THE MANAGEMENT ENVIRONMENT

1.0 SOURCES OF FINANCE

1.1 Introduction

Finance is the lifeblood of business concern, because it is inter linked with all activities
performed by the business concern. In a human body, if blood circulation is not proper, body
function will stop. Similarly, if the finance not being properly arranged, the business system will
stop. Arrangement of the required finance to each department of business concern is highly a
complex one and it needs careful decision. Quantum of finance may be depending upon the
nature and situation of the business concern. Financial requirement of the business differs from
firm to firm and the nature of the requirements on the basis of terms or period of financial
requirement, it may be long term and short-term financial requirements:

1.1.1 Long-term Financial Requirements or Fixed Capital Requirement

Long-term financial requirement means the finance needed to acquire land and building for
business concern, purchase of plant and machinery and other fixed expenditure. Long term
financial requirement is also called as fixed capital requirements. Fixed capital is the capital,
which is used to purchase the fixed assets of the firms such as land and building, furniture and
fittings, plant and machinery, etc. Hence, it is also called a capital expenditure.

1.1.2 Short-term Financial Requirements or Working Capital Requirement

Apart from the capital expenditure of the firms, the firms should need certain expenditure like
procurement of raw materials, payment of wages, day-to-day expenditures, etc. This kind of
expenditure is to meet with the help of short-term financial requirements which will meet the
operational expenditure of the firms. Short-term financial requirements are popularly known as
working capital.

1.2 Meaning of Finance

Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments. Finance also is referred as the provision of money at the time when it
is needed. Finance function is the procurement of funds and their effective utilization in business
concerns. The concept of finance includes capital, funds, money, and amount. But each word is
having unique meaning. Studying and understanding the concept of finance become an important
part of the business concern.

1.2.1 Definition of Finance

According to Khan and Jain, “Finance is the art and science of managing money”. According to
Oxford dictionary, the word ‘finance’ connotes ‘management of money’. Webster’s Ninth
New Collegiate Dictionary defines finance as “the Science on study of the management of funds’

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and the management of fund as the system that includes the circulation of money, the granting of
credit, the making of investments, and the provision of banking facilities.

1.2.2 Definition of Business Finance

According to the Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversation of capital funds in meeting financial needs and overall objectives of
a business enterprise”.

According to the Guthumann and Dougall, “Business finance can broadly be defined as the
activity concerned with planning, raising, controlling, administering of the funds used in the
business”.

In the words of Parhter and Wert, “Business finance deals primarily with raising, administering
and disbursing funds by privately owned business units operating in nonfinancial fields of
industry”.

Corporate finance is concerned with budgeting, financial forecasting, cash management, credit
administration, investment analysis and fund procurement of the business concern and the
business concern needs to adopt modern technology and application suitable to the global
environment.

According to the Encyclopedia of Social Sciences, “Corporation finance deals with the financial
problems of corporate enterprises. These problems include the financial aspects of the promotion
of new enterprises and their administration during early development, the accounting problems
connected with the distinction between capital and income, the administrative questions created
by growth and expansion, and finally, the financial adjustments required for the bolstering up or
rehabilitation of a corporation which has come into financial difficulties”.

1.3 Types of Finance

Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names.

Finance can be classified into two major parts:

Private finance which includes the Individual, Firms, Business or Corporate Financial activities
to meet the requirements.

Public Finance which concerns with revenue and disbursement of Government such as Central
Government, State Government and Semi-Government Financial matters.

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Figure 1.1: Types of Finance

1.4 Sources of Finance

Sources of finance mean the ways for mobilizing various terms of finance to the industrial
concern. Sources of finance state that, how the companies are mobilizing finance for their
requirements. The companies belong to the existing or the new which need sum amount of
finance to meet the long-term and short-term requirements such as purchasing of fixed assets,
construction of office building, purchase of raw materials and day-to-day expenses. Sources of
finance may be classified under various categories according to the following important heads:

1. Based on the Period: Sources of Finance may be classified under various categories
based on the period.

Long-term sources: Finance may be mobilized by long-term or short-term. When the

finance mobilized with large amount and the repayable over the period will be more than
five years, it may be considered as long-term sources. Share capital, issue of debenture,
long-term loans from financial institutions and commercial banks come under this kind of
source of finance. Long-term source of finance needs to meet the capital expenditure of
the firms such as purchase of fixed assets, land and buildings, etc.

Long-term sources of finance include:

 Equity Shares
 Preference Shares
 Debenture
 Long-term Loans
 Fixed Deposits

Short-term sources: Apart from the long-term source of finance, firms can generate
finance with the help of short-term sources like loans and advances from commercial

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 banks, moneylenders, etc. Short-term source of finance needs to meet the operational
expenditure of the business concern.

Short-term source of finance include:

 Bank Credit
 Customer Advances
 Trade Credit
 Factoring
 Public Deposits
 Money Market Instruments
2. Based on Ownership: Sources of Finance may be classified under various categories
based on ownership:

An ownership source of finance include

 Shares capital, earnings

 Retained earnings
 Surplus and Profits

Borrowed capital include

 Debenture
 Bonds
 Public deposits
 Loans from Bank and Financial Institutions.
3. Based on Sources of Generation; Sources of Finance may be classified into various
categories based on the source of generation.

Internal source of finance includes

 Retained earnings
 Depreciation funds
 Surplus

External sources of finance may be include

 Share capital
 Debenture
 Public deposits
 Loans from Banks and Financial institutions

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 4. Based in Mode of Finance

Security finance may be include

 Shares capital
 Debenture

Retained earnings may include

 Retained earnings
 Depreciation funds

Loan finance may include

 Long-term loans from Financial Institutions

 Short-term loans from Commercial banks.

The above classifications are based on the nature and how the finance is mobilized from various
sources. But the above sources of finance can be divided into three major classifications:

 Security Finance
 Internal Finance
 Loans Finance

1.5 Security Finance

If the finance is mobilized through issue of securities such as shares and debenture, it is called as
security finance. It is also called as corporate securities. This type of finance plays a major role
in the field of deciding the capital structure of the company.

1.5.1 Characters of Security Finance

Security finance consists of the following important characters:

i. Long-term sources of finance.

ii. It is also called as corporate securities.
iii. Security finance includes both shares and debentures.
iv. It plays a major role in deciding the capital structure of the company.
v. Repayment of finance is very limited.
vi. It is a major part of the company’s total capitalization.

1.5.2 Types of Security Finance

Security finance may be divided into two major types:

i. Ownership securities or capital stock.

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 ii. Creditorship securities or debt capital.

[Link] Ownership Securities

The ownership securities also called as capital stock, is commonly called as shares. Shares are
the most Universal method of raising finance for the business concern. Ownership capital
consists of the following types of securities.

1. Equity Shares
2. Preference Shares
3. No par stock
4. Deferred Shares

1. Equity Shares: Equity Shares also known as ordinary shares, which means, other than
preference shares. Equity shareholders are the real owners of the company. They have a
control over the management of the company. Equity shareholders are eligible to get
dividend if the company earns profit. Equity share capital cannot be redeemed during the
lifetime of the company. The liability of the equity shareholders is the value of unpaid
value of shares.

Features of Equity Shares

Equity shares consist of the following important features:

i. Maturity of the shares: Equity shares have permanent nature of capital, which has
no maturity period. It cannot be redeemed during the lifetime of the company.
ii. Residual claim on income: Equity shareholders have the right to get income left
after paying fixed rate of dividend to preference shareholder. The earnings or the
income available to the shareholders is equal to the profit after tax minus preference
dividend.
iii. Residual claims on assets: If the company wound up, the ordinary or equity
shareholders have the right to get the claims on assets. These rights are only available
to the equity shareholders.
iv. Right to control: Equity shareholders are the real owners of the company. Hence,
they have power to control the management of the company and they have power to
take any decision regarding the business operation.
v. Voting rights: Equity shareholders have voting rights in the meeting of the company
with the help of voting right power; they can change or remove any decision of the
business concern. Equity shareholders only have voting rights in the company
meeting and also they can nominate proxy to participate and vote in the meeting
instead of the shareholder.
vi. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is
the legal right of the existing shareholders. It is attested by the company in the first
opportunity to purchase additional equity shares in proportion to their current holding
capacity.

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 vii. Limited liability: Equity shareholders are having only limited liability to the value of
shares they have purchased. If the shareholders are having fully paid up shares, they
have no liability. For example: If the shareholder purchased 100 shares with the face
value of #10 each. He paid only #900. His liability is only #100.

Total number of shares 100

Face value of shares #10
Total value of shares 100 × 10 =1,000
Paid up value of shares 900
Unpaid value/liability 100
Liability of the shareholders is only unpaid value of the share (that is #100).

Advantages of Equity Shares

Equity shares are the most common and universally used shares to mobilize finance for
the company. It consists of the following advantages.

i. Permanent sources of finance: Equity share capital is belonging to long-term

permanent nature of sources of finance, hence, it can be used for long-term or fixed
capital requirement of the business concern.
ii. Voting rights: Equity shareholders are the real owners of the company who have
voting rights. This type of advantage is available only to the equity shareholders.
iii. No fixed dividend: Equity shares do not create any obligation to pay a fixed rate of
dividend. If the company earns profit, equity shareholders are eligible for profit, they
are eligible to get dividend otherwise, and they cannot claim any dividend from the
company.
iv. Less cost of capital: Cost of capital is the major factor, which affects the value of the
company. If the company wants to increase the value of the company, they have to
use more share capital because, it consists of less cost of capital (Ke) while compared
to other sources of finance.
v. Retained earnings: When the company have more share capital, it will be suitable
for retained earnings which is the less cost sources of finance while compared to other
sources of finance.

Disadvantages of Equity Shares

i. Irredeemable: Equity shares cannot be redeemed during the lifetime of the business
concern. It is the most dangerous thing of over capitalization.
ii. Obstacles in management: Equity shareholder can put obstacles in management by
manipulation and organizing themselves. Because, they have power to contrast any
decision which are against the wealth of the shareholders.
iii. Leads to speculation: Equity shares dealings in share market lead to secularism
during prosperous periods.
iv. Limited income to investor: The Investors who desire to invest in safe securities
with a fixed income have no attraction for equity shares.

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 v. No trading on equity:When the company raises capital only with the help of equity,
the company cannot take the advantage of trading on equity.

2. Preference Shares: The parts of corporate securities are called as preference shares. It is
the shares, which have preferential right to get dividend and get back the initial
investment at the time of winding up of the company. Preference shareholders are eligible
to get fixed rate of dividend and they do not have voting rights.

Preference shares may be classified into the following major types:

1. Cumulative preference shares: Cumulative preference shares have right to claim

dividends for those years which have no profits. If the company is unable to earn
profit in any one or more years, C.P. Shares are unable to get any dividend but they
have right to get the comparative dividend for the previous years if the company
earned profit.
2. Non-cumulative preference shares: Non-cumulative preference shares have no right
to enjoy the above benefits. They are eligible to get only dividend if the company
earns profit during the years. Otherwise, they cannot claim any dividend.
3. Redeemable preference shares: When, the preference shares have a fixed maturity
period it becomes redeemable preference shares. It can be redeemable during the
lifetime of the company. The Company Act has provided certain restrictions on the
return of the redeemable preference shares.

Irredeemable Preference Shares: Irredeemable preference shares can be redeemed only

when the company goes for liquidator. There is no fixed maturity period for such kind of
preference shares.

Participating Preference Shares: Participating preference shares holders have right to

participate extra profits after distributing the equity shareholders.

Non-Participating Preference Shares: Non-participating preference shares holders are

not having any right to participate extra profits after distributing to the equity
shareholders. Fixed rate of dividend is payable to the type of shareholders.

Convertible Preference Shares: Convertible preference sharesholders have right to

convert their holding into equity shares after a specific period. The articles of association
must authorize the right of conversion.

Non-convertible Preference Shares: There shares, cannot be converted into equity

shares from preference shares.

