Niveshak 4th Anniversary Issue

4th Anniversary Edition

Niveshak THE INVESTOR

VOLUME 5 ISSUE 8

Hawk-Eye The Great Debate

GAAR Monetary Union Financial Inclusion Indirect Tax Reforms Corporate Governance 2012 crisis : Another 1991?

August 2012

FROM EDITOR’S DESK Dear Student Managers,

Niveshak Volume V ISSUE VIII August 2012 Faculty Mentor Prof. P. Saravanan

THE TEAM Editorial Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal Creative Team Anuroop Bhanu Venkata Abhiram M.

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

It seems like yesterday we came out with the first issue of Niveshak and now we have completed four years and entered our fifth year. It gives us immense pleasure to bring to you another issue of our very own magazine which covers the most contemporary issues in the world of Finance. The theme of this month’s issue is Hawk Eye Debate which covers critical views on contemporary burning debates. Some debates are followed by an interview by eminent personalities. The article on Indirect Tax Reforms investigates the recently enacted reforms and studies its impact on the industries. The article on GAAR discusses whether it’s a boon or a bane to the developing economies. The article on Monetary Union argues whether fiscal union is a better option or country level autonomy. The next article focuses on the feasibility of the concept of financial inclusion in the context of capitalist economy. The article on whether 2012 crisis is another 1991 situation reasons opinions for and against the same. The next article discusses the more pertinent issue whether corporate governance really adds value to the stakeholders or is it just a tick mark and regular activity of the compliance officers of the corporate world. The readers of this issue are really going to have a feast as the above mentioned topics are current, highly debated as well as sensitive. My heart-felt congratulations to the ‘brains behind’ Niveshak Team!

P. Saravanan (Faculty Mentor) Dear Niveshaks

4 years. 48 issues. Hundreds of insightful articles.. The spectacular journey of Niveshak achieves another milestone!! As this issue marks a historic feat of Niveshak, we would like to express what we really feel about Niveshak. Niveshak was launched on 15 August 2008, initially meant for intra college circulation. With time, we realized how important can this one-of-a-kind initiative be for the b school community at large, and hence we decided to ‘go-public’. Coming out with an issue every month was not an easy ask, but was very effectively managed by our seniors. The senior team left some huge shoes to fit in, and it has been a challenging ask to live by the high standards set by them. Nevertheless, it is your constant support that gets us going. The readership base is still increasing at an incremental rate, which makes us believe that our magazine is still far from its maturity stage. And in the process, many of you have become regular contributors to Niveshak!! It is difficult to express the adrenaline rush that we get on seeing our inbox being bombarded with articles as the deadline for the respective issue approaches. The articles are scrutinized by each one of us, and it is not once that we debate for hours for choosing the right fit for each section. The sense of satisfaction on the day we upload each month’s issue on our website is difficult to put into words. We would like to extend our gratitude to the corporate sector at large for supporting Niveshak and helping us in our cause whenever we seek any help. As many eminent personalities have now joined Niveshak’s readership base, it seems that the day is not far when Niveshak will come out with an exclusive ‘corporate avatar’!!! The entire IIM Shillong community has been very supportive all throughout, and has stood by us through thick and thin. We hope that we continue to receive this endless contribution from all our stakeholders in the times to come.

Stay Invested! Team Niveshak

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Niveshak Top 5

Hawk-Eye

04 Dr. D. Subbarao 06 Angela Merkel 08 Mario Draghi 10 Pranab Mukherjee 12 Rajat Gupta She speaketh

24 Ms. Judy Manners

2012 crisis : Another 1991?

19 Corporate Governance

Hawk- Eye 28 Financial Inclusion 33 Monetary Union 37 GAAR 42 Indirect Tax Reforms

He Speaketh

25 Mr. K. S. Ramdas

26 Dr. Gautam Naresh

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Niveshak Top Five With our 4th anniversary edition, we present to you team Niveshakâ&#x20AC;&#x2122;s top 5 personalities who have had a profound impact in the world of finance in the past year. The personalities range from bureaucrats to corporate honchos who have made their presence felt in the world. Our top 5 people are as follows...

#1 Dr. D. Subbarao

Governor, Reserve Bank of India

was assigned the Andhra Pradesh cadre. Later, he graduated with a Masters degree in Economics from the Ohio State University, United States in 1978 and studied Quantitative Economic Modelling at MIT. Dr. Subbarao has vast experience in issues pertaining to public finance and has held important posts in this area. He has worked as Secretary to the Prime Ministerâ&#x20AC;&#x2122;s Economic Advisory Council. Initiatives

Dr. Subbarao has served many positions of pertinent responsibility throughout his life as a public servant. Few of the important positions have been tabulated below:Year 1988-1993 Background

Dr. Duvvuri Subbarao (born 11 August 1949) is an Indian economist, central banker and civil servant. He is the current Governor and Director of the Reserve Bank of India, serving under Prime Minister Manmohan Singh. Duvvuri Subbarao was born in Eluru in West Godavari, Andhra Pradesh on August 11, 1949. After finishing his schooling, Subbarao graduated as a gold medallist in B.Sc Honors (Physics) from the Indian Institute of Technology, Kharagpur in 1969. He topped the IAS examination in 1972 and

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1993-1998 1994-2004 2005-2007 2007 Sept 2008

Positions Served Joint Secretary, Department of Economic Affairs, Ministry of Finance, Government of India Finance Secretary, Government of Andhra Pradesh Lead Economist, World Bank Prime Ministers' Economic Advisory Council Finance Secretary, Government of India Governor of the Reserve Bank of India

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along with explicit recognition that some stimulus is necessary as part of the crisis management. A true civil servant at heart, Dr. Subbarao always strived to suggest practical, workable and democratically feasible solutions. Future

Unanimously, investors and economists will agree that RBI, under the guidance of D. Subbarao, has been more proactive than ever in formulating efficient monetary policy for the country. Inspite of pressure from industrial and government bodies, RBI has given priority to controlling inflation to ensure that common people do not face the brunt of economic growth while not receiving any benefit at all. He has been prudently balancing both the inflation and the growth numbers in formulating the monetary policy for the past year. Dr. Subbarao has been a visionary throughout his career. His desire to take India forward is well documented in RBI’s vision document on the road map for the evolution of payment and settlement systems in India for the period 201215. His emphasis on expanding the acceptance infrastructure such as ATMs, PoS (point of service) terminals, micro-ATMs and hand-held devices to smaller towns and villages will transform India into a less cash-handling society like other emerging economies through innovation in payment systems. This will also support the government goal of financial inclusion by ensuring that all payment and settlement systems in the country are safe, efficient, interoperable, authorised and accessible. He is also advocating revision in the subsidy regime of the government especially the farm and fuel subsidies. He opines that if the amount spent on subsidies could be diverted to augment capital formation in agriculture, higher productivity will raise the income of farmers while lowering prices for consumers. There isn’t an iota of doubt that Dr. Subbarao has successfully guided India through some difficult financial situations. His poised and firm demeanour inspires confidence among the Indian citizens that the country’s central bank is in the right hands. However, only time will tell whether India progresses in the direction envisioned by this great personality and transforms itself into an economic superpower in the years to come.

