The Financial Bulletin March 2013
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Transcript of The Financial Bulletin March 2013
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FROM THE EDITOR The Financial Bulletin
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Dear Readers
We congratulate the winner of the “Article of the month”
award, Chandra Sekhar from ABV- Indian Institute of
Information Technology and Management Gwalior, M.P
for his article “Micro credit in modernizing Agriculture:
Indian Perspective” .
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 im-
pact and also the Fed bonds impact. We also discussed
about the micro credits impact in India.
Go through this brilliant collection of articles from the best
minds of Indian B-schools and find out lots of interesting
facts.
Newsletter Editor
Kanchan Kumar Roy
3
The Financial Bulletin March 2013
CONTENTS
04 Budget 2013 –by Aditya Chordia
SCIT 2012-2014
08 MERGERS &
ACQUISITIONS: EVALUATION
OF SYNERGIES -by Prakarsh Jain, Rohit Gambhir S P Jain
School of Global Management, Dubai-
Singapore
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
04 E-Commerce Effervescence
4
BUDGET 2013 In the current scenario, I am sure nobody would
be ready to take on the job of Finance minister of
India. Considering all the corruption scams, policy
inaction and growing inflation which has been the
headlines of the UPA II regime for the past 5 years.
And here comes a Harvard business graduate to
present his 8th budget as a Finance minis-
ter....Welcome Mr. P Chidambaram (Let’s call him
PC). The three big issues that might have been
troubling PC prior to announcing the budget is as
follows:
The widening fiscal deficit
i.e. the difference between
income and expenditure.
PC had promised prior the
budget that he would try to
keep the fiscal deficit to
5.3%.
The decelerating growth combined with an ever
rising inflation.
Finally the rising current account deficit i.e. the
difference between exports and imports due to
rising imports of oil and gold.
Prior to the budget, India was already facing a
threat of downgrade from the Standard and Poor
rating agency which would have seriously affected
the foreign inflows. PC also had to keep in mind
that this is the last budget before the general
elections and hence he had to present a fairly
populist budget but at the same time it also had to
be economically viable for India in the face of
rising uncertainty. Keeping all these points in
consideration below mentioned are the some of
the important decisions taken in the budget 2013.
Fiscal Deficit
PC beat his own estimate of keeping fiscal deficit
to 5.3% by bringing down the number to 5.2%.
But this was largely possible because of a huge
reduction in the planned expenditure (money
used for investment in various sectors for
development of the
country). So basically PC cut
down the expenditure by a
huge margin and with a little
help from the recent
decisions like de-regulation
of diesel prices and capping
the LPG helped in bringing
down the fiscal deficit.
Also PC has aimed to bring down the fiscal deficit
to 4.8% in the coming fiscal year. This reduction is
predicted based on huge ambitious targets like
bringing down the subsidies to fuel, increased tax
collections, spectrum allocation and huge funds
collected from the disinvestment in PSU’s. Of the
above only the target from disinvestments seems
achievable and the tax collections target seems
achievable provided the economy grows at 6.2-
6.3% in the next fiscal.
GST (Goods and Service tax) & DTC (Direct tax
5
code)
PC mentioned that the government has set a
deadline for bringing in DTC and the bill would be
brought in the parliament at the end of the budget
session.
As far as GST is concerned, PC mentioned there is no
deadline as such because it depends on how fast all
the state ministers can come to a conclusion over a
common model and compensation. But PC has set
aside 9000cr (compensation for year 2010-11) for
GST and requested all the state ministers to come a
conclusion as early as possible. It is estimated that
the introduction of GST would add at least 1.5% to
the existing GDP.
Direct benefit transfer (DBT)
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
DBT:
A digitized beneficiary list.
Bank accounts for all beneficiaries.
Aadhaar card.