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 Features of Preference Shares

The following are the important features of the preference shares:

i. Maturity period: Normally preference shares have no fixed maturity period except
in the case of redeemable preference shares. Preference shares can be redeemable
only at the time of the company liquidation.
ii. Residual claims on income: Preferential sharesholders have a residual claim on
income. Fixed rate of dividend is payable to the preference shareholders.
iii. Residual claims on assets: The first preference is given to the preference
shareholders at the time of liquidation. If any extra Assets are available that should
be distributed to equity shareholder.
iv. Control of Management: Preference shareholder does not have any voting rights.
Hence, they cannot have control over the management of the company.

Advantages of Preference Shares

Preference shares have the following important advantages.

i. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is
called as fixed income security because it provides a constant rate of income to the
investors.
ii. Cumulative dividends: Preference shares have another advantage which is called
cumulative dividends. If the company does not earn any profit in any previous
years, it can be cumulative with future period dividend.
iii. Redemption: Preference Shares can be redeemable after a specific period except in
the case of irredeemable preference shares. There is a fixed maturity period for
repayment of the initial investment.
iv. Participation: Participative preference sharesholders can participate in the surplus
profit after distribution to the equity shareholders.
v. Convertibility: Convertibility preference shares can be converted into equity shares
when the articles of association provide such conversion.

Disadvantages of Preference Shares

i. Expensive sources of finance: Preference shares have high expensive source of

finance while compared to equity shares.
ii. No voting right: Generally preference sharesholders do not have any voting rights.
Hence they cannot have the control over the management of the company.
iii. Fixed dividend only: Preference shares can get only fixed rate of dividend. They
may not enjoy more profits of the company.
iv. Permanent burden: Cumulative preference shares become a permanent burden so
far as the payment of dividend is concerned. Because the company must pay the
dividend for the unprofitable periods also.

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 v. Taxation: In the taxation point of view, preference shares dividend is not a
deductible expense while calculating tax. But, interest is a deductible expense.
Hence, it has disadvantage on the tax deduction point of view.

4. No Par Shares: When the shares are having no face value, it is said to be no par shares.
The company issues this kind of shares which is divided into a number of specific shares
without any specific denomination. The value of shares can be measured by dividing the
real net worth of the company with the total number of shares.
The realnetworth
Value of no. per share =
Total no. of shares

5. Deferred Shares: Deferred shares also called as founder shares because these shares
were normally issued to founders. The shareholders have a preferential right to get
dividend before the preference shares and equity shares. According to Companies Act
1956 no public limited company or which is a subsidiary of a public company can issue
deferred shares. These shares were issued to the founder at small denomination to control
over the management by the virtue of their voting rights.

[Link] Creditorship Securities

Creditorship Securities also known as debt finance which means the finance is mobilized from
the creditors. Debenture and Bonds are the two major parts of the Creditorship Securities.

Debentures

A Debenture is a document issued by the company. It is a certificate issued by the company

under its seal acknowledging a debt. According to the Companies Act 1956, “debenture includes
debenture stock, bonds and any other securities of a company whether constituting a charge of
the assets of the company or not.”

Types of Debentures

Debentures may be divided into the following major types:

i. Unsecured debentures: Unsecured debentures are not given any security on assets of the
company. It is also called simple or naked debentures. This type of debentures are treaded
as unsecured creditors at the time of winding up of the company.
ii. Secured debentures: Secured debentures are given security on assets of the company. It
is also called as mortgaged debentures because these debentures are given against any
mortgage of the assets of the company.
iii. Redeemable debentures: These debentures are to be redeemed on the expiry of a certain
period. The interest is paid periodically and the initial investment is returned after the
fixed maturity period.
iv. Irredeemable debentures: These kind of debentures cannot be redeemable during the
life time of the business concern.

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 v. Convertible debentures: Convertible debentures are the debentures whose holders have
the option to get them converted wholly or partly into shares. These debentures are
usually converted into equity shares. Conversion of the debentures may be:
Non-convertible debentures
Fully convertible debentures
Partly convertible debentures
vi. Other types: Debentures can also be classified into the following types. Some of the
common types of the debentures are as follows:
a. Collateral Debenture
b. Guaranteed Debenture
c. First Debenture
d. Zero Coupon Bond
e. Zero Interest Bond/Debenture

Features of Debentures

i. Maturity period: Debentures consist of long-term fixed maturity period. Normally,

debentures consist of 10–20 years maturity period and are repayable with the principle
investment at the end of the maturity period.
ii. Residual claims in income: Debenture holders are eligible to get fixed rate of interest at
every end of the accounting period. Debenture holders have priority of claim in income
of the company over equity and preference shareholders.
iii. Residual claims on asset: Debenture holders have priority of claims on Assets of the
company over equity and preference shareholders. The Debenture holders may have
either specific change on the Assets or floating change of the assets of the company.
Specific change of Debenture holders are treated as secured creditors and floating change
of Debenture holders are treated as unsecured creditors.
iv. No voting rights: Debenture holders are considered as creditors of the company. Hence
they have no voting rights. Debenture holders cannot have the control over the
performance of the business concern.
v. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period.
Hence the business will not affect the yield of the debenture.

Advantages of Debenture

Debenture is one of the major parts of the long-term sources of finance which of consists the
following important advantages:

i. Long-term sources: Debenture is one of the long-term sources of finance to the

company. Normally the maturity period is longer than the other sources of finance.
ii. Fixed rate of interest: Fixed rate of interest is payable to debenture holders, hence it is
most suitable of the companies earn higher profit. Generally, the rate of interest is lower
than the other sources of long-term finance.
iii. Trade on equity: A company can trade on equity by mixing debentures in its capital
structure and thereby increase its earning per share. When the company apply the trade
on equity concept, cost of capital will reduce and value of the company will increase.

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 iv. Income tax deduction: Interest payable to debentures can be deducted from the total
profit of the company. So it helps to reduce the tax burden of the company.
v. Protection: Various provisions of the debenture trust deed and the guidelines issued by
the SEB1 protect the interest of debenture holders.

Disadvantages of Debenture

Debenture finance consists of the following major disadvantages:

i. Fixed rate of interest: Debenture consists of fixed rate of interest payable to securities.
Even though the company is unable to earn profit, they have to pay the fixed rate of
interest to debenture holders, hence, it is not suitable to those company earnings which
fluctuate considerably.
ii. No voting rights: Debenture holders do not have any voting rights. Hence, they cannot
have the control over the management of the company.
iii. Creditors of the company: Debenture holders are merely creditors and not the owners
of the company. They do not have any claim in the surplus profits of the company.
iv. High risk: Every additional issue of debentures becomes more risky and costly on
account of higher expectation of debenture holders. This enhanced financial risk
increases the cost of equity capital and the cost of raising finance through debentures
which is also high because of high stamp duty.
v. Restrictions of further issues: The company cannot raise further finance through
debentures as the debentures are under the part of security of the assets already
mortgaged to debenture holders.

1.6 Internal Finance

A company can mobilize finance through external and internal sources. A new company may not
raise internal sources of finance and they can raise finance only external sources such as shares,
debentures and loans but an existing company can raise both internal and external sources of
finance for their financial requirements. Internal finance is also one of the important sources of
finance and it consists of cost of capital while compared to other sources of finance.

Internal source of finance may be broadly classified into two categories:

a. Depreciation Funds
b. Retained earnings

1.6.1 Depreciation Funds

Depreciation funds are the major part of internal sources of finance, which is used to meet the
working capital requirements of the business concern. Depreciation means decrease in the value
of asset due to wear and tear, lapse of time, obsolescence, exhaustion and accident. Generally
depreciation is changed against fixed assets of the company at fixed rate for every year. The
purpose of depreciation is replacement of the assets after the expired period. It is one kind of

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provision of fund, which is needed to reduce the tax burden and overall profitability of the
company.

1.6.2 Retained Earnings

Retained earnings are another method of internal sources of finance. Actually is not a method of
raising finance, but it is called as accumulation of profits by a company for its expansion and
diversification activities.

Retained earnings are called under different names such as; self finance, inter finance, and
plugging back of profits. According to the Companies Act 1956 certain percentage, as prescribed
by the central government (not exceeding 10%) of the net profits after tax of a financial year
have to be compulsorily transferred to reserve by a company before declaring dividends for the
year.

Under the retained earnings sources of finance, a part of the total profits is transferred to various
reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve
funds and secrete reserves, etc.

Advantages of Retained Earnings

Retained earnings consist of the following important advantages:

i. Useful for expansion and diversification: Retained earnings are most useful to
expansion and diversification of the business activities.
ii. Economical sources of finance: Retained earnings are one of the least costly sources of
finance since it does not involve any floatation cost as in the case of raising of funds by
issuing different types of securities.
iii. No fixed obligation: If the companies use equity finance they have to pay dividend and
if the companies use debt finance, they have to pay interest. But if the company uses
retained earnings as sources of finance, they need not pay any fixed obligation regarding
the payment of dividend or interest.
iv. Flexible sources: Retained earnings allow the financial structure to remain completely
flexible. The company need not raise loans for further requirements, if it has retained
earnings.
v. Increase the share value: When the company uses the retained earnings as the sources
of finance for their financial requirements, the cost of capital is very cheaper than the
other sources of finance; Hence the value of the share will increase.
vi. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive
tax in a company when it has small number of shareholders.
vii. Increase earning capacity: Retained earnings consist of least cost of capital and also it
is most suitable to those companies which go for diversification and expansion.

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Disadvantages of Retained Earnings

Retained earnings also have certain disadvantages:

i. Misuses: The management by manipulating the value of the shares in the stock market
can misuse the retained earnings.
ii. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude
of the company.
iii. Over capitalization: Retained earnings lead to over capitalization, because if the
company uses more and more retained earnings, it leads to insufficient source of finance.
iv. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax
burden through the retained earnings.
v. Dissatisfaction: If the company uses retained earnings as sources of finance, the
shareholder can’t get more dividends. So, the shareholder does not like to use the retained
earnings as source of finance in all situations.

1.7 Loan Financing

Loan financing is the important mode of finance raised by the company. Loan finance may be
divided into two types:

a. Long-Term Sources
b. Short-Term Sources

Loan finance can be raised through the following important institutions.

Figure 1.2: Loan Financing

1.7.1 Financial Institutions

With the effect of the industrial revaluation, the government established nation wide and state
wise financial industries to provide long-term financial assistance to industrial concerns in the
country. Financial institutions play a key role in the field of industrial development and they are
meeting the financial requirements of the business concern.

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1.7.2 Commercial Banks

Commercial Banks normally provide short-term finance which is repayable within a year. The
major finance of commercial banks is as follows:

Short-term advance: Commercial banks provide advance to their customers with or without
securities. It is one of the most common and widely used short-term sources of finance, which
are needed to meet the working capital requirement of the company.

It is a cheap source of finance, which is in the form of pledge, mortgage, hypothecation and bills
discounted and rediscounted.

Short-term Loans: Commercial banks also provide loans to the business concern to meet the
short-term financial requirements. When a bank makes an advance in lump sum against some
security it is termed as loan. Loan may be in the following form:

a. Cash credit: A cash credit is an arrangement by which a bank allows his customer to
borrow money up to certain limit against the security of the commodity.
b. Overdraft: Overdraft is an arrangement with a bank by which a current account holder is
allowed to withdraw more than the balance to his credit up to a certain limit without any
securities.

1.7.3 Development Banks

Development banks were established mainly for the purpose of promotion and development the
industrial sector in the country. Presently, large number of development banks are functioning
with multidimensional activities. Development banks are also called as financial institutions or
statutory financial institutions or statutory non-banking institutions.

Development banks provide two important types of finance:

a. Direct Finance
b. Indirect Finance/Refinance

Presently the commercial banks are providing all kinds of financial services including
development-banking services. Also nowadays development banks and special listed financial
institutions are providing all kinds of financial services including commercial banking services.
Diversified and global financial services are unavoidable to the present day economics. Hence,
we can classify the financial institutions only by the structure and set up and not by the services
provided by them.

Model Questions

1. Explain the various sources of financing.

2. What is meant by security financing?
3. What is debt financing?

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4. Critically examine the advantages and disadvantages of equity shares.
5. Discuss the features of equity shares.
6. What are the merits of the deferred shares?
7. Explain the merits and demerits of preference shares?
8. List out the types of debentures.
9. Evaluate the overall view of debentures.
10. How internal sources of finance is used in the industrial concern?
11. What is retained earnings?
12. Evaluate the advantages and disadvantages of retained earnings.
13. How does depreciation funds help the industrial concern as sources of finance?
14. Evaluate the overall structure of the loan financing?
15. Explain the Commercial Bank financing?
16. Enumerate the major development banks.
17. What is cash credit?