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One of the highlights of his career has been his stint as the governor of the Reserve Bank of India. Dr. Subbarao took charge as the Governor of RBI from Dr. Y.V. Reddy after the latter demit ted his office on September 5, 2008. This phase of his career was to become the most challenging one for him, being tasked with responding to adverse situations like global financial crisis in US and later in EU, deteriorating government finance and uncontrolled inflation, to name a few. Immediately after taking charge he was faced with the job of containing inflation which was running unbridled at 12.34 per cent. The outcome of his intervention was that inflation reduced to manageable levels bringing relief to the common masses. Throughout his tenure, he has received both praises and brickbats for remaining pro common man on various occasions. Dr. Subbarao supported modernization to bring about efficiency and transparency in banking operating in India. He suggested banks to invest in newer technologies. During the global economic crisis in 2011, Subbarao announced that India was ready to extend support to the International Monetary Fund (IMF) for bailing out the troubled nations of the Euro-zone and reiterating India’s commitment to global financial stability. He represented India at various meetings of finance ministers and central bank chiefs of the BRICS (Brazil, Russia, India, China and South Africa) nations and received appreciation from global leaders for his sound and rational suggestions for greater global co-operation. Dr. Subbarao clearly regards financial inclusion as primary to poverty alleviation and reduction of income related inequality. In December 2011, Duvvuri Subbarao planned to make banking accessible to villages of the country with over 2000 population by March 2012. He has been proactive to meet state chief ministers regarding upgradation of entrepreneur centres in the states. In his role as the RBI Governor, he has been able to maintain ‘neutral’ difference of opinion with the government on several issues while at the same time being critical of the government on issues such as autonomy of the central bank and other financial market regulators, responsibility of maintaining financial stability, need for fiscal prudence, etc. His monetary policy statements over the past year have consistently drawn attention to the fiscal deficit concerns

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Niveshak Top Five

#2 Angela Merkel

Chancellor, Germany

Background ‘The de facto leader of the European Union’ is a personality well known by all – Angela Merkel. Born in Hamburg on July 17, 1954, to a Protestant minister, Horst Kasner, and his wife, Herlind, Angela Dorothea Kasner was three months old when her father was asked to take over a country church in Brandenburg. She outshined in school and wanted to become an instructor and an interpreter. But due to her father’s idyllic work, she found those vocations close to her. Therefore in 1973, she chose to study physics at Leipzig University. A former chemist, Mrs Merkel was settling into a career at the Academy of Sciences in East Berlin in 1989 when the Berlin Wall fell. A month later,

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she joined a coalition of pro-democracy parties. She is the first female Chancellor of Germany, Europe’s most vibrant economy, and Chairwoman of the Christian Democratic Union (CDU), a Catholic-leaning traditionalist party whose position has been withered due to prevalent rage in Germany over bailouts for weaker European countries. Merkel is Europe’s and perhaps the world’s most powerful woman. As the leader of Germany, the continent’s wealthiest, most densely inhabited and most productive country, she has played a critical and vital role in the negotiations for the future of the region’s economy and polity. Angela Merkel has been the chancellor of Germany since 2005. She was re-elected in September 2009. This made her one of the longest-serving leaders among Europe’s major powers. However, under her leadership the party had to face worst of its results in 60 years. This echoed the extensive grief over the financial slump, which has cost Germany its position as the world’s leading exporter. She formed a union with the pro-business Free Democrats, but the alliance gradually frayed in the face of intensifying public annoyance over Europe’s debt catastrophe. Initiatives And Impact Ms Merkel has played a dominant role in the issues that were caused by Greece’s debt, and she has annoyed individuals on both sides of the argument. Greece had reported far lesser

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lowering borrowing costs at critical junctures, Merkel has rather wielded the pain of soaring interest rates as a bludgeon to extract painful changes and demand leadership changes in countries like Greece and Italy that have proven resistant to those changes in the past. This strategy allowed her to manipulate the different interest groups where Germans did not want her to offer more assurances of taxpayer’s money to fight the sovereign debt crisis, and where those abroad were pleading her to do so. Current Situation With Francois Nicolas Hollande becoming the new President of France, the partnership between France and Germany which is very vital for functioning of the European Union is under strain. Mr Hollande is in favour of euro bonds and wants that the European Central Bank operates more like the US Federal Reserve and acts as a lender of last resort to guarantee the debts of the euro zone countries. But, on the other hand, Ms Merkel opposes the idea. She stresses on moving ahead with the long-stalled process of European integration. But “more Europe” would mean a substantial loss of French dominance over its national budget and the French financial system. This is an extremely delicate issue for Mr Hollande and his Socialist Party. Any moves towards a deeper union within Europe would require legitimate change. Future If the euro is well-preserved and Europe moves towards a more united future, Ms Merkel will be hailed as Europe’s saviour. Otherwise, she could even earn the blame for ruling over the downfall of the euro, with indescribable consequences for the world economy.

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debt and deficit whereas the reality was different. The revelations made the market frantic. Mrs Merkel then took a tough line in months of discussions with France and the International Monetary Fund over a bailout. She believed that allowing more deficit spending in the name of growth would send the continent back to the beginning of the crisis. She also rejected joint efforts like Eurobonds to pool debt. She reflected the strong resentment among Germans to bailout Greece. But due to further deterioration of the euro, she signed off a series of increasingly larger aid packages. As per the critics, the method followed by Merkel caused a containable problem to inflate into a disaster. However, this support by Merkel to bailout weaker nations caused stingy German voters to rebuff her political party in regional elections in May 2010 and also got them to the streets to protest in June 2010. Later that year, Ms Merkel forced through a policy change that any bailouts after 2013 will require bondholders to take losses on government bonds being rescued. She took this move to re-impose discipline. But this led to creation of strong anti-German sentiments and fuelled rumours of the euro’s impending downfall. Merkel became known across Europe as “Frau Nein” or Madame No. In February 2011, Merkel declared her support for upholding up the euro and creating a more closely integrated economic system. In essence, Germany must be the lender of last resort if the euro is to be saved and a solution found for the debt issues damaging the harmony between the 17-nation euro zone. It was Merkel’s vision of tough austerity and greater fiscal integration that prevailed for the first two years after Greece’s debt crisis broke out in early 2010. By the spring of 2012, as an increasing number of European countries ran into a double-dip recession, a greater number of critics challenged her methodology. Ms Merkel was ready to take up every possible action measure to help Greece restore growth. She was determined to keep the country as a part of the euro zone. Strategy For Remaking The Euro Ms Merkel followed a consistent strategy of politics aimed at remaking the euro zone as per the likeness of Germany. Throughout the crisis, instead of pacifying the financial markets by

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Niveshak Top Five

#3 Mario Draghi

President, European Central Bank

Introduction Mario Draghi, a former head of the Bank of Italy, is the president of the European Central Bank. He succeeded Jean-Claude Trichet in November 2011, in the midst of a worsening sovereign debt crisis that put the very survival of the euro in doubt. Mr. Trichet had been the continent’s most powerful inflation hawk, and had rebuffed all suggestions that the bank made to calm panicky markets by promising to act as a lender of last resort. Mr. Draghi’s nomination was confirmed first by the bank’s board and then by the leaders of the European Union’s 27 member states in June 2011.

