Difference between Tariff and Tax

UPSC Key Points to Remember:

• A tariff is always related to international trade.
• Tax is a broader term, which may include tariffs.

Repo Rate

• Definition:
  The interest rate at which the RBI (Reserve Bank of India) lends short-term funds to commercial banks against the pledge of their government securities.
• Purpose:
  To provide liquidity to banks.
• Example:
  If the RBI’s repo rate is 6.50%, banks will pay this interest rate on loans taken from the RBI.
• Impact:
  • Increasing the repo rate → Loans become costlier → Helps reduce inflation.
  • Decreasing the repo rate → Loans become cheaper → Stimulates economic activity.

Reverse Repo Rate

• Definition:
  The interest rate at which the RBI borrows short-term funds from commercial banks, providing them with government securities in return.
• Purpose:
  To absorb excess liquidity from banks.
• Example:
  If the RBI’s reverse repo rate is 3.35%, banks will earn this interest rate on funds lent to the RBI.
• Impact:
  • Increasing the reverse repo rate → Banks are encouraged to park funds with RBI → Reduces cash in the market.
  • Decreasing the reverse repo rate → Banks are encouraged to lend more in the market → Increases cash flow.

Main Differences – Repo vs Reverse Repo Rate

CRR (Cash Reserve Ratio)

Definition:
The minimum percentage of cash that every commercial bank is required to deposit with the RBI.

Legal Basis:
Under the RBI Act, 1934.

Features:

• Kept only in the form of cash.
• Banks earn no interest on it.
• RBI changes it to control the cash supply in the market.

Example:
If the CRR is 4% and a bank has total deposits worth ₹1000 crore, it must keep ₹40 crore in cash with the RBI.

Purpose:

• Control inflation.
• Manage liquidity in the economy.

SLR (Statutory Liquidity Ratio)

Definition:
The minimum percentage of a commercial bank’s net demand and time liabilities (NDTL) that it must maintain in the form of approved securities, gold, or cash before offering credit.

Legal Basis:
Under the Banking Regulation Act, 1949.

Features:

• Can be kept in cash, gold, or approved government securities.
• Remains with the bank itself, not with the RBI.
• Banks can earn interest on it if invested in government securities.

Example:
If the SLR is 18% and a bank has deposits of ₹1000 crore, it must keep ₹180 crore in approved forms.

Purpose:

• Ensure the financial stability of banks.
• Maintain demand for government bonds.

Key Differences – Table

Bank Rate

Definition:
The interest rate at which RBI lends long-term loans to commercial banks without any repurchase agreement (repo).

Features:

• Usually applicable on loans for more than 90 days.
• Direct impact on inflation and cost of credit.
• Higher bank rate → banks borrow at higher cost → loans to the public become costlier.

Example:
If the bank rate is 6.75%, then for any long-term borrowing from the RBI, banks will pay 6.75% interest.

Floating Rate

Definition:
An interest rate that changes from time to time and is linked to a benchmark rate (such as MCLR, Repo Rate, or an external benchmark).

Features:

• Common in home loans, car loans, etc.
• If interest rates fall → EMI decreases; if rates rise → EMI increases.

Example:
If your home loan is at MCLR + 1% and MCLR falls to 7%, your rate becomes 8%; if MCLR rises to 8%, your rate becomes 9%.

MCLR (Marginal Cost of Funds Based Lending Rate)

Definition:
The minimum lending rate below which a commercial bank cannot give loans. Introduced by the RBI in 2016 to replace the Base Rate system.

Calculation Based On:

• Marginal cost of funds.
• Impact of CRR.
• Operating costs.
• Tenor premium (time period premium).

Features:

• Different for each bank.
• Usually reviewed monthly or quarterly.

Example:
If SBI’s 1-year MCLR is 8% and the loan is at “MCLR + 0.50%”, the interest rate will be 8.50%.

Key Differences – Table

Currency Convertibility
Meaning:
Currency convertibility means the freedom to exchange a country’s domestic currency into foreign currencies and foreign currencies into the domestic currency without any government restrictions.