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2.0 MONEY AND CREDIT

2.1 Money as a Medium of Exchange

The use of money spans a very large part of our everyday life. Look around you and you would
easily be able to identify several transactions involving money in any single day. Can you make
a list of these? In many of these transactions, goods are being bought and sold with the use of
money. In some of these transactions, services are being exchanged with money. For some, there
might not be any actual transfer of money taking place now but a promise to pay money later.

Have you ever wondered why transactions are made in money? The reason is simple. A person
holding money can easily exchange it for any commodity or service that he or she might want.
Thus everyone prefers to receive payments in money and then exchange the money for things
that they want. Take the case of a shoe manufacturer. He wants to sell shoes in the market and
buy wheat. The shoe manufacturer will first exchange shoes that he has produced for money, and
then exchange the money for wheat. Imagine how much more difficult it would be if the shoe
manufacturer had to directly exchange shoes for wheat without the use of money. He would have
to look for a wheat growing farmer who not only wants to sell wheat but also wants to buy the
shoes in exchange. That is, both parties have to agree to sell and buy each others commodities.
This is known as double coincidence of wants. What a person desires to sell is exactly what the
other wishes to buy. In a barter system where goods are directly exchanged without the use of
money, double coincidence of wants is an essential feature.

In contrast, in an economy where money is in use, money by providing the crucial intermediate
step eliminates the need for double coincidence of wants. It is no longer necessary for the shoe
manufacturer to look for a farmer who will buy his shoes and at the same time sell him wheat.
All he has to do is find a buyer for his shoes. Once he has exchanged his shoes for money, he can
purchase wheat or any other commodity in the market. Since money acts as an intermediate in
the exchange process, it is called a medium of exchange.

2.2 The Function of Money

2.2.1 The General Economic Conditions for the Use of Money

Where the free exchange of goods and services is unknown, money is not wanted. In a state of
society in which the division of labour was a purely domestic matter and production and
consumption were consummated within the single household it would be just as useless as it
would be for an isolated man. But even in an economic order based on division of labour, money
would still be unnecessary if the means of production were socialized, the control of production
and the distribution of the finished product were in the hands of a central body, and individuals
were not allowed to exchange the consumption goods allotted to them for the consumption goods
allotted to others.

The phenomenon of money presupposes an economic order in which production is based on

division of labour and in which private property consists not only in goods of the first order
(consumption goods), but also in goods of higher orders (production goods). In such a society,

17
there is no systematic centralized control of production, for this is inconceivable without
centralized disposal over the means of production. Production is 'anarchistic'. What is to be
produced, and how it is to be produced, is decided in the first place by the owners of the means
of production, who produce however, not only for their own needs, but also for the needs of
others, and in their valuations take into account, not only the use-value that they themselves
attach to their products, but also the use-value that these possess in the estimation of the other
members of the community.

The balancing of production and consumption takes place in the market, where the different
producers meet to exchange goods and services by bargaining together. The function of money is
to facilitate the business of the market by acting as a common medium of exchange.

2.2.1 The 'Secondary' Functions of, Money

The simple statement, that money is a commodity whose economic function is to facilitate the
interchange of goods and services, does not satisfy those writers who are interested rather in the
accumulation of material than in the increase of knowledge. Many investigators imagine that
insufficient attention is devoted to the remarkable part played by money in economic life if it is
merely credited with the function of being a medium of exchange; they do not think that due
regard has been paid to the significance of money until they have enumerated half a dozen
further 'functions' - as if, in an economic order founded on the exchange of goods, there could be
a more important function than that of the common medium of exchange.

After Menger's review of the question, further discussion of the connection between the
secondary functions of money and its basic function should be unnecessary. Nevertheless,
certain tendencies in recent literature on money make it appear advisable to examine briefly
these secondary functions - some of them are coordinated with the basic function by many
wnters - and to show once more that all of them can be deduced from the function of money as
common medium of exchange.

This applies in the first place to the function fulfilled by money in facilitating credit
transactions. It is simplest to regard this as part of its function as medium of exchange. Credit
transactions are in fact nothing but the exchange of present goods against future goods.

The functions of money as a transmitter of value through time and space may also be directly
traced back to its function as medium of exchange. The European farmer who emigrates to
America and wishes to exchange his property in Europe for a property in America, sells the
former, goes to America with the money (or a bill payable in money), and there purchases his
new homestead. Here we have an absolute text-book example of an exchange facilitated by
money.

Particular attention has been devoted, especially in recent times, to the function of money as a
general medium of payment. Indirect exchange divides a single transaction into two separate
parts which are connected merely by the ultimate intention of the exchangers to acquire
consumption goods. Sale and purchase thus apparently become independent of each other.
Furthermore, if the two parties to a sale-and-purchase transaction perform their respective parts

18
of the bargain at different times, that of the seller preceding that of the buyer (purchase on
credit), then the settlement of the bargain, or the fulfillment of the seller's part of it (which need
not be the same thing), has no obvious connection with the fulfillment of the buyer's part.

2.3 Forms of Money

We have seen that money is something that can act as a medium of exchange in transactions.

 Ancient period: Grain and cattle were used as money.

 Medieval period: Metallic coins of gold, silver, copper and lead were used as money.
 Modern period: Paper currency and coins are used as money.

2.3.1 Modern Forms of Money

[Link] Currency

Modern forms of money include currency — paper notes and coins, bank deposits Unlike the
things that were used as money earlier, modern currency is not made of precious metal such as
gold, silver and copper. And unlike grain and cattle, they are neither of everyday use. The
modern currency is without any use of its own.

Then, why is it accepted as a medium of exchange? It is accepted as a medium of exchange

because the currency is authorized by the government of the country.

In Nigeria, the Central Bank of Nigeria issues currency notes on behalf of the Federal
Government. As per Nigeria law, no other individual or organization is allowed to issue
currency. Moreover, the law legalizes the use of Naira and Kobo as a medium of payment that
cannot be refused in settling transactions in Nigeria. No individual in Nigeria can legally refuse a
payment made in Naira and Kobo. Hence, the Naira is widely accepted as a medium of
exchange.

[Link] Banks Deposits

The other form in which people hold money is as deposits with banks. At a point of time, people
need only some currency for their day-to-day needs. For instance, workers who receive their
salaries at the end of each month have extra cash at the beginning of the month. What do people
do with this extra cash? They deposit it with the banks by opening a bank account in their name.
Banks accept the deposits and also pay an amount as interest on the deposits. In this way
people’s money is safe with the banks and it earns an amount as interest. People also have the
provision to withdraw the money as and when they require. Since the deposits in the bank
accounts can be withdrawn on demand, these deposits are called demand deposits.

Demand deposits offer another interesting facility. It is this facility which lends it the essential
characteristics of money (that of a medium of exchange). You would have heard of payments
being made by cheques or through transfer (internet banking) instead of cash. For payment
through cheque, the payer who has an account with the bank, makes out a cheque for a specific

19
amount. A cheque is a paper instructing the bank to pay a specific amount from the person’s
account to the person in whose name the cheque has been issued.

Cheque Payments: A shoe manufacturer, M. Salim has to make a payment to the leather supplier
and writes a cheque for a specific amount. This means that the shoe manufacturer instructs his
bank to pay this amount to the leather supplier. The leather supplier takes this cheque, and
deposits it in his own account in the bank. The money is transferred from one bank account to
another bank account in a couple of days. The transaction is complete without any payment of
cash.

Thus we see that demand deposits share the essential features of money. The facility of cheques
or through transfer (internet banking) against demand deposits makes it possible to directly settle
payments without the use of cash. Since demand deposits are accepted widely as a means of
payment, along with currency, they constitute money in the modern economy.

You must remember the role that the banks play here. But for the banks, there would be no
demand deposits and no payments by cheques against these deposits. The modern forms of
money — currency and deposits — are closely linked to the working of the modern banking
system.

Characteristics of Bank Deposits

 People deposit their money in banks by opening a bank account.

 Banks keep the money safe and also provide interest on the deposited amount of money
to the depositors.
 The deposited money can be withdrawn from banks as and when required on demand.
Hence, bank deposits are also called demand deposits.
 Bank deposits also facilitate easy transfers of money through cheques, demand drafts or
internet banking.

2.4 Credits

2.4.1 Loan Activities of Banks

What do the banks do with the deposits which they accept from the public? There is an
interesting mechanism at work here. Banks keep only a small proportion of their deposits as cash
with themselves. For example, banks these days hold about 15 per cent of their deposits as cash.
This are kept as provision to pay the depositors who might come to withdraw money from the
bank on any given day. Since, on any particular day, only some of its many depositors come to
withdraw cash, the bank is able to manage with this cash.

Banks use the major portion of the deposits to extend loans. There is a huge demand for loans for
various economic activities. Banks make use of the deposits to meet the loan requirements of the
people. In this way, banks mediate between those who have surplus funds (the depositors) and
those who are in need of these funds (the borrowers). Banks charge a higher interest rate on loans

20
than what they offer on deposits. The difference between what is charged from borrowers and
what is paid to depositors is their main source of income.

 Banks provide loans to people at some interest rate.

 Banks keep only 15% of their total deposits as cash to meet the day-to-day withdrawal
demands.
 Rest of the cash is extended as loans to those who need it (borrowers) at a specific rate of
interest.
 The interest provided by banks to depositors is less than the interest charged by banks
from borrowers on loans. This difference is the main source of income of banks.
 Banks provide housing loans, vehicle loans, farm loans, education loans, personal loans
etc. to meet the specific requirements of borrowers.

2.5 Two Different Credit Situation

A large number of transactions in our day-to-day activities involve credit in some form or the
other. Credit (loan) refers to an agreement in which the lender supplies the borrower with money,
goods or services in return for the promise of future payment. Let us see how credit works
through the following two examples.

1. Festival Season: It is festival season two months from now and the shoe manufacturer,
Salim, has received an order from a large trader in town for 3,000 pairs of shoes to be
delivered in a month time. To complete production on time, Salim has to hire a few more
workers for stitching and pasting work. He has to purchase the raw materials. To meet
these expenses, Salim obtains loans from two sources. First, he asks the leather supplier
to supply leather now and promises to pay him later. Second, he obtains loan in cash
from the large trader as advance payment for 1000 pairs of shoes with a promise to
deliver the whole order by the end of the month. At the end of the month, Salim is able to
deliver the order, make a good profit, and repay the money that he had borrowed.

In this case, Salim obtains credit to meet the working capital needs of production. The
credit helps him to meet the ongoing expenses of production, complete production on
time, and thereby increase his earnings. Credit therefore plays a vital and positive role
in this situation.
2. Swapna’s Problem: Swapna, a small farmer, grows groundnut on her three acres of
land. She takes a loan from the moneylender to meet the expenses of cultivation, hoping
that her harvest would help repay the loan. Midway through the season the crop is hit by
pests and the crop fails. Though Swapna sprays her crops with expensive pesticides, it
makes little difference. She is unable to repay the moneylender and the debt grows over
the year into a large amount. Next year, Swapna takes a fresh loan for cultivation. It is a
normal crop this year. But the earnings are not enough to cover the old loan. She is
caught in debt. She has to sell a part of the land to pay off the debt.

In Swapna’s case, the failure of the crop made loan repayment impossible. She had to sell
part of the land to repay the loan. Credit, instead of helping Swapna improve her
earnings, left her worse off. This is an example of what is commonly called debt-trap.

21
 Credit in this case pushes the borrower into a situation from which recovery is very
painful.

In one situation credit helps to increase earnings and therefore the person is better off than
before. In another situation, because of the crop failure, credit pushes the person into a debt trap.
To repay her loan she has to sell a portion of her land. She is clearly much worse off than before.
Whether credit would be useful or not, therefore, depends on the risks in the situation and
whether there is some support, in case of loss.

Debt Trap: It is a situation in which a person is caught in the vicious cycle of debts. He/she
takes loans for meeting his/her requirements and on being unable to pay back the loan, takes a
fresh loan to repay the old loan. This leaves him/her indebted all through his/her life.