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An American-trained economist, Mr. Draghi was backed for the central bank post by Nicolas Sarkozy, the president of France, and clinched the job when he won the support of Angela Merkel, the German chancellor, after convincing her of his commitment to fiscal soundness. Impact Mr. Draghi took office promising more of the same. But he cut the central bank’s main interest rate only two days later, and cut it again in December, dropping it to 1 percent. More important, under his direction, in December the central bank also quietly began providing emergency loans to European banks. Banks could borrow as much as they wanted provided they posted collateral. They jumped at the opportunity: 523 banks borrowed 489 billion euros, or $647 billion. But by the spring new questions about the efficacy of the loans had risen. Mr. Draghi responded in late May with his bluntest criticism of political leaders, saying that their half measures had made the structure of the euro zone “unsustainable.’’ He also called on the European Union to move toward becoming a banking union, that is, to establish a deposit insurance fund to reassure citizens that money in European banks is safe, and to give the E.C.B. powers to regulate big banks at a European rather than national level. By early July, the spotlight in the debt crisis had shifted decisively toward Mr. Draghi, who

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stimulate the economy. The E.C.B. also left its benchmark interest rate unchanged at 0.75 percent. Future Outlook Beneath the gratitude toward Mr. Draghi for the loans, some economists fear that the easy money could simply be creating the conditions for another banking crisis several years from now. Because of the central bank’s cheap financing, some economists warn, sick banks face less pressure to confront their problems — to clean out bad loans and other impaired assets, or even wind down operations if there was no hope of a turnaround. The central bank, they say, could inadvertently spawn a cohort of “zombie banks,” burdened by nonperforming loans and assets that remain on the books, like the ones that helped make the 1990s a lost decade for Japan. Zombie banks tend to keep lending to troubled borrowers to avoid recognizing losses from bad loans. As a result, the healthiest and most productive companies will struggle to find credit. The cascade of cash has lifted sentiment in the euro zone, and may even help the region avoid a serious economic downturn. But it is not yet clear how banks would use the money, and whether they would spend it wisely. Some banks — no one knows how many — are bound to use it to cover up past mismanagement and books full of bad assets. Overall, Mr. Draghi, has indeed left an indelible mark in the world of finance this past year and only time will tell if his actions and measures will have profound effect on the Euro Zone.

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emerged from the June E.U. summit meeting in Brussels with a general agreement that the continent would move in that direction. Many of the longer-run plans under discussion, like European deposit insurance, would mean shifting further responsibilities towards the bank, arguably giving Mr. Draghi the most influential executive powers in Europe. Late in the month, Mr. Draghi appeared to seek to calm investors by saying that the bank would “do whatever it takes to preserve the euro.” The bank has long insisted that it is barred from lending to governments simply to give them money. But Mr. Draghi suggested that the bank could enter the bond market to drive down a government’s borrowing costs on the basis of protecting the bank’s ability to influence rates, its main tool in promoting price stability. Mr. Draghi, who raised market expectations in late July when he said the E.C.B. would “do whatever it takes to preserve the euro,” may also have disappointed investors when he characterized his remarks on bond buying merely as “guidance,” backed by all 23 members of the E.C.B. governing council except one: Jens Weidmann, president of the Bundesbank, the German central bank. Dissent by the powerful Bundesbank, which tends to be in tune with German public opinion, could have made investors doubt the E.C.B.’s resolve and undercut any attempts to lower borrowing costs for countries including Spain and Italy. High borrowing costs for some countries were interfering with the E.C.B.’s ability to influence interest rates, Mr. Draghi said, adding that these are “unacceptable and they need to be addressed in a fundamental manner.” Mr. Draghi also said that the E.C.B. would only buy bonds if governments kept promises to restructure their economies, and only after the European bailout fund bought bonds first. In addition, a country such as Spain would have to request relief, which none have done yet. Given European leaders’ record of slow decision making, those conditions may have led investors to doubt whether E.C.B. bond buying would be decisive enough to influence borrowing costs. The decision came a day after the U.S. central bank, the Federal Reserve, disappointed many by declining to make any immediate moves to

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Niveshak Top Five

#4 Pranab Mukherjee

President of India

a few, and undoubtedly has been the trouble shooter for UPA government from last 8 years because of his vast experience. Initiatives

Background

William Wordsworth once said “The education of circumstances is superior to that of tuition” and what better example than Pranab Mukherjee, India’s 13th President and former Union Finance Minister, to prove the same? It may be Mr. Mukherjee’s stint as Deputy Chairman of Planning Commission during 1991-1996 when the country was in dire need of economic reforms or his tenure as Finance Minister from 2009 to 2012 when the global economy faced the worst ever financial crisis, he has emerged as a true leader. Known for his sharp intellect, Mr. Mukherjee has the vast experience of holding various portfolios like Ministry of Commerce, Ministry of Defence and Ministry of External Affairs ministry to name

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Pranab Mukherjee’s first stint as Finance Minister in 1982 can be described by the ability he showed in handling the last installment of IMF loan due on India and the decision of appointing Mr. Manmohan Singh as the Governor of RBI. He was also awarded “Finance Minister of the Year” by the prestigious Euromoney magazine in 1984. Mr. Mukherjee was appointed as deputy chairman of planning commission in 1991, when the country was in huge economic crisis. The team of Mr. Mukherjee and then finance minister Mr. Manmohan Singh gave a new life to the dying country with the policies of liberalization, privatization and globalization at a time when the foreign reserves of the country were sufficient to support the imports for merely two weeks. Pranab Mukherjee’s latest stint as finance minister of India could be termed as the most significant part of his political career. The challenges he faced were enormous, the most important of them being economic crisis combined with the obligations of a coalition government. The pressure from the industry to bring reforms like Goods and Services Tax were huge. Pranabda will be known both for various reforms undertaken by him and the reforms he initiated but failed to materialize. Deregulation of petrol prices by EGoM, headed

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issues lies with the central bank, Ministry of Finance was alleged for playing the role of a mere spectator. The Indian currency has depreciated around 12% from 2011 till date. Inflation in the country has surpassed all levels in the current year and is at 7.25% in June 2012, a high level by any standard. The negative influences of a depreciating currency and high inflation are evident as GDP grew only at 5.3% for fourth quarter in 2011-2012 and the IIP is performing worse than expected. At the end of his tenure, the introduction of General Anti Avoidance Rule and the controversies regarding the conflict between Finance Ministry and PMO on GAAR guidelines also proved to be troublesome for Pranab Mukherjee. Although the clarifications were made but still there are no defined guidelines in spite of the fact that GAAR will be a milestone in tax reforms, if implemented. Future

While the Indian economy is finding it hard to restore the lost balance and Pranab Mukherjee is said to be responsible for the same, we should not forget that he is the person who saved India from the worst ever financial crises both in 1991 and 2008 and also the current situation of the country is more because of the global turmoil and not only policy paralysis. Looking at Mr. Mukherjee’s tenure as finance minister one can observe the various hits and misses and at the same time it is very hard to overrule the fact that the weight carried by “hits” is far more than the “misses”. The conviction and determination, Mr. Mukherjee has shown as Finance Minister of India, is unparalleled. The way he has worked in a coalition government and implemented various reforms shows the unmatchable skills and ability he possesses. The same can be expected of him as President of country and we hope he will again prove himself as a “Man of all Seasons”.

