UNIT-4

CHAPTER-1

INFLATION AND MONETORY POLICY

One of the most intricate challenges of our present times is the problem of rising Inflation. Its
effect can be felt by each and every person to at least some degree, whether he is an engineer,
doctor, lawyer, govt. servant or anybody. Inflation makes no partiality in choosing its innocent
victims. So, what exactly is inflation and how is it caused? Whether it originates in our home
country or it is imported from abroad? What are our Economists doing to control Inflatio n?
These are the questions that naturally arise in anyone's mind.
1.1 INTRODUCTION
Inflation is defined as a general rise in prices of all commodities. In the words of
Samuelson, “by inflation we mean a time of generally rising prices for goods and factors of
production – rising prices of bread, cakes, haircuts, rising wages, rents etc”. It is not the rise in
the price of my favorite commodity e.g. McDonalds Pizza, but the overall rise in the prices of
all the goods and services manufactured and consumed within the territory of a nation. When
we say that the monthly rate of Inflation is 12%, what it means is that on an average, the prices
of all goods and services have increased by 12% in the period of last one month. The essence
of inflation is disequilibrium between aggregate demand and aggregate supply, i.e. excess of
demand over supply that keeps the price level rising over time
1.2 MEASURES OF INFLATION
In India, Inflation is measured using WPI (Wholesale Price Index). It is very tedious to track
each and every commodity and calculate its price rise. Instead of that an Index of several goods
and services is prepared. India's WPI is a weighted- index of 435 commodities. It means price-
rise of all commodities will not be treated equally. The price-rise of rice will have more weight-
age than price-rise of a Maruti-car. That is because rice is consumed by a very large number of
people compared to a Maruti car. The weight-age of a Mercedez car will be still lower in the
WPI. So when this WPI increases from say 100 to 112, we say that the rate of inflation is 12%.
Many other countries like UK, USA, China, etc. use CPI (Consumer Price Index) to measure
inflation. This is a more realistic measure because it computes the index based on the increase
in actual price paid by the consumer. On the other hand, WPI considers the rise in the price by
the Wholesalers of the goods and services.
1.3 TRENDS OF PRICE MOVEMENT
Inflation wise, the past half a century can be divided into distinct phases, viz.,
i. Period of relative price stability (1951-1956). The average annual rate of price rise or
inflation was almost nil during this period. Within this period the price changes varied
between negative to positive. The overall price stability, or even negative inflation rate
was mainly the result of bumper agricultural production and tremendous success of the
 first plan. However, pressures of high demand towards the beginning of Second Plan
caused the prices to rise.
ii. Phase of Moderate Inflation (1956-1971). During the period 1956-1971, average
annual inflation rate rose to 6.4 per cent. The price position during third five-year plan
deteriorated badly. The average increase in prices was around 5.8 per cent. However
there was a small decline (-1.1 per cent) during 1968-69 mainly due to the impact of a
bumper crop in the year1966-67.
iii. Period of High Inflation Rate (1971-1981). During the decade 1971-81, the annual
average inflation rate (rate of increase in price level) became still higher to reach 10
percent. The crop failure in 1972 and the oil shock of 1973 were the main factors behind
the inflation. The average inflation rate which was higher at 12 per cent during 1971-
72 to 1975-76 and slightly lower at 8.5 per cent during 1976-77 and 1980-81. Planwise,
the inflation rate which was high at around 9 percent during the fourth plan (1969-74)
came down to 6.3 percent during the fifth plan 1974-79.
iv. Slow down of Inflation (1981-1991). During this phase the annual inflation rate
slightly came down to 8 per cent. The highest recorded price rise during this decade
was 18 per cent in 1980-81 and lowest of 4.4 percent in 1985-86. But during the five-
year period (seventh plan 1985-90) it rose to around 8 percent.
v. Price situation in the Nineties. The 1991-1996 periods witnessed the revival of strong
inflationary pressures. But 1996 onwards inflation declined and inflation rate has
declined to moderate levels varying between 4 to 6 per cent. Since then, the inflatio nar y
situation came under control with a noticeable decline in the prices of primary food
articles as well as manufactured food products.

vi. Recent Rise in Inflation. The price situation was stable and largely comfortable during
the tenth plan (2002-2007) period. With the annual rate of inflation in India having
touched 7 per cent on a point-to-point basis during the week-ending March 22,
2008. Indeed, by July 2008, the key Indian Inflation Rate, the Wholesale Price Index,
has risen to 11.89%, its highest rate in 13 years. This is more than 6% higher than a
year earlier and almost three times the RBI’s target of 4.1%.

1.4 CAUSES OF RISING PRICES

To understand the various causes that have contributed to the continuing price rise or infla tio n
in India, we have to look into factors which have on one side, pulled the demand upwards and
on the other side, prevented supply from keeping pace with this rising demand. Inflation is
basically a combination of two types of phenomenon. Its causes could be nailed down to Cost-
Push inflation and Demand-Pull inflation.
1. Cost-Push Inflation is caused by rise in the cost of factors of production. In classical
economic theory, there used to be only three factors of production - land, labor and
capital. However, in today's complex world, infinite factors are required to produce a
single product or commodity e.g. house-rent, electricity, admin-expenses, raw-
materials, fuel (petroleum), steel, etc. The price rise in any one or more of these factors
 will increase the cost of production of the final product. The producer of the commodity
(the businessman) will naturally shift this cost to his consumers by raising the cost of
his final product. This phenomenon is called Cost-Push Inflation.
There are some of factors that have contributed to increase in cost of production are as follows :
I. Fluctuation in output and supply.
II. Increase in taxes i.e. taxation, as a factor in rising costs and prices.
III. Changes in administered prices.
IV. Hike in oil prices and global inflation.
Let us take a simple example. Suppose a bakery owner produces bread by using several factors
like wheat, flour, machines, labor, etc. The cost of production of one piece of bread comes to
$8. He adds $2 as his profit-margin and sells it to consumers at $10. This continues for several
days. Now suppose the price of wheat increases due to low production or crop failure. Now the
owner recalculates his cost of production. It comes to $10. He now adds his margin of $2 and
increases the cost of bread to $12. This directly results in 2% rise in the cost of bread, or in the
bread component of the WPI.
2. Demand-Pull Inflation is another type of inflation. In this case, the cost of factors of
production remains same. However, due to increase in the demand of the commodity
by consumers in the market relative to its supply, the owner will naturally increase the
prices. In this case, demand has increased, but supply has remained constant.
There are some factors behind rapid increase in demand and relatively slow growth over the
past few decades. This is as follows:
I. Increase in money supply.
II. Massive increase in government expenditure.
III. Rapid increase in population.
IV. Growth of black money.
Let us take a simple example, suppose the cost of production of one piece of bread remains
constant at $8. He adds his margin of $2 and charges $10 to each consumer. Now suppose the
preference of his bread increases among the consumers, as it becomes more popular. This
results in an increased demand for bread (This is a simplified example, in real world demand
and supply is more complex). So sensing more demand for his product, the owner increases
the price to $12.
3. Liquidity: The term Liquidity is usually used to identify hard cash. In fact Liquid ity
just means money in any form. Liquidity is also referred to the ability and ease with
which an asset could be converted to money. For e.g. cash is the most liquid asset.
Savings-account deposit could also be called liquid asset. How is Liquidity related to
Inflation you may ask? The answer is simple. It's because of Demand-Pull Inflatio n.
The demand for the commodity is directly influenced by the amount of money that
people have. The Government or Central Bank can directly influence demand- pull
inflation by controlling liquidity.
1.4 CONSEQUENCES OR EFFECTS OF RISING PRICE
Inflation had caused serious imbalances in the Indian economy. Price relationships were badly
distorted and production pattern had gone out of line with demand.
1. Adverse effect on production. Inflation had led to economic recession in many sectors
of the Indian economy. Due to inflation, prices of certain important articles of
consumption such as textiles had increased to very high levels forcing demand for such
goods to decline specially from the poorer sections of the country. With increasing
expenditure on essential goods, the expenditure on the other goods had declined. While
demand had declined, production too had declined due to shortage of raw materia ls,
transport, power and so on. Production had adversely affected by frequent labour
troubles such as strikes and lockouts. Over and above all these, the rise in the price level
had eroded the volume of investment in real terms. The decline in real investme nt
worsened the economic recession still further till recently.
2. Adverse effect on the distribution of income. Under mild inflation or continued slow
rise in prices, profit keep on increasing. As wages and salaries remain more or less
fixed, income of the industrial and business classes increases relative to the income of
working classes. Thus, there is a redistribution of income in favour of the rich capitalist
and business people and therefore the gap between the rich and the poor increases. The
share of profits in national income increases whereas that of wages and salaries falls
and thus income redistribution takes place in favour of the richer section of society.
1.5 OBJECTIVES OF PRICE POLICY
Inflation is unjust and inequitable. It upsets the entire production process, generates speculative
tendencies, hits the poor hard and adversely affects economic growth. Thus inflation needs to
be controlled. But an undue reduction in price level can set deflationary trend in motion. This
would adversely affect business activity through reduced profit expectations, and hamper the
growth process. Thus, a suitable price policy is needed which fulfils the following objectives:
I. To maintain price stability of foodgrains and other goods consumed by the poor to
insulate them against inflation.
II. To maintain incentives for stimulating production and economic growth, which can be
done through a mild, slow and gradual price increases, and
III. To maintain inter-sectoral balance in prices of agriculture goods, industrial products
and prices of other goods and services.
It is with these objectives in mind that various policy instruments have been used to
control inflation and achieve a measure of price stability in India.

1.6 REMEDIAL MEASURES TO CONTROL RISING PRICES

In India, the Ministry of Finance and the RBI (Reserve Bank of India) always strive to control
inflation. Efforts should be made to curtail demand and improve supply management to control
rising prices. Some of the measures to control inflation are discussed as below.
“The guiding principal in respect to inflation management continues to be that in the medium
to long run, the increase in prices is largely sustained by monetary expansion. In short run,
however, inflation could be affected by non-monetary, essentially supply side factors.”
1.7 MONETARY POLICY

Monetary policy is the macroeconomic policy laid down by the central bank. It involves
management of money supply and interest rate and is the demand side economic policy used
by the government of a country to achieve macroeconomic objectives like inflatio n,
consumption, growth and liquidity.

In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of
money in order to meet the requirements of different sectors of the economy and to increase
the pace of economic growth.

The RBI implements the monetary policy through open market operations, bank rate policy,
reserve system, credit control policy, moral persuasion and through many other instrume nts.
Using any of these instruments will lead to changes in the interest rate, or the money supply in
the economy. Monetary policy can be expansionary and contractionary in nature. Increasing
money supply and reducing interest rates indicate an expansionary policy. The reverse of this
is a contractionary monetary policy.

For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the
RBI is dependent on the monetary policy. By purchasing bonds through open market
operations, the RBI introduces money in the system and reduces the interest rate.

1.8 OBJECTIVES OF MONETARY POLICY FISCAL POLICY

1. NEUTRALITY OF MONEY

Economists like Wicksteed, Hayek and Robertson are the chief exponents of neutral money.
They hold the view that monetary authority should aim at neutrality of money in the economy.
Any monetary change is the root cause of all economic fluctuations. According to neutralis ts,
the monetary change causes distortion and disturbances in the proper operation of the economic
system of the country.

They are of the confirmed view that if somehow neutral monetary policy is followed, there will
be no cyclical fluctuations, no trade cycle, no inflation and no deflation in the economy. Under
this system, money is kept stable by the monetary authority. Thus the main aim of the monetary
authority is not to deviate from the neutrality of money. It means that quantity of money should
be perfectly stable. It is not expected to influence or discourage consumption and production
in the economy.

2. EXCHANGE STABILITY
Exchange stability was the traditional objective of monetary authority. This was the main
objective under Gold Standard among different countries. When there was disequilibrium in
the balance of payments of the country, it was automatically corrected by movements. It was
popularly known, “Expand Currency and Credit when gold is coming in; contract currency and
credit when gold is going out.” This system will correct the disequilibrium in the balance of
payments and exchange stability will be maintained.

It must be noted that if there is instability in the exchange rates, it would result in outflow or
inflow of gold resulting in unfavorable balance of payments. Therefore, stable exchange rates
play a key role in international trade. Thus, it is clear from this fact that: the main objective of
monetary policy is to maintain stability in the external equilibrium of the country. In other
words, they should try to eliminate those adverse forces which tend to bring instability in
exchange rates.

(i) It leads to violent fluctuations resulting in encouragement to speculative activities in the

market.

(ii) Heavy fluctuations lead to loss of confidence on the part of domestic and foreign capitalis ts
resulting in adverse impact in capital outflow which may also result in capital formation and
growth.

(iii) Fluctuations in exchange rates bring repercussions in the internal price level.

3. PRICE STABILITY
The objective of price stability has been highlighted during the twenties and thirties of the
present century. In fact, economists like Crustar Cassels and Keynes suggested price
stabilization as a main objective of monetary policy. Price stability is considered the most
genuine objective of monetary policy. Stable prices repose public confidence because cyclica l
fluctuations are totally eliminated.