As per PC, the digitized beneficiary list is almost
ready and once the list is ready, bank accounts for
all beneficiaries will be opened and Aadhaar is
doing the catch-up work. PC also mentioned that
the food and fertilizers benefit would be kept out of
the current DBT as they are complicated and some
work needs to be done.
Taxing Super rich
PC has proposed to charge a surcharge of 10% for
those earning more than 1 crore and the
surcharge for a domestic firm earning more than
10 crore has been increased to 10% from 5%.
Though he has mentioned that this surcharge
would be valid only for one year. Nearly 49500
people earn more than 1 crore as per
government estimates. Really this number
baffles me!!!!! (Only 49000...come on yaar)
The government has increased excise duty on
SUV’s to 30%. Cigarettes and mobile phones
also attract more taxes. There has been an
increase in customs duty for luxury cars and
bikes. Also import duty of used cars has been
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.
Energy & Manufacturing
Electricity is set to become costlier as duty will be
charged on imported coal (be it stem coal or
bituminous coal) with 2% custom duty and 2%
CVD (countervailing duty—a duty that is applied
to offset subsidized export from another
country).
Also to revive the manufacturing sector,
government has planned an investment
allowance of 15% over an investment of 100
crores for all investments in plant & machinery
in the coming two years. PC has also raised the
custom duty on electronics goods which is a
positive sign for the local electronic
6
manufacturing units.
Incubators
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.
Real estate
The government has proposed that a 25 lakh home
loan will get tax deduction of an additional one lakh
tax deduction on interest payments for the first
year. Overall a person taking a home loan of 25 lakh
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
hence this step wouldn’t make any significant
difference to their prospects. Instead the real estate
sector expected some perks on the premium home
side rather than the affordable home section.
Foreign investment
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
25% from 10%.
Also PC has clearly stated the difference between FII
(Foreign institutional investment) and FDI
(Foreign direct investment). Any 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.
These decisions have spooked the foreign
investors from investing their funds in the Indian
economy.
Women Power
PC has allocated nearly 2000crores for the
women and child development ministry and
1000crores for the “Nirbhaya fund” in honour of
the Delhi gang-rape victim to promote women’s
safety.
But Congress has faced to pass the bill which
reserves 33% of the seats for women in
Parliament as though it has been passed by
Rajya sabha, it has still not been cleared in the
Lok Sabha. All these steps clearly indicate
Congress is trying to woo the second largest
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.
Health care
Universal health coverage (UHC) one of the
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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
8
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.
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.
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.
Introduction
The Words
MERGERS & ACQUISITIONS:
EVALUATION OF SYNERGIES
9
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.
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.
Why Merger and Acquisition ?
Valuation
10
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.
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
Probing Synergies
11
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.
12
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
“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.
Conclusion
Prakarsh Jain
S P Jain School of Global Management,
Dubai-Singapore
Rohit Gambhir
S P Jain School of Global Management, Dubai
-Singapore
13
Micro credit in modernizing Agriculture: Indian Perspective
Microcredit (MC) has become a buzz word among
the development practitioner. Term 'microcredit'
means providing very poor families with very small
loans to help them engage in productive activities or
develops their tiny businesses. Agriculture is a
major contributor to India Gross Domestic Product
(14.6% - 2013) and small-scale farmers play a
dominant role in this contribution but their
productivity and growth are hindered by limited
access to credit
facilities. Agriculture is
the most important
sector of the country
because the main
policies of output
growth, poverty
alleviation, social justice and equity are best served
in this sector. The participation of commercial banks
was negligible in agricultural loans. Farmers’ level of
income was low and they were hesitant to use
technology. Therefore, agriculture Micro credit
policy aimed at increasing the flow of institutional
credit at reasonable rate of interest to agriculture
sector. The cooperative credit structure was
strengthened by reorganizing and merging weak
societies with strong societies. Credit institutions
can be categorized into three groups: first one is
