Volume 21, Issue 1
1
The Financial Bulletin
FROM THE EDITOR
Money Matters Club IBS,Hyderabad Established—2005
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The March edition holds a lot of interesting articles to read Where at one side we tried to analyze the Budget 2013, Is taxing the super-rich justified? On the other side we also get to know about the Mergers and De-mergers and its impact and also the Fed bonds impact. We also discussed about the micro credits impact in India.
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The Financial Bulletin March 2013
CONTENTS 04 Budget 2013 –by Aditya Chordia SCIT 2012-2014
08 MERGERS & ACQUISITIONS: E VALUATION OF S YNERGIES -by Prakarsh Jain, Rohit Gambhir S P Jain School of Global Management, DubaiSingapore
04 E-Commerce Effervescence
13 Micro credit in modernizing Agriculture: Indian Perspective -by Chandra Sekhar ABV - Indian Institute of Information Technology & Management, Gwalior
16 Taxing the Super-rich – A costly move! –by Nitin Bhat, Infosys
20 Emerging Market shines over Euro zone -by Kunal Sanghvi SIMSREE
27 Bank Consolidation: An Overhyped Idea? -by Aarzoo sharma, Krupa shah MET institute of management Mumbai University
32 Impact of Fed Bond Buying on the Economy –by Yogesh Athale, SIMSREE
3
BUDGET 2013 In the current scenario, I am sure nobody would
be economically viable for India in the face of
be ready to take on the job of Finance minister of
rising uncertainty. Keeping all these points in
India. Considering all the corruption scams, policy
consideration below mentioned are the some of
inaction and growing inflation which has been the
the important decisions taken in the budget 2013.
headlines of the UPA II regime for the past 5 years.
Fiscal Deficit
And here comes a Harvard business graduate to
PC beat his own estimate of keeping fiscal deficit
present his 8th budget as a Finance minis-
to 5.3% by bringing down the number to 5.2%.
ter....Welcome Mr. P Chidambaram (Let’s call him
But this was largely possible because of a huge
PC). The three big issues that might have been
reduction in the planned expenditure (money
troubling PC prior to announcing the budget is as
used for investment in various sectors for
follows:
development
of
the
The widening fiscal deficit
country). So basically PC cut
i.e. the difference between
down the expenditure by a
income and expenditure.
huge margin and with a little
PC had promised prior the
help
budget that he would try to
decisions like de-regulation
keep the fiscal deficit to
of diesel prices and capping
5.3%.
the LPG helped in bringing
from
the
recent
The decelerating growth combined with an ever
down the fiscal deficit.
rising inflation.
Also PC has aimed to bring down the fiscal deficit
Finally the rising current account deficit i.e. the
to 4.8% in the coming fiscal year. This reduction is
difference between exports and imports due to
predicted based on huge ambitious targets like
rising imports of oil and gold.
bringing down the subsidies to fuel, increased tax collections, spectrum allocation and huge funds
Prior to the budget, India was already facing a
collected from the disinvestment in PSU’s. Of the
threat of downgrade from the Standard and Poor
above only the target from disinvestments seems
rating agency which would have seriously affected
achievable and the tax collections target seems
the foreign inflows. PC also had to keep in mind
achievable provided the economy grows at 6.2-
that this is the last budget before the general
6.3% in the next fiscal.
elections and hence he had to present a fairly
GST (Goods and Service tax) & DTC (Direct tax
populist budget but at the same time it also had to 4
code)
Taxing Super rich
PC mentioned that the government has set a
PC has proposed to charge a surcharge of 10% for
deadline for bringing in DTC and the bill would be
those earning more than 1 crore and the
brought in the parliament at the end of the budget
surcharge for a domestic firm earning more than
session.
10 crore has been increased to 10% from 5%.
As far as GST is concerned, PC mentioned there is no
Though he has mentioned that this surcharge
deadline as such because it depends on how fast all
would be valid only for one year. Nearly 49500
the state ministers can come to a conclusion over a
people earn more than 1 crore as per
common model and compensation. But PC has set
government estimates. Really this number
aside 9000cr (compensation for year 2010-11) for
baffles me!!!!! (Only 49000...come on yaar)
GST and requested all the state ministers to come a
The government has increased excise duty on
conclusion as early as possible. It is estimated that
SUV’s to 30%. Cigarettes and mobile phones
the introduction of GST would add at least 1.5% to
also attract more taxes. There has been an
the existing GDP.
increase in customs duty for luxury cars and
Direct benefit transfer (DBT)
bikes. Also import duty of used cars has been
The flagship programme of UPA for the forthcoming elections “Direct benefit transfer” as per PC is on right tracks and some modifications here and there are required. According to PC, there are 3 pillars for
increased to 125% from 100% which curbs the import of luxury second hand cars. Even A/C restaurants have to pay more as part of their service tax.
DBT:
Energy & Manufacturing
A digitized beneficiary list.
Electricity is set to become costlier as duty will be charged on imported coal (be it stem coal or
Bank accounts for all beneficiaries.
bituminous coal) with 2% custom duty and 2%
Aadhaar card.
CVD (countervailing duty—a duty that is applied
As per PC, the digitized beneficiary list is almost
to offset subsidized export from another
ready and once the list is ready, bank accounts for
country).
all beneficiaries will be opened and Aadhaar is Also to revive the manufacturing sector, doing the catch-up work. PC also mentioned that government has planned an investment the food and fertilizers benefit would be kept out of allowance of 15% over an investment of 100 the current DBT as they are complicated and some
crores for all investments in plant & machinery
work needs to be done.
in the coming two years. PC has also raised the custom duty on electronics goods which is a positive 5
sign
for
the
local
electronic
manufacturing units.
(Foreign
institutional investment) and
Incubators
(Foreign
direct
PC mentioned in his budget speech that funding will be given to incubators on college campuses. Also the
corporate
sector’s
investment
in
such
incubators will be considered as CSR (Corporate social responsibility). The corporate’s will be more than happy to invest in such incubators as they are interested in giving funding to entrepreneur’s.
investment).
Any
FDI
foreign
institution having more than 10% stake will be considered as FDI and less than 10% will be considered as FII. This step has left many foreign institutions to change their holding pattern in the Indian organizations. Also PC has stated that along with tax certificates,
a
beneficiary
certificate is also necessary to avoid double taxation.
Real estate
These decisions have spooked the foreign
The government has proposed that a 25 lakh home
investors from investing their funds in the Indian
loan will get tax deduction of an additional one lakh
economy.
tax deduction on interest payments for the first year. Overall a person taking a home loan of 25 lakh
Women Power PC has allocated nearly 2000crores for the
will get tax deduction of 2.5lakh. This step surely augurs well for the real estate sector as it has been reeling under low demand from the customers. But the real estate sector feels that there are very few homes available at that rate and
women and child development ministry and 1000crores for the “Nirbhaya fund” in honour of the Delhi gang-rape victim to promote women’s safety.
hence this step wouldn’t make any significant
But Congress has faced to pass the bill which
difference to their prospects. Instead the real estate
reserves 33% of the seats for women in
sector expected some perks on the premium home
Parliament as though it has been passed by
side rather than the affordable home section.