It promotes business activity and ensures equitable distribution of income and wealth. As a
consequence, there is general wave of prosperity and welfare in the community. Price stability
also impedes economic progress as there is no incentive left with the business community to
increase production of qualitative goods.

It discourages exports and encourages imports. But it is admitted that price stability does not
mean ‘price rigidity’ or price stagnation’. A mild increase in the price level provides a tonic
for economic growth. It keeps all virtues of a stable price.

4. FULL EMPLOYMENT
During world depression, the problem of unemployment had increased rapidly. It was regarded
as socially dangerous, economically wasteful and morally deplorable. Thus, full employme nt
assumed as the main goal of monetary policy. In recent times, it is argued that the achieveme nt
of full employment automatically includes prices and exchange stability.
However, with the publication of Keynes’ General Theory of Employment, Interest and Money
in 1936, the objective of full employment gained full support as the chief objective of monetary
policy. Prof. Crowther is of the view that the main objective of monetary policy of a country is
to bring about equilibrium between saving and investment at full employment level.

Similarly, Prof. Halm has also favoured Keynes’ view. Prof. Gardner Ackley regards that the
concept of full employment is ‘slippery’. Classical economists believed in the existence of full
employment which is the normal feature of an economy. Full employment, thus, exists when
all those who are ready to work at the existing wage rate get work. Voluntary, frictional and
seasonal unemployed are also called employed.

According to their version, full employment means absence of involuntary unemployme nt.
Therefore, it implies not only employment of all types of labourers but also includes the
employment of all economic resources. It is not an end in itself rather a pre-condition for
maximum social and economic welfare.

5. ECONOMIC GROWTH
In recent years, economic growth is the basic issue to be discussed among economists and
statesmen throughout the world. Prof. Meier defined “Economic growth as the process whereby
the real per capita income of a country increases over a long period of time.” It implies an
increase in the total physical or real output, production of goods for the satisfaction of human
wants.

In other words, it means utilization of all the productive natural, human and capital resources
in such a manner as to ensure a sustained increase in national and per capita income over time.

Therefore, monetary policy promotes sustained and continuous economic growth by

maintaining equilibrium between the total demand for money and total production capacity and
further creating favourable conditions for saving and investment. For bringing equality
between demand and supply, flexible monetary policy is the best course.

In other words, monetary authority should follow an easy or tight monetary policy to suit the
requirements of growth. Again, monetary policy in a growing economy, has to satisfy the
growing demand for money. Thus, it is the responsibility of the monetary authority to circulate
the proper quantity and quality of money.

6. EQUILIBRIUM IN THE BALANCE OF PAYMENTS

Equilibrium in the balance of payments is another objective of monetary policy which emerged
significant in the post war years. This is simply due to the problem of international liquidity on
account of the growth of world trade at a faster speed than the world liquidity.

It was felt that increasing of deficit in the balance of payments reduces, the ability of an
economy to achieve other objectives. As a result, many less developed countries have to curtail
their imports which adversely effects development activities. Therefore, monetary authority
makes efforts that equilibrium should be maintained in the balance of payments.

1.9 MONETARY POLICY TOOLS

Monetary policy refers to the policy measures that affect the economic variables, viz., output,
prices, etc., through changes in money supply. In India, the RBI, being the central bank of the
country formulates and implements monetary policy with the objective of stabilizing prices
and promoting growth generating forces in output and employment levels. In general term, RBI
uses its monetary policy to achieve a judicious balance between the growth of production and
control of the general price level. They control inflation by directly affecting the demand pull
inflation by changing the amount of liquidity circulating in the economy. It helps to check
speculative activity (in period of inflation). In July 2008, RBI has raised the interest rates and
cash reserve ratio to check the volume of liquidity and credit in the country and thereby contr ol
the inflationary rise in prices taking place. The RBI (the Central Bank of India) can change the
liquidity by its various tools. These tools of controls are broadly two: quantitative and
qualitative controls.
Quantitative controls are used to control the volume of credit and indirectly to control
inflationary and deflationary pressures caused by expansion and contraction of credit.
Quantitative controls are also known as general credit controls and consist of CRR, Bank-Rate
(REPO and Reverse-REPO), SLR, etc.
 CRR (Cash Reserve Ratio) is the proportion of amount which each commercial bank
has to maintain in the form of hard cash. All commercial banks accept deposits from
individuals and lend it to borrowers at a higher interest rate. The difference between the
interest rate which they collect from borrowers and which they pay to their depositors
is their profit. Naturally, each bank will try to lend all the money they collect from
depositors. However, banks can't lend all the money they have. Under law, each bank
has to maintain a certain proportion of cash as reserve. This is known as CRR. For e.g.
if the CRR is 5% and the bank collects Rs. 100 from its depositors. Then it has to
maintain Rs.5 as Reserve. It can lend other Rs.95 to its borrowers. RBI can decrease
vast amounts of liquidity circulating in the economy by raising the CRR. When RBI
increases the CRR, the bank's lending power decreases. Less lending means less
borrowing, this in turn means less money in the economy. In July 2008, the RBI
increased the CRR from 8.75% to 9% to control inflation.
 SLR (Statutory Liquidity Ratio) is also similar to CRR. But in case of SLR,
Government-Securities need to be maintained by the commercial banks instead of cash.
All commercial banks have to maintain liquid assets in the form of cash, gold and
unencumbered approved securities equal to not less than 25 percent of their total
demand and time deposit liabilities. RBI has stepped up the liquidity ratio for two
reasons:
a) Higher liquidity ratio forces commercial banks to maintain a larger proportion of their
resources in liquid form and thus reduces their capacity to grant loans and advances to
business and industry- thus it is anti-inflationary
 b) Higher SLR was used to divert bank funds to finance government expenditure.
It may be mentioned here that stepping up statutory liquidity requirements (SLR) and the cash
reserve ratio (CRR) have same effect, viz., they reduce the capacity of commercial banks to
expand credit to business and industry and thus are anti-inflationary.
 Bank-Rate is basically the interest rate at which the Central Bank borrows
from the other scheduled commercial banks. This rate is directly linked to the
interest rates charged in turn by all the commercial banks to its customers. All these
other interest rates on Home-loans, Personal-loans, etc. also increase with the increase
in bank-rate. Thus, by raising the Bank-Rate and in turn all other Interest Rates, the RBI
makes borrowing money from banks a very costly affair. People are thus discouraged
to borrow more money and total amount of liquidity decreases in the economy. In July
end, the RBI increased the Bank Rate from 8.5% to 9.5%. This was an increase of 50
basis-points (0.5%) to control inflation.
Although the rise in interest rates initially makes life difficult for people who have taken loans
on floating interest rates, it is a required step to bring down inflation which is a larger evil. It
might also be noted that RBI, by making the policy changes can control only one type of
inflation i.e. demand-pull inflation. It cannot affect the other type of inflation i.e. cost-push
inflation which is caused by rise in prices of raw-materials and other factors of production.
That is why the rate of inflation is increasing continuously since last six months although the
RBI is trying to control it.
 Open market operation: During inflation, the central bank sells government securities
and price bonds in the open market in order to contract the supply of money. This is
done to influence the volume of cash reserves with commercial banks and thus
influence the volume of loans and advances they can make to the industrial and
commercial sectors. RBI had not used this tool for many years. Such a policy of buying
government securities will be adopted to reverse economic recession in the country. It
appears that RBI will actively use open market operations as an instrument of monetary
policy and not simply to support the market for government bonds.

1.10 HOW IT WORKS

Central bank tools work by increasing or decreasing total liquidity. That’s the amount
of capital available to invest or lend. It's also money and credit that consumers spend. It's
technically more than the money supply, known as M1 and M2. The M1 symbol
denotes currency and check deposits. M2 is money market funds, CDs and savings accounts.
Therefore, when people say that central bank tools affect the money supply, they are
understating the impact.
 CHAPTER-2

FISCAL POLICY

2.1 FISCAL POLICY

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy. It is the sister strategy to monetary policy through
which a central bank influences a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals. Here we look at how fiscal policy works,
how it must be monitored and how its implementation may affect different people in an
economy.

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known
as Keynesian economics, this theory basically states that governments can influe nce
macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
This influence, in turn, curbs inflation (generally considered to be healthy when between 2-
3%), increases employment and maintains a healthy value of money. Fiscal policy plays a very
important role in managing a country's economy. For example, in 2012 many worried that the
fiscal cliff, a simultaneous increase in tax rates and cuts in government spending set to occur
in January 2013, would send the U.S. economy back into recession. The U.S. Congress avoided
this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1, 2013.

The idea is to find a balance between tax rates and public spending. For example, stimula ting
a stagnant economy by increasing spending or lowering taxes runs the risk of causing infla tio n
to rise. This is because an increase in the amount of money in the economy, followed by an
increase in consumer demand, can result in a decrease in the value of money - meaning that it
would take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer spending
is down, and businesses are not making substantial profits. A government may decide to fuel
the economy's engine by decreasing taxation, which gives consumers more spending money,
while increasing government spending in the form of buying services from the market (such as
building roads or schools). By paying for such services, the government creates jobs and wages
that are in turn pumped into the economy. Pumping money into the economy by decreasing
taxation and increasing government spending is also known as "pump priming." In the
meantime, overall unemployment levels will fall.

With more money in the economy and less taxes to pay, consumer demand for goods and
services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant
to active.
If, however, there are no reins on this process, the increase in economic productivity can cross
over a very fine line and lead to too much money in the market. This excess in supply decreases
the value of money while pushing up prices (because of the increase in demand for consumer
products). Hence, inflation exceeds the reasonable level.

For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if
not improbable, means to reach economic goals. If not closely monitored, the line between a
productive economy and one that is infected by inflation can be easily blurred.

2.2 TYPES OF FISCAL POLICY

1. Neutral Fiscal Policy: This implies a balanced budget where (Government spending = Tax
revenue). It further means that government spending is fully funded by tax revenue and overall
the budget outcome has a neutral effect on the level of economic activity.
2. Contractionary (restrictive) Fiscal policy: This policy involves raising taxes or cutting
government spending, so that (Government spending < Tax revenue) it cuts up on the aggregate
demand (thus, economic growth) and to reduce the inflationary pressures in the economy.
3. Expansionary Fiscal Policy: It is generally used for giving stimulus to the economy ,i.e.,
to speed up the rate of GDP growth or during a recession when growth in national income is
not sufficient enough to maintain the present standards of living. A tax cut and/or an increase
in government spending would be implemented to stimulate economic growth and lower
unemployment rates. This is not a sustainable policy, as it leads to budget deficits and thus,
should be used with caution.
4. Compensatory Fiscal Policy: The compensatory fiscal policy aims at continuo us ly
compensating the economy against chronic tendencies towards inflation and deflation by
manipulating public expenditures and taxes. It, therefore, necessitates the adoption of fiscal
measures over the long-run rather than once-for-all measures it a point of time.

When there are deflationary tendencies in the economy, the government should increase its
expenditures through deficit budgeting and reduction in taxes. This is essential to compensate
for the lack in private investment and to raise effective demand, employment, output and
income within the economy.

On the other hand, when there are inflationary tendencies, the government should reduce its
expenditures by having a surplus budget and raising taxes in order to stabilise the economy at
the full employment level.

The compensatory fiscal policy has two approaches:

(1) Built-in stabilisers; and

(2) Discretionary fiscal policy.

(1) Built-in Stabilisers:
The technique of built-in flexibility or stabilisers involves the automatic adjustment of the
expenditures and taxes in relation to cyclical upswings and downswings within the economy
without deliberate action on the part of the government. Under this system, changes in the
budget are automatic and hence this technique is also known as one of automatic stabilisatio n.

The various automatic stabilisers are corporate profits tax, income tax, excise taxes, old age,
survivors and unemployment insurance and unemployment relief payments. As instruments of
automatic stabilisation, taxes and expenditures are related to national income. Given an
unchanged structure of tax rates, tax yields vary directly with movements in national income,
while government expenditures vary inversely with variations in national income.

In the downward phase of the business cycle when national income is declining, taxes which
are based on a percentage of national income automatically decline, thereby reducing the tax
yield. At the same time, government expenditures on unemployment relief and social security
benefits automatically increase. Thus there would be an automatic budget deficit which would
counteract deflationary tendencies.

On the other hand, in the upward phase of the business cycle when national income is rising
rapidly, the tax yield would automatically increase with the rise in tax rates. Simultaneous ly,
government expenditures on unemployment relief and social security benefits automatica lly
decline. These two forces would automatically create a budget surplus and thus inflatio nar y
tendencies would be controlled automatically.

MERITS
1. The built-in stabilisers serve as a cushion for private purchasing power when it falls and
lessen the hardships on the people during deflationary period.