2.6 Terms of Credit

Every loan agreement specifies an interest rate which the borrower must pay to the lender along
with the repayment of the principal. In addition, lenders may demand collateral (security) against
loans. Collateral is an asset owned by the borrower such as land, building, vehicle, livestock etc.,
which is kept with the lender as a guarantee against a loan until the loan is repaid. If the
borrower fails to repay the loan, the lender has the right to sell the asset or collateral to obtain
payment. Property such as land titles, deposits with banks, livestock are some common
examples of collateral used for borrowing.

Interest rate, collateral and documentation requirement, and the mode of repayment together
comprise what is called the terms of credit. The terms of credit vary substantially from one credit
arrangement to another. They may vary depending on the nature of the lender and the borrower.

2.7 Loans from Cooperatives

Besides banks, the other major source of cheap credit are the cooperative societies (or
cooperatives). Members of a cooperative pool their resources for cooperation in certain areas.
There are several types of cooperatives possible such as farmers cooperatives, weavers
cooperatives, industrial workers cooperatives, etc. It accepts deposits from its members. With
these deposits as collateral, the Cooperative has obtained a large loan from the bank. These funds
are used to provide loans to members. Once these loans are repaid, another round of lending can
take place.

Loans from Cooperatives

 Cooperative societies are small scale organizations formed by people themselves.

 The members of cooperatives pool their resources in the account of the cooperative and
then extend loans to those in need.
 Cooperatives also take loan from banks.

22
2.8 Formal Sector Credit

We have seen in the above examples that people obtain loans from various sources. The various
types of loans can be conveniently grouped as formal sector loans and informal sector loans.
Among the former are loans from banks and cooperatives. The informal lenders include
moneylenders, traders, employers, relatives and friends, etc.

2.8.1 Formal Sector Loans

 These consist of loans from banks and cooperatives

 These loans are supervised by the Central Bank of Nigeria
 The terms of credit are fixed
 Rate of interest is not very high
 It comprises 52% of the total loans given in the country

2.8.2 Informal Sector Loans

 These consist of loans from moneylenders, landlords, traders, relatives and friends etc.
 They are not under the control of the Central Bank of Nigeria
 The rates of interests are exorbitant
 It comprises 48% of the credit in the country
 It is mostly taken by poor rural households

2.9 Self Help Groups

While formal sector loans need to expand, it is also necessary that everyone receives these loans.
At present, it is the richer households who receive formal credit whereas the poor have to depend
on the informal sources. It is important that the formal credit is distributed more equally so that
the poor can benefit from the cheaper loans. In the previous section we have seen that poor
households are still dependent on informal sources of credit. Why is it so? Banks are not present
everywhere. Even when they are present, getting a loan from a bank is much more difficult than
taking a loan from informal sources. As we saw, bank loans require proper documents and
collateral. Absence of collateral is one of the major reasons which prevents the poor from getting
bank loans. Informal lenders such as moneylenders, on the other hand, know the borrowers
personally and hence are often willing to give a loan without collateral. The borrowers can, if
necessary, approach the moneylenders even without repaying their earlier loans. However, the
moneylenders charge very high rates of interest, keep no records of the transactions and harass
the poor borrowers.

In recent years, people have tried out some newer ways of providing loans to the poor. The idea
is to organise rural poor, in particular women, into small Self Help Groups (SHGs) and pool
(collect) their savings. A typical SHG has 15-20 members, usually belonging to one
neighbourhood, who meet and save regularly. Members can take small loans from the group
itself to meet their needs. The group charges interest on these loans but this is still less than what
the moneylender charges. After a year or two, if the group is regular in savings, it becomes
eligible for availing loan from the bank.

23
Most of the important decisions regarding the savings and loan activities are taken by the group
members. The group decides as regards the loans to be granted — the purpose, amount, interest
to be charged, repayment schedule etc. Also, it is the group which is responsible for the
repayment of the loan. Any case of non repayment of loan by any one member is followed up
seriously by other members in the group. Because of this feature, banks are willing to lend to the
poor women when organised in SHGs, even though they have no collateral as such.

Thus, the SHGs help borrowers overcome the problem of lack of collateral. They can get timely
loans for a variety of purposes and at a reasonable interest rate. Moreover, SHGs are the building
blocks of organisation of the rural poor. Not only does it help women to become financially self-
reliant, the regular meetings of the group provide a platform to discuss and act on a variety of
social issues such as health, nutrition, domestic violence, etc.

Summary

In this chapter we have looked at the modern forms of money and how they are linked with the
banking system. On one side are the depositors who keep their money in the banks and on the
other side are the borrowers who take loans from these banks. Economic activities require loans
or credit. Credit, as we saw can have a positive impact, or in certain situations make the borrower
worse off.

Credit is available from a variety of sources. These can be either formal sources or informal
sources. Terms of credit vary substantially between formal and informal lenders. At present, it is
the richer households who receive credit from formal sources whereas the poor have to depend
on the informal sources. It is essential that the total formal sector credit increases so that the
dependence on the more expensive informal credit becomes less. Also, the poor should get a
much greater share of formal loans from banks, cooperative societies etc. Both these steps are
important for development.

Model Questions

1. How does the use of money make it easier to exchange things?

2. Can you think of some examples of goods / services being exchanged or wages being
paid through barter?
3. Why are demand deposits considered as money?
4. What are the differences between formal and informal sources of credit?
5. Why should credit at reasonable rates be available for all?
6. In situations with high risks, credit might create further problems for the borrower.
Explain.
7. How does money solve the problem of double coincidence of wants? Explain with an
example of your own.
8. How do banks mediate between those who have surplus money and those who need
money?
9. Why do we need to expand formal sources of credit?
10. What is the basic idea behind the SHGs for the poor? Explain in your own words.
11. What are the reasons why the banks might not be willing to lend to certain borrowers?

24
3.0 Balance of payments

3.1 Definition of Balance of Payments

Balance of payments (BOP) of a country is a systematic summary statement of a country’s

international economic transactions during a given period of time, usually a year. The study of
balance of payments represents macroeconomic aspect of international economics.

As cited in Lindert (2002) Kindleberger defines “ The balance of payments of a country is a

systematic record of all economic transactions between residents of that country and the rest of
the world during a given period of time.”

The International Monetary Fund defines the term Balance of Payments more clearly and
explicitly as follows – “the balance of payments is a statistical statement that systematically
summarises for a specific time period, the economic transactions of an economy with the rest of
the world. Transactions, for the most part between residents and nonresidents, consists of those
involving goods, services, and income; those involving financial claims on, and liabilities to, rest
of the world; and those (such as gifts) classified as transfers, which involve offsetting entries to
balance – in an accounting sense – one sided transaction.”

In general, Balance of Payments (BOP) of a country is “a systematic record of all economic

transactions between the residents of the reporting country and the residents of the rest of the
world for a given period of time usually a year.” Thus, it comprises all types of transactions of a
country like – exports and imports of goods and services, purchase and sale of foreign assets,
foreign direct investment and portfolio investment as well as borrowing from and lending to the
rest of the world.

3.1.1 Importance of Balance of Payments

A study of BOP is important because –

i. It serves as an indicator of the changing international economic or financial position

of a country.
ii. It helps in formulation of a country’s monetary, fiscal and trade policies.
iii. It helps in determining the influence of foreign trade & transactions on the level of
national income of a country.
iv. It is useful to banks, firms, financial institutions and individuals which are directly or
indirectly involved in international trade and finance.
v. It is an economic barometer of nation’s progress vis-à-vis rest of the world.

3.2 Balance of Payments Accounting

The BOP accounts of a country is constructed on the basis of an accounting procedure known as
double entry book - keeping. Double entry book keeping means that each international
transaction is recorded twice, once as a credit entry and once as a debit entry of equal amount.
The reason for this is that in general every transaction has two sides that is credit and debit.
25
When a payment is received from a foreign country, it is a credit transaction or credit entry,
while payment to a foreign country is a debit transaction or debit entry. In a country’s BOP,
credit transactions or entries are entered with a positive sign (+), and debit transactions or entries
are entered with a negative sign (-).

In general, the credit transactions would include - exports of goods and services, unilateral
receipts such as gifts, grants etc. from foreigners, borrowings from abroad, investments by
foreigners in the country, (capital inflows) and official sale of reserve assets including gold to
foreign countries and international agencies. While, the debit transactions would include - import
of goods and services, unilateral payments such as gifts, grants, etc. to foreigners, lending to
foreign countries, investments by residents in foreign countries, (capital outflows) and official
purchase of reserve assets or gold from foreign countries and international agencies.

These credit and debit transactions are shown vertically in the balance of payments account of a
country. Horizontally they are divided into three categories:- the current account, the capital
account and the official settlements account or the official reserves account.

3.3 Structure of Balance of Payments

The Balance of Payments of a country is mainly divided into two types of accounts – Current
Account and Capital Account.

3.3.1 Current Account

The current account of a country’s balance of payments consists of all transactions related to
trade in goods, services, income and unilateral transfers. The current account includes following
items –

(a) Merchandise Exports & Imports – Merchandise exports and imports are the most
important items in the current account. In general, it covers a significant portion of total
transactions recorded in the BOP of a country. Generally, exports are calculated on free
on board (f.o.b.) basis which means that the costs of transportation, insurance, etc. are
excluded. Generally, imports are calculated on carriage, insurance and freight (c.i.f.)
basis which means that costs of transportation, insurance and freight are included.
(b) Invisible Exports & Imports - Invisible exports & imports also known as service exports
& imports are another important component of current account. Important invisible items
would include – travel, insurance, transportation, investment income in the form of
profits, dividends, etc. and Government not included elsewhere.(g.n.i.e)
(c) Unilateral Transfers – Unilateral transfers or transfer payments are the third important
component of current account. Unilateral transfers include gifts, grants, etc. either
received from abroad (credits) or given abroad. (debits). They are one sided transactions,
without a quid pro quo that has a measurable value. The unilateral transfers could be
official or private.

26
3.3.2 Capital Account

The capital account of a country consists of its transactions in financial assets in the form of
short term and long term lending and borrowing and private and official investments. In other
words, the capital account shows international flow of loans and investments, and represents a
change in the country’s foreign assets and liabilities. The capital account mainly consists of –

a) Borrowing from & Lending to Foreign Countries – Borrowing from foreign countries
are credit entries because they are receipts from foreign countries. Lending to foreign
countries are debit entries because they are payments to foreign countries. This
borrowing or lending could be of short term i.e. up to one year or long term i.e. more than
one year. Borrowing from & lending to foreign countries could be also called as net sale
of assets to foreigners and net purchases of assets from foreigners.
b) Direct Investment & Portfolio Investment – Direct investment is investment in
enterprises located in one country but effectively controlled by residents of another
country. As a rule, direct investment takes the form of investment in branches and
subsidiaries by parent companies located in another country. Portfolio investment refers
to purchases of foreign securities that do not carry any claim on control or ownership of
foreign enterprises. In brief, borrowing from foreign countries and direct & portfolio
investment by foreign countries represent capital inflows. On the other hand, lending to
foreign countries and direct & portfolio investment in foreign countries represent capital
outflows.

In broader terms, real or income creating transactions are entered into current account of BOP,
while financial or capital transactions are entered into capital account of BOP. Lindert (2002)
remarks that “ Balance –of –payments accounting is unique in that it shows all the real and
financial flows between a country and the rest of the world.”

3.3.3 Other Components

Apart from the above two main accounts, BOP of a country also includes some other entries like
(a) Transactions with IMF,
(b) SDR allocations,
(c) Errors & Omissions and
(d) Official settlements / Reserve account.

Table 3.1 shows broad structure of a balance of payments statement.