Rajya sabha, it has still not been cleared in the Lok Sabha. All these steps clearly indicate
Foreign investment
Congress is trying to woo the second largest
The government has proposed a 20% tax on profits distributed through buyback of shares (government felt many firms instead of distributing profit through dividends opted for the route of buyback of shares). Also there has been an increase on tax on royalties, companies pay to their parents abroad to
base of voters. Also PC has proposed to open an All-women bank which
will
lend
specifically
to
women
entrepreneurs and women self-help groups. It will also be managed completely by women.
25% from 10%.
Health care
Also PC has clearly stated the difference between FII
Universal health coverage (UHC) one of the
6
flagship programmes of UPA takes a back seat and 21,239 crores have been allocated for National Health mission (NHM). Also allocation for the Integrated Child development services has been increased 11.7% to 17,700 crores. Allocation to the Ministry of drinking water and sanitation was increased to 15,260 crores from 14,000 crores. But the health care industry feels there has been only a marginal increase in the budget allocated to them when compared with the previous year. Also the experts feel that the government is not concerned about the health of the people.
Education The education sector has been allocated roughly 65,000 cr, an increase of 7% from that of the current fiscal year. Major portion of this budget goes to Sarva Shiksha Abhiyan (SSA) which is entrusted with implementing the Right to education act. Also 1000cr have been set aside by PC for a scheme in which 1 million students will get Rs.10,000 each on completing skills training course. CONCLUSION Considering the current scenario, it has been a satisfactory budget and let’s hope that the country rises to a growth of 6% plus. It’s achievable provided the investment cycle improves which has been stagnant due to various bottlenecks. Moreover everybody can’t be made happy in a budget!!!!!!.
Aditya Chordia SCIT 2012-2014
7
MERGERS & ACQUISITIONS: E VALUATION OF S YNERGIES I purchase companies, split them into small arms, and sell them off; it’s worth more than the whole one of it, explicated by the corporate acquirer, in the movie, Pretty Woman, which displays a company acquired through uncongenial bid and thereon striped-off its assets, entirely disregarding the decades of sweat-work seated by its holders. This is what actually happens in cutthroat environment and therefore a need arises for a guard to take care of the interest from third party interference. To mitigate this problem, there are laws across globe that are in place, dealing with mergers and acquisitions. Hence, one thing stands clear, before doing any number-crunching and other planning; we have to consider if systems are in place to follow the law of the land.
Introduction Mergers & acquisitions has been big part of the corporate world since decades. It deals with conjoining entities for gaining various operational/financial benefits. From the capital market viewpoint, the promulgation of merger sends a strong message, such that the company is moving forward in the business and probable increase in the market capitalization. The main aim of M&A is to create positive synergy effects in business. “One plus One makes Three� - this statement represents the main philosophy behind M&A.
The Words Merger and Acquisitions are used as synonyms, but they mean slightly different.
Merger:
Blend of two or more companies, dealt by offering the stockholders securities in the acquiring company in exchange for the surrender of their stock.
Acquisition:
The target company ceases to exist and the acquirer continues to trade its own shares. Acquisitions can be either friendly or unfriendly; it depends on the accordance of the target company.
Synergy:
A concept that the value and performance of two companies combined will be greater than the sum of the separate individual parts.
8
Why Merger and Acquisition ? Following would give us clarity on the above: Inorganic Growth: Organic is limited to the stand-alone growth of the company, whereas, merger/ acquisition leads to immediate growth in size and market capitalisation/valuation. Acquiring intellectual capital/technology Tax considerations and Overcoming government policies Restructuring the business Cost reduction and efficiency leverage Capital optimization
To top it all, the overarching reason for a decision on merger and acquisition taken by a company is the synergy it would provide.
Valuation The synergy provided by an event of M&A can be calculated on estimating the value of the company to be acquired. There are various methods of doing so; some of them are as follows:
Discounted Cash-Flow Analysis: This method involves discounting the expected future cash flow to the present value in order to derive an estimated value of the company. The terminal value too, is taken into consideration, which is discounted to perpetuity.
Assets Based Valuation: A method wherein valuation is based on the assets and liabilities of the company. It plays an important role where companies have large investments in fixed assets to generate earnings. It is also a sought out approach by companies that are “worth more dead than alive.�
Comparable Company Analysis: The analyst first defines a set of other companies that are similar to the target company. This may include companies within the target’s primary industry or in similar industries. 9
A company’s enterprise value is the market value of its debt and equity to cash flows, enterprise value to EBITDA, to EBIT and to sales. The equity can also be valued using equity multiples.
Other considerations: Brand Valuation Relative Valuation: Price Earnings Ratios, P/B Ratio, Tobin Q, Price to Sales Ratio
Valuation of combined firm should be greater than the value of companies on stand-alone basis.
Probing Synergies Creating value of the enterprise that exceeds the cost of acquisition is the primary objective of the management based on which the market pays-off or punishes the shareholders of a combined company. When employed on to valuation and other deal theories, synergy would mean, the companies win, in which the seller receives an acquisition deal premium and the buyer realizes shareholders value. The fundamental and the only palpable justification, which appeals to the owners and management of the company, is the synergy that an M&A would provide and therefore, the centering is on identifying and tracking synergy. A chiseled and crystal-clear approach to synergies, gives rise in the probability of achieving the objectives. Such an approach would involve:
Prototyping-Synergies Synergy Identification and Validation: For preparing, a deal model the company that is acquiring would need to validate assumptions that are sensitive to the deal. When it comes to an auction process, the amount of information to reveal or not to reveal is completely in the hands of the seller. Hence due diligence is extremely essential to identify and authenticate value drivers. To prototype synergies, assumptions are based on information, which is target provided and using public data. The corporate development and finance teams develop these assumptions. Hence, higher the level of detailing in the initial assumptions would be of relevance to negotiate approval process. Many companies face challenges when they are approaching diligence in the form of unraveling, what could be wrong with the target company. To overcome this challenge a more efficient approach would be to break down risk areas and important value drivers. Prior to realizing synergies from an acquisition, it is essential that the synergy assumptions are identified and validated by the functional units. Once the functional units have ownership of the numbers and the 10
same are verified by experts the credibility of the synergy estimates go up. Synergies are easier to realize if the acquirer has a good understanding of the business, he is acquiring. In general, cost synergies are more successful than revenue synergies. This could be true because cost synergies-reduce headcount, overhead reduction, etc. involve lesser variables and rely less on subjective variables as compared to revenue synergies. Companies face possible risks if they don’t validate the synergies with the functional owners. Firstly, inaccurate estimates have a higher chance of occurrence with no validation from functional owners. Secondly, a chance of shortfall in synergy increases once the deal is completed. Hence, vetting these costs and including these numbers in the overall valuation is extremely critical to create a realistic model.
Carrying-Out Challenges of Synergy Realization: The most common reason for acquisitions not realizing their full potential lies in weak execution. This in turn hampers the ability to create shareholder wealth through acquisitions. Factors that play a key role in realizing synergies from a deal depend on the type of synergy target. For cost synergies the management’s tone and supervision is critical. The revenue synergies are more about aligning efforts through combination of technical knowledge.