2. They prevent national income and consumption spending from falling at a low level.

3. There are automatic budgetary changes in this device and the delay in taking administrative
decisions is avoided.

4. Automatic stabilisers minimise the errors of wrong forecasting and timing of fiscal measures.

5. They integrate short-run and long-run fiscal policies.

LIMITATIONS

1. The effectiveness of built-in stabilisers as an automatic compensatory device depends on the

elasticity of tax receipt, the level of taxes and flexibility of public expenditures. The greater the
elasticity of tax receipts, the greater will be the effectiveness of automatic stabilisers in
controlling inflationary and deflationary tendencies. But the elasticity of tax receipts is not so
high as to act as an automatic stabiliser even in advanced countries like America.

2. With low level of taxes even a high elasticity of tax receipts would not be very signific a nt
as an automatic stabiliser doing a downswing.

3. The built-in stabilisers do not consider the secondary effects of stabilisers on after-tax
business incomes and of consumption spending on business expectations.

4. This device keeps silent about the stabilising influence of local bodies, state governme nts
and of the private sector economy.

5. They cannot eliminate the business cycles. At the most, they can reduce its severity.

6. Their effects during recovery from recession are unfavourable. Economists, therefore,
suggest that built-in stabilisers should be supplemented by discretionary fiscal policy.

5. Discretionary Fiscal Policy:

Discretionary fiscal policy requires deliberate change in the budget by such actions as changing
tax rates or government expenditures or both.

It may generally take three forms:

(i) Changing taxes with government expenditure constant,

(ii) changing government expenditure with taxes constant, and

(iii) variations in both expenditures and tax simultaneously.

(i) When taxes are reduced, while keeping government expenditure unchanged, they increase
the disposable income of households and businesses. This increase private spending. But the
amount of increase will depend on whom the taxes are cut, to what extent, and on whether the
taxpayers regard the cut temporary or permanent.

If the beneficiaries of tax cut are in the higher middle income group, the aggregate demand will
increase much. If they are businessmen with little incentive to invest, tax reductions are
temporary. This policy will again be less effective. So this is more effective in controlling
inflation by raising taxes because high rates of taxation will reduce disposable income of
individuals and businesses thereby curtailing aggregate demand.

(ii) The second method is more useful in controlling deflationary tendencies. When the
government increases its expenditure on goods and services, keeping taxes constant, aggregate
demand goes up by the full amount of the increase in government spending. On the hand,
reducing government expenditure during inflation is not so effective because of high business
expectations in the economy which are not likely to reduce aggregate demand.

(iii) The third method is more effective and superior to the other two methods in controlling
inflationary and deflationary tendencies. To control inflation, taxes may be increased and
government expenditure be raised to fight depression.

LIMITATIONS

1. Accurate forecasting is essential to judge the stage of cycle through which the economy is
passing. It is only then that appropriate fiscal action can be taken. Wrong forecasting may
accentuate rather than moderate the cyclical swings. Economics is not an exact science in
correct forecasting. As a result, fiscal action always follows after the turning points in the
business cycles.

2. There are delays in proper timing of public spending. In fact, discretionary fiscal policy is
subject to three time lags.

(i) There is the “decision lag,” the time required in studying the problem and taking the
decision. The lag involved in this process may be too long.

(ii) Once the decision is taken, is an “execution lag.” It involves expenditure which is to be
allocated for the execution of the programme. In a country like the USA it may take two years
and less than a year in the U.K.

(iii) Certain public work projects are so cumbersome that it is not possible to accelerate or slow
them down for the purpose of raising or reducing spending on them.

2.3 VARIOUS COMBINATIONS OF FISCAL POLICIES

Reduction in Government Spending and no Change in Tax Rates (Contractionary fiscal policy) :
This policy is useful in moderate inflation, which though is part of government’s priority, is
not the foremost objective. This would affect the growth little and sometimes even boost
growth due to cut in inflation.
Reduction in Government Spending and Increase in Tax Rates (Contractionary fiscal policy) :
This policy is useful in high inflation, when curbing inflation is the foremost objective, even
above the economic growth in the short run.

Rigid Government Spending and Increasing Tax Rates (Contractionary fiscal policy): This is
used when economy is overheated (When a prolonged period of good economic growth and
activity causes high levels of inflation as producers overproduce and create excess production
capacity in an attempt to capitalize on the high levels of wealth) due to too much exciteme nt
on the part of investors. Increase in taxes and interest rates (through monetary policy) would
curb the investments in short-run and prevent economy from going into recession after over-
heating.
Reduction in Government Spending and an Equivalent Reduction in Taxes (Balanced Fiscal
Policy): This, is a balanced budget approach, when a government decides to reduce its size and
level of its intervention in economy, then this policy can be adopted. It simply means
government is managing less money and hence less impact on markets and business.
Increase in government spending and tax rates (Balanced fiscal policy): This would be opposite
to the previous policy as it would increase the size of government. A government on the path
of socialization would adopt such policy.

Increase in government spending and decrease in tax rates (Expansionary fiscal policy): This
would be adopted to give economy a stimulus though injection of funds, first the governme nt
decreases taxes and leaves more income with people to spend and invest, then it also spends
more to give further boost to demand through additional income generated through governme nt
work. This is only possible in short-run as this policy leads to massive deficits and thus, should
be used when situation is alarming.

Increase in government spending and no change in tax rates (Expansionary fiscal policy): This
is also a stimulus policy (through public sector), but a more moderate one, which can be used
for a bit longer compared to previous.
Rigid Government spending and decrease in tax rates (Expansionary fiscal policy): This policy
is usually adopted to give incentive to private sector to invest and boost growth. Again, a short-
run stimulus policy like previous two.

2.4 MEASURES OF FISCAL POLICY

Fiscal policy is the policy under which the government of a country uses fiscal measures (or
instruments) to correct excess demand and deficient demand and to achieve other desirable
objectives. There are mainly three types of fiscal measures, viz.

a. Taxes

b. Public expenditure

c. Public borrowing

d. Subsidies

(a) Taxes:

Excess of aggregate demand over aggregates supply is caused due to the excess amount of
money income is the hands of the people in relation to the available output in the country. In
order to correct such situation personal disposable incase should be reduced. Therefore,
government should increase the rate of personal income tax, and corporate income tax so that
people will have less money in their hands and aggregates demand will fall.
On the other hand, deficient demand is caused due to low level of personal disposable income.
Therefore, government of a country should reduce the rate of direct taxes such as personal
income tax, and corporate tax.

(b) Public expenditure:

Public expenditure is an important component of aggregate demand. Therefore, excess demand

can be corrected by reducing government expenditure. Reduction in government expenditure
also leads to a decline in the volume of national income due to the backward operation of
investment multiplier. Reduction in national income leads to a decline in aggregate demand
and fall in the price level.

On the other hand, government should increase expenditure on public works programmes such
as the construction of roads, expansion of railways, setting up of power projects, constructio n
of irrigation projects, schools and colleges, hospitals and parks and so on. Besides, governme nt
should also enhance expenditure on social security measures, like old age pensions,
unemployment allowances, sickness benefits etc. As a result, national income would rise due
to the operation of multiplier and aggregate demand for goods would expand.

(c) Public borrowing:

Like tax and public expenditure, public borrowing is also an important anti – inflatio nar y
instrument. Government of a country should resort to borrowing from the non-bank public to
keep less money in their hands for correcting the state of excess demand and inflatio nar y
situation. On the other hand, to correct deficient demand, government should reduce borrowing
from the general public so that purchasing power in the hands of the people is not reduced.
Rather, government should repay the past loans to the people to increase their disposable
income.

(d) Subsidies

The massive amount of money that is used for subsidies on food, fertilizers, etc., must be
rationalized. Only those subsidies which really help the poor and actually reach them and those
which are crucial for country’s development should be continued and all others must be
abolished. Thus subsidies need to be reduced substantially while protecting the interest of the
really poor people. The government should also avoid popular measures and pre-election doles
to retain political power.

Besides the above fiscal measures, government should resort to deficit financing to correct
deficient demand. Deficit financing is a technique of financing a deficit budget by (i) printing
notes, & (ii) borrowing from the central bank or drawing down the cash balances on part of the
government from the central bank. In any case, deficit financing makes an addition to the total
money supply of the country and can correct deficient demand. However, deficit financ ing
beyond a limit may produce inflationary situation in a country. Therefore, deficit financ ing
must be kept within a limit and should be used with caution and care.
However, fiscal measures alone cannot eliminate the situations of excess demand and deficie nt
demand.

Briefly, then, a reduction in public expenditure, and an increase in taxes produces a cash surplus
in the budget. Keynes, however, suggested a programme of compulsory savings, such as
“deferred pay” or “forced savings” as an anti- inflationary measure. Private savings have a
strong disinflation effect on the economy and an increase in these is an important measure for
controlling inflation. Government policy should, therefore, include devices for increasing
savings. A strong savings drive reduces the spendable income of the people, without any
harmful effect of the kind associated with higher taxation. Moreover, the effects of a large
deficit budget, which is mainly responsible for inflation, can be reduced by covering the deficit
through public borrowings. Further, public debt may be managed in such a way that the supply
of money in the country may be controlled. The government should avoid paying back any of
its past loans during inflation in order to prevent an increase in the circulation of money. Anti-
inflationary debt management also includes cancellation of public debt held by the central bank
out of a budgetary surplus
2.5 REDESIGNING PUBLIC DISTRIBUTION
It is necessary to so recast the distribution system that it serves better the interest of the poor.
To enable people to purchase wheat, rice, kerosene etc at reasonable prices, the governme nt
had opened around 4.74 lakh fair price shops. People below the poverty line would get the
foodgrains at half the price charged from those above e the poverty line. To make the system
effectively serve the weaker sections, the income tax players have been excluded from the PDS.
 CHAPTER-3

FOREIGN EXCHANGE MANAGEMNET ACT

3.1 INTRODUCTION

The Foreign Exchange Management Act (FEMA) was an act passed in the winter session of
Parliament in 1999, which replaced Foreign Exchange Regulation Act. This act seeks to make
offences related to foreign exchange civil offences. It extends to the whole of India.

The Foreign Exchange Regulation Act (FERA) of 1973 in India was replaced on June 2000 by
the Foreign Exchange Management Act (FERA), which was passed in 1999. The FERA was
passed in 1973 at a time when there was acute shortage of foreign exchange in the country.

FEMA had become the need of the hour to support the pro- liberalisation policies of the
Government of India. The objective of the Act is to consolidate and amend the law relating to
foreign exchange with the objective of facilitating external trade and payments for promoting
the orderly development and maintenance of foreign exchange market in India.

FEMA extends to the whole of India. It applies to all branches, offices and agencies outside
India owned or controlled by a person, who is a resident of India and also to any contraventio n
there under committed outside India by two people whom this Act applies.

3.2 OBJECTIVE OF THE FEMA ACT

The object of the act is to consolidate and amend the law relating to foreign exchange With the
objective of facilitating external trade and payments and for promoting the Orderly
development and maintenance of foreign exchange market in India. FEMA extends to the
whole of India. It applies to all branches, offices and agencies outside India owned or controlled
by a person who is a resident of India and also to any Contravention there under committed
outside India by any person to whom this act Applies.

Except with the general or special permission of the reserve bank of India, no person can

 Deal in or transfer any foreign exchange or foreign security to any person not being an
authorized person;
 Make any payment to or for the credit of any person resident outside India in any
Manner;
 receive otherwise through an authorized person, any payment by order or on behalf of
any person resident outside india in any manner;
 Reasonable restrictions for current account transactions as may be prescribed.
 Any person may sell or draw foreign exchange to or from an authorized person for a
capital account transaction. The reserve bank may, in consultation with the Central
government, specify
 1. any class or classes of capital account transactions which are permissible;
2. the limit up to which foreign exchange shall be admissible for such transactions
However, the reserve bank cannot impose any restriction on the drawing of foreign exchange
for payments due on account of amortization of loans or for depreciation of direct investme nts
in the ordinary course of business. The reserve bank can, by regulations, prohibit, restrict or
regulate the following

 Transfer or issue of any foreign security by a person resident in India;

 Transfer or issue of any security by a person resident outside India;
 Transfer or issue of any security or foreign security by any branch, office or agency in
India of a person resident outside India;
 Any borrowing or lending in foreign exchange in whatever form or by whatever name
called;
 Any borrowing or tending in rupees in whatever form or by whatever name called
between a person resident in India and a person resident outside India;
 Deposits between persons resident in India and persons resident outside India;
 Export, import or holding of currency or currency notes;
 Transfer of immovable property outside India, other than a lease not exceeding five
years, by a person resident in India;
 Acquisition or transfer of immovable property in India, other than a lease not exceeding
five years, by a person resident outside India;
 Giving of a guarantee or surety in respect of any debt, obligation or other liability
incurred
(I) by a person resident in India and owed to a person resident outside India or
(ii) by a person resident outside India.
A person, resident in India may hold, own, transfer or invest in foreign currency, foreign
security or any immovable property situated outside India if such currency, security or property
was acquired, held or owned by such person when he was resident outside India or inherited
from a person who was resident outside India
A person resident outside India may hold, own, transfer or invest in Indian currency, security
or any immovable property situated in India if such currency, security or property was acquired,
held or owned by such person when he was resident in India or inherited from a person who
was resident in India.