S/No Particulars Credits ( + ) Debits ( - )
1 Current
Account
(A)Exports (B)Imports
(a)Goods (a)Goods
(b)Services (b)Services
(C) Unilateral Transfer receipts (C)Unilateral Transfer payments to
from abroad (Gifts, grants, etc abroad (Gifts, grants, etc. given)
recd)
2 Capital

27
 Account
(a)Borrowing from Foreign (a)Lending to Foreign Countries /
Countries / Net sale of assets to Net purchases of assets from
foreigners foreigners
(b) Direct & Portfolio (b)Direct & Portfolio Investment
Investment by Foreign Countries in Foreign Countries
3 Errors &
Omissions
4 Overall
Balance of
Payments
5 Official
Settlement /
Reserves
Account
4 Overall
Balance of
Payments

3.4 Balances within the Balance of Payments Statement

As the BOP statement is constructed on the basis of double entry book keeping, the total credits
will be always equal to total debits. We can find out net balances for different items in the
balance of payment statement. However, from the policy makers point of view some of the
important balances are –

i. Balance of Trade - There are two definitions with reference to the concept of balance of
trade or trade balance. (a) Narrow definition and (b) Broad definition.
a. Narrow Definition – The narrow definition considers “Balance of trade as the difference
between the value of merchandise (or goods) exports and the value of merchandise (or
goods) imports.” In this sense, it can be called as – Merchandise balance or Goods
balance.
b. Broad Definition – The broad definition of balance of trade is given by economist
James Meade and is accepted by most of the modern economists. In the broader
sense, Balance of trade is the difference between the value of goods & services
exported and imported by a country. Balance of trade in this sense is also known as
Balance of Goods & Services. In the familiar macro-economic equation,

Y = C + I + G + (X – M), in which Y = National income, C = Consumption, I =

Investment, G = Government expenditure, X = Exports of Goods & Services, M =
Imports of Goods & Services, the expression X – M denotes balance of trade in
Meade’s terms. Balance of trade is national income injection and for that reason it is
better to use Meade’s concept of balance of trade. Equating balance of trade with
goods balance alone is to ignore the importance of service balance as a factor
determining national income.

28
ii. Balance of Current Account – The concept of balance of current account or current
account balance is broader than the concept of balance of trade. It is said to be mirror
image of capital account including official reserves. The current account balance includes
the sum of three balances – merchandise balance, services balance and unilateral transfers
balance. In other words, it includes trade balance (in Meade’s terms) and transfers
balance.

Balance of Current Account = Merchandise balance + Services Balance + Unilateral

transfers balance.

The current account reflects the value of the flow of goods, services, income and gifts
between the home country and the foreign countries. Current account balance refers to
the net of these flows. The balance of current account can be either surplus or deficit. A
current account surplus means an excess of exports over imports of goods, services
investment income and unilateral transfers. A current account deficit means excess of
imports over exports of goods, services, investment income and unilateral transfers. In
other words, if the sum of the exports of goods, services , investment income and
unilateral transfers is greater than the sum of the imports of goods, services, investment
income and unilateral transfers, then there will be current account surplus and vice –
versa.

Importance of the Concept of Balance of Current Account - The balance of current

account is a very important concept, as it shows the flow aspect of a country’s
international transactions. It represents bottom line of a nation’s income statement. It
shows the change in reporting country’s net foreign wealth. As pointed out by Salvatore
(2005) –“The current account lumps together all sales and purchases of currently
produced goods & services, and investment income, and unilateral transfers and provides
the link between the nation’s international transactions and its national income.
Specifically, a current account surplus stimulates domestic production, while a current
account deficit dampens domestic production and income.” The concept of current
account balance is linked with national income accounting and its components in the
following manner:

(a) Link with national saving and domestic investment - A country can do two things
with its national savings (S): (i) Invest in home country (Id) or (ii) Invest in foreign
country (If). Hence, S = Id + If . Therefore, a country’s net foreign investment (current
account balance - CAB) equals the difference between national saving and domestic
investment. i.e. CAB = If = S - Id . Thus, the concept is synonymous with net foreign
investment in national income accounting.
(b) Link with domestic production, income and expenditure – A country’s current account
balance is the difference between its domestic production of goods and services and
its total expenditure on goods and services.

A country’s national output maybe represented as –

29
 Y = C + Id + G + X –M …. (1).

Where Y = National product / output, C = domestic consumption, Id = domestic

investment, G = Government expenditure, X = exports of goods & services, M =
imports of goods & services. C, Id and G all include purchases of both domestically
produced and imported goods & services. But, imports must be subtracted separately
because imports are not demand for the home country’s products.

A country’s total expenditure on goods and services i.e. C + Id + G is sometimes

referred to as absorption (A).

It can be represented as - A = C + Id + G … (2)

Therefore, Y = A + ( X – M ) … (3)

The above analysis implies that national product (Y) differs from national
expenditure or absorption (A= C + Id + G) by the amount of current account balance,
or the difference between exports and imports of goods and services (including gifts),
or X – M.

In a nutshell, the current account balance (CAB) in a balance of payment statement

implies –

a) the difference between exports of goods & services & imports of goods &
services (X – M),
b) Net foreign investment (If),
c) The difference between national savings and domestic investment (S - Id), and
d) The difference between national product and national expenditure / absorption. (Y
– A).
iii. Balance of Capital Account – Until recently, capital account was not a significant
component of balance of payments. This was because of severe restrictions adopted by
the countries on international capital movements. However, in due course of time due to
liberalization of trade, the countries have also eased or removed their restrictions on
international capital movements. Normally, the capital account consists of all types of
capital inflows and outflows. In general, it is observed that the developing countries have
surplus in their capital account, while the developed countries have deficit in their capital
account.
iv. Overall Balance of Payments - It is the sum of the balance of current account and
balance of capital account (including errors & omissions ). In some countries, overall
balance is also called as official settlement balance. The overall balance of payments may
either balance, or have a surplus, or have a deficit. In general it can be said that
(a) If the overall surplus in the BOP was caused by current account surpluses but not
capital account surpluses, then the surplus may be a good sign for the country.

30
 (b) If the overall deficit in the BOP was caused by current account deficit rather than
capital account deficits, then the deficit may be considered as a bad sign for the
reporting country.

Thus, not only the extent but location of overall surplus or deficit is important. It is to be
noted that different nations use different measures of the overall balance of payments
surplus or deficit. Some compare the net increase in their official reserves with the net rise
in a wide definition of liquid foreign claims against the country. Others simply measure
the change in official reserves alone.

3.5 Equilibrium & Disequilibrium in Balance of Payments

A country’s balance of payments is said to be always ‘balanced’ in accounting sense so there

would be no ‘imbalance’ in a country’s BOP. However, we come across the term ‘equilibrium’
or ‘disequilibrium’ in relation to a country’s BOP. This is because the term ‘balance’/
‘imbalance’ is used in accounting sense while the term ‘ equilibrium’ / ‘disequilibrium’ is used
in economic sense. As Sodersten (1980) remarks - “The problem of judging equilibrium position
of a country’s balance of payments becomes fairly complicated and soon takes us outside the
sphere of book – keeping.” Thus, while analyzing the equilibrium /disequilibrium in balance of
payments one has to consider the nature of international transactions in the BOP.

3.5.1 Autonomous & Accommodating Transactions

The nature of international transactions could be autonomous or accommodating.

(a) Autonomous Transactions – Autonomous transactions are those transactions that take
place regardless of the size of other items in the balance of payments. They are also
called as ‘above the line transactions.’ All the transactions in the current and capital
account are autonomous because they are undertaken for business or profit motives and
are independent of balance of payments situations. They are the cause of BOP situation.
For accounting purposes it is reasonable to treat all the current and capital account
transactions as autonomous or above the line transactions. In brief, all the credit and debit
entries in the current and capital accounts are regarded as ‘autonomous’ transactions.
(b) Accommodating Transactions – Accommodating transactions are those transactions
which are undertaken deliberately to correct disequilibrium in balance of payments. They
are also called as ‘below the line transactions’. They are the result of balance of
payments situation. The transactions in the official reserve account are of accommodating
nature undertaken by monetary authorities to bring balances in the balance of payments.
In brief, all the credit and debit entries in the Official reserve account are regarded as
accommodating transactions.

[Link] Definition of Equilibrium / Disequilibrium in Balance of Payments

The distinction between autonomous and accommodating transactions is useful in defining

equilibrium / disequilibrium (surplus / deficit) in balance of payments.

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 a. Equilibrium in BOP - A country’s balance of payments is said to be in equilibrium when
its autonomous receipts (credits) are equal to its autonomous payments (debits).

Equilibrium in BOP → Autonomous Receipts = Autonomous Payments

b. Disequilibrium in BOP - A country’s balance of payments is said to be in disequilibrium

when its autonomous receipts (credits) are not equal to its autonomous payments (debits).

Disequilibrium in BOP → Autonomous Receipts ≠ Autonomous Payments

Disequilibrium in BOP could be in the form of surplus or deficit in the balance of payments.

i. Surplus in BOP – When the autonomous receipts (credits) are greater than autonomous
payments (debits), the balance of payments will be in surplus or favourable. In other
words, if total credits are more than total debits in the current and capital account
(including errors & omissions), the net credit balance measures the surplus in the nation’s
balance of payments. This surplus is settled with an equal amount of net debit in the
official reserves account.
ii. Deficit in BOP – When the autonomous receipts (credits) are smaller than autonomous
payments (debits), the balance of payments will be in deficit or unfavourable or adverse.
In other words, if total debits are more than total credits in the current and capital
accounts (including errors & omissions), the net debit balance measures the deficit in the
nation’s balance of payments. This deficit is settled with an equal amount of net credit in
the official reserve account.

The analysis of equilibrium & disequilibrium in balance of payments is summarized in table 3.2.
S/No Nature of transactions BOP Situation Official Changes in
Reserve Foreign Exchange
Account Reserves
01 Autonomous Receipts = Equilibrium in Zero ( i.e. No No change
Autonomous Payments Balance of credit or debit
[ Total credits = Total debits Payments entry)
in current & capital accounts
(including errors &
omissions)]
02 Autonomous Receipts ≠ Disequilibrium in Credit or Debit Increase or
Autonomous Payments Balance of entry Decrease
Payments
02 A Autonomous Receipts > Surplus in Net Debit Increase
Autonomous Payments Balance of entry
[ Total credits > Total debits Payments =
in the current and capital Favourable BOP
accounts(including errors &
omissions)
02 B Autonomous Receipts < Deficit in Balance Net Credit Decrease
Autonomous Payments of Payments = entry

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 [ Total debits > Total credits Unfavourable
in the current & capital BOP , Adverse
accounts ( including errors & BOP.
omissions)

3.5.2 Types of Disequilibrium

Disequilibrium in balance of payments can be classified as follows: -

(a) Temporary Disequilibrium – Temporary disequilibrium in the form of deficits or

surpluses tend to last for a short period of time. They are the result of temporary changes
in the economy like - crop failure, seasonal fluctuations, effect of weather on agricultural
production, etc. Such a disequilibrium may occur once a while and gets automatically
corrected. It does not pose a serious problem for a country.
(b) Fundamental Disequilibrium – There is no precise definition of the term fundamental
disequilibrium. Economists generally define fundamental disequilibrium as - “a deep
rooted persistent deficit or surplus in the BOP of a country.” It is a chronic BOP deficit,
according to IMF. It is of long term nature and a matter of serious concern for the
country.
(c) Cyclical Disequilibrium – Cyclical fluctuations in the business activity also lead to BOP
disequilibrium. Cyclical disequilibrium occurs because – (i) Trade cycles follow different
paths and patterns in different countries. (ii) Different countries follow different
stabilization programmes. (iii) Differences in price and income elasticities of demand for
imports.
(d) Structural Disequilibrium – Structural disequilibrium occurs due to structural changes in
the economy. Some of the structural changes would include – changes in technology,
changes in tastes and preferences, changes in long – term capital movements, etc.

3.5.3 Causes of Disequilibrium

The factors leading to disequilibrium (surplus or deficit) in balance of payments could be broadly
categorized into three –

i. Economic factors – The important economic factors are (a) structural changes in the
economy, (b) changes in exchange rates (overvaluation / undervaluation), (c) Changes in
the level of foreign exchange reserves, (d) Cyclical fluctuations, (e) Inflation / deflation
(f) Developmental expenditure undertaken by developing countries, etc.
ii. Social factors – The social factors may include changes in tastes & preferences due to
demonstration affect, population growth rate, rate of urbanization, etc.
iii. Political factors – The political factors may include – political stability / instability in a
country, war, change in diplomatic policy, etc.