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by Pranab Mukherjee, was the decision that caught everyone’s eye as the losses to oil marketing companies were huge and the oil imports bill was rising at a fast pace in 2010. Although the decision to deregulate diesel, kerosene and LPG prices was deferred, the deregulation of petrol prices was a path- breaking one and the impact can be very well estimated from the fact that oil marketing companies were suffering losses of around Rs. 8000 crore per annum at the time when the decision was taken and oil import bill was at a life time high. The decision also removed a substantial subsidy burden and was expected to ease government deficit. The highlight of Mr. Mukherjee’s stint will be the tax reforms like Goods and Services Tax (GST) and Direct Tax Code (DTC). The importance of tax reforms, which are expected to repeal the age old tax laws and bring some stability in the complex tax structure of the country, cannot be overruled. Although he failed to address the apprehensions of states and other stakeholders relating to the reforms and it seems the government has lost the track on these reforms but once implemented, the impact of the start he has made will surely bring long terms gains for Indian economy. The contribution of Mr. Mukherjee, although he failed to deliver, lies in the fact that he, at least, started the debate on the age old but the most crucial tax reforms for Indian Economy. Talking about the reforms that failed to materialize, Pranab Mukherjee’s move to amend the tax law retrospectively to get merger and acquisition deals such as the Hutch-Vodafone transaction in the tax was highly criticized by the industry veterans. The ghost of black money also came back to haunt the Indian economy in early 2011 with various researches and reports showing the huge amounts of black money being deposited in Swiss Banks by Indians. The fivefold strategy introduced by Mr. Mukherjee along with signing of various tax Information Exchange Agreements and Double Taxation Avoidance Agreements (DTAA) and the revision of the provisions of the existing DTAAs were considered to be insufficient by the experts and finance minister was criticized for his failure to act boldly on the matter. Mr. Mukherjee has been widely criticized for the high level of inflation and the depreciating currency. Although the responsibility of both the

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Niveshak Top Five

#5 Rajat Gupta

Ex-CEO, McKinsey & Company

Background

Walt Disney’s famous quote “If you can dream it, you can do it” couldn’t have been said in a better context than Mr. Rajat Gupta’s life. Hailing from a middle class background, Mr. Gupta’s consistent efforts and illustrious career prove to be an inspiration for many. After securing a national rank of 15 in the IIT JEE, Mr. Gupta proceeded to the US to complete his MBA from the prestigious Harvard University in the year 1973. Needless to say, there was no looking back after that. Mr. Rajat Gupta became one of the first Indian Americans in the field of consultancy when he joined McKinsey & Company after his MBA. In McKinsey, he quickly rose through the ranks to become the firm’s managing director in the year

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1994. Under him, the firm saw aggressive expansion of its activities with offices in 23 new countries and doubled its consultancy base. Apart from being a part of McKinsey, Mr. Gupta also co-founded a few other organizations like American Indian Foundation and Scandent. Mr. Gupta also co-founded the Indian School of Business in 1997. He has also served on the board of directors of organizations like Goldman Sachs, Procter & Gamble, AMR, etc. Due to his philanthropic efforts, Mr. Gupta has also been associated with well-known institutions in the fields of education, health and business. Some of these include Harvard Business School, Kellogg’s School of Management, The Gates Foundation, and Global Health Council among others. Impact

During his last few years at McKinsey, Mr. Rajat Gupta thought about establishing an investment firm. In 2006, he partnered with Galleon’s Rajaratnam to establish a new investment firm named the New Silk Route. US prosecutors alleged that Mr. Gupta used to disclose the insider information gathered during his official talks with the clients and Mr. Rajaratnam traded on this information using his investment firm. One such instance which started the suspicion of a large scandal was Mr. Gupta’s conference call on September 23, 2008 with the Goldman Sachs board. Mr. Gupta came to know about the Berkshire Hathaway’s investment of $5 billion preferred stock in Goldman Sachs during the call and the information was passed to Mr. Rajarat-

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Gupta-gate scandal was a blow to McKinsey’s reputation and the company had to take several measures to get back on track. The firm started communicating with its employees from the day Mr. Anil Kumar was arrested. It took the legal help of outside firms and started an independent enquiry. The ethical policies were reviewed and protection of confidential client data was improved. It added a whole new set of training policies as well as a defined list of client stocks that no employee can trade. A similar restructuring happened in other management consultancy companies to reassure their clients about the commitment of the firms against insider trading. Conclusion

Good corporate governance is the key for the success of any organization. It takes people with personal and professional integrity to lead the organization to greater heights. The values on which a company is founded must be practiced rather preached. Top management has to be honest and its actions should always be for the betterment of the company. Mr. Rajat Gupta may have been convicted for insider trading but conviction alone does not provide a feasible solution to the problem of insider trading. The rules have to be clearly defined regarding leakage and usage of confidential information. Until miscreants are really scared and their chances of getting caught increase, the shock waves sent by Gupta’s case will be soon forgotten.

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nam by Mr. Gupta’s assistant through a phone call, 16 seconds after the conference call. Mr. Anil Kumar, the colleague and mentee who helped Mr. Rajat Gupta to establish Indian School of Business was involved in the setting up of a company known as Mindspirit LLC. According to SEC filings, Mr. Kumar’s and Mr. Gupta’s wives became the founding members of the Mindspirit. McKinsey believes that the company became an investment vehicle for both the consultants to offer advisory services to the parent company Infogroup. In 2009, during the US government wide range investigations into insider trading, Mr. Rajaratnam and Mr. Anil Kumar were arrested indicating a huge conspiracy. In the criminal trial of the scandal, around 18,150 wiretapped recordings involving over hundreds of clients and friends were handed over by the United States Attorney’s Office. Mr. Anil Kumar later admitted leaking and using of the information that he had gathered during his tenure at McKinsey. This information was passed on to Mr. Rajaratnam for his hedge fund decisions. This scandal involving high profile people questioned the employee values followed at McKinsey and several other consulting firms. Senior partners in organizations like McKinsey are seen as trusted advisors to the clients and are regularly present in the client top management boards. After the incident several management consultancy firms feared that clients may become a bit more careful and extra cautious in sharing insider information with the advisors and thus, started reassuring their clients that it was a single instance where such wrongdoing has taken place. For McKinsey, the incident proved to be a nightmare and experts believed that it will take a few years for the company to re-establish “TRUST” factor with the clients. The scandal also gave critics a chance to question McKinsey with respect to it’s much talked about selling proposition. McKinsey generally pitches to the client saying that it has the knowledge to work on the new project as it knows how the client’s competitors work. In the “Gupta-gate” scandal, the information which should have been used for the client was used by the consultants to gain personal wealth. This agitated the skeptics tremendously and they started questioning the entire selling proposition of the firm.

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Another 1991?