The reserve bank may, by regulation, prohibit, restrict, or regulate establishment in India of a
branch, office or other place of business by a person resident outside India, for carrying on any
activity relating to such branch, office or other place of business. Every exporter of goods and
services must

 Furnish to the reserve bank or to such other authority a declaration in such form and in
such manner as may be specified, containing true and correct material particula rs,
including the amount representing the full export value or, if the full export value of the
 goods is not ascertainable at the time of export, the value which the exporter, having
regard to the prevailing market conditions, expects to receive on the sale of the goods
in a market outside India;
 Furnish to the reserve bank such other information as may be required by the reserve
bank for the purpose of ensuring the realization of the export proceeds by such exporter.
The Reserve bank may, for the purpose of ensuring that the full export value of the goods or
such reduced value of the goods as the reserve bank determines, having regard to the prevailing
market-conditions, is received without any delay, direct any exporter to comply with such
requirements as it deems fit.

Where any amount of foreign exchange is due or has accrued to any person resident in India,
such person shall take all reasonable steps to realize and repatriate to India such foreign
exchange within such period and in such manner as may be specified by the reserve bank.
3.3 THE FEMA IS APPLICABLE
 To the whole of India.
 Any Branch, office & agency, which is situated outside India, but is owned or controlled by
a person resident in India.

3.4 FEATURES OF FEMA

(1.) It is consistent with full current account convertibility and contains provisions for
progressive liberalisation of capital account transactions.

(2.) It is more transparent in its application as it lays down the areas requiring specific
permissions of the Reserve Bank/Government of India on acquisition/holding of
foreign exchange.

(3.) It classified the foreign exchange transactions in two categories, viz. capital account
and current account transactions.

(4.) It provides power to the Reserve Bank for specifying, in , consultation with the
central government, the classes of capital account transactions and limits to which
exchange is admissible for such transactions.

(5.) It gives full freedom to a person resident in India, who was earlier resident outside
India, to hold/own/transfer any foreign security/immovable property situated
outside India and acquired when s/he was resident.

(6.) This act is a civil law and the contraventions of the Act provide for arrest only in
exceptional cases.
 (7.) FEMA does not apply to Indian citizen’s resident outside India.

3.5 DIFEFRENCE BETWEEN FERA AND FEMA

FERA, 1973 FEMA, 1999

It is an old enactment. It was passed in 1973 It is a new enactment and passed in year
and now this act has been repeated. 1999.

It was a long enactment with 81 sections, It is small enactment with 49 sections

which was very strict in nature.

An act promulgated, regulate payments and FEMA an act initiated to facilitate external
foreign exchange in India, is FERA trade and payments to promote orderly
management of the forex market in the
country.

Violation of FERA rules was a crimina l Violation of FEMA rules is a civil offence.
offence.

If anyone found guilty of FERA violatio n; Fine or imprisonment (if the person does not
there was a provision of punishment directly. deposit the prescribed penalty within 90 days
from the date of conviction).

Under FERA, only "citizenship" was a As per this law; a person who is living in
criterion to conclude the residential status of India from last 6 months can be considered
a person. as an Indian.

A person has to obtain permission of RBI There is no requirement of pre approval from
with regard to transfer of funds related to RBI related to remittances & external trade.
external operations.

Currently it is not in force. Currently it is not in force.

3.6 Major Provisions of FEMA Act 1999

Here are major provisions that are part of FEMA (1999) –

 Free transactions on current account subject to reasonable restrictions that may be imposed.
 RBI controls over capital account transactions.
 Control over realization of export proceeds.
 Dealing in foreign exchange through authorized persons like authorized dealer or money
changer etc.
 Appeal provision including Special Director (Appeals)
 Directorate of enforcement
 Any person can sell or withdraw foreign exchange, without any prior permission from RBI
and then can inform RBI later.
 Enforcement Directorate will be more investigative in nature
 FEMA recognized the possibility of Capital Account convertibility.
 The violation of FEMA is a civil offence.
 FEMA is more concerned with the management rather than regulations or control.
 FEMA is regulatory mechanism that enables RBI and Central Government to pass
regulations and rules relating to foreign exchange in tune with foreign trade policy of India.
3.7 Applicability of FEMA Act
 Exports of any foods and services from India to outside, foreign currency, that is any
currency other than Indian currency,
 Foreign exchange,
 Foreign security,
 Imports of goods and services from outside India to India,
 Securities as defined in Public Debt Act 1994,
 Banking, financial and insurance services,
 Sale, purchase and exchange of any kind (i.e. Transfer),
 Any overseas company that is owned 60% or more by an NRI (Non Resident Indian) and
 any citizen of India, residing in the country or outside (NRI).

3.8 CONTRAVENTIONS AND PENALTIES

If any person contravenes any provision of this Act, or contravenes any rule, regulatio n,
notification, direction or order issued in exercise of the powers under this Act, or contravenes
any condition subject to which an authorization is issued by the Reserve Bank, he shall, upon
adjudication, be liable to a penalty up to thrice the sum involved in such contravention where
such amount is quantifiable, or up to two lakh rupees where the amount is not quantifiable, and
where such contravention is a continuing one, further penalty which may extend to five thousand
rupees for every day after the first day during which the contravention continues.

Any Adjudicating Authority adjudging any contravention may, if he thinks fit in addition to any
penalty which he may impose for such contravention direct that any currency, security or any
other money or property in respect of which the contravention has taken place shall be
confiscated to the Central Government and further direct that the foreign exchange holdings, if
any, of the persons committing the contraventions or any part thereof, shall be brought back into
India or shall be retained outside India in accordance with the directions made in this behalf.

"Property” in respect of which contravention has taken place, shall include deposits in a bank,
where the said property is converted into such deposits, Indian currency, where the said property
is converted into that currency; and any other property which has resulted out of the conversion
of that property.
If any person fails to make full payment of the penalty imposed on him within a period of ninety
days from the date on which the notice for payment of such penalty is served on him, he shall
be liable to civil imprisonment.

3.9 INVESTIGATION

The Directorate of Enforcement investigate to prevent leakage of foreign exchange which

generally occurs through the following malpractices:
• Remittances of Indians abroad otherwise than through normal banking channels, i.e. through
compensatory payments.
• Acquisition of foreign currency illegally by person in India.
• Non-repatriation of the proceeds of the exported goods.
• Unauthorised maintenance of accounts in foreign countries.
• Under-invoicing of exports and over-invoicing of imports and any other type of invoice
manipulation.
• Siphoning off of foreign exchange against fictitious and bogus imports.
• Illegal acquisition of foreign exchange through Hawala.
• Secreting of commission abroad.

3.10 ORGANISATIONAL SET UP AND FUNCTIONS OF ENFORCEMENT

DIRECTORATE

Directorate of Enforcement has to detect cases of violation and also perform substantia lly
adjudicatory functions to curb above malpractices. The Enforcement Directorate, with its
Headquarters at New Delhi has seven zonal offices at Bombay, Calcutta, Delhi, Jalandhar,
Madras, Ahmedabad and Bangalore. The zonal offices are headed by the Deputy Directors.
The Directorate has nme sub-zonal offices at Agra, Srinagar, Jaipur, Varanasi, Trivandr um,
Calicut, Hyderabad, Guwahati and Goa, which are headed by the Assistant Directors. The
Directorate has also a Unit at Madurai, which is headed by a Chief Enforcement Officer.
Besides, there are three Special Directors of Enforcement and one Additional Director of
Enforcement. The main functions of the Directorate are as under:

• To collect and develop intelligence relating to violation of the provisions of Foreign Exchange
Regulation Act and
while working out the same, depending upon the circumstances of the case.
• To conduct searches of suspected persons, conveyances and premises for seizing
incriminating materials (including Indian and foreign currencies involved) and/or.
• To enquire into and investigate suspected violations of provisions of the Foreign Exchange
Management Act.
• To adjudicate cases of violations of Foreign Exchange Management Act for levying penalties
departmentally and also for confiscating the amounts involved in contraventions;
• To realise the penalties imposed in departmental adjudication.
3.11 PROCEDURAL PROVISIONS
For enforcing the provisions of various sections of FEMA, 1999, the officers of Enforceme nt
Directorate of the level of Assistant Director and above will have to undertake the following
functions

• Collection and development of intelligence/information.

• Keeping surveillance over suspects.
• Searches of persons/vehicles by provisions of Income-tax Act, 1961.
• Searches of premises as per provisions of Income-tax Act, 1961.
• Summoning of persons for giving evidence and producing of documents as per provisions of
Income-tax Act, 1961.
• Power to examine persons as per provisions of Income-tax Act, 1961.
• Power to call for any information/document as per provisions of Income-tax Act, 1961.
• Power to seize documents etc. as per provisions of Income-tax Act, 1961.
• Custody of documents as per Income-tax Act, 1961.

3.12 CONCLUSION

As per Section 3 of FEMA, all the current account transactions are free; however central
government at any time could impose reasonable instructions by issuing special rules. As per
Section 6 of FEMA, Capital Account Transactions are permitted only to the extent as specified
by RBI in its issued regulations. As per Section 10 of FEMA, RBI have controlling role in its
management however RBI cannot directly handle foreign exchange transaction and must
authorize a person to deal with it as per directions set by RBI. FEMA also have provisions of
various enforcement, penalties, adjudication and appeals in this area.
 CHAPTER –4
FOREIGN DIRECT INVESTMENT

4.1 INTRODUCTION
Foreign capital has a key role in the economic development process of the country. It is a source
of modernization, income and employment generation in the economy. India’s recent
liberalization of its foreign investment regulations has generated strong interest by foreign
investors, turning India into one of the fastest growing destinations for global investme nt
inflows. Foreign firms are setting up joint ventures and wholly owned enterprises in services
such as computer software, telecommunications, financial services, and tourism. The present
chapter examines the recent trends and pattern of foreign capital flows in India.

4.2 COMPONENTS OF FOREIGN CAPITAL IN INDIA

Foreign capital refers to the capital flows from resident entity of one country to the resident
entity of another country. The resident entity may be an individual, corporate firm or a
Government. In India, there are three important components of foreign capital flows :
4.2.1) Foreign Capital Investments
1. Foreign Capital Investments:

Foreign capital investments refer to investments made by an entity which is not the
resident of the country. In India there are two components of foreign capital Investments:
(i) Foreign Direct Investments (FDI)
(ii) Foreign Portfolio Investments (FPI)
(i) Foreign Direct Investments (FDI): FDI refers to the physical investments made by foreign
investors in the domestic country. The physical investments refer to the direct investments into
building, machinery and equipments. Reserve bank of India (RBI) defines FDI as a process
whereby resident of one country (i.e. home country) acquires ownership for the purpose of
controlling production, distribution and other activities of a firm in the another country.( i.e.
the host country). It reflects the lasting interest by the foreign direct investors in the entity or
enterprise of domestic economy. There exists a long-term relationship between the foreign
investor and the domestic enterprise. The foreign direct investors generally exert a high degree
of influence on the management of the entity. The direct investor can be an individual, public
or private enterprises (referred to multinational corporations or MNCs)) or Government. The
management influence is exerted if foreign investor holds significant shareholding or voting
power in domestic entity. FDI can be equity or debt investment. In India there are
three important element of FDI:
1. Equity investments by foreign investors;
2. Reinvested earnings i.e retained earning of FDI companies;
 3. Debt Investment (particularly the inter-corporate debt between related entities).
The important forms of FDI are investments through:
(i) Financial Collaboration
(ii) Joint Ventures and Technical Collaboration

(iii) Capital Markets

(iv) Private Placements.
MEANING OF FOREIGN DIRECT INVESTMENT

Foreign Direct Investment (FDI) has been affecting global business affairs for decades. A
country, whether developed or developing, necessitates more FDI entry than other countries
because the FDI inflow may bring certain advantages such as capital accumulation, knowledge,
know-how transfer, and obtainment of updated technology. Thus, the entry of FDI into a host
country is expected to reveal positive aftermaths.

Foreign direct investment (FDI) is an investment made by a firm or individual in one country
into business interests located in another country. Generally, FDI takes place when an investor
establishes foreign business operations or acquires foreign business assets, includ ing
establishing ownership or controlling interest in a foreign company. Foreign direct investme nts
are distinguished from portfolio investments in which an investor merely purchases equities of
foreign-based.

Foreign direct investments are commonly made in open economies that offer a skilled
workforce and above-average growth prospects for the investor, as opposed to tightly regulated
economies. Foreign direct investment frequently involves more than just a capital investme nt.
It may include management or technology as well. The key feature of foreign direct investme nt
is that it establishes either effective control of, or at least substantial influence over, the decision
making of a foreign business.

METHODS OF FOREIGN DIRECT INVESTMENT

1.HORIZONTAL DIRECT INVESTMENTS

A horizontal direct investment refers to the investor establishing the same type of business
operation in a foreign country as it operates in its home country. For eg. A cell phone provider
based in the United States opening up stores in China.