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[Link] Implications of Disequilibrium

A disequilibrium (surplus or deficit) in balance of payments is considered as undesirable for a

country. However, the implication of disequilibrium depends on location or source and duration.
In this context the following generalizations are possible –

a) With respect to location it could be said that a surplus in the combined current and capital
accounts should be considered desirable for a country. On the other hand, a deficit in the
combined current and capital account should be considered as undesirable for the
country.
b) With respect to duration it could be said that if the disequilibrium (surplus / deficit) is
temporary or short term, then it is not much a serious concern for the country. But, if the
disequilibrium (surplus / deficit) is persistent or long term, it is a matter of serious
concern for the country and needs corrective policy action.
c) A fundamental disequilibrium (in the form of deficit ) is undesirable because –
(i) Under a system of fixed exchange rates it forces the country to go for devaluation,
while under flexible exchange rates it causes depreciation in the external value of
the currency.
(ii) It would lead to an increase in external debt of the country and may lead to
external debt trap.
(iii) It leads to depletion in foreign exchange reserves and again makes the position of
country extremely vulnerable.
(iv) It makes the country totally dependent on the loans supplied by international
organizations and foreign governments and raises serious doubt about the
maintenance of its external sovereignty.
d) It is observed that disequilibrium in the form of surpluses are very rare while
disequilibrium in the form of deficits are a common phenomenon. Hence, in practice, the
term disequilibrium is normally associated with deficits in BOP.

3.6 Measures to Correct Disequilibrium in Balance of Payments

The policy makers in different countries of the world always aim at achieving equilibrium in the
balance of payments over a period of time. As pointed out above disequilibrium in the form of
deficit is a matter of grave concern for the country. Hence, if the country has a deficit in its BOP,
then efforts are made by policy makers to either remove or at least reduce the deficit and bring
adjustment in its BOP.

The adjustment measures to correct disequilibrium in BOP can broadly divided into two types –
(A) Automatic (B) Policy Induced or Deliberate.

(A) Automatic Adjustment – Under automatic adjustment, as the name implies, the BOP
adjustment comes about automatically, and it is not brought about deliberately by
government policy or intervention. The burden of adjustment is on the economy and
market forces and not on the government. It is argued that under automatic adjustment if
market forces of demand and supply are allowed to have a free play, in course of time,
BOP equilibrium will be automatically restored. Assuming fixed or flexible exchange

34
 rates, the automatic adjustment in BOP takes place through changes in prices, interest
rates, income and capital flows. Thus, under automatic adjustment there is no government
intervention. However, it is to be noted that automatic adjustment does not confirm to
reality and has unwanted side effects.
(B) Policy Induced or Deliberate Measures – Under policy induced adjustment there is
government intervention in correcting disequilibrium in BOP. As the name implies,
deliberate measures are undertaken by the government to correct disequilibrium in BOP.
The government tries to correct disequilibrium through its policy instruments like –
monetary & fiscal policy, trade policy, devaluation, exchange controls etc. Thus, BOP
adjustment becomes a matter of policy. However, the government policies designed to
correct disequilibrium in BOP cannot neglect the internal problems related to the
economy like unemployment, inflation, economic growth etc.

3.6.1 Policy Induced Measures

The most important objectives of a nation are:

(a) internal balance,

(b) external balance
(c) a reasonable rate of growth,
(d) an equitable distribution of income and
(e) adequate protection of the environment, etc.

In the present context, internal balance and external balance are the two objectives or targets of
government policy. Internal balance refers to the achievement of full employment and price
stability. While external balance refers to the achievement of equilibrium in balance of
payments. Thus, internal balance is achieved by reducing inflation and unemployment to zero
and external balance is achieved by reducing BOP deficits and surpluses to zero. Generally,
government places priority on internal over external balance, but they are sometimes forced to
switch their priority when faced with large and persistent external imbalances. The government
through its various policy instruments tries to achieve internal balance and external balance

To achieve the objectives of internal & external balance the main policy instruments at the
disposal of government are as follows –

1) Monetary & Fiscal Policy (Expenditure – Changing Policies) – Monetary and fiscal
policy are the two tools or instruments through which the twin objectives of internal and
external balance are achieved.

Monetary policy affects the economy through changes in money supply and interest rates.
An expansionary monetary policy will increase the money supply and decrease interest
rates. While a contractionary monetary policy will decrease the money supply and
increase interest rates. An expansionary monetary policy will lead to increase in the level
of investment, output, income and imports. On the other hand, a contractionary monetary
policy will work in the opposite way.

35
Fiscal policy affects the economy through changes in government expenditure and taxes.
An expansionary fiscal policy means an increase in government expenditure and /or
decrease in taxes, while a contractionary fiscal policy means a decrease in government
expenditure and / or increase in taxes. An expansionary fiscal policy will lead to increase
in production, income and imports, while contractionary fiscal policy will do the
opposite.

It is to be noted that the effects of monetary policy on the BOP situation of a country are
highly predictable, whereas the effects of fiscal policy on the BOP are less predictable.
These policies seek to achieve internal & external balances by altering the aggregate level
of demand for goods and services, both domestic and imported, by increasing or reducing
the aggregate expenditure in the economy. Hence, these two policies are also called as
‘expenditure changing policies.’

Economists like Trevor Swan and others have identified four possible cases (zones) of
internal and external imbalance which calls for an appropriate mix of monetary and fiscal
policy. The four cases are –

(1) Unemployment – BOP Surplus

(2) Inflation – BOP Surplus
(3) Inflation – BOP deficit
(4) Unemployment – BOP Deficit.

It is argued that an expansionary monetary & fiscal policy is suitable for solving the
problem of unemployment & BOP surplus. (Case 1). While, a contractionary monetary &
fiscal policy is suitable for solving the problem of inflation and BOP deficit. (Case 3).
But the situation of inflation & BOP surplus (Case 2) and unemployment & BOP deficit
(Case 4) represent a policy dilemma. This is because reducing inflation needs a
contractionary policy while reducing BOP surplus needs an expansionary policy.
Similarly, reducing unemployment needs an expansionary policy while reducing BOP
deficit needs a contractionary policy. Hence, both the cases need appropriate assignment
of monetary & fiscal policies.

Trevor Swan (1955) argued that a country should achieve internal as well as external
balances simultaneously by using a flexible exchange rate policy and monetary & fiscal
policy package on the other. According to Swan, the role of attaining external balance
should be given to the flexible exchange rate system (through currency devaluation /
revaluation), while monetary & fiscal policy should take care of internal balance.
However, his solution is not accepted by economists because when the economy follows
monetary & fiscal policies simultaneously for achieving internal balance (one target), it
moves away from external balance (the other target). (Case 2 & 4).

Swan Diagram: Trevor Swan’s analysis can be explained by Swan Diagram. (Fig.3.1).

36
 Fig. 3.1: The Swan Diagram

In fig. 3.1 the vertical axis measures the exchange rate, and the horizontal axis measures
the real domestic expenditure or absorption. Points on the EE curve refer to external
balance, with points to the left indicating external surplus and points to the right
indicating external deficit. Points on the YY curve refer to internal balance, with points to
the left indicating internal unemployment and points to the right indicating internal
inflation. The crossing of EE and YY curves defines the four zones of external and
internal imbalance and helps us to determine the appropriate policy mix to reach external
and internal balance simultaneously at point F. If the economy is not at point F, then it is
in disequilibrium, i.e. it is in one of the four zones. When the economy follows
expenditure changing monetary and fiscal policies simultaneously in zones II & IV, to
achieve internal balance (one target) it moves away from external balance (the other
target).

Mundell’s Assignment Rule : Mundell has given solution to the solve the dilemma with
the help of assignment. The assignment problem involves the pairing of a particular
policy instrument with a particular target. According to the principle of effective market
classification developed by Mundell the policy assignment is stable when each policy
instrument is assigned to that target on which it has relatively the most influence. Robert
Mundell’s (1962) assignment rule provides a useful guideline for assigning policy tasks
to monetary and fiscal policies. According to him, under fixed exchange rates, assigning
monetary policy for external balance and fiscal policy for internal balance would be an
“appropriate” assignment. Thus, for solving Unemployment – BOP deficit case, the
country should adopt expansionary fiscal policy and contractionary monetary policy.
While for solving Inflation – BOP surplus case, the country should adopt contractionary
fiscal policy and expansionary monetary policy. Hence, Mundell’s assignment rule calls
for a judicious mix of monetary & fiscal policy. Mundell’s analysis can be summarized in
table 3.3.

Table 3.3: Monetary – Fiscal Policy Mix for Internal & External Balance
State of Balance of State of the Domestic economy
Payments
High Unemployment Rapid Inflation
Surplus A C
Expansionary Monetary & Contractionary Fiscal Policy &
Fiscal Policies Expansionary Monetary Policy

37
 Deficit B D
Expansionary Fiscal Policy & Contractionary Monetary &
Contractionary Monetary Policy Fiscal Policies

2) Devaluation (Expenditure Switching Policy) - Devaluation means reduction in the

external value of the country’s currency undertaken by the government officially. It is a
deliberate action taken by the government deliberately and legally. Devaluation does not
change internal purchasing power of a currency. A country devalues its currency in order
to correct its BOP deficit. Devaluation is considered as ‘expenditure switching policy’
because it switches expenditure from imported goods to domestic goods & services.
Thus, when a country with BOP deficit devalues its currency, the domestic price of its
imports increases and the foreign price of its exports falls. This makes exports cheaper
and imports costlier. Now the foreigners can buy more goods by paying less money than
before devaluation. This encourages exports. This causes expenditure to be switched
from foreign to domestic goods as the country’s exports increase and the country
produces more to meet the domestic and foreign demand for goods. On the other hand,
with imports becoming costlier than before, they decline. Thus, with the rise and exports
and fall in imports, BOP deficit is corrected. It is to be noted that the IMF considers
devaluation as a means to correct fundamental disequilibrium in a country’s BOP but it is
to be used only as a last resort.

Effects of Devaluation - Theoretically it is said that devaluation would –

(a) encourage exports and discourage imports of goods and services and thereby improve
trade balance and current account balance.
(b) It would encourage capital inflows and improve capital account balance. The two
tendencies together would improve the overall BOP situation of the country.
(c) The effect of devaluation on terms of trade depends on demand and supply elasticities
for exports and imports.
(d) The effect of devaluation on national income depends on whether devaluation
improves or worsens terms of trade. If the terms of trade improve, national income
will rise and vice versa.

Conditions for the success of Devaluation – The success of devaluation depends on

some essential conditions which are as follows –

i. The demand for exports & imports should be fairly elastic. In other words, it should
satisfy Marshall – Lerner condition.
ii. The supply of exports should be adequate to meet the increased demand for exports
after devaluation.
iii. There should be domestic price stability after devaluation.
iv. Devaluation will be successful only if other countries do not devalue their
currencies simultaneously. In other words, there should not be retaliation.
v. There should be international cooperation. In other words, the other countries
should not adopt measures to counter the effects of devaluation. Such measures
would include – increase in tariff duties, export subsidies, etc.

38
 vi. Devaluation cannot be successful in isolation, so it should be supported by
monetary, fiscal and other trade policy measures.

There are also two issues which are associated with the effects of devaluation. They are (a) J
– Curve effect and (b) Currency – Pass through relationship.

(a) J – Curve Effect: It is generally argued that devaluation will initially deteriorate
trade balance, and later on improve trade balance. In other words, following a
devaluation or depreciation of the domestic currency, the balance of trade typically
worsens for several months before it eventually improves. This phenomenon is
known as J- curve, because the trade balance traces a J –shaped curve through time.
Thus, J – curve effect shows the time path of the response of trade flows to
devaluation. Fig. 3.2 shows a typical J – curve.

Fig. 3.2:- A Typical “J - Curve”

In fig.3.2, trade balance is measured on vertical axis, and time is measured on

horizontal axis. Assuming that the original trade balance is zero, a devaluation or
depreciation of the nation’s currency will first result in deterioration of the nation’s
trade balance before showing a net improvement after time A.