Kunal Ashok

Introduction A nine year low 5.3% GDP growth last quarter, an unprecedented current account deficit (CAD) of 4.3% of GDP, loss of investor confidence in the Indian markets, high interest rates, stubborn inflation, a falling rupee , depleting reserves, stalled foreign investments projects of the likes of POSCO, policy paralysis on FDI in retail, insurance and aviation, a fiscal deficit that has overshot estimates and a government that is losing face within the country over corruption and is incapable of taming its smaller allies are all ingredients of a crisis. Interestingly many of the features of this impending crisis (or are we in it already?) remind one of the debilitating balance of payment crisis of 1991 when the nation pushed to the brink of financial disaster was rescued in dramatic fashion by Dr. Manmohan Singh – the hero of the 1991 episode but perhaps as Times magazine dub him as an “underachiever” 20 years later. Balance of Payment is an account of the country’s ability to balance the inflow and outflow of foreign funds. Thus while a country may have a surplus or deficit through international trade and remittances into or out of the country by citizens outside or foreign employees inside the country (such transactions constitute the current account), it also transacts internationally through ownership investments (FDI), portfolio investments, or by borrowing from

IIM Bangalore

foreign lenders. While all this happens the country needs to ensure that it has sufficient funds to meet its external payment obligations. If the country manages this well and has a net inflow of funds then its foreign exchange reserves receive a boost else there is a drawdown on the reserves. This explains why countries with large current account deficit but iffy capital flows prefer to have large forex reserves. The problem arises, like it did for India in 1991, when the forex reserves are already so low that the country is unable to honor its international obligations. In India’s case, the oil bill is huge and since we produce little oil ourselves the demand is price inelastic. Thus unless the country is able to increase its exports such that it outpaces the growth in imports, the CAD is for here to stay. Hence there is a need to allow foreign funds in the country to ward off a BOP event. That said, the question that we face now is whether India has, in recent times, because of the unchecked rise of its trade deficit and policy inaction pushed itself to a 1991 déjà vu? Arguments in favor of a crisis The similarity is evident. Both in 1991 and 2012, the country ran uncomfortable current account deficits. In fact in all the years post 1991 till now, India consistently ran CAD in excess of -2.5% (Fig 1). In 1991, the economic slowdown of the mid 80s had hurt India’s exports while the oil shock post the Sad-

Fig. 1: India’s Current Account Deficit to GDP

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dam invasion shot up India’s oil bill and subsequent trade deficit. NRIs shied away from the country as the nation was locked in an overvalued currency. The story repeats in 2012. The CAD has been above -2.5% since 2009 on account of inelastic imports of crude and gold. The export of gems and software has seen subdued growth due to slowdown in the western economies. Though NRI deposits remain strong and India still receives the largest repatriation of money for any country by its citizens outside, the huge trade imbalance has caused the CAD to reach a historic high of -4.3% of GDP. India’s GDP growth had fallen to a paltry 1.4% in 1991. Despite Indian companies beginning to free themselves from the shackles of government control the country still did not attract foreign investments. Part of the reason could be India’s inflation figure of 13% at that time. Statutory restrictions on FDI in the closed economy resulted in an FDI 0.13bn USD in the year. Paradoxically the nation was still investment grade which meant it could keep on borrowing externally to balance off its current account deficit. As such the country built up foreign currency liabilities to the extent of 27% of GDP with a debt service ratio of a whopping 30.2%. Presently, as the nation barely hangs on to its investment grade rating (BBBnow by S&P), foreign investors have started pulling away from the Indian markets. In fact given the high interest rate, +9% inflation rates and depreciating rupee, the portfolio investors turned net sellers in 2011 as they received fewer bangs for their bucks in the Indian market. With India having shifted from a pattern of foreign loan based funding to a foreign investment based funding, the external debt remained at 18% of GDP (high but not uncomfortable). This meant that for only the 2nd time in more than a decade did India have to draw down its reserves to the extent of 12.8bn USD in ’12 fiscal (Fig 2) to strike the BOP balance. With the minister’s flip flopping over allowing foreign players in Insurance, retail and a host of other sectors which are crying out for foreign funds and related technical know-how, the country’s leaders have not sent the right message to the international community on the long term investment front either. In most cases a negative outlook follows a downgrade. With India’s disinvestments going awry, the

monsoons being 23% deficient (hinting at greater govt. help to farmers), reluctance of the govt. to deregulate diesel prices or implement the GST; the rating agency may not take a favorable stance on India and may eventually downgrade it. Losing investment grade status may cost the country heavily as it will make borrowing abroad costly (increase in interest expense) and result in investors pulling out from the country as many investors are statutorily allowed to invest only investment grade countries. The double whammy is sure to push India towards a payment mismatch. The inflation for the current fiscal has been high though lower than similar figures last year. Inflation makes the cost of inputs for firms more expensive and affects their profitability and in turn the willingness of foreign investors to invest in them. With the GoM already thinking about making provisions for a possible drought and if the commodity futures are of any indication, food inflation is going to get worse. The central bank will then see little scope of reducing interest rates. Much has been talked about the policy paralysis in the country. Even in issues where the Congress does not have widespread disagreement with its allies there has been no definite move – 100% FDI in single brand retail for instance. The proposal got notified by the govt. on Jan 10, 2012. IKEA still awaits ironing out of issues till it is able to begin the process of investing. Not to mention the other more contentious issues of FDI in multi-brand retail, insurance, aviation and land acquisition for POSCO. Added to this is the govt.’s long observed ambiguity with taxation rules such as retrospective amendment and GAAR and also issues of corruption where the nation’s Supreme Court cancelled 122 licenses in the 2G auctions much to the ire of foreign players such as Sistema who had bought such licenses. The UPA looks in complete disarray and the investor community has begun questioning India’s ability to remain as a top notch investment destination. With foreign exchange reserves of $294 bn the country may think it is appropriately buffered but 2008 should act as a reminder. The nation’s reserves dipped to a low of 245bn from 316bn (Fig 3), a fall of

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Fig. 2: India’s foreign exchange reserves drawdown (in USD mn)

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$ 316 billion

$ 308.2 billion

$ 245.8 billion

Fig. 3: Fall of reserves in 2008 due to FII pull out

23% in less than a year. This was during the global economic turmoil of 2008. With the European story not having played out fully and with Spain and Italy lining themselves appropriately as worthy recipients of a Germany led bailout, the global crisis is far from over. Should Greece exit the Euro, foreign investors could start pulling out of emerging market even quicker. As investors look to invest in the eternal safe haven of US securities the rupee will come under further pressure which may force the RBI into selling its dollars to prevent a rupee free fall. Such being a scenario, it remains to be seen if Indiaâ&#x20AC;&#x2122;s reserves will provide sufficient buffer to ward off a BOP crisis.