2.VERTICAL DIRECT INVESTMENTS

A vertical investment is one in which different but related business activities from the
investor’s business activities from investor’s main business are established or acquired in a
foreign country, such as when a manufacturing company acquires an interest in a foreign
company that supplies parts or raw materials required for the manufacturing company to make
its products.

3. CONGLOMERATE DIRECT INVESTMENTS

A conglomerate direct investment is one where a company or individ ual makes a foreign direct
investment in a business that is unrelated to its existing business in its home country. Since this
type of investment involves entering an industry the investor has no previous experience in, it
often takes a joint venture with a foreign company already operating in foreign country.

IMPORTANCE OF FDI
1. FDI provides Capital

Foreign Direct Investment is expected to bring needed capital to developing countries. The
developing countries need higher investment to achieve increased targets of growth in nationa l
income. Since they cannot normally have adequate savings, there is a need to suppleme nt
savings of these countries from foreign savings. This can be done either through external
borrowings or through permitting and encouraging Foreign Direct Investment. Foreign Direct
Investment is an effective source of this additional capital and comes with its own risks.

2. FDI removes Balance of Payments Constraint

FDI provides ‘ inflow of foreign exchange resource and removes the constraints on balance of
payment. It can be seen that a large number of developing countries suffer from balance of
payments deficits for their demand for foreign exchange which is normally far in excess of
their ability to earn. FDI inflows by providing foreign exchange resources remove the
constraint of developing countries seeking higher growth rates. FDI has a distinct advantage
over the external borrowings considered from the balance of payments point of view. Loan
creates fixed liability. The governments or corporations have to repay. The resulting
international debt of the government and the corporation parts a fixed liability on balance of
payments. This means that they have to repay loans along with interest over a specific period.
In the context of FDI this fixed liability is not there. The foreign investor is expected to generate
adequate resources to finance outflows on account of the activity generated by the FDI. The
foreign investor will also bear the risk.

3. FDI brings Technology, Management and Marketing Skills

FDI brings along with it assets which are crucially either missing or scarce in developing
countries. These assets are technology and management and marketing skills without which
development cannot take place. This is the most important advantage of FDI. This advantage
is more important than bringing capital, which perhaps can be had from the international capital
markets and the governments.
4. FDI promotes Exports of Host Developing Country
Foreign direct investment promotes exports. Foreign enterprises with their global network of
marketing, possessing marketing information are in a unique position to exploit these strengths
to promote the exports of developing countries.

5. FDI provides Increased Employment:

Foreign enterprises by employing the nationals of developing countries provide employme nt.
In the absence of this investment, these employment opportunities would not have been
available to many developing countries.

Further, these employment opportunities are expected to be in relatively higher skill areas. FDI
not only creates direct employment opportunities but also through backward and forward
linkages, it is able generate indirect employment opportunities as well.

6. FDI results in Higher Wages

FDI also promotes higher wages. Relatively higher skilled jobs would receive higher wages.

7. FDI generates Competitive Environment in Host Country

Entry of foreign enterprises in domestic market creates a competitive environment compelling
national enterprise to compete with the foreign enterprises operating in the domestic market.
This leads to higher efficiency and better products and services. The Consumer may have a
wider choice.

DISADVANTAGES OF FDI

1. DISAPPEARANCE OF COTTAGE AND SMALL SCALE INDUSTRIES

Some of the products produced in cottage and village industries and also under small scale
industries had to disappear from the market due to the onslaught of the products coming from
FDIs. Example: Multinational soft drinks.

2. CONTRIBUTION TO THE POLLUTION

Foreign direct investments contribute to pollution problem in the country. The developed
countries have shifted some of their pollution-borne industries to the developing countries. The
major victim is automobile industries. Most of these are shifted to developing countries and
thus they have escaped pollution.

3. EXCHANGE CRISIS
Foreign Direct Investments are one of the reason for exchange crisis at times. During the year
2000, the Southeast Asian countries experienced currency crisis because of the presence of
FDls. With inflation contributed by them, exports have dwindled resulting in heavy fall in the
value of domestic currency. As a result of this, the FDIs started withdrawing their capital
leading to an exchange crisis. Thus, too much dependence on FDls will create exchange crisis.
4. CULTURAL EROSION
In all the countries where the FDls have made an inroad, there has been a cultural shock
experienced by the local people, adopting a different culture alien to the country. The domestic
culture either disappears or suffers a setback. This is felt in the family structure, social setup
and erosion in the value system of the people. Importance given to human relations, hither to
suffers a setback with the hi-fi style of living.

5. POLITICAL CORRUPTION
In order to capture the foreign market, the FDIs have gone to the extent of even corrupting the
high officials or the political bosses in various countries. Lockheed scandal of Japan is an
example. In certain countries, the FDIs influence the political setup for achieving their personal
gains. Most of the Latin American countries have experienced such a problem. Example: Drug
trafficking, laundering of money, etc.

6. INFLATION IN THE ECONOMY

The presence of FDIs has also contributed to the inflation in the country. They spend lot of
money on advertisement and on consumer promotion. This is done at the cost of the consumers
and the price is increased. They also form cartels to control the market and exploit the
consumer. The biggest world cartel, OPEC is an example of FDI exploiting the consumers.

7.TRADE DEFICIT

The introduction of TRIPs (Trade Related Intellectual Property Rights) and TRIMs (Trade
Related Investment Measures) has restricted the production of certain products in other
countries. For example, India cannot manufacture certain medicines without paying royalties
to the country which has originally invented the medicine. The same thing applies to seeds
which are used in agriculture. Thus, the developing countries are made to either import the
products or produce them through FDIs at a higher cost. WTO (World Trade Organization) is
in favour of FDIs.

8.WORLD BANK AND LMF AID

Some of the developing countries have criticized the and (International Monetary Fund) in
extending assistance. There is a discrimination shown by these international agencies. Only
those countries which accommodate FDIs will receive more assistance from these internatio na l
institutions.

9.CONVERTIBILITY OF CURRENCY

FDIs are insisting on total convertibility of currencies in under-developed countries as a

prerequisite for investment. This may not be possible in many countries as there may not be
sufficient foreign currency reserve to accommodate convertibility. In the absence of such a
facility, it is dangerous to allow the FDIs as they may withdraw their investments the moment,
they find their investments unprofitable.
(ii) Foreign Portfolio Investments (FPI): FPI refers to the short-term investments by foreign
entity in the financial markets. These are indirect investments and include investment in
tradable securities, such as shares, bonds, debenture of the companies. Foreign Portfolio
investors don’t exert management control on the enterprise in which they invest. The important
objective of FPI is the appreciation of the capital investment regardless of any long- term
relationship with enterprise (IMF, Balance of Payment Manual). These investments are made
with short-term speculative gains. There are three kinds of FPI in India:
a) Foreign Institutional Investment: These are the investments made by foreign
institutions like pension funds, foreign mutual funds etc. in the financial markets.
b) Funds raised through Global Depository Receipts or American Depository
Receipts (GDRs/ADRs): GDRs and ADRs are instruments which signify the
purchase of share of Indian companies by foreign investors or American investors
respectively.
c) Off-shore funds: The schemes of mutual funds that are launched in the foreign
country.
FOREIGN DIRECT INVESTMENTS (FDI) VS. FOREIGN PORTFOLIO
INVESTMENT (FPI)
The relative significance of two important components of foreign investments can be
summarized as follows:
(a) FDI accelerates growth process mainly due to superior technology transfers and greater
competition that generally accompany FDI. Domestic firms improve R&D to sustain
competition with foreign firms or multinational firms. FDI also improves export
competitiveness of the country. So, FDI has a positive spillover effects on the
economy. FPI enables the country to use huge pooled foreign funds and directly
doesn’t involve any kind of superior technology or managerial transfers. Thus FPI has
limited spillover effects than FDIs.
(b) FDI reflects seriousness and commitment on part of foreign investors since FDI causes
high initial set up cost and higher exit costs in terms of difficulty in selling stake in the
firm. Thus foreign direct investor stay invested forlong-term in the country and so
help to improve growth prospects of the country. FPI is guided by short-termga ins
and involves problems to exit the country. FPI tends to be more volatile than direct
investments.The sudden FPI outflows at the time of domestic crisis may disrupt the
development process of the country.
(c) Portfolio investors due to their short-term perspective may indulge into speculative
activities in the domestic financial market and may cause problems for the domestic
investors.
(d) FDIs are directly managed by foreign owners FPI on the other hand are managed by
“outside managers”. So FDI results into better asset management.
(e) The increased FDI flows give positive signal about the long-term prospects of domestic
economy and greater creditability of the country. A very substantial amount of FPI of
short-term nature depicts risk in the domestic economy.
4.2.2) Foreign Aid

External aid refers to the concessional foreign finance with flexible terms and
conditions. It may be in the form of long term concessional debt or grants (doesn’t involves
any repayment obligations). The tenure of the aid is generally very long. The
important sources of foreign aid in India are:
(i) Official Aid:
It is given by foreign governments or international official bodies such World Bank,
International Monetary Fund (IMF), Asian Development Bank (ADB) etc. It can be:
(a)Bilateral Aid: Loans or grants under bilateral (i.e. between two countries) agreement.
(b)Multilateral Aid: loans or grants extended by multilateral (i.e. more than two countries)
agencies e.g. Loans from IMF, World Bank etc.
Further, official aid (Bilateral or Multilateral) can be Government Aid (i.e. aid that passes
through government) orNon-Government Aid (i.e. aid received by non-government bodies
directly from bilateral or multilateral agencies).
(ii) PRIVATE AID: It is the fund which is received from private individuals, firms or
institutions.
External aid may also be distinguished as tied aid or untied aid. The tied aid is given with
conditions in terms of its use e.g for the purchase of goods for specific purpose or to be spent
on specific country. The untied aid can be used freely by the recipient country. Foreign aid
allows an access to foreign funds without putting pressures of their repayment. In the initia l
growth process the country having saving- investment gap, fails to attract enough private
foreign capital. Foreign aid helps to reduce the financial constraints on the growth of the
economy. In the absence of foreign aid country would have to rely on commercial borrowings
that involve huge interest burden on the country. Foreign aid can be used to create infrastruc ture
and basic industries and thus helps to contribute towards economic development of the country.
There are certain problems with the use of foreign aid discussed as follows:

(a) Political Pressures: Heavy dependence on foreign aid may introduce politica l
compulsions on the economy. Donor countries may put certain pressures and lead to
decisions not in the interest of the country. Sanctions imposed against for taking nuclear
test is a recent example of pressures that developed nations imposed on developing
nations.

(b) Uncertainty of Aid: Aid moves at the convenience of the donor countries. The delay or
uncertainty in the aid may cause harmful consequences on the projects dependent upon
aid.
(c) Restrictive Use: Aid generally involves conditions upon its use and may result in
undesirable production and consumption pattern in the economy. For example donor
countries may insist upon purchase from specified sellers. The foreign suppliers may
charge higher price and cause high cost of the project. Tied aid may not allow the free-
use of funds in the sectors important for the development process of the country. The real
cost of aid appears to be high due to conditions imposed on its use.
(d) Low Utilization Rate: It is ironical that developing nations having scarcity of capital and
resources are not able to utilize the total amount of sanctioned aid. This may be due to
the lack of complementary domestic resources or experience to use aid. Further the
procedural delay also cause low aid utilization.