(b) Currency – Pass through Relationship – The effect of devaluation also depends
on currency – pass through relationship. The extent to which changing currency
values lead to changes in import and export prices is known as currency – pass
through relationship. It is theoretically assumed that a given change in the exchange
rate brings about a proportionate change in import prices. In practice, however, this
relationship may be less than proportionate, thus weakening the influence of a
change in the exchange rate on the volume of trade.
3) Exchange Control – Exchange control also forms a part of expenditure – switching
policy because they too aim at switching of expenditure from imported goods and
services to domestic goods and services. Exchange control serves the dual purpose of
restricting imports and regulating foreign exchange.

39
 Under the exchange control, the whole foreign exchange resources of the nation,
including those currently occurring to it, are usually brought directly under the control of
the exchange control authority. The exchange control authority is usually the government
or central bank of the country. Dealings and transactions are regulated by the exchange
control authority.

The recipients of foreign exchange like exporters are required to surrender foreign
exchange to the exchange control authority in exchange for domestic currency. The
exchange control authority allocates the foreign exchange on the basis of national
priorities.

Exchange control methods could be direct and indirect. Direct methods would include –
intervention and regulation in matters concerning exchange rates, foreign exchange
restrictions, multiple exchange rate policies, exchange clearing agreements, etc. Indirect
methods would include – import tariffs & quotas, export subsidies, etc.

4) Trade Policy Measures – Trade policy measures would include measures which would
reduce imports and promote exports. The important trade policy measures are - (a) Import
controls (b) Export promotion.
a. Import controls - A country may control its imports by imposing or increasing import
duties, restricting imports through import quotas, licensing, prohibiting altogether the
import of certain non essential items, etc.
b. Export promotion – A country would promote exports by reducing or abolishing
export duties, providing export subsidies, encouraging production of exportables,
provide monetary, fiscal, physical and institutional incentives and facilities to
exporters, etc.

To sum up, there are four policy induced measures to correct disequilibrium in balance of
payments. They are (1) Monetary & fiscal policy, (2) Devaluation, (3) Exchange control and (4)
Trade policy measures. However, in practice none of these measures are used in isolation. On the
contrary, majority of them are used together and hence can be said to be complimentary to each
other.

40
4.0 Insurance

It is a commonly acknowledged phenomenon that there are countless risks in every sphere of
life. For property, there are fire risks; for shipment of goods, there are perils of sea; for human
life, there are risks of death or disability; and so on. The chances of occurrences of the events
causing losses are quite uncertain because these may or may not take place. In other words, our
life and property are not safe and there is always a risk of losing it. A simple way to cover this
risk of loss money-wise is to get life and property insured. In this business, people facing
common risks come together and make their small contributions to the common fund. While it
may not be possible to tell in advance, which person will suffer the losses, it is possible to work
out how many persons on an average out of the group may suffer the losses.

When risk occurs, the loss is made good out of the common fund. In this way, each and every
one shares the risk. In fact, insurance companies bear risk in return for a payment of premium,
which is calculated on the likelihood of loss. In this lesson, you will learn Insurance, its various
kinds, premium calculation, calculation of paid up/surrender value etc in details.

4.1 Nature of Business Risks

If you decide to engage yourself in any business activity your main objective will naturally be to
earn profit. It is the most important objective of every business because without profit your
capital will get reduced and may be totally lost. So you will do your best to manage your
business efficiently. Sometimes you may find that sale of goods produced in your factory is
declining. That is a warning signal. You may then try to find out the reasons behind it. If you can
identify the reasons, you may find some remedies. Suppose you find that imported goods of the
same quality are being sold by competing traders at a much lower price. You have to face the
loss as a result of the change in market conditions. There are other reasons, which may also
result in loss of income or profit. Goods may be lost in course of transportation. There may be
accidental fire in the godown, workers of the factory may go on strike. You may not be able to
anticipate or control some of these possibilities. This is the concept of risk. Risk is the possibility
of loss or damage due to factors over which the businessman has little or no control.

All business activities are subject to uncertain events or happenings and may suffer loss or
damage. Timely precaution can be taken to avoid some of the losses. But certain losses and
damages have either to be borne by the businessman himself, or if possible, shared with others.

The possibility of loss or damage can be divided into two broad categories: uncertainties and
risks. Uncertainties are the events, which cannot be foreseen. But risks can be anticipated in the
light of past experience. The chances of fire in the factory or godown depend upon precautions
taken to prevent its occurrence, or having necessary preparedness to keep the resulting loss at a
minimum level. So is the case with loss or damage by theft or accidents.

Now take another type of situation. Every person has to think of his future needs when he is not
able to work or suffers from old age and illness. This is not an uncertain occurrence. Illness is
bound to be there for living beings sometime or the other and more likely after a certain age. It is

41
also necessary to consider that death may strike at a time when there will be a family to be
looked after and provided with a means of living.

There are also risks, which have a significant place in business. While goods are transported
from place to place, there may be accidents causing, damage or loss of goods. Trains may be
derailed, bridges may collapse, or airplane may crash due to engine trouble. Trucks may be
looted on their way to another city. Damage may be caused to goods sent by ship at the time of
loading or unloading at sea ports. Can such damages or losses be shared with any other party?
Let us note how these can be shared by means of insurance.

4.2 What is an Insurance

Insurance is a tool by which fatalities of a small number are compensated out of funds collected
from the insured. Insurance companies pay back for financial losses arising out of occurrence of
insured events, e.g. in personal accident policy the insured event is death due to accident, in fire
policy the insured events are fire and other natural calamities. Hence, insurance is a safeguard
against uncertainties. It provides financial recompense for losses suffered due to incident of
unanticipated events, insured within the policy of insurance.

Insurance, essentially, is an arrangement where the losses experimented by a few are extended
over several who are exposed to similar risks. Insurance is a protection against financial loss
arising on the happening of an unexpected event.

An individual who wants to cover risk pays a small amount of money to an organization called
on Insurance Company and gets insured. An insurance company insures different people by
collecting a small amount of money from each one of them and collectively this money is
enough to compensate or cover the loss that some members may suffer.

The fixed amount of money paid by the insured to the insurance company regularly is
called premium. Insurance company collects premium to provide security for the purpose.

Insurance is an agreement or a contract between the insured and the Insurance Company
(Insurer).

4.3 Nature of Insurance

On the basis of the definition of insurance discussed above, one can observe its following
characteristics:

4.3.1 Risk Sharing and Risk Transfer

Insurance is a mechanism adopted to share the financial losses that might occur to an individual
or his family on the happening of a specified event. The event may be death of earning member
of the family in the case of life insurance, marine-perils in marine insurance, fire in fire insurance
and other certain events in miscellaneous insurance, e.g., theft in burglary insurance, accident in

42
motor insurance, etc. The loss arising from these events are shared by all the insured in the form
of premium. Hence, risk is transferred from one individual to a group.

4.3.2 Co-operative Device

Insurance is a cooperative device under which a group of persons who agree to share the
financial loss may be brought together voluntarily or through publicity or through solicitations of
the agents. An insurer would be unable to compensate all the losses from his own capital. So, by
insuring a large number of persons, he is able to pay the amount of loss.

4.4 Importance of Insurance

To appreciate the importance of insurance we have to discuss the benefits that we derive from it.

As explained in the previous section, insurance serves as a very useful means of spreading the
effects of personal as well as business risks by way of loss or damage among many. Thus, the
insured have a sense of security. Individuals who pay premium periodically out of current
income can look forward to an assurance of receiving a fixed amount on retirement or his family
being secured in the event of his death. Businessmen also pay premium for insurance of risk of
loss without constant worry about the possibility of loss or damage.

Insurance plays a significant role particularly in view of the large-scale production and
distribution of goods in national and international market. It is an aid to both trading and
industrial enterprises, which involve huge investments in properties and plants as well as
inventories of raw materials, components and finished goods. The members of business
community feel secured by means of insurance as they get assurance that by contributing a token
amount they will be compensated against a loss that may take place in future.

From the national economic point of view, insurance enables savings of individuals to
accumulate with the insurance companies by way of premium received. These funds are invested
in securities issued by big companies as well as Government.

Individuals who insure their lives to cover the risks of old age and death are induced to save a
part of their current income, which is by itself of great importance.

Insurance is also a source of employment for the people. The people get employed directly in its
offices spread over the country and it also provides opportunities to the people to earn their
livelihood by working as agent of the insurance companies.

4.5 Types of Insurance

Insurance occupies an important place in the modern world because the risk, which can be
insured, have increased in number and extent owing to the growing complexity of the present
day economic system. It plays a vital role in the life of every citizen and has developed on an
enormous scale leading to the evolution of many different types of insurance. In fact, now a day
almost any risk can be made the subject matter of contract of insurance. The different types of

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insurance have come about by practice within insurance companies, and by the influence of
legislation controlling the transacting of insurance business. Broadly, insurance may be classified
into the following categories:

i. Classification on the basis of nature of insurance

a. Life Insurance
b. Fire Insurance
c. Marine Insurance
d. Social Insurance
e. Miscellaneous Insurance
ii. Classification from business point of view:
(a) Life Insurance
(b) General Insurance
iii. Classification from risk point of view:
(a) Personal Insurance
(b) Property Insurance
(c) Liability Insurance
(d) Fidelity Guarantee Insurance

However, in the present lesson we will discuss insurance in business point of view, personnel
insurance and property insurance.

4.5.1 Life Insurance

A contract of life insurance (also known as ‘life assurance’) is a contract whereby the insurer
undertakes to pay a certain sum either on the death of the insured or on the expiry of a certain
number of years. In return, the insured agrees to pay an amount as premium either in a lump sum
or in periodical instalments, annually or half-yearly. The risk insured against in this case is
certain to happen. Hence, life insurance is also referred to as life assurance. The written form of
contract is known as life insurance policy. It provides for the payment of a fixed sum to the
insured either on a fixed date or on the happening of an event, which is certain. Businessmen can
provide for life insurance of all their employees by way of group insurance. It also develops
loyalty among employees and can be used as a security for raising loans.

There are two basic types of life assurance policies (a) Whole-life policy, and (b) Endowment
Policy. A whole life policy runs for the whole life of the insured and premium is payable all
along. The sum assured becomes due for payment to the heirs of the insured only after his death.
An endowment policy on the other hand, runs for a limited period or upto a certain age of the
insured. The sum assured becomes due for payment at the end of the specified period or on the
death of the insured, if it occurs earlier.

4.5.2 Fire Insurance

A contract of fire insurance is a contract whereby the insurer, on payment of premium by the
insured, undertakes to compensate the insured for the loss or damage suffered by reason of
certain defined subject matter being damaged or destroyed by fire. It is a contract of indemnity,

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that is, the insured cannot claim anything more than the value of property lost or damaged by fire
or the amount of policy, whichever is lower. The claim for loss by fire is payable subject to two
conditions, viz; (a) there must have been actual fire; and (b) fire must have been accidental, not
intentional; the cause of fire being immaterial. The basic principle applied with regard to claim is
the principle of indemnity. The insured is entitled to be compensated for the amount of actual
loss suffered subject to a maximum amount for which he had taken the policy. He cannot make a
profit through insurance. For example, if a person takes a fire insurance policy of #. 20,000/- on
certain goods. Out of these, goods worth #15,000/- are destroyed by fire. The insured can only
claim an amount to the extent of loss i.e., #15,000/- (and not #20, 000/-) for the damage from the
insurance company.

4.5.3 Marine Insurance

Marine insurance is an agreement (contract) by which the insurance company (also known as
underwriter) agrees to indemnify the owner of a ship or cargo against risks, which are incidental
to marine adventures. It also includes insurance of the risk of loss of freight due on the cargo.
Marine insurance that covers the risk of loss of cargo by storm known as cargo insurance. The
owner of the ship may insure it against loss on account of perils of the sea. When the ship is the
subject matter of insurance, it is known as hull insurance. Further, where freight is payable by
the owner of cargo on safe delivery at the port of destination, the shipping company may insure
the risk of loss of freight if the cargo is damaged or lost. Such a marine insurance is known as
freight insurance. All marine insurance contracts are contracts of indemnity.

