such property.
----------------------
----------------------
---------------------- 1.
What are the main functions of the Financial Intelligence Unit of India in
relation to prevention of money laundering?
---------------------- 2.
What is meant by Money Laundering?
---------------------- 3.
How are Banks and Financial Institutions concerned with the offence of
Money Laundering?
----------------------
4.
Explain the information/records to be maintained by the Banks and Financial
---------------------- Institutions under the Prevention of Money Laundering Act, 2002.
---------------------- 5.
In what form and how should the information be maintained by the Banks
and Financial Institutions under the Prevention of Money Laundering Act,
---------------------- 2002?
---------------------- 6.
Why is the identity of the Client important? How does a Bank/Financial
Institution verify the identity of the Client?
----------------------
7.
Discuss the following in the context of the Prevention of Money Laundering
---------------------- Act, 2002: (a) Black Money (b) Terrorism and (c) Criminal Activity such as
Drug Trafficking etc.
----------------------

8.
What are the main provisions under the USA Patriot Act to prevent money Notes
laundering and terrorist financing activities?
9.
What are the main objectives behind enactment of USA Patriot Act? ----------------------
----------------------
----------------------
----------------------
----------------------
1. FIU-IND:
i. Refers to Financial Intelligence Unit-India ----------------------
ii. Aims to prevent money laundering and related crimes ----------------------
iii. Multidisciplinary body ----------------------
2. The process of money laundering can be analysed into:
----------------------
i. Placement
----------------------
iii. Layering
iv. Integration ----------------------
3. Objectives of Prevention of Money laundering Act are: ----------------------
i. To prevent money laundering ----------------------
ii. To combat and control money laundering
----------------------
iii. To monitor suspicious transactions
----------------------
1. True ----------------------
2. False ----------------------
3. False
----------------------
----------------------
Fill in the blanks.
1. Uniting (and) Strengthening America (by) Providing Appropriate Tools ----------------------
Required (to) Intercept (and) Obstruct Terrorism Act of 2001 means USA ----------------------
PATRIOT ACT and is commonly known as Patriot Act.
2. For verification of records of identity by banks for partnership firm, the ----------------------
banker should obtain partnership deed and registration certificate along ----------------------
with the firm’s authority to partner/person to operate the account.
3. The rules governing money laundering under PATRIOT Act are divided ----------------------
into three subtitles, namely strengthening international banking rules, ----------------------
improvement in communication between law making agencies and FIs
and currency smuggling and counterfeiting. ----------------------

Notes
Suggested Reading
----------------------
1. Abhyankar, Dr. Hemant and Shri S. V. Hajeri. Foreign Trade & Foreign
---------------------- Policy.
2. Foreign Trade Policy by Exim Management Institute
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
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Global Banking and Finance

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GLOBAL BANKING & FINANCE

(FOR PRIVATE CIRCULATION ONLY)

COURSE DESIGN AND REVIEW COMMITTEE

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

Copyright © 2018 Symbiosis Open Education Society

Unit No. TITLE Page No.

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 1

---------------------- • Define the terminologies used in foreign trade

---------------------- 1.1 INTRODUCTION TO GLOBAL BANKING & FINANCE

2 Global Banking & Finance

In 1970, the Govt. of India introduced NRI Banking in order- ----------------------

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 3

---------------------- Check your Progress 1

4 Global Banking & Finance

– A person resident in India, in a previous year in respect of any source of ----------------------

Who is a Non - Resident? ----------------------

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 5

---------------------- • A Hindu Undivided Family

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 7

8 Global Banking & Finance

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 9

10 Global Banking & Finance

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 11

---------------------- Check your Progress 2

12 Global Banking & Finance

• Government dated securities /Treasury bills ----------------------

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 13

---------------------- • The payment of purchase price, if any, should be made out of

14 Global Banking & Finance

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 15

---------------------- Resident Foreign Currency (RFC) Accounts Scheme

---------------------- The salient features of the scheme are as under

16 Global Banking & Finance

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 17

18 Global Banking & Finance

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 19

---------------------- • ertificate of Origin of Goods (COO) - A document in international trade

20 Global Banking & Finance

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 21

---------------------- a) Non- Resident Ordinary Rupee account (NRO) a/c.

---------------------- Self-Assessment Questions

Introduction to Global Banking & Finance (Introduction to NRI/PIOS) 23

24 Global Banking & Finance

---------------------- • Identify the provisions of Foreign Trade (Development &

---------------------- 2.2 INTERNATIONAL ORGANISATIONS FOR TRADE &

26 Global Banking & Finance

---------------------- Fill in the blanks.

28 Global Banking & Finance

Pillar II requires that a comprehensive assessment of risks be carried out ----------------------

---------------------- Summary of Important Measures taken by RBI for implementation of

30 Global Banking & Finance

32 Global Banking & Finance

34 Global Banking & Finance

---------------------- What is Value at Risk?

36 Global Banking & Finance

---------------------- 2.4 RBI - EXCHANGE CONTROL AUTHORITY

38 Global Banking & Finance

40 Global Banking & Finance

Check your Progress 2 ----------------------

42 Global Banking & Finance

C) Formats prescribed for declarations of exports and disposal thereof. GR ----------------------

---------------------- • The item of export is not subject to floor price restrictions.

44 Global Banking & Finance

---------------------- Status Holders

– A person resident in India, in a previous year in respect of any source of ----------------------

---------------------- • ertificate of Origin of Goods (COO) - A document in international trade

---------------------- • Identify the provisions of Foreign Trade (Development &

C) Formats prescribed for declarations of exports and disposal thereof. GR ----------------------

---------------------- 1. The benefits of deemed exports shall be available for supply to

The system of flexible exchange rates reinforces the effectiveness of ----------------------