(e) Complacent domestic initiatives: Foreign aid brings moral hazards in the recipient
country. It results in the complacent behavior on part of government to improve resource
generation.
 CHAPTER -5
WORLD TRADE ORGANISATION
5.1 INTRODUCTION
The World Trade Organization (WTO) is an intergovernmental organization which
regulates international trade. The WTO officially commenced on 1 January 1995 under
the Marrakesh Agreement, signed by 123 nations on 15 April 1994, replacing the General
Agreement on Tariffs and Trade (GATT), which commenced in 1948. The WTO deals with
regulation of trade between participating countries by providing a framework for negotiating
trade agreements and a dispute resolution process aimed at enforcing participants' adherence
to WTO agreements, which are signed by representatives of member governments and ratified
by their parliaments. Most of the issues that the WTO focuses on derive from previous trade
negotiations, especially from the Uruguay Round (1986–1994).
The WTO is attempting to complete negotiations on the Doha Development Round, which was
launched in 2001 with an explicit focus on developing countries. As of June 2012, the future
of the Doha Round remained uncertain: the work programme lists 21 subjects in which the
original deadline of 1 January 2005 was missed, and the round is still incomplete. The conflict
between free trade on industrial goods and services but retention of protectionism on farm
subsidies to domestic agricultural sector (requested by developed countries) and
the substantiation of fair trade on agricultural products (requested by developing countries)
remain the major obstacles. This impasse has made it impossible to launch new WTO
negotiations beyond the Doha Development Round. As a result, there have been an increasing
number of bilateral free trade agreements between governments. As of July 2012, there were
various negotiation groups in the WTO system for the current agricultural trade negotiatio n
which is in the condition of stalemate.
The WTO's current Director-General is Roberto Azevêdo, who leads a staff of over 600 people
in Geneva, Switzerland. A trade facilitation agreement known as the Bali Package was reached
by all members on 7 December 2013, the first comprehensive agreement in the organizatio n's
history.
5.2 THE GATT AND FORMATION OF WTO

Following the end of second world-war, the winning side, the United States and its allies,
decided that a prosperous and lasting peace depended not only on the creation of a stable
international political order based on principles embedded in the United Nations (UN) Charter,
but also on the creation of a stable liberal international economic order. Therefore, the victor
nations sought to create institutions that would eliminate the causes of war. Their princip les
were to resolve or prevent war through the United Nations and to

eliminate the economic causes of war by establishing three international economic institutio ns.
The three institutions were: The International Monetary Fund (IMF), The World Bank and The
International Trade Organization (ITO). The 3 were known as the Bretton Woods. The
economic philosophy of these Bretton Woods institutions was classical economic
neoliberalism.
Originally the ITO which was negotiated in Havana, Cuba was planned to be the formal
trade management global organization in the post second world-war era. The USA Did not
object to the establishment of the World Bank and the IMF but refused to agree to the ITO on
the grounds that it would cede too much sovereignty to an international body. Thus, politica l
disagreements especially led by USA ultimately spelled the end of the ITO as a formal
organization, yet participants considered trade issues important enough to resurrect portions of
the ITO charter and transform them into a less formal, free standing trade agreement known as
the General Agreement on Tariffs and Trade. (GATT).
The General Agreement on Tariffs and Trade (GATT), which was signed in 1947, is a
multilateral agreement regulating trade among about 150 countries. According to its preamble,
the purpose of the GATT is the "substantial reduction of tariffs and other trade barriers and the
elimination of preferences, on a reciprocal and mutually advantageous basis." The GATT was
established in 1948 as a body to govern the rules of the international trading system. It mainly
provided the international trading rules and regulations for the world trade to the economies.
GATT presided over periods saw unprecedented growth in international trade and commerce.
During the first twenty odd years of its existence, members of GATT focused almost
entirely on negotiations aimed at reducing tariffs, taxes on imported goods. Several rounds of
negotiations, accomplished substantial tariff reductions in the manufacturing sector among the
then most industrialized states, the United States, the member states of the European Economic
Community, the UK and Japan.

Over the years, GATT played effective and continued role in reducing tariffs and other
trade barriers. But all was not well. As time passed new problems arose. Mainly, combined
with a series of economic recessions in the 1970s and early 1980s, drove governments to devise
other forms of protection for sectors facing increased foreign competition. High rates of
unemployment and constant factory closures led governments in Western Europe and North
America to seek bilateral market-sharing arrangements with competitors and to embark on a
subsidies race to maintain their holds on agricultural trade.
By the 1970s, with tariffs on most goods substantially reduced, and the world falling into a
depression and inflation cycle due to the twin oil price shocks, states began implementing other
non-tariff policies as a way to protect their industries from import competition. Governme nt
policies promoting industry subsidization, export credits and legislative codes and standards as
import obstructions, collectively came to be known as non-tariff barriers to trade.

These changes undermined GATT’s credibility and effectiveness. The Tokyo Round in
the 1970s was an attempt to tackle some of these but its achievements were limited. This was
a sign of difficult time and these changes undermined GATT’s credibility and effectiveness.
The problem was not just a deteriorating trade policy environment. By the early 1980s
the General Agreement was clearly no longer as relevant to the realities of world trade as it had
been in the 1940s. For a start, world trade had become far more complex and important than
40 years before: the globalization of the world economy was underway, trade in services not
covered by GATT rules was of major interest to more and more countries, and internatio na l
investment had expanded.

The expansion of services trade was also closely tied to further increases in world
merchandise trade. Even GATT’s institutional structure and its dispute settlement system were
causing concern. These and other factors convinced GATT members that a new effort to
reinforce and extend the multilateral system should be attempted. That effort resulted in the
Uruguay Round, the Marrakesh Declaration, and the creation of the WTO.
The momentum of trade liberalization helped ensure that trade growth consistently out-
paced production growth throughout the GATT era, a measure of countries’ increasing ability
to trade with each other and to reap the benefits of trade. The rush of new members during the
Uruguay Round demonstrated that the multilateral trading system was recognized as an anchor
for development and an instrument of economic and trade reform.
The last and largest GATT round, was the Uruguay Round which lasted from 1986 to
1994. The seeds of the Uruguay Round were sown in November 1982 at a ministerial meeting
of GATT members in Geneva. Although the ministers intended to launch a major new
negotiation, the conference stalled on agriculture and was widely regarded as a failure. In fact,
the work programme that the ministers agreed formed the basis for what was to become the
Uruguay Round negotiating agenda.
Nevertheless, it took four more years of exploring, clarifying issues and painstaking
consensus-building, before ministers agreed to launch the new round. They did so in September
1986, in Punta del Este, Uruguay. They eventually accepted a negotiating agenda that covered
virtually every outstanding trade policy issue. The talks were going to extend the trading system
into several new areas, notably trade in services and intellectual property, and to reform trade
in the sensitive sectors of agriculture and textiles. All the original GATT articles were up for
review. It was the biggest negotiating mandate on trade ever agreed, and the ministers gave
themselves four years to complete it.
Two years later, in December 1988, ministers met again in Montreal, Canada, for what
was supposed to be an assessment of progress at the round’s half-way point. The purpose was
to clarify the agenda for the remaining two years, but the talks ended in a deadlock that was
not resolved until officials met more quietly in Geneva the following April.
Despite the difficulty, during the Montreal meeting, ministers did agree a package of
early results. These included some concessions on market access for tropical products mainly
aimed at assisting developing countries as well as a streamlined dispute settlement system, and
the Trade Policy Review Mechanism which provided for the first comprehensive, systematic
and regular reviews of national trade policies and practices of GATT members. The round was
supposed to end when ministers met once more in Brussels, in December 1990. But they
disagreed on how to reform agricultural trade and decided to extend the talks. The Uruguay
Round entered its bleakest period.
 Despite the poor political outlook, a considerable amount of technical work continued,
leading to the first draft of a final legal agreement. This draft “Final Act” was compiled by the
then GATT Director-General, Arthur Dunkel, who chaired the negotiations at officials’ level.
It was put on the table in Geneva in December 1991. The text fulfilled every part of the Punta
del Este mandate, with one exception — it did not contain the participating countries’ lists of
commitments for cutting import duties and opening their services markets. The draft became
the basis for the final agreement.
Over the following two years, the negotiations lurched between impending failure, to
predictions of imminent success. Several deadlines came and went. New points of major
conflict emerged to join agriculture: services, market access, anti-dumping rules, and the
proposed creation of a new institution. Differences between the United States and European
Union became central to hopes for a final, successful conclusion.
In November 1992, the US and EU settled most of their differences on agriculture in a
deal known informally as the “Blair House accord”. By July 1993, US, EU, Japan and Canada
announced significant progress in negotiations on tariffs and related subjects (market access).
It took until 15 December 1993 for every issue to be finally resolved and for negotiations on
market access for goods and services to be concluded. On 15 April 1994, the deal was signed
by ministers from most of the 123 participating governments at a meeting in Marrakesh,
Morocco which finally led to the formation of WTO. The WTO came into existence on
1st January 1995.
5.3 THE WORLD TRADE ORGANIZATION (WTO)
The World Trade Organization (WTO) which came into existence on 1 st January, 1995 mainly
deals with the rules of trade between nations at a global or near-global level. The WTO is the
only global international organization dealing with the rules of trade between nations. At its
heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations
and ratified in their parliaments. The goal is to help producers of goods and services, exporters,
and importers conduct their business.
More specifically, WTO is an organization for liberalizing trade where it provides a
forum for governments of different economies to negotiate trade agreements between them.
Unlike, GATT its agreements now cover trade in services, and in traded inventions, creations
and designs (intellectual property).
The WTO provides a forum for negotiating agreements aimed at reducing obstacles to
international trade and ensuring a level playing field for all, thus contributing to economic
growth and development. The WTO also provides a legal and institutional framework for the
implementation and monitoring of these agreements, as well as for settling disputes arising
from their interpretation and application. The current body of trade agreements comprising the
WTO consists of 16 different multilateral agreements (to which all WTO members are parties)
and two different plurilateral agreements (to which only some WTO members are parties). The
specific activities of the WTO are as follows:
1) Negotiating the reduction or elimination of obstacles to trade such as import tariffs,
other barriers to trade and agreeing on rules governing the conduct of international trade
viz., antidumping, subsidies, product standards.
2) Administering and monitoring the application of the WTO's agreed rules for trade in
goods, trade in services, and trade-related intellectual property rights.
3) Monitoring and reviewing the trade policies of our members, as well as ensuring
transparency of regional and bilateral trade agreements.
4) Settling disputes among our members regarding the interpretation and application of
the agreements.
5) Building capacity of developing country government officials in international trade
matters.
6) Assisting the process of accession of some 30 countries who are not yet members of
the organization.
7) Conducting economic research and collecting and disseminating trade data in support
of the WTO's other main activities.
The WTO's founding and guiding principles remain the pursuit of open borders, the
guarantee of most-favoured- nation principle and non-discriminatory treatment by and among
members, and a commitment to transparency in the conduct of its activities. The opening of
national markets to international trade, with justifiable exceptions or with adequate flexibilities,
will encourage and contribute to sustainable development, raise people's welfare, reduce
poverty, and foster peace and stability. At the same time, such market opening must be
accompanied by sound domestic and international policies that contribute to economic growth
and development according to each member's needs and aspirations.

Over the past 60 years, the WTO, which was established in 1995, and its predecessor
organization the GATT have helped to create a strong and prosperous international trading
system, thereby contributing to unprecedented global economic growth. The WTO currently
has 153 members, of which 117 are developing countries or separate customs territories. WTO
activities are supported by a Secretariat of some 700 staff, led by the WTO Director General.
The Secretariat is located in Geneva, Switzerland, and has an annual budget of approximate ly
$180 million. The three official languages of the WTO are English, French and Spanish.
Decisions in the WTO are generally taken by consensus of the entire membership. The
highest institutional body is the Ministerial Conference, which meets roughly every two years.
A General Council conducts the organization's business in the intervals between Minister ia l
Conferences. Both of these bodies comprise all members. Specialized subsidiary bodies such
as Councils, Committees and Sub-committees also comprising all members administer and
monitor the implementation by members of the various WTO agreements.
5.4 WTO AND THE PRINCIPLE OF TRADING SYSTEM
The WTO agreements are lengthy and complex because they are legal texts covering a wide
range of activities. They deal with: agriculture, textiles and clothing, banking,
telecommunications, government purchases, industrial standards and product safety, food
sanitation regulations, and intellectual property. But a number of simple, fundame nta l
principles run throughout all of these documents. These principles are the foundation of the
multilateral trading system.