Transparency: Transparency is extremely essential to maximize synergy realization. The company that is being acquired should have a clear link to its internal and external financial statements. This is important information that stakeholders can use to authenticate value creation. In addition, management’s commitment is extremely essential to the successful creation of synergies.
Talent Retention: Another essential factor for realizing synergies is the retention of talent that would help maximize the benefits from the integration of the acquirer and the company being acquired. Certain companies use financial incentives to retain certain key members of the firm until the synergy realization is maximized.
Integration: Certain companies make an error in judgment by delaying integration and underestimating its complexity. To avoid making this error companies should focus on accelerating the transition, prepare for day one and at the same time establish leadership on all levels. More importantly, the company should manage the integration as a business process.
11
Tracking-Synergies It is simple, if your operating profit is good, then its working well for you. The focus is on tracking if the actual income, sales/gross receipts, and the spending budget and see if that makes sense. More often than not, the first few years’ performance is solid because that is something, which is the near future, and that we have an integration team for, but we really have a hard time tracking it beyond a certain point of time. The bottom line and typically the revenue lag a little bit behind. Usually, we never get the sales synergies as we expect it to be. Comparing this with the prototyping is the basic that we are to undertake. Companies in present times also track non-financial metrics such as employee and customer retention. Preeminent practises make us conclude that the success of the deal puts emphasis on: Synergy-tracking Deal-process Measuring Share-holder value
Conclusion
“Mergers are like speed-dating. There is a short chronology involved in making a vital decision that would lead to union. The company acquired shows off its colours, and you need to differentiate between fascination and a perfect match.” Leveraging operations, human-resources, and tools that rapidly and accurately track synergies is indispensable to an effective M&A. These elements may not vouch value creation, but without these, a dealmaker’s chance for success diminishes substantially.
Prakarsh Jain
Rohit Gambhir
S P Jain School of Global Management,
S P Jain School of Global Management, Dubai
Dubai-Singapore
-Singapore
12
Micro credit in modernizing Agriculture: Indian Perspective
Microcredit (MC) has become a buzz word among
Financial Institutions: such as Non-governmental
the development practitioner. Term 'microcredit'
Organizations –Microfinance Institutions (NGOs –
means providing very poor families with very small
MFIs) and the last and Third one is Cooperative
loans to help them engage in productive activities or
Societies. Agricultural credit specifically involves
develops their tiny businesses. Agriculture is a
enjoying control over the use of money, goods
major contributor to India Gross Domestic Product
and services in the present in the exchange for a
(14.6% - 2013) and small-scale farmers play a
promise to repay at a future date. With
dominant role in this contribution but their
agricultural credit, a lender forgoes the use of his
productivity and growth are hindered by limited
money or its equivalent in the present by
access
to
extending credit to a
credit
facilities. Agriculture is
borrower
the most important
promises to repay on
sector of the country
terms specified in the
because
the
loan agreement. Many
policies
of
growth,
main
who
microcredit
output
policies
had seen launched in
poverty
India
alleviation, social justice and equity are best served
with
the
in this sector. The participation of commercial banks
objectives of providing microcredit to the rural
was negligible in agricultural loans. Farmers’ level of
poor farm households. Microcredit has also been
income was low and they were hesitant to use
acknowledged as one of the prime strategies to
technology. Therefore, agriculture Micro credit
achieve the Millennium Development Goals
policy aimed at increasing the flow of institutional
(MDGs). Access to adequate financial services
credit at reasonable rate of interest to agriculture
enables
sector. The cooperative credit structure was
productive assets, reduce their vulnerability to
strengthened by reorganizing and merging weak
external
societies with strong societies. Credit institutions
efficiency. Microcredit involves the supply of
can be categorized into three groups: first one is
loans, savings and other basic financial services to
Formal Financial Institutions: such as Commercial
the poor farm households. The small-holder
banks, Microfinance Banks, Development Finance
farmers require diverse range of financial
Institutions (DFIs), and State Government –owned
instruments to meet working capital requirement,
Credit Institutions. Second one is Semi-Formal
build assets, stabilize consumption and shield
13
small-holder
shocks
and
farmers
increased
to
procure
production
themselves against risks. In practice, microcredit is
to family agriculture are numerous and have been
much more than disbursement, management and
well identified. In order to develop agricultural
collection of small amount of loans. It recognizes
finance, different kinds of innovations regarding
the peculiar challenges of micro enterprises and their owners. It also recognizes the inability of the rural farm households
to
provide
tangible collateral and thus promotes
collateral
substitution.
Farmers,
especially
rural
farm
households are constrained by credit from both formal and informal sources. As the microcredit revolution
products and services as well as institutional
spreads the rural farm households are seen as
aspects are very important. The challenge is two-
micro-entrepreneurs with no collateral to pledge
fold: improve financial inclusion through better
but with a business world to conquer with the help
outreach of marginalized populations as well as
of micro credit. Financial services are needed by the
financial services that fit the diversity of financial
rural farm households to improve their wellbeing
needs. Other solutions to promote efficient,
through the upgrading of their farms and small
sustainable and accessible financial services for
scale businesses for positive impact on their
smallholder farmers are being found in terms of
livelihood. Judicious use of credit to acquire
institutional
productive resources will not only lead to on farm
diversification
capitalization but will also increase the production
borrowers or between agricultural activities and
efficiency of the farmers. The objective was to
less risky economic activities within rural areas in
promote agricultural development by modernizing
order to mitigate risk.
agriculture. The most common approach involved
With the help of some approach /character
direct government intervention via state-owned
reference we can improve the situation of rural
development banks and direct donor intervention
financial
in credit markets with favorable terms and
countries like Financial Sector Reform which is
conditions like soft interest rates or lenient
essential to restructure the financial sector aiming
guarantees.
at
The
factors
that
hinder
the
development of financial services made accessible 14
organization between
services
eliminating
such urban
generally
financial
as
in
market
portfolio
and
rural
developing
distortions,
restoring the health of the existing financial
institutions. Rural Finance which should be set up to design better operational procedures to improve staff and management performance to install adequate management information systems for use by the local farmer. Formal Financial Sector and Informal Financial Intermediaries can be used to reduce their information costs to link rural savings mobilization with credit and to facilitate loan supervision and loan recovery and also provide marketing loans which can be guaranteed by the government to contracted input dealers or traders. On the other hand Cooperatives and Role of government used to strengthening the business character of these organizations by providing adequate training marketing, financial management, accounting and auditing. Therefore, the government should take the responsibility of shifting the operation of informal cooperatives to formal cooperatives so that they will stand the chance of equal status and financial support. Last but certainly not the least I have concluded
that Micro credit helps to modernize production in
agriculture and place farmers in a proper position to employ mechanized equipment that can lead to increased agricultural productivity. Increased credit could accelerate rural development, reduce income disparities and create income increases that would improve welfare.
Chandra Sekhar ABV - Indian Institute of Information Technology & Management, Gwalior
15
Taxing the Super-rich – A costly move! Until a few days back, with the budget around the intentions of increasing the country’s revenues, corner, taxing the superrich seemed to be the gossip sky-rocketing tax rates led to large scale tax of the town. With an ominously increasing fiscal evasion, increased incidences of smuggling and deficit, this move would aim at improving direct tax emergence of underground black markets. This revenues, simultaneously giving an upward boost to counteractive sway of high tax rates became the our Tax/GDP ratio.