Arguments against a crisis But hang on. Are we writing off the India story too soon? It quite possibly could be so. Despite a slowdown in growth the country is still the second fastest growing economy in the world at 6.8%, much higher than those achieved in the years leading up to 1991. The IIP figures in May showed a 2.8% growth

Indicator Fiscal Deficit Total as % of GDP Fiscal Deficit Center as % of GDP Govt. debt as % of GDP Forex reserves in bn USD GDP in bn USD GDP growth Trade deficit in bn USD CAD in bn USD CAD as % of GDP Capital account in bn USD FDI in bn USD Exports in bn USD Forex drawdown in bn USD Inflation Gross Capital formation External debt in bn USD External debt as % of GDP Debt Service ratio Forex cover

thus arresting the downward spiral. An important year for comparison is the year 2008 when the global economic crisis showed its effect on India with the exports slowing and FIIs pulling out of the country. Compared to 2008 the country has been doing well in most indicators of development (Table 1). Even in 2008 the country was not close to a BOP crisis. The alarm bells seem to be on unnecessary over drive. The drawdown of the reserves is concerning but things are looking up albeit marginally. FIIs have till date been net buyers to the tune of 10bn USD in 2012 â&#x20AC;&#x201C; a 336% improvement over the same period last year. With the exchange rate at historic highs (Fig 4) and inflation cooling to 7.25% (Fig 5) in May, staying invested in the country in the long run seems inviting. In many ways the worst in terms on domestic macroeconomics (high inflation, interest rate and a weak rupee) is already upon us. The expectation by most banks is that the rupee will strengthen significantly by December and the RBI eventually will cut down interest rates. With the fundamentals of Indian company remaining strong, India still is a huge untapped market for growth and hence the need to stay invested. The other strong story has been on the FDI front. Despite all the cries of policy paralysis, the FDI inflows to the country have remained very strong (even in 2008) (Fig 6). The country may not be realizing its true FDI potential but large companies still believe that India is their future for ownership investments. In fact the capital inflows were at a record 67.8bn USD in 2012-12. Were it not for the high oil import

2008

2012

8.4% 6.0% 75% 260 $1,224 6.7% $118.90 $27.90 2.4% $6.80 $33 $189 $20.00 9% 34% 224 18% 4.4% 116%

8.3% 5.9% 68% 294 $1,848 6.9% $189.70 $78.20 4.2% $67.80 $37.60 $288 $12.80 8% 35% 326 18% 4.6% 90%

Table 1: Comparison of economic indicators between years 2008 and 2012

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Fig. 4: Rupee at historic lows

Fig. 5: Inflation seen cooling down in 2012

bill, the country would have registered a forex surplus once again. Let us also not forget the country’s nonresident citizens who repatriate huge sums of money to their families back home. India receives the highest remittances for any country from its citizens abroad. Since the RBI freed up interest rates on NRI accounts in December, there has been a huge influx of NRI money which helped the country hold fort against a fund outflow from January to March 2012. In fact the NRIs had poured in 7.5bn USD till the month of March into the NRO accounts alone. That the NRI inflows are situation inelastic is evident from continuously increasing NRI inflow figures (Fig 7).

On the deficit front, the country is not in its worst years. The nation ran a much larger debt to GDP ratio in the mid-2000s. Yes, fiscal profligacy has led to a worsening of the scene on the fiscal front (fiscal deficit for 2012 was 5.9%) but it was much worse in 2008 and the country has shown a willingness to come back to good health. It will be immature to think that the same leaders who checked the country’s fiscal excesses will not be able to repeat the performance. Fiscal consolidation needs time. The govt. in fact seemed very prudent when they targeted a more realistic target of pursuing a fiscal deficit of 5.1% this year. The center’s deficit in 1991 was at a much more uncomfortable 8.4% in 1991.

Fig. 6: FDI inflows in India

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Fig. 7: NRI remittances to India

While the nation does depend on foreign funds for investments, it has steadily built up its savings leading to a savings rate of 34%, an improvement over the 21% savings rate in 1991. This savings has helped India create capacity in the past and given that this trend is likely to continue, the country should be able to the create capacity it needs. The argument of a BOP crisis falls flat on its face when one looks at the size of the reserve. With 294bn USD of reserves the country can finance imports for the next 8-9 months and cover 90% of its total foreign borrowing obligation (though this figures has come down from 116% in 2008). Unless an apocalypse to the extent of Greece, Spain and Italy falling together happen no matter how much the FIIs pull out the reserves, the country will be able to meet the external obligations. Remember FII and foreign remittances are doing well. The fundamental of Indian companies still remain strong. Indian companies are able to raise foreign currency debt consistently. SBI SDR issue in the US got lapped up in no time .It was subscribed 5.4 times. The auction of Indian govt. bonds after a hike in the limit of FII investments in govt. bonds also went well. This shows that despite downgrades, international investors still repose tremendous faith in Indian companies. While the weak demand in US and Europe is going to impact exports, it is going to impact the oil prices as well. Oil prices are expected to remain subdued with an Iran war out of everyone’s mind at the moment. This may just be the lucky break the govt. have been looking for given that a lot hinges on the price of oil. The demand for Gold, India’s second largest imported commodity, has also remained subdued after the imposition of 1% excise duty on unbranded gold and a weak rupee which has made gold very expensing in rupee terms for the Indian buyer. In fact gold imports fell by 56% in Q1 2012 and is expected to fall by 53% for the entire fiscal (Bombay Bullion Association). While India will be displaced as the world’s largest imported of gold, it may not be such a bad thing.

Conclusion With negative sentiment all around, it may perhaps be

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natural although not entirely reasonable for analysts to sound the alarm bells over India’s ability to meet its external financial commitments. But one should not confuse between the concerns that actually exist and the one’s that doomsayers want us to believe. Agreed that the nation is in the midst of a slowdown and that policy paralysis has forced the Indian economy to grow below its actual potential .But that is precisely what the concern should be - whether India will be able to bounce back and realize its true potential growth rate of 8.5-9% in the medium to long term and not whether the country will go back to the dark days of 1991 and be unable to pay foreign money to its lenders. That is the distortion which speculators have created by believing or feeding the belief that India’s growth story is over. In the long term India should remain as a great investment destination. The nation has world class companies, the richest CEOs, a fiercely independent and brilliantly competent central bank, a judiciary that foreign investors repose immense faith in, Oxford and Harvard educated Prime minister and Finance minister and as history has shown time and time again the ability to bounce back when the chips are down. If India does default on its BOP then it will be the biggest country to do so. No country, the current size of India’s economy has gone through a payment crisis. Indonesia, Mexico, Thailand and Malaysia were all much smaller economies when crisis hit them. The country is the 4th largest economy in terms of GDP PPP, is a G-20 member, a Security Council seat seeker and has a history of meeting its payment commitments for 20 years now – despite S&P stubbornly holding India at BBB- while countries such as Italy dance away with better ratings. A more powerful India of 2012 will be able to negotiate better deals when it comes to international borrowings should a crisis near. Presently, the country is quite some distance away from a crisis. Then is there no reason to worry? There is. India needs to grow at 9 % for as long as it can to pull its millions out of abject poverty. That should be the challenge and it comparing against this benchmark be the definition of a crisis, then so be it.

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Aniket Sarkar

VGSOM, IIT Kharagpur Introduction What is corporate governance and its current situation? Corporate governance refers to the set of systems, principles and processes by which a company is governed. It provides the guidelines as to how the company can be directed or controlled such that it can fulfill its goals and objectives in a manner that adds to the value of the company and is also beneficial for all the stakeholders in the long term. It refers to a set of control mechanisms that the company adopts to dissuade potentially self-interested managers who would otherwise use or find means that would be detrimental to the welfare of all the stakeholders. Corporate governance system adopts a set of rules that not only provides job creation, economic growth, and private sector led poverty alleviation but also a holistic development of the environment in which the company operates. The examples of companies like “Enron” in the west and “Satyam” in the east clearly leave us in a maze as to whether corporate governance exists in reality. Research has shown that corporate governance has no definite set of rules but the model varies from market to market i.e. the guidelines that ensure good corporate governance in one country may or may not prove to be beneficial to another com-

pany operating in some other geography or market to be precise. In such a format whether the company is following corporate governance in letter and spirit can be judged by none other than the market which remains the supreme. Companies mainly in emerging economies have evolved over time to accept the corporate governance practices as tools that provide the investors and market more clarity and confidence on where and how much to invest. Three-quarters of investors in a Mc Kinsey Survey say that board practices are of very less importance to them as against financial performance when they are evaluating companies for investment. Reports like these though add motion in favor of corporate governance; instances still remain where the dominant shareholder may manipulate the entire system or rule book for his benefit, thus, leaving the minority shareholders in the cloud. The report seeks to identify the correct state of corporate governance i.e. whether it has penetrated in the minds of the management or is still just used as a “Box ticking “exercise with a group of compliance officers.