The following are the principles of the multilateral trading system governed by the
WTO:
1) Most-favoured-nation (MFN): Under the WTO agreements, countries cannot
normally discriminate between their trading partners. Grant someone a special favour
such as a lower customs duty rate for one of their products and you have to do the same
for all other WTO members. This principle is known as most-favoured-nation (MFN)
treatment. However, some exceptions are allowed. For example, countries can set up a
free trade agreement that applies only to goods traded within the group discrimina ting
against goods from outside. Or they can give developing countries special access to
their markets. Or a country can raise barriers against products that are considered to be
traded unfairly from specific countries. And in services, countries are allowed, in
limited circumstances, to discriminate. But the agreements only permit these exceptions
under strict conditions. In general, MFN means that every time a country lowers a trade
barrier or opens up a market, it has to do so for the same goods or services from all its
trading partners whether rich or poor, weak or strong.
2) National Treatment: Imported and locally-produced goods should be treated equally
at least after the foreign goods have entered the market. The same should apply to
foreign and domestic services, and to foreign and local trademarks, copyrights and
patents. This principle of “national treatment” that is giving others the same treatment
as one’s own nationals is found in all the three main WTO agreements (Article 3 of
GATT, Article 17 of GATS and Article 3 of TRIPS), although once again the princip le
is handled slightly differently in each of these. National treatment only applies once a
product, service or item of intellectual property has entered the market. Therefore,
charging customs duty on an import is not a violation of national treatment even if
locally-produced products are not charged an equivalent tax.
3) Freer Trade: Lowering trade barriers is one of the most obvious means of encouraging
trade. The barriers concerned include customs duties and or tariffs and measures such
as import bans or quotas that restrict quantities selectively.
4) Predictability: Sometimes, promising not to raise a trade barrier can be as important
as lowering one, because the promise gives businesses a clearer view of their future
opportunities. With stability and predictability, investment is encouraged, jobs are
created and consumers can fully enjoy the benefits of competition choice and lower
prices. The WTO’s multilateral trading system is an attempt by governments to make
the business environment stable and predictable. Many WTO agreements require
governments to disclose their policies and practices publicly within the country or by
notifying the WTO. The regular surveillance of national trade policies through the
Trade Policy Review Mechanism provides a further means of encouraging transparency
both domestically and at the multilateral level.
5) Promoting Fair Competition: The WTO is sometimes described as a “free trade”
institution, but that is not entirely accurate. The system does allow tariffs and, in limited
circumstances, other forms of protection. More accurately, it is a system of rules
dedicated to open, fair and undistorted competition. The rules on non-discriminatio n,
MFN and national treatment are designed to secure fair conditions of trade. Many of
the other WTO agreements aim to support fair competition: in agriculture, intellectua l
property, services, for example.
6) Encouraging Development and Economic Reform: The WTO system contributes to
development. On the other hand, developing countries need flexibility in the time they
take to implement the system’s agreements. And the agreements themselves inherit the
earlier provisions of GATT that allow for special assistance and trade concessions for
developing countries for higher growth and development.
5.5 DECISION MAKING PROCESS
The WTO is run by its member governments. All major decisions are made by the membership
as a whole, either by ministers who meet at least once every two years or by their ambassadors
or delegates who meet regularly in Geneva. Decisions are normally taken by consensus. In this
respect, the WTO is different from some other international organizations such as the World
Bank and International Monetary Fund. In the WTO, power is not delegated to a board of
directors or the organization’s head. When WTO rules impose disciplines on countries’
policies, that is the outcome of negotiations among WTO members. The rules are enforced by
the members themselves under agreed procedures that they negotiated, including the possibility
of trade sanctions. But those sanctions are imposed by member countries, and authorized by
the membership as a whole. This is quite different from other agencies whose bureaucracies
can, for example, influence a country’s policy by threatening to withhold credit.
Reaching decisions by consensus among all the members can be difficult. Its main
advantage is that decisions made this way are more acceptable to all members. And despite the
difficulty, some remarkable agreements have been reached. Nevertheless, proposals for the
creation of a smaller executive body perhaps like a board of directors each representing
different groups of countries are heard periodically. But for now, the WTO is a member-drive n,
consensus-based organization. So, the WTO belongs to its members. The countries make their
decisions through various councils and committees, whose membership consists of all WTO
members.
Topmost is the ministerial conference which has to meet at least once every two years.
The Ministerial Conference can take decisions on all matters under any of the multilateral trade
agreements.

5.6 PRINCIPLES
The agreements of WTO cover everything from trade in goods, services and agricultur a l
products. These agreements are based on the principles mentioned as below:
(i) Non-Discrimination:
 This principle requires every member country must treat all its trading partners equally
without any discrimination. It means that if a country offers any special concession to one
trading partner, such concessions need to be extended to its other trading partners as well in
entirety. This principle effectively gets translated into "MFN" or the Most Favored Nation.

(ii) Reciprocity:
This Principle reflects that any concession extended by one country to another need to be
reciprocated with an equal concession such that there is not a big difference in the countries
payments situation. This was further relaxed for developing countries facing severe Balance of
Payments crisis. This principle along with the first principle would actually result in more and
more liberalization of the world trade as any country relaxing its trade barriers need to extend
it to all other members and this would be reciprocated.
(iii) Transparency:
This principle requires that there is transparency in the domestic trade policies of member
countries. The member countries are required to sequentially phase out the tariff barriers and
non-tariff barriers through negotiations.
These principles are designed to serve the purpose of freer and fair trade and also to encourage
competitive environment in the global market.
5.7 IMPLICATIONS OF WTO ON MEMBERS COUNTRIES
The World Trade organization was established with an objective of enhancing the free and fair
trade, improve growth rate of world trade by encouraging members to reduce trade barriers and
to increase the overall prosperity in the global economies. The implication of WTO can be
mentioned as follows:
- Promote Peace in the world trade as the disputes are handled at WTO forum
constructively.
- Freer trade reduces the costs of living.
- Wider choice of products and services.
- Promotes Economic Growth as result of increased trade.
- Encourages Efficiency
5.8 WTO AND INDIA

India is a founder member of World Trade Organization and also treated as the part of
developing countries group for accessing the concessions granted by the organization. As a
result, there are several implications for India for the various agreements that are signed under
WTO discussed as follows:
(i) Reduction of Tariff and Non-Tariff Barriers: The agreement involves an overall
reduction of peak and average tariffs on manufactured products and phasing out the quantitative
restrictions over a period. The important implication is that the firms that have competitive
advantage would be able to survive in the long run.
(ii) Trade Related Investment Measures (TRIMS): The agreement prohibits the host
country to discriminate the investment from abroad with domestic investment i.e. agreement
requires investment to be freely allowed by nations.
(iii)Trade Related Intellectual Property Rights (TRIPS): An intellectual property right
seeks to protect and provide legal recognition to the creator of the intangible illegal use of his
creation. This agreement includes several categories of property such as Patents, Copyrights,
Trademarks, Geographical indications, Designs, Industrial circuits and Trade secrets. Since the
law for these intangibles vastly varied between countries, goods and services traded between
countries which incorporated these intangibles faced severe risk of infringement. Therefore the
agreement stipulated some basic uniformity of law among all trading partners. This require d
suitable amendment in the domestic International Property Rights (IPR) laws of each country
over a period of time. As a result Patents Act, Trade and Merchandise Mark Act and the
Copyright Right Act were amended in India. The main impact of this is on industries such as
pharma and bio-technology. Further, the technology transfer from abroad is expected to
become costly and difficult.
(iv)Agreement on Agriculture (AOA): The agreement on agriculture broadly deals with
providing market access, reduction of export subsidies and government subsidies on agriculture
products by member countries. The reduction of tariffs and subsidy in export and import items
would open up competition and provide a better access to Indian products abroad.
(v) Agreement on Sanitary and psyto-sanitary measures (SPM): This agreement refers to
restricting exports of a country that do not comply with the international standards of
germs/bacteria etc. Since allowing such products inside the country, there would be spread of
disease and pest in the importing country. The implication of these agreements is that there is
an urgent need to educate the exporters regarding the changing scenario and standards at the
international arena especially in food processing, marine food and other packed food industr ies.
(vi) Multi-Fiber Agreement (MFA): This agreement is dismantled with effect from 1 January
2005. The result was removal of quantitative restrictions (QRs) on the textile imports in several
European countries. As a consequence a huge textile market is opened up for developing
countries like India. In order to take advantage of opening up better preparedness is required
in terms of modernization, standardization, cost efficiency, and customization to meet
challenges of foreign customers.
Besides these major agreements there are several other agreements such as agreement
on Market Access, which propagates free market access to products and reduction of tariff and
non-tariff barriers; agreement to have Safeguard Measures if there is an import surge and it
is liable to affect the domestic industries in the transition economies. These measures can
include imposing Quantitative Restrictions (QRs) for a certain period and also imposing tariffs
on the concerned products, Agreement on Counter-Veiling Duties (CVD), Anti-Dumping
Duty (ADD) against imported products if the charges of Dumping are proved against the
exporting country.
5.9 FEATURES OF WTO
  WTO it is a legal entity.

 Unlike the International Monetary Fund (IMF) and the World Bank (WB) it is not an
agent of the United Nations.

 Unlike the IMF and the World Bank, there is no weighted voting, but all the WTO
members have equal rights.

 The agreements under the WTO are permanent and binding to the member countries.

 The WTO dispute settlement system is based not on dilatory but automatic mechanis m.
It is also quicker and binding on the members. As such, the WTO is a powerful body.

 The WTOs approach is rule- based and time-bound.

 The WTOs have a wider coverage. It covers trade in goods as well as services.

 The WTOs have a focus on trade-related aspects of intellectual property rights and
several other issues of agreements.

 The WTO is a huge organisational body with a large secretariat.

5.10 STRUCTURE OF WTO

The Ministerial Conference (MC) is at the top of the structural organisation of the WTO. It is
the supreme governing body which takes ultimate decisions on all matters. It is constituted by
representatives of (usually, Ministers of Trade) all the member countries.

The General Council (GC) is composed of the representatives of all the members. It is the real
engine of the WTO which acts on behalf of the MC. It also acts as the Dispute Settlement Body
as well as the Trade Policy Review Body.

There are three councils, viz.: the Council for Trade in Services and the Council for Trade-
Related Aspects of Intellectual Property Rights (TRIPS) operating under the GC. These
councils with their subsidiary bodies carry out their specific responsibilities

Further, there are three committees, viz., the Committee on Trade and Development (CTD),
the Committee on Balance of Payments Restrictions (CBOPR), and the Committee on Budget,
Finance and Administration (CF A) which execute the functions assigned to them by e WTO
Agreement and the GC.
The administration of the WTO is conducted by the Secretariat which is headed by the Director
General (DG) appointed by the MC for the tenure of four years. He is assisted by the four
Deputy Directors from different member countries. The annual budget estimates and financ ia l
statement of the WTO are presented by the DG to the CBFA for review and recommendatio ns
for the final approval by the GC.

5.11 OBJECTIVES OF THE WTO

The purposes and objectives of the WTO are spelled out in the preamble to the Marrakesh
Agreement.

In a nutshell, these are:

1. To ensure the reduction of tariffs and other barriers to trade.

2. To eliminate discriminatory treatment in international trade relations.

3. To facilitate higher standards of living, full employment, a growing volume of real income
and effective demand, and an increase in production and trade in goods and services of the
member nations.

4. To make positive effect, which ensures developing countries, especially the least developed
secure a level of share in the growth of international trade that reflects the needs of their
economic development.

5. To facilitate the optimal use of the world’s resources for sustainable development.

6. To promote an integrated, more viable and durable trading system incorporating all the
resolutions of the Uruguay Round’s multilateral trade negotiations.

Above all, to ensure that linkages trade policies, environmental policies with sustainab le
growth and development are taken care of by the member countries in evolving a new economic
order.

5.12 FUNCTIONS OF THE WTO

The WTO consisting a multi-faced normative framework: comprising institutional substantive
and implementation aspects.

The major functions of the WTO are as follows:

1. To lay-down a substantive code of conduct aiming at reducing trade barriers including tariffs
and eliminating discrimination in international trade relations.

2. To provide the institutional framework for the administration of the substantive code which
encompasses a spectrum of norms governing the conduct of member countries in the arena of
global trade.

3. To provide an integrated structure of the administration, thus, to facilitate the

implementation, administration and fulfilment of the objectives of the WTO Agreement and
other Multilateral Trade Agreements.

4. To ensure the implementation of the substantive code.

5. To act as a forum for the negotiation of further trade liberalisation.

6. To cooperate with the IMF and WB and its associates for establishing a coherence in trade
policy-making.

7. To settle the trade-related disputes.

5.13 WTO’S EVOLVING ROLE
WTO comprises of 147 member nations and accounts for approximately 97% of world trade
and is the only international organization dealing with the global rules of trade between
nations. As mentioned, the central objective of the WTO is to ensure that trade flows as
smoothly, predictably and freely as possible by encouraging the liberalization of multinatio na l
trade in goods, services and intellectual property. The main functions characterizing the WTO
are designed to achieve the central objective of regulating international trade. The strengths of
the WTO, many of which are the very reasons for its establishment, embrace the benefits of
free trade and a rules-based organization.
The WTO assigns benefits to promoting a multilateral trading system many of which
are reasons for the WTO’s establishment. The benefits are listed below:
1. The WTO being a system of international governance contributes to international peace.
2. WTO has the power to settle disputes and create agreements that bind members; an
underlying strength of the WTO is preventing trade disputes evolving into war.
3. WTO plays a very crucial role in reducing inequality, the product of a rules based
organization and non-discrimination. Given agreements are derived from consensus both
developed and developing countries have equal contribution in decision making and
settling of disputes.
4. Assisting developing and transition economies, where, the WTO Secretariat, alone or in
cooperation with other international organizations, conducts missions and seminars and
provides specific, practical technical cooperation for governments and their officia ls
dealing with accession negotiations, implementing WTO commitments or seeking to
participate effectively in multilateral negotiations.
5. The WTO Secretariat also provides training courses. These take place in Geneva twice a
year for officials of developing countries. Since their inception in 1955 and up to the end
of 1994, the courses have been attended by nearly 1400 trade officials from 125 countries
and 10 regional organizations. Since 1991, special courses have been held each year in
Geneva for officials from the former centrally-planned economies in transition to market
economies.
6. An important aspect of the WTO's mandate is its role to cooperate with the Internatio na l
Monetary Fund, the World Bank and other multilateral institutions to achieve greater
coherence in global economic policy-making.