Populists and generalists raison d’ etre for steady decline in tax rates to
supported this view; however the economists came their current levels. out against it vehemently. While the former were of the opinion that marginal tax rates should increase as incomes rose, leading to greater tax collections, the latter argued that this move would have a detrimental effect on the economy due to increased incidences of tax evasions. Both arguments had their
Fast forward to 2013 January, the government was faced with quite the opposite situation. The economy has an untamable tiger, the rising fiscal deficit. High disposable incomes and low Tax/GDP ratio as compared to other developing countries forced to government to rethink the prevailing
merits in place, what mattered was the cost at which the
benefits Country would be accrued. Pre-liberalization,
on all terms with the common man. In 1970-71, the
tax
Marginal Tax Rate
Tax/GDP ratio (%)
rates. Table 1
UK
50%
39
details
the
Brazil
28%
34.4
marginal
tax
50%
30.8
rates and the
50%
28.3
Tax/GDP ratio
US
40%
26
China
45%
17
India
30%
10.3
India had an un- Australia friendly tax re- Japan gime, unfavorable
marginal
of some of the developing and developed countries
of
personal income tax had 11 tax brackets with the tax the world. A quick scan tells us that India has the rates progressively rising from 10 per cent to 85 per lowest Tax/GDP ratio among countries having cent. In the decades that followed, marginal taxes similar/greater marginal tax rates. were progressively reduced from the astronomical levels of 85% to less than 40%. Post liberalization, in 1997-98, income tax brackets were defined at 10%, 20% and 30% and haven’t changed since. Postindependence, though the government had noble 16
For a country with one of the lowest marginal tax rates, this is an indicative of the low levels of fiscal jurisprudence among the masses. Other factors which can be attributed to this anomaly are:
1.
2.
3.
High poverty levels and low disposable
in-
makes the most economic sense for the following
comes
reason. The surcharge of 10% on the highest tax
Inability of the govt. to capture the earnings
bracket of 30%, translates to an effective tax rate
of
of 33.99% (with education cess included). Such
SME’s/proprietary
firms
across
the
country
individuals were so far taxed at 30.90 % for
High tax exemptions to certain sectors like
incomes exceeding 10, 00,000 rupees. Under the
agriculture
new tax regime, such individuals
The finance minister was treading on thin ice when he presented this year’s budget. Among others, fiscal consolidation, reeling inflation,
will have to pay the new tax of just 33.99% on
contain-
income exceeding 10 times their sum. For
ing fiscal deficit and tax reforms were some of the
individuals with such high incomes, this increase in
key expectations from the common man. The fi-
tax is too small an incentive to launder the excess
nance minister did manage to live up to the expectations of the common man by
money in the hope of tax evasion. They might as
proposing appro-
well as end up paying it rather than being
priate measures to bring the economy back on
questioned about a suspicious tax evading deal.
tracks. The bone of contention was on the issue of
The costs associated with tax avoiding money
taxing the superrich. The finance minister offered
laundering
his two cents by main-
activities
are far higher than the
taining the marginal
benefits of being tax
tax rates as it, while
complaint.
imposing an additional
This will
ensure a greater ratio
10% surcharge on indi-
of tax compliance thus
vidual and corporate
boosting
incomes rising above 1
collections
crore rupees. Given the
the
tax
of
the
government.
large number of concessions and exemp-
Other than the one
tions
reason mentioned in
available,
the
number of tax-paying entities falling in this range is
the above paragraph, there are quite a few
small. The Minister himself provides a figure of a
economic implications entailing higher taxes for
paltry 42,800
individuals who qualify. With
the superrich. They also serve as reasons why the
due considerations to economic implications, the
superrich should not be taxed extra. Any tax
finance minister expects this move to add about
regime needs to give due considerations to these
180 billion rupees to the revenue base. This move
points, failing which the myopic vision of 17
increasing revenue will cloud the greater evil of tax
disastrous experience by levying exorbitant taxes
evasion.
on the rich. At its zenith, taxes were more than
The classical Laffer curve explanation: The
90% which achieved unintended objectives of
Laffer curve is a representation of the relationship
massive tax evasion and erosion of national
between possible rates of taxation and the resulting
character. As per Laffer, there was no incentive
levels of government revenue. It illustrates the
whatsoever for any individual to part with so
concept of taxable income elasticity—i.e., taxable
much of earnings with the government. This led
income will change in response to changes in the
to large scale unaccounted cash transactions, thus
rate of taxation. It postulates that no tax revenue
fuelling a massive black market economy.
will be raised at the extreme tax rates of 0% and
Historically, there is not a single instance where
100% and that there must be at least one rate
taxing the superrich has worked as a solution to
where tax revenue would be a non-zero maximum.
increase tax revenues. Similar problems, albeit on
The "economic effect" assumes that the tax rate will
a much compounded scale can be expected in
have an impact on the tax base itself. At the
case similar tax regimes are adopted.
extreme of a 100% tax rate, the government
Burdening the honest tax payer: In the past,
theoretically
the honest tax payer has always been haunted by
collects
zero
revenue
because
taxpayers change their behavior in response to the
the image of the vicious tax official waiting to
tax rate: either they have no incentive to work or
wring every last penny out of people’s pockets.
they find a way to avoid paying taxes. Thus, the
More often than not, the IT department knocks
"economic effect" of a 100% tax rate is to decrease
down the doors of individuals and corporates who
the tax base to zero.
religiously pay their taxes. Be it a regular salaried job individual or a reputed MNC entering India through an acquisition, they are harassed and
This theory also subtly hints that as the tax rate crosses the optimal tax rate where the tax revenue is maximum; imposing any additional taxes will act as a negative incentive for citizens to pay taxes. Thus, citizens of such economies resort to money laundering measures to avoid taxes from the government. Increasing taxes acts as a disincentive for tax compliance and causes tax avoidance. (The
interrogated about their supposedly suspicious transactions, the IT dept. turns a nelson’s eye towards sectors like liquor, real-estate, education where massive tax evasion is prevalent. Such incidences have eroded the faith of the tax system in the eyes of the so-called-rich, who continue to look for greener pastures outside the Indian economy.
tax rate t* is an indicative value varying across The dishonest rich: According to the Ministry
economies.)
of Finance, India has nearly 35 million taxpayers, Historical failure: In the past, India has had a 18
but only 1.7 million have a declared income of more than Rs 10 lakh. Nearly 89 per cent say their income is under Rs 5 lakh. A paltry 400,000 people declare an income of more than Rs 20 lakh. From the data provided, it is evident that the tax base of the superrich is a sliver of the total taxable population. Nearly 60 per cent of the economy is out of the tax net and tax collections from services, which account for more than half of the economy, are less than one per cent of GDP. Instead of increasing the marginal tax
rate, the finance ministry needs to shift focus on increasing the taxable base. An attempt to tax the super -rich will drive a greater proportion of income underground, thereby fuelling the incentive to buy goods and services without accounting for it. Heavily taxing this base of population will result in a distinct class of dishonest rich, leading to large scale migration of bright minds from India to other countries in search of regimes which are more favorable to stash their kitties. If the below picture is any indication of the magnitude of the tax evasion at current tax rates, it would not be a “taxing� exercise to determine the sky-rocketing levels to which these figures will soar to if the marginal tax rates are increased.