Formal Financial Institutions: such as Commercial
banks, Microfinance Banks, Development Finance
Institutions (DFIs), and State Government –owned
Credit Institutions. Second one is Semi-Formal
Financial Institutions: such as Non-governmental
Organizations –Microfinance Institutions (NGOs –
MFIs) and the last and Third one is Cooperative
Societies. Agricultural credit specifically involves
enjoying control over the use of money, goods
and services in the present in the exchange for a
promise to repay at a future date. With
agricultural credit, a lender forgoes the use of his
money or its equivalent in the present by
extending credit to a
borrower who
promises to repay on
terms specified in the
loan agreement. Many
microcredit policies
had seen launched in
India with the
objectives of providing microcredit to the rural
poor farm households. Microcredit has also been
acknowledged as one of the prime strategies to
achieve the Millennium Development Goals
(MDGs). Access to adequate financial services
enables small-holder farmers to procure
productive assets, reduce their vulnerability to
external shocks and increased production
efficiency. Microcredit involves the supply of
loans, savings and other basic financial services to
the poor farm households. The small-holder
farmers require diverse range of financial
instruments to meet working capital requirement,
build assets, stabilize consumption and shield
14
themselves against risks. In practice, microcredit is
much more than disbursement, management and
collection of small amount of loans. It recognizes
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
spreads the rural farm households are seen as
micro-entrepreneurs with no collateral to pledge
but with a business world to conquer with the help
of micro credit. Financial services are needed by the
rural farm households to improve their wellbeing
through the upgrading of their farms and small
scale businesses for positive impact on their
livelihood. Judicious use of credit to acquire
productive resources will not only lead to on farm
capitalization but will also increase the production
efficiency of the farmers. The objective was to
promote agricultural development by modernizing
agriculture. The most common approach involved
direct government intervention via state-owned
development banks and direct donor intervention
in credit markets with favorable terms and
conditions like soft interest rates or lenient
guarantees. The factors that hinder the
development of financial services made accessible
to family agriculture are numerous and have been
well identified. In order to develop agricultural
finance, different kinds of innovations regarding
products and services as well as institutional
aspects are very important. The challenge is two-
fold: improve financial inclusion through better
outreach of marginalized populations as well as
financial services that fit the diversity of financial
needs. Other solutions to promote efficient,
sustainable and accessible financial services for
smallholder farmers are being found in terms of
institutional organization such as portfolio
diversification between urban and rural
borrowers or between agricultural activities and
less risky economic activities within rural areas in
order to mitigate risk.
With the help of some approach /character
reference we can improve the situation of rural
financial services generally in developing
countries like Financial Sector Reform which is
essential to restructure the financial sector aiming
at eliminating financial market distortions,
restoring the health of the existing financial
15
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
16
Taxing the Super-rich – A costly move!
Until a few days back, with the budget around the
corner, taxing the superrich seemed to be the gossip
of the town. With an ominously increasing fiscal
deficit, this move would aim at improving direct tax
revenues, simultaneously giving an upward boost to
our Tax/GDP ratio. Populists and generalists
supported this view; however the economists came
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
merits in place, what mattered was the cost at which
the benefits
would be accrued.
Pre-liberalization,
India had an un-
friendly tax re-
gime, unfavorable
on all terms with
the common man.
In 1970-71, the
personal income tax had 11 tax brackets with the tax
rates progressively rising from 10 per cent to 85 per
cent. In the decades that followed, marginal taxes
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. Post-
independence, though the government had noble
intentions of increasing the country’s revenues,
sky-rocketing tax rates led to large scale tax
evasion, increased incidences of smuggling and
emergence of underground black markets. This
counteractive sway of high tax rates became the
raison d’ etre for steady decline in tax rates to
their current levels.
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
marginal tax
rates. Table 1
details the
marginal tax
rates and the
Tax/GDP ratio
of some of the
developing
and developed
countries of
the world. A quick scan tells us that India has the
lowest Tax/GDP ratio among countries having
similar/greater marginal tax rates.