5.14 ADVANTAGES OF WTO

1. Helps promote peace within nations: Peace is partly an outcome of two of the most
fundamental principle of the trading system; helping trade flow smoothly and providing
countries with a constructive and fair outlet for dealing with disputes over trade issues.
Peace creates international confidence and cooperation that the WTO creates and
reinforces.
 2. Disputes are handled constructively: As trade expands in volume, in the numbers of
products traded and in the number of countries and company trading, there is a greater
chance that disputes will arise. WTO helps resolve these disputes peacefully and
constructively. If this could be left to the member states, the dispute may lead to serious
conflict, but lot of trade tension is reduced by organizations such as WTO.
3. Rules make life easier for all: WTO system is based on rules rather than power and
this makes life easier for all trading nations. WTO reduces some inequalities giving
smaller countries more voice, and at the same time freeing the major powers from the
complexity of having to negotiate trade agreements with each of the member states.
4. Free trade cuts the cost of living: Protectionism is expensive, it raises prices, and
WTO lowers trade barriers through negotiation and applies the principle of non-
discrimination. The result is reduced costs of production (because imports used in
production are cheaper) and reduced prices of finished goods and services, and
ultimately a lower cost of living.
5. It provides more choice of products and qualities: It gives consumer more choice
and a broader range of qualities to choose from.
6. Trade raises income: Through WTO trade barriers are lowered and this increases
imports and exports thus earning the country foreign exchange thus raising the country's
income.
7. Trade stimulates economic growth: With upward trend economic growth, jobs can
be created and this can be enhanced by WTO through careful policy making and powers
of freer trade.
8. Basic principles make life more efficient: The basic principles make the system
economically more efficient and they cut costs. Many benefits of the trading system are
as a result of essential principle at the heart of the WTO system and they make life
simpler for the enterprises directly involved in international trade and for the producers
of goods/services. Such principles include; non-discrimination, transparency, increased
certainty about trading conditions etc. together they make trading simpler, cutting
company costs and increasing confidence in the future and this in turn means more job
opportunities and better goods and services for consumers.
9. Governments are shielded from lobbying: WTO system shields the government from
narrow interest. Government is better placed to defend themselves against lobbying
from narrow interest groups by focusing on trade-offs that are made in the interests of
everyone in the economy.
10. The system encourages good governance: The WTO system encourages good
government. The WTO rules discourage a range of unwise policies and the commitme nt
made to liberalize a sector of trade becomes difficult to reverse. These rules reduce
opportunities for corruption.

5.15 DISADVANTAGES OF WTO

1. The WTO is fundamentally undemocratic: The policies of the WTO impact all
aspects of society and the planet, but it is not a democratic, transparent institution. The
WTO rules are written by and for corporations with inside access to the negotiatio ns.
 For example, the US Trade Representative gets heavy input for negotiations from 17
"Industry Sector Advisory Committees" Citizen input by consumer, environmenta l,
human rights and labor organizations is consistently ignored. Even simple requests for
information are denied, and the proceedings are held in secret.
2. The WTO won’t make us safer: The WTO would like you to believe that creating a
world of free trade will promote global understanding and peace. On the contrary, the
domination of international trade by rich countries for the benefit of their individ ua l
interests’ fuels anger and resentment that make us less safe. To build real global
security, we need international agreements that respect people's rights to democracy
and trade systems that promote global justice.
3. The WTO tramples labour and human rights: WTO rules put the rights of
corporations to profit over human and labour rights. The WTO encourages a race to the
bottom in wages by pitting workers against each other rather than promoting
internationally recognized labour standards. The WTO has ruled that it is illegal for a
government to ban a product based on the way it is produced, such as with child labour.
It has also ruled that governments cannot take into account non-commercial values such
as human rights, or the behaviour of companies that do business with vicious
dictatorships such as Burma when making purchasing decisions.
4. The WTO Would Privatize Essential Services: The WTO is seeking to privatize
essential public services such as education, health care, energy and water. Privatiza tio n
means the selling off of public assets such as radio airwaves or schools to private
corporations, to run for profit rather than the public good. The WTO's General
Agreement on Trade in Services, or GATS, includes a list of about 160 threatened
services including elder and child care, sewage, garbage, park maintena nce,
telecommunications, construction, banking, insurance, transportation, shipping, postal
services, and tourism. In some countries, privatization is already occurring. Those least
able to pay for vital services working class communities and communities of color - are
the ones who suffer the most.
5. The WTO Is Destroying the Environment: The WTO is being used by corporations
to dismantle hard-won local and national environmental protections, which are attacked
as barriers to trade. The very first WTO panel ruled that a provision of the US Clean
Air Act, requiring both domestic and foreign producers alike to produce cleaner
gasoline, was illegal. The WTO declared illegal a provision of the Endangered Species
Act that requires shrimp sold in the US to be caught with an inexpensive device
allowing endangered sea turtles to escape. The WTO is attempting to deregulate
industries including logging, fishing, water utilities, and energy distribution, which will
lead to further exploitation of these natural resources.
6. The WTO is Killing People: The WTO's fierce defense of Trade Related Intellectua l
Property rights (TRIPs) patents copyrights and trademarks comes at the expense of
health and human lives. The WTO has protected for pharmaceutical companies right to
profit against governments seeking to protect their people's health by providing
lifesaving medicines in countries in areas like sub-saharan Africa, where thousands die
every day from HIV/AIDS. Developing countries won an important victory in 2001
when they affirmed the right to produce generic drugs (or import them if they lacked
production capacity), so that they could provide essential lifesaving medicines to their
populations less expensively. Unfortunately, in September 2003, many new conditio ns
were agreed to that will make it more difficult for countries to produce those drugs.
Once again, the WTO demonstrates that it favours corporate profit over saving human
lives.
 CHAPTER-6

GENERAL AGREEMENT ON TARIFFS AND TRADE

6.1 INTRODUCTION

The General Agreement on Tariffs and Trade was formed in 1948 after World War II. GATT is
an international trade treaty designed to boost countries' economic recovery following WWII.
GATT's primary purpose was to increase international trade by eliminating or reducing various
tariffs, quotas and subsidies while maintaining meaningful regulatio ns.

GATT became law on Jan. 1, 1948, and 23 countries signed it. GATT has been refined since
its initial introduction and eventually led to the creation of the World Trade Organization on
Jan. 1, 1995 with 123 member countries. The Council for Trade in Goods (Goods Council),
which is made up of representatives from all WTO member countries, is responsible for the
GATT. The current chair is Canadian Ambassador Stephen de Boer. The Goods Council has
10 committees that address subjects including agriculture, market access, subsidies and anti-
dumping measures.

The General Agreement on Tariffs and Trade was a free trade agreement between 23 countries
that eliminated tariffs and increased international trade. It was the first worldwide multilater a l
free trade agreement. It was in effect from June 30, 1948 until January 1, 1995. It ended when
it was replaced by the more robust World Trade Organization.

6.2 PURPOSE

The purpose of GATT was to eliminate harmful trade protectionism. That had sent global trade
down 65 percent during the Great Depression. GATT restored economic health to the world
after the devastation of the depression and World War II.

6.3 THREE PROVISIONS

GATT had three main provisions. The most important requirement was that each member must
confer most favored nation status to every other member. All members must be treated equally
when it comes to tariffs. It excluded the special tariffs among members of the Britis h
Commonwealth and customs unions. It permitted tariffs if their removal would cause serious
injury to domestic producers.

Second, GATT prohibited restriction on the number of imports and exports. The exceptions
were:

 When a government had a surplus of agricultural products.

 If a country needed to protect its balance of payments because its foreign exchange reserves
were low.
 Emerging market countries that needed to protect fledgling industries.

In addition, countries could restrict trade for reasons of national security. These
included protecting patents, copyrights, and public morals.

The third provision was added in 1965. That was because more developing countries joined
GATT, and it wished to promote them. Developed countries agreed to eliminate tariffs on
imports of developing countries to boost their economies. It was also in the stronger countries'
best interests in the long run. It would increase the number of middle-class consumers
throughout the world.

6.4 HISTORY

GATT grew out of the Bretton Woods Agreement. The summit at Bretton Woods also created
the World Bank and the International Monetary Fund to coordinate global growth.

The summit almost led to a third organization. It was to be the highly ambitious Internatio na l
Trade Organization. The 50 countries that started negotiations wanted it to be an agency within
the United Nations that would create rules, not just on trade, but also employment, commodity
agreements, business practices, foreign direct investment, and services. The ITO charter was
agreed to in March 1948, but the U.S. Congress and some other countries' legislatures refused
to ratify it. In 1950, the Truman Administration declared defeat, ending the ITO.

At the same time, 15 countries focused on negotiating a simple trade agreement. They agreed
on eliminating trade restrictions affecting $10 billion of trade or a fifth of the world’s total.
Under the name GATT, 23 countries signed the deal on October 30, 1947. It was put into force
on June 30,1948. GATT didn’t require the approval of Congress. It was technically just an
agreement under the provisions of U.S. Reciprocal Trade Act of 1934. It was only supposed to
be temporary until the ITO replaced it.

Throughout the years, rounds of further negotiations on GATT continued. The main goal was
to further reduce tariffs. In the mid-1960s, the Kennedy round added an Anti-
Dumping Agreement. The Tokyo round in the seventies improved other aspects of trade. The
Uruguay round lasted from 1986 to 1994 and created the World Trade Organization.

6.5 OBJECTIVES OF GATT

By reducing tariff barriers and eliminating discrimination in international trade, the

GATT aims at:
1. Expansion of international trade,

2. Increase of world production by ensuring full employment in the participating nations,

3. Development and full utilisation of world resources, and

4. Raising standard of living of the world community as a whole.

However, the articles of the GATT do not provide directives for attaining these objectives.
These are to be indirectly achieved by the GATT through the promotion of free (unrestric ted)
and multilateral international trade.

As such, the rules adopted by GATT are based on the following fundamental principles:

1. Trade should be conducted in a non-discriminatory way;

2. The use of quantitative restrictions should be condemned; and

3. Disagreements should be resolved through consultations.

In short, members of GATT agree to reduce trade barriers and to eliminate discrimination in
international trade so that multilateral and free trade may be promoted, leading to wider
dimensions of world trade and prosperity.

6.6 TARIFF NEGOTIATIONS

GATT recognises that tariffs are the main impediments to the growth of international trade.
Thus, the contracting parties are authorised to occasionally negotiate for a substantial reduction
of tariffs.

The following guidelines are to be followed in tariff negotiations:

1. Reduction in tariffs is to be negotiated on a reciprocal and mutually advantageous basis.

2. The negotiations should be either for reduction of tariffs or binding of low tariffs. Binding
of low tariffs is advantageous as traders will be assured of the continuance of low tariffs so that
they can take up business expansion and productive investments without any risk (of high
tariff).

3. Each member has to work in good faith and not raise its tariffs and other qualitative measures
with a view to increasing its bargaining power in tariff negotiations (when anticipated).

The GATT adopted the bilateral- multilateral technique of negotiating reduction in tariffs. It
was a bilateral method in the sense that the negotiations were carried on a nation-to-natio n
basis. In fact, the contracting parties formed pairs among themselves and each pair conducted
negotiations on a selective commodity-by- commodity basis. The negotiations had multilater a l
aspects also as the tariff reductions agreed within bilateral pairs of negotiating parties were
made generally applicable to all contracting parties through the ‘most-favoured nation clause.’
The bilateral- multilateral method of tariff negotiations was in vogue till the operation of the
Kennedy Round, on May 4, 1964. Before Kennedy Round five main tariff negotiating
conferences had been held which effected agreements (bindings) to reduce or to stabilise about
60,000 tariff rates between the participating countries.

The bilateral-multilateral technique of tariff reduction has the following drawbacks:

1. It leads to unfavourable terms of trade to the underdeveloped primary producing nations on
account of their weak bargaining position in a bilateral agreement with an advanced nation.
The principle of reciprocity was injurious to their interest.

2. It creates uncertainty and instability in the tariff structure of various countries.

3. It causes injustice to the already low-tariff countries, as they are in a very weak bargaining
position and have little to offer in exchange for concessions offered by other countries
(previously with high tariffs).

4. It is a very slow method of reducing tariffs. Hence the achievements made during a long
period of 14 years of its operation are not very substantial or encouraging.

In fact, at the ministerial meeting of the contracting parties in 1961, it was agreed that the
reduction of tariffs on a most favoured nation basis should be continued but in view of the
changing conditions of world trade, the traditional GATT technique for tariff negotiation on a
commodity-by-commodity and nation-by-nation basis are inadequate and inappropriate.
Hence, ultimately the bilateral aspect of negotiations was given up in Kennedy Round.
 PRACTICE QUESTION

1. What is inflation? Explain the trend of inflation in India since independence and how
monetary and fiscal policy help in dealing with inflation and recession.
2. What is Monetary Policy and what are the measures taken by government to manage
inflation with the help of monetary policy?
3. What is fiscal policy? Explain various tools of fiscal policy adopted by government.
4. What is FDI? Explain different types of FDIs and role of FDI in economic growth and
development.
5. What is WTO? Elaborate its role in development of world economy.
6. Explain structure and Principals of WTO.
7. Explain the role of GATT in world economic development.
8. What is role of FEMA in the growth of Indian Economy?
9. How FEMA panelise in case of violation of rules and regulations?
10. Differentiate between FERA and FEMA.