Nitin Bhat, Infosys
19
Emerging Market shines over Euro zone EXECUTIVE SUMMARY: The emerging markets have become favorable destination for investments for its resilient nature and improved policies. Before European crisis, emerging economies have been attracting investments from European Union (EU). Post crisis absolute quantum of inflows from EU into emerging markets have reduced considerably. However momentum is sustained because of bilateral treaties and aggressive entrepreneurial environment in emerging economies. Globalization made EU crisis affect emerging countries and the domestic demands in the emerging economies were not as strong enough to fill the demand shortfall that Euro zone created. During the East Asian crisis, emerging countries lacked countercyclical measures and policies. Since then many financial reforms with strong institutional architecture started attracting investors.
1. INVESTMET ACROSS BORDERS 1.1 Foreign Direct Investment (FDI) Global inflows are expected to pick up to over $1.2 trillion in 2010, rise further to $1.3–1.5 trillion in 2011, and head towards $1.6–2 trillion in 2012, UNCTAD reported. In 2011 Emerging economy alone contributes
to 51 %( $776 billion) of the total FDI inflows which is 12% more than previous year .The two large economies India and China showed a rise in FDI of 8% and 31% respectively. The top 5 sectors which attracted major portion of FDI are 1) Mining 2) Chemicals 3) Utilities 4) Transportation 5) Communication. FDI flows into Europe showed 19% increase due to M&A by transnational companies (TNC). Emerging markets have outperformed Europe in sectors like information, communication, machinery, services, and mining.
Figure 1 FDI inflow 20
1.1.1 FDI inward Potential: FDI inward potential takes depend upon factors such as GDP per capita, exports, telephone lines, R&D spending, exports, country risk, world market share of imports of products and services, energy consumption, stock data etc. The graph shows that, the inward potential of Emerging markets started rising not after the Euro crisis, but from 2005, continuing its rally till 2011.
Figure 2 FDI INFLOWS 1.2 Private Equity: It can be either through FDI route or FII route .Two important reasons for which PE deal decreased in Euro Zone Cost of debt and debt availability. Economic weakness and market volatility. Hence the global buyout deal value showed CAGR of (-2%) in Europe from 2010-20011 which is sharp decline when compared to the 2009-2011 CAGR value of 58%, emerging markets showed 32% CAGR in 2010-11. Private equity firms have seen a growth of 18% to $77 billion; it has lost momentum because of the crisis. The deterioration of the finance industry in most of the regions of Europe proved tough for them to rise their funding. As a result funds raised have fallen by 50% to $180 billion.
Venture Capital (VC): It can be either through FDI route or FII route. Corporate venture capital has played a major role in the past, accounting for 6% to 10% of all VC globally. Emerging economies have begun challenging Europe in attracting investments from VC. The European VC deals decreased which essentially means exit options are very less. The total value holding by the European VC firms is at $138 billion dollars of unutilized amount, seeking for opportunities of investments. In 2011 US$5.9 billion was raised in China and India, since 2005-2011 a tremendous change in the investment took place from $0.3 billion to $1.5 billion with 150 rounds of fund raising.
21
1.4 Trading Volume: The debt and equity market of emerging markets has showed a positive trend since 2005.
Figure 3: Debt and Equity Flows Debt Instruments: From the recent quarter of 2012, among the instruments traded across the world Brazilian instruments, according to EMTA (Emerging Market Trade Association) making $250 billion turnover a 34% increase from $187 billion previous year. Followed by Mexican debt instrument, with a turnover of $230 billion an 8% increase and then Russian instrument in 3 rd position with turnover $ 130 billion. The total debt instruments of Emerging markets contribute to $1.43 trillion a decline of 17% although this is a sign of volatility and many investors followed buy and hold strategy expecting future returns. CDS: CDS also traded at $218 billion for this quarter 2012, main reason being China’s slowdown in the second quarter and a marginal improvement in Euro zone. Bond Issuance: Emerging markets issued bonds and raised more than $300 billion and it was due to investors’ belief about emerging markets as well as high yield on bonds Funds: Emerging markets have attracted more than $21 billion in debt funds according to EPFR global source data released. Corporate issuance has touched $255 billion. 1.5 Exit opportunities: When VC investors evaluate the exit possibilities for emerging markets, they look at only two routes Selling to Private Equity Firms IPO Since the emerging markets like Brazil, India, China, Mexico showed a positive trend in IPO and private equity investments; emerging markets are safe and attractive haven for Venture Capitalist and PE 22
investors to enter and exit.
2. HOW INVESTORS VALIDATE INVESTMENT DECISIONS? 2.1 Credit Rating of Country The credit rating of a country gives a broad perspective about the country’s economic and political scenario. With the rating for almost all Emerging markets remain stable to positive except for Egypt due to political turmoil .For India; S&P rated B with negative outlook due to political and economic slowdown. On the other hand European Union which was hit by the crisis was given a higher rating except for Greece still the outlook for countries are negative.
Emerging
European
Country Brasil Turkey Russia Mexico Indonesia India Egypt Chile China France Italy Germany Ireland Portugal Greece
Credit rating July 2012 Moody's/Outlook Fitch/Outlook Baa2/Stable BBB/Stable Ba1/Positive BB+/Positive Baa1/Stable BBB/Positive Baa1/Stable BBB/Stable Baa3/Stable BBB-/Stable Baa3/Stable BBB-/Stable B-/Under Review B+/Negative
S&P/Outlook BBB/Stable BB+/Positive BBB/Stable BBB/Stable BB+/positive BBB-/Negative B/Negative
Aa3/Positive Aaa/Negative Baa2/Negative Aaa/Negative Ba1/Negative Ba3/negative C/Substantial Risk
AA-/Stable AA+/Negative BBB+/Negative AAA/Negative BBB+/Stable BB/Negative CCC/Stable
A+/Stable AAA/Stable A-/Negative AAA/Stable BBB+/Negative BB+/Negative CCC/Negative
2.2 Corruption One of the important reasons for Euro zone crisis is corruption in Greece. India’s case of 2G spectrum allocation, common wealth games scam, coal allocation scam. China, Mexico, Brazil, Russia are not an exception. Investors started demanding safety and security for their efforts as part of the policy reforms in order to invest, hence with increase in corruption decrease in investors’ interest to invest. 2.2.1 Corruption Perception Index (CPI) Ranks Germany 14,Ireland 19,Chile 22,France 25, Spain 31, Portugal 32, Turkey 61, Italy 69, Greece 80, India 95, Indonesia 100,Mexico 100, Egypt 112, Russia 143. Most of the European countries scored better rankings in the CPI index. But in the past seven years “Corruption Perception Index Ranking” of the Emerging markets and Euro zone is shown below.
23
Emerging Country
Euro zone
Figure 4: Corruption Perception Index
2.3. Political Factors 2.3.1 Government The government needs a robust and executable policy without much cumbersome procedures. European Union has free trade agreements with Emerging countries such as Chile, Turkey, Egypt and Mexico, Brazil, Chile. FTA with India is expected to be completed in few years. EU goods exports to India as of 2010 are €34.7 billion and EU goods imports from India as of 2010 are €33.2 billion, which is expected to improve after free trade agreement. Similarly EU has bilateral free trade agreements with many countries to increase import and export which is a lesson learnt by Emerging countries and in the current scenario it is working in their favor.