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:
Country Marginal Tax Rate Tax/GDP ratio (%)
UK 50% 39
Brazil 28% 34.4
Australia 50% 30.8
Japan 50% 28.3
US 40% 26
China 45% 17
India 30% 10.3
17
1. High poverty levels and low disposable in-
comes
2. Inability of the govt. to capture the earnings
of SME’s/proprietary firms across the
country
3. High tax exemptions to certain sectors like
agriculture
The finance minister was treading on thin ice when
he presented this year’s budget. Among others,
fiscal consolidation, reeling inflation, contain-
ing fiscal deficit and tax reforms were some of the
key expectations from the common man. The fi-
nance minister did manage to live up to the expec-
tations of the common man by proposing appro-
priate measures to bring the economy back on
tracks. The bone of contention was on the issue of
taxing the superrich. The finance minister offered
his two cents by main-
taining the marginal
tax rates as it, while
imposing an additional
10% surcharge on indi-
vidual and corporate
incomes rising above 1
crore rupees. Given the
large number of con-
cessions and exemp-
tions available, the
number of tax-paying entities falling in this range is
small. The Minister himself provides a figure of a
paltry 42,800 individuals who qualify. With
due considerations to economic implications, the
finance minister expects this move to add about
180 billion rupees to the revenue base. This move
makes the most economic sense for the following
reason. The surcharge of 10% on the highest tax
bracket of 30%, translates to an effective tax rate
of 33.99% (with education cess included). Such
individuals were so far taxed at 30.90 % for
incomes exceeding 10, 00,000 rupees. Under the
new tax regime, such individuals
will have to pay the new tax of just 33.99% on
income exceeding 10 times their sum. For
individuals with such high incomes, this increase in
tax is too small an incentive to launder the excess
money in the hope of tax evasion. They might as
well as end up paying it rather than being
questioned about a suspicious tax evading deal.
The costs associated with tax avoiding money
laundering activities
are far higher than the
benefits of being tax
complaint. This will
ensure a greater ratio
of tax compliance thus
boosting the tax
collections of the
government.
Other than the one
reason mentioned in
the above paragraph, there are quite a few
economic implications entailing higher taxes for
the superrich. They also serve as reasons why the
superrich should not be taxed extra. Any tax
regime needs to give due considerations to these
points, failing which the myopic vision of
18
increasing revenue will cloud the greater evil of tax
evasion.
The classical Laffer curve explanation : The
Laffer curve is a representation of the relationship
between possible rates of taxation and the resulting
levels of government revenue. It illustrates the
concept of taxable income elasticity—i.e., taxable
income will change in response to changes in the
rate of taxation. It postulates that no tax revenue
will be raised at the extreme tax rates of 0% and
100% and that there must be at least one rate
where tax revenue would be a non-zero maximum.
The "economic effect" assumes that the tax rate will
have an impact on the tax base itself. At the
extreme of a 100% tax rate, the government
theoretically collects zero revenue because
taxpayers change their behavior in response to the
tax rate: either they have no incentive to work or
they find a way to avoid paying taxes. Thus, the
"economic effect" of a 100% tax rate is to decrease
the tax base to zero.
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
tax rate t* is an indicative value varying across
economies.)
Historical failure : In the past, India has had a
disastrous experience by levying exorbitant taxes
on the rich. At its zenith, taxes were more than
90% which achieved unintended objectives of
massive tax evasion and erosion of national
character. As per Laffer, there was no incentive
whatsoever for any individual to part with so
much of earnings with the government. This led
to large scale unaccounted cash transactions, thus
fuelling a massive black market economy.
Historically, there is not a single instance where
taxing the superrich has worked as a solution to
increase tax revenues. Similar problems, albeit on
a much compounded scale can be expected in
case similar tax regimes are adopted.