Types

1. Current Account Convertibility
   • Meaning: The freedom to exchange currency for international transactions related to goods, services, and income.
   • In India:
     • Implemented in 1994 under IMF Article VIII.
     • This means transactions in foreign currency (like USD) are allowed for exports-imports, foreign travel, education, remittances, etc.
2. Capital Account Convertibility
   • Meaning: The freedom to exchange currency for capital transactions such as foreign investments, shares, bonds, and property transactions.
   • In India:
     • Partially implemented.
     • Not fully implemented due to the risk of rapid capital inflows and outflows (capital flight), which can be dangerous for the economy.

Advantages

• Attracts foreign investment.
• Facilitates global trade and capital flows.
• Increases global confidence in the currency.

Disadvantages / Challenges

• Risk of capital flight.
• Higher currency volatility.
• Greater vulnerability of weak economies to external shocks.

📌 Key UPSC Points:

• India: Full convertibility on the Current Account, partial on the Capital Account.
• 1994: India adopted Current Account Convertibility under IMF Article VIII.
• Full Capital Account Convertibility was studied by the Tarapore Committee (1997, 2006).

Balance of Payments (BoP)

Definition:
The Balance of Payments is a systematic record of all economic transactions between a country and the rest of the world over a specific period (usually one year).
It includes transactions related to goods, services, investments, loans, aid, and capital flows.

Main Components

1. Current Account
   Includes:
   1. Merchandise Trade – Exports (+) and Imports (–)
   2. Services Trade – IT services, tourism, shipping, etc.
   3. Income Receipts/Payments – wages, interest, dividends
   4. Unilateral Transfers – remittances, gifts, grants from abroad

• • Surplus: Country earns more from exports than it spends on imports.
  • Deficit: Imports/spending are more than exports/income.

2. Capital Account
   Includes:
   • Foreign Direct Investment (FDI)
   • Foreign Portfolio Investment (FPI)
   • External Commercial Borrowings (ECBs)
   • Changes in foreign exchange reserves

Represents transactions in capital assets.

BoP Balancing:

• BoP is always balanced → If there is a current account deficit, there must be a surplus in the capital account, or foreign exchange reserves will decrease.
• The RBI uses forex reserves to manage imbalances.

Difference Between BoP and BoT

📌 Key UPSC Points:

• India: Usually has a Current Account Deficit (CAD) and a surplus in the Capital Account.
• CAD: When the total current account transactions are negative.
• BoP Crisis: In 1991, India faced a severe shortage of foreign exchange reserves.

FDI (Foreign Direct Investment) – Direct Foreign Investment
Definition:
When a foreign company or individual invests in a country’s business, industry, or infrastructure for the long term with direct ownership and control.

Key Points:

• Setting up factories, plants, offices, joint ventures, or subsidiaries.
• Investor gets participation in management and voting rights.
• Long-term and permanent investment.

Example:
Toyota (Japan) setting up a manufacturing plant in India.

FII (Foreign Institutional Investors) – Foreign Institutional Investors
Definition:
Foreign investors who invest in a country’s financial markets (shares, bonds, derivatives) but do not have direct control over the company’s management.

Key Points:

• Institutions such as mutual funds, insurance companies, pension funds.
• Investment is often for the short term.
• Funds can enter and exit the market quickly → called Hot Money.

Example:
A US pension fund investing in the Indian stock market.

Portfolio Investment
Definition:
A type of foreign investment in financial assets such as shares, bonds, and mutual funds, without direct control over production or management.

Key Points:

• Includes FII.
• Done purely for financial returns (capital gains).
• More volatile and short-term.

Example:
A US investor buying shares of TCS without any role in its management.

Key Differences – Table

📌 UPSC Tip:

• Remember: FDI → “Factory”, FII → “Finance”.
• In India:
  • FDI policy is handled by DPIIT (Department for Promotion of Industry and Internal Trade).
  • FII/Portfolio investment is regulated by SEBI (Securities and Exchange Board of India).