Figure 5: Economic freedom Index 2012 2.3.2 Conflicts In the past 30 years, 72 politicians were murdered in Brazil which fairly gives an idea of degree of conflict in the country. Brazil, the fight between “drug trafficking organizations” like Camando Vermelho (CV) and Amigos dos Amigos (ADA). India being the most conflict hit country in Asia with 21 conflicts, happened mostly by Naxalites. In China it is peasants who protested for the land seizures against government. In Mexico, it is drug cartels who involve in violence and 150 paramilitary groups are present. “Zapatista Army of National Liberalization” (EZLN) of Mexico, demands for autonomy and conflict with ideology. 24
Comparatively Euro zone had lesser conflicts and ranked better in conflict barometer
2.4 Economic Factors 2.4.1. Microeconomic factors include demand for product, labor force, skill sets, and labor laws and wage (both compulsory wage rate proposed by Government and general wage demand) 2.4.2 Macroeconomic factors include volatility in inflation rate, exchange rate, interest rates and tax rate Main macroeconomic indicators are GDP, Industrial production and trade balance, current account balance, unemployment rate. 2.4.2.1 Industrial Production, Current Account surplus/deficit: Europe has showed a positive trend in industrial production though it is marginal 0.6%, while India posted a yearly average of 6.8%, and China 9.4%, Mexico with 4% .Industrial production for Emerging economy slipped because of weak demand from the Euro area. In India exports grown by 2% in contrast to 21% increase. India has current account deficit of 4.3 %( % of GDP) which is lowest since economic crisis of 1991.Brazil showed a sharp bounce back in exports hence trade deficit decreased. Russia bounced back to 5.5% of GDP. The whole of Euro area showed a current account deficit of 0.6% of GDP 2.4.2.2 GDP: World GDP to be more than $ 69 trillion, and emerging economy alone constitutes, more than 50% of GDP. Of emerging countries China tops with $7.3 trillion, Brazil at 6th place and India at 11th position with $1.8 trillion. And Euro Union at $17.6 trillion (2011).This trend is gradually shifting and Emerging economy has begun too dominate.
Figure 6: GDP Emerging Vs. Advanced Economies
25
2.4.2.3 Unemployment Rate: The unemployment rate of Euro zone has reached a new high of 11.6%, whereas emerging markets are at around 5.9%. 2.4.2.4 Inflation Rate (Wholesale Price Index) Annual inflation rate for the Europe Union is estimated to be 2.5% including all items such as food, alcohol, tobacco, energy, non energy industrial goods. Compared to countries such as Germany (2%), France (1.9%), Spain (3.5%), Portugal (2.9%), China (1.9%), Mexico (4.77%), Brazil (5.28%), Russia (6.6%), India has the highest inflation rate of around 7.8%. 3. CONCLUSION Investors looking at emerging economy favorably because of rapid industrialization , high economic growth, marked improvement in Infrastructure, aggressive business environment, connectivity, education (Employable population), Information Technology, technological advancements, resilience to crisis like situation, improvement in quality of life . Since emerging markets not only believe in investments from across boundaries but create a “self economy� environment, this is to meet our own demand hence many emerging markets are not much affected by crisis situation. Although investments across these markets partially declined due to cautious move by investors to withhold investments and partially due to reduced demand from Euro Zone. Few demerits such as weak legal and institutional frameworks/systems, unpredictable tax regimes, transfer and convertibility risk, volatile operating environment- social /political investors hamper investment. But merits of emerging market such as policy reforms in such a way to remain resilient, lesser intense domestic shocks, aggressive entrepreneurial environment overcome the demerits, making the emerging markets a favorable destination for investors
Kunal Sanghvi SIMSREE
26
BANK CONSOLIDATION:AN OVERHYPED IDEA ? INTRODUCTION
fragmented nature of the Indian banking system
Consolidation in the banking industry is one of the
and the small size of the typical bank, some
most crucial issues facing the Indian financial
consolidation may be in order for banks that aim
sector at present. The logic of consolidation in
to play on a larger stage.
Indian banks is twofold. First, it is generally
The reasons for consolidation in India are the
accepted that India has too many banks of national
following:
spread and it will help the cause of a strong banking industry to reduce the number of banks through permitting greater consolidation in the industry. Secondly, going forward, increasing globalization in financial sector and opening up of Indian banking industry progressively to the foreign banks will require Indian banks to be globally competitive wherein size of the banks will be one of the most important dimensions.
Basel Norms: Basel III requires banks to meet tougher and higher capital adequacy norms such as capital allocation towards operational risk, in addition to credit and market risks. According to the Reserve Bank of India‟s report on “ Currency and Finance „‟ released on September 4, 2008, the banking sector would require an additional capital of Rs 5,68,744 cr in the
next five years. This is based on the The Raghuram Rajan Committee, in general, has recommended to encourage, but not force, consolidation amongst Public Sector Banks (PSBs). The Committee has observed that given the 27
assumption that banks would maintain Capital –to Risk –weighted Assets ratio (CRAR) at 12. 5%. Over the next five years,
PSBs would require Rs 3,69,115 cr (64.9% of
To Attain Global Competitiveness: Indian
total requirements , old private sector banks
banks are not able to compete globally in
Rs 23,319 cr (4.1%). New private sector
terms
banks Rs 113,180 cr (19.9%), and foreign
disbursal, investment and rendering of
banks Rs 63,131 cr(11.1%). To maintain the
financial services. The main reason behind
51 per cent minimum government share,
it is the size of the industry. In 2008, there
PSBs
capital
was only one Indian lender - SBI, at eighth
directly from the public and with this view it
place among the top 25 Asian banks.
promotes bank mergers. Consolidation may
Industrial and Commercial Bank of China,
be a route for smaller banks to infuse funds
the biggest Asian bank and the world’s
to strengthen their capital base.
eighth biggest bank, is four times bigger
cannot
collect
additional
of
fund
mobilization,
credit
than SBI, both in terms of tier-I capital as
Fragmented Size It is felt that India has many commercial
well as assets. Another recent study
banks that are very small. That is of the 53
„Report on Currency and Financeâ€&#x; released
domestic
by the RBI reveals that
banks
(both
the combined assets of
public
and
the five largest Indian
private ), the
banks - SBI, ICICI Bank,
size
Punjab
of
16
National
Bank,
banks at end
Canara Bank and Bank of
March
Baroda are just about
2007
individually
half the asset size of the
was less than
largest
0.5 percent of
Bank of China. The bank
size
is 3.6 times larger than
of
the
Chinese
bank,
banking sector. Indian banking industry is
SBI in terms of assets, branches and
highly skewed and almost 67 banks have a
profits.
less than 2.0% market share in India. There should be a small number of large banks
Indian banking industry
rather than a large number of small banks so that Indian banks could keep up with the
The banking industry in India has been in the
growing balance sheets of large Indian
process of transformation and consolidation ever
companies and play a role in big takeover .
since 1961. The Banking Regulation Act, 1949 empowers the regulator with the approval of the 28
government to amalgamate weak banks with Weaknesses stronger ones. Majority of the mergers in India have been crafted to bail out weak banks to safeguard depositors’ interest and to protect the financial system. The report of the Committee on Banking Sector Reforms (the Second Narasimham Committee - 1998), however, discouraged this practice. It recommended a multi-tier banking system with existing banks to merge into 3-4 international banks at the topmost level, 8-10 national banks engaged in universal banking at the next level and local and rural bank
confined.