Burdening the honest tax payer : In the past,
the honest tax payer has always been haunted by
the image of the vicious tax official waiting to
wring every last penny out of people’s pockets.
More often than not, the IT department knocks
down the doors of individuals and corporates who
religiously pay their taxes. Be it a regular salaried
job individual or a reputed MNC entering India
through an acquisition, they are harassed and
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.
The dishonest rich: According to the Ministry
of Finance, India has nearly 35 million taxpayers,
19
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
20
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
21
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.
22
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 3rd 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
23
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 sce-
nario. 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.
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.
Country Moody's/Outlook Fitch/Outlook S&P/Outlook
Emerging Brasil Baa2/Stable BBB/Stable BBB/Stable
Turkey Ba1/Positive BB+/Positive BB+/Positive
Russia Baa1/Stable BBB/Positive BBB/Stable
Mexico Baa1/Stable BBB/Stable BBB/Stable
Indonesia Baa3/Stable BBB-/Stable BB+/positive
India Baa3/Stable BBB-/Stable BBB-/Negative
Egypt B-/Under Review B+/Negative B/Negative
Chile
China Aa3/Positive A+/Stable AA-/Stable
European France Aaa/Negative AAA/Stable AA+/Negative
Italy Baa2/Negative A-/Negative BBB+/Negative
Germany Aaa/Negative AAA/Stable AAA/Negative
Ireland Ba1/Negative BBB+/Negative BBB+/Stable
Portugal Ba3/negative BB+/Negative BB/Negative
Greece C/Substantial Risk CCC/Negative CCC/Stable
Credit rating July 2012
24
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.
25
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
26
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, alco-
hol, 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
27
BANK CONSOLIDATION:AN OVERHYPED IDEA ?
INTRODUCTION
Consolidation in the banking industry is one of the
most crucial issues facing the Indian financial
sector at present. The logic of consolidation in
Indian banks is twofold. First, it is generally
accepted that India has too many banks of national
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.
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
fragmented nature of the Indian banking system
and the small size of the typical bank, some
consolidation may be in order for banks that aim
to play on a larger stage.
The reasons for consolidation in India are the
following:
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
assumption that banks would maintain
Capital –to Risk –weighted Assets ratio
(CRAR) at 12. 5%. Over the next five years,
28
PSBs would require Rs 3,69,115 cr (64.9% of
total requirements , old private sector banks
Rs 23,319 cr (4.1%). New private sector
banks Rs 113,180 cr (19.9%), and foreign
banks Rs 63,131 cr(11.1%). To maintain the
51 per cent minimum government share,
PSBs cannot collect additional capital
directly from the public and with this view it
promotes bank mergers. Consolidation may
be a route for smaller banks to infuse funds
to strengthen their capital base.
Fragmented Size
It is felt that India has many commercial
banks that are very small. That is of the 53
domestic
banks (both
public and
private ), the
size of 16
banks at end
March 2007
individually
was less than
0.5 percent of
size of the
banking sector. Indian banking industry is
highly skewed and almost 67 banks have a
less than 2.0% market share in India. There
should be a small number of large banks
rather than a large number of small banks so
that Indian banks could keep up with the
growing balance sheets of large Indian
companies and play a role in big takeover .
To Attain Global Competitiveness: Indian
banks are not able to compete globally in
terms of fund mobilization, credit
disbursal, investment and rendering of
financial services. The main reason behind
it is the size of the industry. In 2008, there
was only one Indian lender - SBI, at eighth
place among the top 25 Asian banks.
Industrial and Commercial Bank of China,
the biggest Asian bank and the world’s
eighth biggest bank, is four times bigger
than SBI, both in terms of tier-I capital as
well as assets. Another recent study
„Report on Currency and Finance‟ released
by the RBI reveals that
the combined assets of
the five largest Indian
banks - SBI, ICICI Bank,
Punjab National Bank,
Canara Bank and Bank of
Baroda are just about
half the asset size of the
largest Chinese bank,
Bank of China. The bank
is 3.6 times larger than
SBI in terms of assets, branches and
profits.