Argument For The Judgement Why do I think corporate governance adds value to an organization? It is worthwhile to remember the rationale given by

Fig. 1: Selected determinants and participants in corporate governance systems

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Does Corporate Governance add Value to an organization or is it just an Eye-Wash?

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Fig. 2: Results of McKinsey Investor Opinion Survey

Sir Cadbury who said, “the important reason why I believe it is vital for enterprises to set and maintain high ethical standards is that good companies attract good people.” Corporate governance as laid down by the Securities and exchange board of India (SEBI) is “a set of systems, processes and principles which ensure that a company is governed in the best interest of all stakeholders.” There can be no doubt about the fact that corporate governance is a completely indispensible tool considering the fact that investors and market as a whole today look forward to companies that not only show good financial performance but also have an ethical boardroom. The system of corporate governance that employs an entire “circle of trust” comprising of the auditors, regulators, independent directors and analysts, not only ensure that a particular company or business is making profit but also shows whether all the concerns and interests of the stakeholders and the minority shareholders are taken into account. Today more and more investors across the world wanting to invest in emerging economies are willing to pay a premium for those companies that have all the corporate governance rules in place. This in turn unleashes the value of the specific company leading to better share value appreciation for all shareholders during stake sale or an IPO. This process is also known as “Unlocking Value”. The framework makes way for a clear and detailed explanation and disclosure of the financial statements of the company thereby providing clarity to the investors and general public about the operations of the company. The clause 49 under the SEBI guidelines made after the Kumar Mangalam Birla report and the committee under Narayan Murthy recommendations on corporate governance has ensured greater involvement of the Independent directors along with a change in defining

them, strengthening the responsibilities of the auditor committee, improving the quality of financial disclosures and thereby leading to a much more transparent and flexible system which is no doubt a very value enhancing process for the company. The chart above (Fig. 2) clearly shows that a huge percentage of investors across geographies would be willing to pay a considerably fair amount of premium for companies following definite corporate governance practices. It is true that there is a difference created in the minds of the investors and the operating markets by companies following good corporate governance. Also, the value of those companies that do not follow corporate governance but have a well laid down procedure increases to a great extent. Apart from adding financial value and enhancing brand equity of the company the framework tries to increase the trust of the shareholders and stakeholders on the whole (forming special grievance portal under Clause 49 of SEBI for addressing the issues of minority shareholders). More importantly during downtimes and recessions the company can attract funding, different kinds of financial support that would allow the organization to pass these tough times. There are cases wherein a company took a wrong managerial decision leading to unwanted losses but the company was successful in shielding its brand value from an impending attack from the market due to the corporate governance practices followed by it. “In short corporate governance equals better risk management.

Corporate Governance In Asia The chart shows very high scores in the area of enforcement which can be attributed to the better regulatory systems in place with stronger private enforcement in the form of voting of shares and company engagement. Also one key element of improving microeconomic ef-

Fig. 3: Corporate Governance

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Table 1: Corporate governance scores of different countries

ficiency is corporate governance. Corporate governance affects the development and functioning of capital markets and exerts a strong influence on resource allocation. It impacts the behavior and performance of firms, its innovative activities, entrepreneurship, and the development of an active SME sector. In an era of increasing capital mobility and globalization, corporate governance has become an important framework condition affecting the industrial competitiveness of OECD countries. The stress on increased earnings as a measure of productivity also develops the atmosphere of entrepreneurship. An effective corporate governance framework can also minimize the agency costs and hold-up problems associated with the separation of ownership and control. So apart from a method of better shareholder communication the concentration of power in the hands of the management is reduced by incorporating more number of independent directors.

Against The Judgement Why it could be just an eye wash? How effective corporate governance is today is evident from the fact that in 2008 Satyam received the “Golden Peacock award” for excellence in corporate governance and next year itself its founder Ramalinga Raju was arrested for what seems to be the biggest corporate fraud in the history of Indian business. Corporate governance today has turned into a compliance government where the company employs special compliance officers who have turned the set of rules and guidelines into a “box ticking” exercise. There are considerable examples (Enron

known for the biggest corporate fraud ever had principles well-built for its employees) to show that even after years of incorporating the measures it is hardly followed in spirit. The essence of corporate governance has disappeared because the management is more interested in building their own wealth pie keeping the minority shareholders in the cloud. The rules are followed only as a means of compliance and if it is met the executives are more than happy to say that the company is well governed. This actually leads to a situation where the entire purpose of better and transparent operation of the company is sacrificed.

Status Of Corporate Governance In Asia Except for two to three of the countries which show fair improvements the others show sign of degrading corporate governance culture, loss of focus and weak political system leading to the suspicion that even if the score improves there might be difficulty in sustaining it. Corporate governance still remains a very state-led top down approach with the culture failing to catch up. From the graph above it is clear that though some countries like Singapore, Hongkong have good scores but they have remained mostly flat throughout the decade. For the others the behavior shows a clear loss in focus with activities like insider trading, market manipulation and other types of frauds still prevalent. Clearly the problem today is not about corporate governance but about “Good” corporate governance. The recent study according to the EFI (Economic free-

Table 2: Status of corporate governance in Asia

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Fig. 4: Comparison of corporate governance scores

dom Index) shows that the corporate governance scores in the ASEAN countries is still very low with many countries having a mountain to climb. The reason is not vague with higher concentration of power in the hands of the owners, weak enforcement by the judiciary and regulatory officials being prone to bribery and corruption, high leverage by the companies and inadequate monitoring by the banks and financial institutions of the money taken. Though rules are in place, the basic problem is with the implementation as the corrupt and lethargic officials give in to the tricks of the dominant shareholders thereby depriving the minority shareholders of their rights and unfortunately making them helpless.

Fig. 5: Quality of corporate governance in Asian countries

The problem of ownership structure is one of the critical issues that are crippling the ASEAN companies. It is basically relationship based where a person, individual or family owns the majority of the shares of a company. Structures such as this are more seen in Asian countries other than Japan and on a company basis are more prevalent in smaller companies than in larger ones. Moreover, in some companies the ownership control exceeds 60%, and if the family does not hold the majority of the shares they sometimes have a person in the position of an

executive director in the board to retain control. In this way the minority shareholders are deprived of their fair share of say in the dealings or management of the company.