Competition from foreign banks: Foreign banks will be soon allowed to spread their business in India which will create intense competition for Indian banks. The RBI Report on Currency and Finance presents the view that mergers are the only way to face competition from foreign banks. High level of fragmentation: There is a high level of fragmentation, especially among cooperative banks, as compared to some of the advanced economies of the world, which poses a serious threat to their
Following are the existing strengths and weaknesses of the Indian banking system and potential opportunities
and
threats
if
it
undertakes
consolidation by M&A as an avenue of inorganic growth.
profitability and viability in conducting business. Lack of product differentiation: The financial products offered by banks in India are similar across the industry with no distinctive features, thereby leading to
Strengths
unhealthy competition.
Liquidity:. Banks are required to keep a
Low
penetration: There is an uneven
stipulated proportion of their total demand
distribution of banking services in the
and time liabilities in the form of liquid assets
country. It is limited to few customer
which affect their liquidity position. RBI has
segments and geographies only. There is a
been easing the requirements with several
need for banks to open branches at these
rounds of reduction in the Statutory Liquidity
locations and establish connectivity with
Ratio (SLR) and Cash Reserve Ratio (CRR).
the help of a core banking solution.
Sound banking systems: The banking system in
Opportunities
India has generally been stable and sound in terms
of
growth,
asset
quality
and
profitability. It is because of healthy, prudent and well capitalized policies and practices
Advanced
technology:
generation
private sector banks and foreign banks are technologically more advanced in terms of management
implemented by the RBI from time to time.
New
information
systems,
delivery mechanisms, etc. These systems 29
and
processes
require
substantial
Product diversification: Merger creates the
investments which may be possible after
opportunity to cross-sell products and
consolidation.
leverage alternative delivery channels. Old
Basel norms: Basel III requires banks to meet
generation banks can merge with the new
tougher and higher capital adequacy norms
generation private sector banks and
such as capital allocation towards operational
foreign banks to diversify their credit
risk, in addition to credit and market risks.
profile. They can sell technology-based
Many Indian banks, especially public sector
innovative products.
banks, cooperative banks and regional rural banks
are
unprepared
for
this Threats
implementation due to capital inadequacy. Cost cutting: Many branches and ATMs of various banks are congregated in the same areas
Alignment of technology: The technology
leading to pointless outlay on premises,
infrastructure, system platforms, network
manpower
facilities.
architecture, database vendors and IT-
Consolidation may lead to redeployment and
enabled synergies should be compatible in
rationalization of such infrastructure, human
banks desiring to merge. Most of the
resources and other administrative facilities
public sector banks are at different stages
thereby undercutting the cost factor.
of technology implementation. It would
Enlarged
and
customer
maintenance
base:
The
combined
pose a stiff challenge to such merging
customer base may increase the volume of
entities to integrate their technology and
business. The enhanced rural branch network
working platforms.
may lead to increase in microfinance activities
Customer dissatisfaction: The change in the
and lending to the agriculture sector. M&A
nature and quality of financial products
may be a far-sighted conclusion to increase
may dissatisfy the customers, even if the
the market share.
products are better. In some cases
Geographical spread: Banks can diversify the risk
customers may be deterred by the
of concentrated lending through mergers.
acquiring company for various reasons
They can also have a greater market access
which may affect brand loyalty of the
thereby widening the deposit base. The RBI
combined entity.
has imposed strict licensing norms for
Integration of people: The acquirer bank may
opening of new branches and hence via
have to absorb the entire workforce of
consolidation, the acquirer will have access to
the target bank which may push up the
ready physical infrastructure.
wage cost. It also requires the integration 30
of the heterogeneous work cultures. The The changing regulatory environment has paved varied aspects of the work environment, if the way for foreign banks to enter Indian market not
handled
properly,
may
lead
to with their huge capital reserves, skilled personnel
resentment and shrinkage in productivity.
and cutting edge technology. Mergers will enable
Marginalization of small customers: Larger enti- Indian banks to compete effectively with these ties may neglect small customers and concen- foreign banks by enhancing their capital reserves trate on affluent customers or High Net worth and improving their operational efficiency and Individuals (HNIs).
distribution efficiency.
Regulatory hurdles: Some of the legal barriers need to be removed to make PSBs, which still control about 68 per cent of the Indian banking sector, active participants in the consolidation process. Rise of monopolistic structures: They may give rise to monopolistic structures and lower competition.
Monopolistic
entities
may
charge higher fees for services rendered in case there is no effective competition. The
Aarzoo sharma MET institute of management Mumbai University
motive should be to increase the size but not in isolation. CONCLUSION The benefits of consolidation far outweigh its drawbacks. The major gains from merger are the increase in size of the banks, the strengthening of the
Krupa shah
performance of the banks, effective absorption of
MET institute of management
new technologies, capability to meet the demand for
Mumbai University
sophisticated products and services, strengthening of risk management systems and the ability to arrange funding for major development works. Consolidation leads to cost reduction and revenue enhancement. It enhances the reach of the banks to the underserved segment and also reduces the cost of intermediation.
31
IMPACT OF FED BOND BUYING ON THE ECONOMY
On September 13, the US Federal Reserve launched its third round of Quantitative Easing. In addition, the Fed officially stated – for the first time – that it would keep short-term rates low through 2015. In contrast to the first two rounds of QE, this round is open-ended – meaning that the Fed can keep pumping money into the system indefinitely. In its statement, the Fed set forth the plan that if the outlook for the labour market does not improve substantially, the committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. The Fed is buying $85 billion in new assets, including $40 billion in mortgage-backed securities every month until the end of the year. As expectations grew before the first round of quantitative easing in 2008, QE1, and then the second in the fall of 2010, demand for Treasuries rose and their yields fell—as expected from programs that included direct purchase of U.S. government securities. But once the purchases began, prices fell (and yields rose) as investors steered the Fed's newly unleashed liquidity into riskier assets and sold down their holdings in safe-haven Treasuries. The 10-year yield rose 1.46 percentage points between the start and end of QE1. It rose 0.38 through QE2. RATES AT THE BEGINNING OF QE3
32
The Fed is weighing the costs and benefits of its bond purchases. It has a dual mandate: to both maximize employment and maintain low inflation. The central bank has pledged to keep the target range for the Federal Funds rate at 0 to 1/4 percent until the national unemployment rate falls to at least 6.5%, and as long as inflation stays in line with its 2% target. It anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015. On Feb 26, 2013 Chairman Ben Bernanke stood behind the Federal Reserve's low-interest-rate policies and sought to reassure members of Congress that the central bank has a handle on the risks. Bernanke told members of the House Financial Services Committee that the Fed's bond purchases are needed to boost a still-weak economy and that they have helped create jobs for average Americans. The bond purchases are intended to lower long-term interest rates. That encourages more borrowing and spending, which generates growth. However, continually pumping more money into the financial system, the bond purchases could ignite inflation.