Indian banking industry
The banking industry in India has been in the
process of transformation and consolidation ever
since 1961. The Banking Regulation Act, 1949
empowers the regulator with the approval of the
29
government to amalgamate weak banks with
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.
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.
Strengths
Liquidity:. Banks are required to keep a
stipulated proportion of their total demand
and time liabilities in the form of liquid assets
which affect their liquidity position. RBI has
been easing the requirements with several
rounds of reduction in the Statutory Liquidity
Ratio (SLR) and Cash Reserve Ratio (CRR).
Sound banking systems: The banking system in
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
implemented by the RBI from time to time.
Weaknesses
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
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
unhealthy competition.
Low penetration: There is an uneven
distribution of banking services in the
country. It is limited to few customer
segments and geographies only. There is a
need for banks to open branches at these
locations and establish connectivity with
the help of a core banking solution.
Opportunities
Advanced technology: New generation
private sector banks and foreign banks are
technologically more advanced in terms of
management information systems,
delivery mechanisms, etc. These systems
30
and processes require substantial
investments which may be possible after
consolidation.
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.
Many Indian banks, especially public sector
banks, cooperative banks and regional rural
banks are unprepared for this
implementation due to capital inadequacy.
Cost cutting: Many branches and ATMs of various
banks are congregated in the same areas
leading to pointless outlay on premises,
manpower and maintenance facilities.
Consolidation may lead to redeployment and
rationalization of such infrastructure, human
resources and other administrative facilities
thereby undercutting the cost factor.
Enlarged customer base: The combined
customer base may increase the volume of
business. The enhanced rural branch network
may lead to increase in microfinance activities
and lending to the agriculture sector. M&A
may be a far-sighted conclusion to increase
the market share.
Geographical spread: Banks can diversify the risk
of concentrated lending through mergers.
They can also have a greater market access
thereby widening the deposit base. The RBI
has imposed strict licensing norms for
opening of new branches and hence via
consolidation, the acquirer will have access to
ready physical infrastructure.
Product diversification: Merger creates the
opportunity to cross-sell products and
leverage alternative delivery channels. Old
generation banks can merge with the new
generation private sector banks and
foreign banks to diversify their credit
profile. They can sell technology-based
innovative products.
Threats
Alignment of technology: The technology
infrastructure, system platforms, network
architecture, database vendors and IT-
enabled synergies should be compatible in
banks desiring to merge. Most of the
public sector banks are at different stages
of technology implementation. It would
pose a stiff challenge to such merging
entities to integrate their technology and
working platforms.
Customer dissatisfaction: The change in the
nature and quality of financial products
may dissatisfy the customers, even if the
products are better. In some cases
customers may be deterred by the
acquiring company for various reasons
which may affect brand loyalty of the
combined entity.
Integration of people: The acquirer bank may
have to absorb the entire workforce of
the target bank which may push up the
wage cost. It also requires the integration
31
of the heterogeneous work cultures. The
varied aspects of the work environment, if
not handled properly, may lead to
resentment and shrinkage in productivity.
Marginalization of small customers: Larger enti-
ties may neglect small customers and concen-
trate on affluent customers or High Net worth
Individuals (HNIs).
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
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
performance of the banks, effective absorption of
new technologies, capability to meet the demand for
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.
The changing regulatory environment has paved
the way for foreign banks to enter Indian market
with their huge capital reserves, skilled personnel
and cutting edge technology. Mergers will enable
Indian banks to compete effectively with these
foreign banks by enhancing their capital reserves
and improving their operational efficiency and
distribution efficiency.
Aarzoo sharma
MET institute of management
Mumbai University
Krupa shah
MET institute of management
Mumbai University
32
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
33
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.
34
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 phase-
out 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.
35
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.
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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.
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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
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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
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