The followings are the different types of marine insurance policies

(a) Time Policy – This policy insures the subject matter for specified period of time, usually
for one year. It is generally used for hull insurance or for cargo when small quantities are
insured.
(b) Voyage Policy - This is intended for a particular voyage, without any consideration for
time. It is used mostly for cargo insurance.
(c) Mixed Policy – Under this policy the subject matter (hull, for example) is insured on a
particular voyage for a specified period of time. Thus, a ship may be insured for a voyage
between Mumbai and Colombo for a period of 6 months under a mixed policy.
(d) Floating Policy - Under this policy, a cargo policy may be taken for a round sum and
whenever some cargo is shipped the insurance company declares its value and the total
value of the policy is reduced by that amount. Such shipments may continue until the
total value of the policy is exhausted.

4.5.4 Other types of Insurance

Apart from life, fire and marine insurance, general insurance companies can insure a variety of
other risks through different policies. Some of these risks and the different policies are outlined
below.

(a) Motor vehicles Insurance: Insurance of all types of motor vehicles- passenger cars,
vans, commercial vehicles, motor cycles, scooters, etc., covers the risks of damage of the

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 vehicle by accident or loss by theft, as also risks of liability arising out of injury or death
of third party involved in an accident. Third party risk insurance is compulsory under the
Motor Vehicles Act.
(b) Burglary Insurance: Under this insurance the insurance company undertakes to
indemnify the insured against losses from burglary i.e., loss of moveable goods by
robbery and theft by breaking the house.
(c) Fidelity Insurance: As a protection against the risks of loss on account of embezzlement
or defalcation of cash or misappropriation of goods by employees, businessmen may get
policies issued covering the risks of loss on account of fraud and dishonesty on the part of
employees handling cash or in charge of stores. This is called fidelity insurance policy.
The employees may also be required to sign a fidelity guarantee Bond.

4.6 Principles of Insurance

There are certain principles that may apply to the contracts of insurance between insurer and
insured, which are as follows.

i. Utmost goods faith: Insurance contracts are the contract of mutual trust and
confidence. Both parties to the contract i.e., the insurer and the insured must disclose
all relevant information to each other. For example, while entering into a contract of
life insurance, the insured must declare to the insurance company if he is suffering
from any disease that may be life threatening.
ii. Insurable interest: It means financial or pecuniary interest in the subject matter of
insurance. A person has insurable interest in the property or life insured if he stands to
gain from its existence or loose financially from its damage or destruction. In case of
life insurance, a person taking the policy must have insurable interest at the time of
taking the policy. For example, a man can take life insurance policy on the name of
his wife and if later they get divorced this will not affect the insurance contract
because the man had insurable interest in the life of his wife at the time of entering
into the contract. In case of marine insurance insurable interest must exist at the time
of loss or damage to the property. In contract of fire insurance, it must exist both at
the time of taking the policy as well as at the time of loss or damage to the property.
iii. Indemnity: The word indemnity means to restore someone to the same position that
he/she was in before the event concerned took place. This principle is applicable to
the fire and marine insurance. It is not applicable to life insurance, because the loss of
life cannot be restored. The purpose of this principle is that the insured is not allowed
to make any profit from the insurance contract on the happening of the event that is
insured against. Compensation is paid on the basis of amount of actual loss or the sum
insured, which ever is less.
iv. Contribution: The same subject matter may be insured with more than one insurer.
In such a case, the insurance claim to be paid to the insured must be shared or
contributed by all insurers.
v. Subrogation: In the contract of insurance subrogation means that after the insurer has
compensated the insured, the insurer gets all the rights of the insured with regard to
the subject matter of the insurance. For example, suppose goods worth Rs. 20,000/-
are partially destroyed by fire and the insurance company pays the compensation to

46
 the insured, then the insurance company can take even these partially destroyed goods
and sell them in the market.
vi. Mitigation: In case of a mishap the insured must take all possible steps to reduce or
mitigate the loss or damage to the subject matter of insurance. This principle ensures
that the insured does not become negligent about the safety of the subject matter after
taking an insurance policy. The insured is expected to act in a manner as if the subject
matter has not been insured.
vii. Causa-proxima (nearest cause): According to this principle the insured can claim
compensation for a loss only if it caused by the risk insured against. The risk insured
should be nearest cause (not a remote cause) for the loss. Then only the insurance
company is liable to pay the compensation. For example a ship carrying orange was
insured against losses arising form accident. The ship reached the port safely and
there was a delay in unloading the oranges from the ship. As a result the oranges got
spoilt. The insurer did not pay any compensation for the loss because the proximate
cause of loss was delay in unloading and not any accident during voyage.

4.7 Payment of Bonus

Financial soundness of a company is determined by comparing all assets with all liabilities. In a
valuation of a life Insurance Company, the liabilities pertaining to life Insurance policies are
worked out. Other liabilities, like outstanding capital etc. are already determined clearly and
don’t have to be estimated or assessed every time. The policies liabilities as determined by the
valuation have to be compared with all the assets less what is earmarked for other liabilities,
which are known. The net figure of assets is equal to what appears as “life fund” on the liabilities
side and is the fund set aside for meeting the claim of policyholders. There is surplus if the actual
life fund exceeds the liabilities shown by the valuation, which means that the fund set aside for
policyholders is more than the need. If the fund is less there is deficit.

If a surplus is shown in a valuation, it has to be distributed amongst the policyholder. Any bonus
distribution system should be equitable to existing and new policyholders, simple to operate,
easy to understand and flexible. Following are the main systems of distribution of bonus:

1. Reversionary Bonus: Under this system, bonus is given as uniform percentage additions
to the basic sum assured and is payable with the sum assured. It is called Simple
Reversionary Bonus. If the bonus is calculated as a percentage of the basic sum assured
plus any existing bonus previously declared it is known as Compound Reversionary
Bonus.
2. Interim Bonus: Generally the bonus vests on policies that are in force on the date of
valuation. Policies resulting into claims by death or maturity subsequent to the policy
year containing the date of valuation will not have any bonus that year. Therefore, interim
bonus may be declared to be paid along in such claims. This is with a view to facilitate
settlement of claims that may arise before the next valuation is completed and avoid
reopening of all these cases at a later date.
3. Terminal Bonus: This benefit is payable on policies which are in force for the full sum
assured for a minimum period of 15 years before resulting into claim by death or
maturity. This bonus is in addition to the reversionary or interim bonus, if any. Terminal

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 Bonus is not payable for paid up policies, surrendered, or discounted policies. The bonus
is always paid on Sum Assured.

4.8 Calculation of Age of the Life to be Assured

Risk of death is closely related to the age of the life to be assured. Hence, the age at entry into
the contract of insurance becomes the most significant factor to determine premium. Months and
days over the completed years of age are not taken as such, but the age to be taken is rounded off
to the years in integer may be defined as:

(1) Age nearer to the birthday

(2) Age on next birthday
(3) Age on last birthday

If a person was born 22 years 8 months earlier, Then

(1) Age nearer to the birthday is 23

(2) Age on next birthday is 23
(3) Age as on last birthday is 22

If a person is 22 years 5 months 29 days then the age nearer birthday will be 22 years and if the
age is 22 years 5 months 30 days the age nearer birthday will be 23 years.

We will explain this with the help of the following examples:

(1) If a person is born on 1/1/1980, then on 1/8/2000 he is 20 years 7 months and 1 day old
therefore:
(a) his age nearer to his birthday 21 years.
(b) his age as per last birthday 20 years.
(c) his age as per next birthday 21 years.
(2) If a person is born on 1/1/1980, then on 11/4/2000 he is 20 years 3 months and 11 days
old therefore:
(a) his age nearer to his birthday 20 years.
(b) his age as per last birthday 20 years.
(c) his age as per next birthday 21 years.

4.9 Calculation of Actual Premium

After calculating the age, the premium will be calculated as follows:

i. Tabular premium for the age concerned

ii. Loading proposal for reason of health and/or physical impairments. Extras on adverse
health features or adverse Medical report e.g. Blood pressure, sugar, diabetic, smokers,
etc.
iii. Extra for occupation: There are extra premium on hazardous or extra-hazardous
occupations e.g. Aviation and defense, mining and other occupational risks.

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 iv. Extra for accident benefits (if asked and if allowed): To get additional benefit on account
of accidental death, the extra premium is to be paid for Double Accident
Benefit (DAB) and Extended Permanent Disability Benefit (EPDB).
v. Extra for premium waiver benefit: If a person becomes disabled then he will not be
able to pay the premium because he may not be able to earn because of his disability.
Therefore, the company waives off the premium on payment of additional premium.
vi. Mode of Payment: Adjustment are made for different mode of payment as per details
given below:

Mode Rebates
1. Yearly 3% of Tabular premium
2. Half Yearly 1.5% of Tabular premium
3. For Quarterly mode and Monthly mode No Rebate : No loading
under Salary Saving Scheme (SSS)
4. For Ordinary Monthly mode except Loading of 5% on Tabular Premium
Salary Saving Scheme for monthly
payment

vii. Rebate for large sum assured: Adjustments are also made for higher sum assured. For
every new policy there are certain:
a. ‘fixed costs’ which are uniform for all policies irrespective of sum assured, for
example, cost of policy preparation or postal expenses for mailing the policy
document.
b. ‘variable costs’ depending on the sum assured; for example stamp duty on the policy
document or medical examiner’s fee.

When the sum assured is large, fixed costs get reduced per thousand sum assured
resulting into savings to the insurer. Insurer shares these savings with the policy holders
by offering rebate in tabular premium for large sum assured.

4.10 General Insurance

The various schemes of the General Insurance cover

(1) Movable and Immovable Property Insurance

(2) Vehicle Insurance
(3) Goods in Transit Insurance

Let us study something about each one of them.

1. Movable and Immovable Property Insurance: Movable and Immovable Property

belonging to an individual or an organization can be insured fire, theft, natural
calamities, riots etc.
2. Vehicle Insurance: There are two types of insurance for vehicle.
(i) Act Insurance or the Third party Insurance: This is compulsory for all vehicles
under the Motor Vehicle Act. If a vehicle is insured under “Act Insurance” only,

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 then the damage caused to another person or his property (Including Vehicle) is
payable by the company in case of an accident i.e. the person who suffers the loss is
compensated and not the insured. The insured doesn’t get any compensation.
(ii) Comprehensive Insurance : Under this scheme, the person whose vehicle is
assured also gets compensation, in addition to the money paid to the third party.
Thus, the insured also gets a cover for the damage or loss suffered by him (or her)
or his/her vehicle. No Claim Bonus: If no claim is made during the year of
comprehensive insurance, the company allows a rebate to the insured (i.e. owner of
the vehicle) in the premium to be paid in the successive year. The rate of rebate
continues to increase year after year if no claim is made on the policy. This is called
“No Claim Bonus”. Note: ‘No Claim Bonus’ is not given on ‘Act Insurance’.
‘No Claim Bonus’ is a sort of reward for not claiming any damages by the insured
and not for the vehicle.
(4) Goods in transit insurance : When goods are sent from one place to another, there is a
possibility of loss/damage occurring in transit due to accident, strike, riots etc. The mode
of transit could be road, rail, sea or air. To cover such risk, there are many policies with
different rates of premium.

Difference between Life Insurance and General Insurance

Life Insurance General Insurance
1. Amount assured becomes payable on Actual financial loss suffered becomes payable
death or maturity. subject to the limit of sum assured.
2. It is for whole life or for a specified Usually for a period of one year
period
3. It promotes savings along with It provides financial protection only.
financial protection.

Let us take some examples

Example 1: A man insured his house for #420,000 against fire and other calamities at the rate of
1% premium. What annual premium he has to pay?

Solution: Value of the house = #420000

Rate of premium = #10 per thousand
420000×10
Annual premium to be paid = ( 1000 ) = 4200

Example 2: If a car costs #220,000, then what will be the comprehensive insurance of the car if
the tabular premium charged is #4113 for #130,000 and 2.95% of the excess amount and the act
insurance is #160.

Solution: Tabular premium = #4113

Excess amount = #(220,000 - 130,000) = #90,000

2.95
The premium on excess amount = # ( 100 × 90000) = #2655
Premium = #(4113 + 2655) = #6768

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 Act Insurance = #160
Premium to be paid = #(6768 + 160) = #6928
Thus, premium to be paid = #6928

Note: If the owner of the car is allowed No Claim Bonus, it will be calculated on #6768 and then
Act insurance will be added.

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