POSITIVES:
The Fed's low-interest-rate policies are giving crucial support to an Economy still burdened by high unemployment. The aggressive program to buy $85 billion a month in Treasuries and Mortgage bonds had kept borrowing costs low, and that, in turn, has helped strengthen sectors such as housing and autos. 33
The Fed estimates are that its policy in recent months has helped create many private-sector jobs. People are able to buy houses at very low mortgage rates, refinancing at low mortgage rates. People are able to get car loans at low rates. The low borrowing costs have boosted demand, and that has helped to lift home prices, making homeowners feel more financially secure. US FISCAL CLIFF AND SEQUESTRATION In the United States, the fiscal cliff was the sharp decline in the federal budget deficit that could have occurred beginning in early January 2013 due to increased taxes and reduced spending as required by previously enacted laws. The deficit—the amount by which government spending exceeds its revenue—was projected to be reduced by roughly half in 2013. The Congressional Budget Office (CBO) had estimated that the fiscal cliff would have likely led to a mild recession with higher unemployment in 2013, followed by strengthening in the labour market with increased economic growth. Under the fiscal-cliff scenario, some major programs like Social Security, Medicaid, federal pay (including military pay and pensions) and veterans' benefits would have been exempted from the spending cuts. Discretionary spending for federal agencies and cabinet departments would have been reduced through broad cuts referred to as budget sequestration. Instead, the American Taxpayer Relief Act of 2012 (ATRA) largely eliminated the revenue side of the fiscal cliff by implementing a higher deficit and a smaller increase compared to the previously enacted laws. ATRA eliminated much of the tax side of the fiscal cliff while the reduction in spending due to budget sequestration was delayed for two months. The raise in revenue contained in the act came from: increased marginal income and capital gains tax rates relative to their 2012 levels for annual income over $400,000 ($450,000 for couples); a phaseout of certain tax deductions and credits for those with incomes over $250,000 ($300,000 for couples); an increase in estate taxes relative to 2012 levels on estates over $5 million; and expiration of payroll tax cuts (a 2% increase for most taxpayers earning under approximately $110,000). None of these changes would expire. Around 2 am EST on January 1, 2013, the U.S. Senate passed this compromise bill by a margin of 89–8. At about 11 pm that evening, the U.S. House of Representatives passed the same legislation without amendments by a vote of 257–167.U.S. President Barack Obama signed it into law the next day. However, the budget sequestration was only delayed and the debt ceiling was not changed, leading to further debate during early 2013. 34
In addition to the income tax rates and spending cuts, the package includes rise in inheritance taxes from 35% to 40% after the first $5m for an individual and $10m for a couple. However, President Obama is expected to order the highly-anticipated, much-dreaded "sequestration" - an across-the-board set of budget cuts totaling $1.2 trillion from defense and non-defense spending over the course of the next ten years. The administration has been vehement in its calls for Congress to find a way to avert the legally-mandated package. The cuts may result in hundreds of thousands of lost jobs, crippling losses for the nation's public education system, defense cuts that would leave the country unprepared for future military engagements, and a number of day-to-day inconveniences, like long lines at the airport and the shuttering of some public parks. As sequestration officially becomes law of the land, however, its impacts won't immediately be clear. Despite warnings of an economic turndown, cuts for 2013 may be rolled out over the next several months, triggering a government slowdown that will hit different agencies with various degrees of speed and impact as time goes on. And its toll, whatever it ends up being, will likely be drawn out and murky, with sources nearly unidentifiable to the average voter. According to the Budget Control Act of 2011, sequestration will cut $85 billion from the federal budget in the remainder of the 2013 fiscal year, slashing about $1.1 trillion more over the next decade. The White House has recently released a slew of memos detailing what they believe those cuts would look like on both a state and program level: The Office of Management and Budget (OMB) has calculated that sequestration will require an annual reduction of roughly 5 percent for nondefense programs and roughly 8 percent for defense programs. However, given that these cuts must be achieved over only seven months instead of 12, the effective percentage reductions will be approximately 9 percent for nondefense programs and 13 percent for defense programs. These large and arbitrary cuts will have severe impacts across the government.
NEGATIVES Unemployment remains high at around 7.9% and job creation has been weak even with all the stimulus the Fed has provided, although Inflation has been low and contained.
35
Some are of the view that the Fed's actions are counterproductive and believe that the Fed's intentions to jump start growth are actually working against the economy, and are of the view that if it were as easy as printing money or creating credit to levitate an economy or to reactivate business activity the world would have been richer many generations ago. The 2012 fourth quarter GDP of US went into the Red for the first time since 2009. The 0.1% contraction is indicative of the "low-level virus" attacking the domestic economy. Some economists believe the Fed's perpetual low-interest rate policy will lead to the next big economic crisis in this country: the bursting of the bond bubble. The viewpoint is that Fed’s easing policy is wrong, and it would be much better to allow a cathartic depression to engulf the United States for about a year and it will emerge on the other side of that clean, with a strong currency and a sound balance sheet. The danger in this policy is that it is enabling the federal government to run trillion-dollar-plus deficits — about 7 percent of GDP per annum, robbing the middle class of their purchasing power, creating bubble after bubble. The bubble will eventually burst because the Fed will stop buying securities or the market will push up interest rates or Inflation will increase.
36
The Fed's bond-buying may eventually lead to higher interest rates and inflation. In an ideal world, moves such as the Fed's bond buying should have ended already, but because the markets would suffer from an immediate stop to Treasury and mortgage bond buying, it may be best to taper the bond buying so that markets can adjust gradually to the eventual removal of this treatment and return to pricing securities on the basis of fundamentals.
It is important to slow down and not stop the buying outright. As the Housing market recovery appears to be starting, the Fed may be risking "overkill" by 37
continuing to buy the bonds that support that sector. The wealth effect of Fed stimulus has been unbalanced. Main Street does not seem to have been impacted to the same degree as Wall Street Also, Huge market gains seen under recent rounds of Fed interventions may be illusions. Credit is super-abundant and stock market behavior is conditioned not so much by the fundamental performance of its underlying companies but by increasing Money being pumped into the Economy. Ultimately, it appears Fed policy right now may be counterproductive to its goals. The Fed's legal mandate to promote maximum sustainable job growth may turn out to be a bad idea as it draws the central bank into political issues it naturally wants to avoid. The fears a rapidly rising interest-rate environment might cause the Fed to lose money are overdone due to the way the central bank accounts for its holdings, but there is a concern that the Congress might forget how much money the Fed has returned to the Treasury in the form of excess profits over recent years. When it eventually comes time to raise rates and tighten monetary policy, the difficulty of exiting will be much more difficult than the theoreticians believe. Conclusion: While the measures taken by the Fed seem to be right taking into account the current economic conditions, only time will tell whether these decisions prove right impact in the Long term.
Yogesh Athale SIMSREE
38
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MONEY MATTERS CLUB “Beyond the realms of Finance”
All Rights reserved, Money Matters Club, The official Finance Club of IBS Hyderabad
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