Study of two sectors The public sector units In the governance of the PSUs the board has become totally irrelevant in its role and power. Where as in the US and UK there is stress on strengthening the board, here the board has little say in matters such as appointment of CEOs or in the composition of the board. The government as the majority shareholder takes decisions about the company through the Public Enterprises selection board with the help of the concerned ministry. The board can neither fire the CEO nor can it change his compensation package and as far as audit is concerned there is the CAG (Comptroller Auditor General) who is the whole and sole and the board can hardly add anything to it. The board is powerful in paper only and not in reality because the delegation of financial powers to the board is very limited. Many operating decisions have to be brought to the board for decision making but this does not, however, make up for an effective board because it shifts the process from “Directing” to “Managing”. To make it all the more worse, all the strategic decisions are made by the government being the dominant shareholder along with the concerned ministry.

The MNCs The government in the 90s liberalized the law to allow the MNCs to invest in India through the subsidiaries with holding up to 100% (in certain cases) stake, which created a lot of corporate governance issues. The foreign companies in order to comply with the law issued shares to the Indian public at

Table 3: Rule of law indicators in Asian crisis economies

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Conclusion There is no doubt about the fact that corporate governance is the way forward but it should be followed not only in letter but also in spirit. The recent initiatives on the part of the government, like the Adi Godrej committee on increasing the quality of corporate governance “under the “National Corporate Governance Policy are all steps in this direction. We have realized the difference between Corporate governance and “Good” corporate governance and investors and markets all across the world are aware

of it and are actually judging the companies based on how “good” the governance actually is. The model of Corporate Governance is not absolute as the environment in which the companies operate is different across geographies. There is also a difference in the organizational structure of the companies like in the West i.e. in US and UK the issue is about separating ownership and management while in the Asian countries the issue is about disciplining the dominant shareholder. Consequently the companies have their own version or definitions of Corporate Governance. But the good thing is that the SEBI has under CLAUSE 49 striven to make the measures stricter in terms of involving more Independent Directors, more responsible Audit Committee, enhancing the quality of Financial Reporting and others. But no matter what “good” corporate governance will stem only from a vibrant capital market. Corporate governance is such a burning issue for regulators that it is often forgotten that the capital market by itself exercises considerable discipline over the dominant shareholder. Minority investors may rarely attend shareholder meetings where the dice are loaded against them, but they are continuously voting with their wallets. They can vote with their wallets in the primary market by refusing to subscribe to any fresh issues by the company. They can also sell their shares in the secondary market thereby depressing the share price. The concept therefore is that corporate governance is not an aim in itself but only the means to an end. Post globalization the era of Corporate Governance has not only provided a framework in which corporations should function but most importantly it has spurred the spirit of entrepreneurship among the masses leading to a flourishing SME sector. The newly unleashed forces of deregulation, disintermediation, institutionalization, globalization and tax reforms are making the minority shareholders more powerful and forcing the companies to adopt healthier governance practices. Instances like the compensation committee of the board strengthening itself to exercise greater control over CEO compensation is following widespread complaints of disproportionate management pay to performance further boosts my thinking that the benefits of corporate governance have a long way to go. The balanced way could be to use a “compliance or explained approach” where the particular company has choice between strictly or religiously following the governance and guidelines. In case it doesn’t, it will have to, under all circumstances, explain to the shareholders and market why it was not able to do so.

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deep discounts at prevailing market rates which caused considerable losses for the minority shareholders. There are also instances where the MNCs extracted loyalties from their subsidiaries for using their brands. There are also cases where a particular parent company had two subsidiaries in the country with varying holdings. In such cases many times the company transfers assets to the most important brands to the subsidiary with more holding thereby devaluing the holding of the minority shareholders who were also a part of the brand building process. The irony is that all such decisions get clearance in the shareholder meetings where the dominant shareholder exercises all his rights and power to get it through. In such cases the minority shareholder can do nothing. For improvement of these above described issues the onus lies on the government owned regulator and the market itself. As for the regulator, disciplining the dominant shareholder would mean micromanaging the businesses, which is beyond its mandate and competence. For the market which though understands the intricacies, does not possess the powers of the regulator. The board which acts like the bridge between the ownership and management should infact discipline the management which derives all the powers from the board and solves the differences that arise between ownership and management. But a critical issue is that - in reality the board is unable to control the ownership as it derives all its powers from them. The problem of this dominant shareholder appears in the form of three main chunks i.e. in the PSUs (government), MNCs (the foreign entity) and finally the Indian Business Houses (individuals/family/ friends& relatives). Even if the owner does not hold the majority of the shares he/she emerges out to be the dominant one as the financial institutions which form a critical percentage mostly play a passive role in the decision making process. So all kinds of manipulations such as improper accounting practices, transfer of assets between group companies, amorphous shareholding between owner and his family, black money usage and false reporting of financial statements, etc. take refuge under these circumstances, thereby, cheating the minority shareholder or general public.

She Speaketh

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Ms. Judy Manners

Executive Director, Asset Management, JP Morgan Chase The philosophy behind Corporate Governance is a sound one. A code of conduct has always been there. You can look at society, you can look at religion, there have always been some basic principles and tenets that need to be followed. But, I think, the first economic depression in 1929 was the first wake up call. More so in the last few years, we see a catapult effect among the countries. The financial markets, the economic scenario and the employment scene all take a hit if there is a problem in one country, mainly owing to the phenomenon of globalization. Corporate Governance is very important but then it becomes an eye-wash when it is not dynamic. The way we change our electronic gadgets, the way we update our playlists, the same thing needs to be applied to corporate governance. Niveshak: How effective do you think regulations are in Corporate Governance? Is it something that must come from within or is it something that can be imposed on a person?

Ms. Manners: The ideal world to live in with respect to Corporate Governance is one wherein you have a set of rules that you follow, without realizing that it is actually part of your DNA. It is a classic case of “Act as one with a shared direction.” But, in the corporate world, we are far away from that. Therefore, it becomes necessary for a global regulator, say for instance, the World Bank or the IMF to step in. Sometimes it becomes crucial that even economic superpowers call for things like Anti Money Laundering, Know Your Customer etc. This is probably what is required. It would be lovely to have it inbuilt, but sadly it needs to be imposed and the people who impose it need to be one step ahead of everyone else. Hence, we need a proactive rather than a reactive response. Niveshak: Many

Sarbanes-Oxley act have not been used. Instead of Civil Prosecution, there is also scope for Criminal act for penalty, for imprisonment and all those were not used. How effective do you think is the implementation of these regulations? Having the regulations in place and implementing them are two different aspects that we need to take care of. provisions of the

Ms. Manners: When you talk about implementation, it’s about managing all the stakeholders. For the judicial system, the laws need to be revamped accordingly; getting public support is also critical. But I feel that getting the judiciary in place is one step in the right direction. This is mainly because your entire setup is as strong as your weakest link.

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Niveshak: The parameters on which Corporate Governance is judged these days; the board of directors, the auditors, the regulators; do you think that is causing the problem these days? (Example: Satyam was given the Golden Peacock award the same year when the scam happened) Ms. Manners: If I were to formulate guidelines for measuring Corporate Governance, I would adopt a slightly different strategy. Firstly, I always look for something unusual, be it positive or negative variance. Positive variance is something that can give you cues towards manipulation, fraud etc. My major focus would be on patterns and anything that would be a deviation. At the end of the day, it is about the people. Having independent auditors, management team and having a robust legal system is what is needed today. Corporate Governance is all about Personal Governance at a higher level. Niveshak: Many of the companies feel that this will be an additional burden on them. It could mean public scrutiny of their confidential data, loss of core competency etc. Are the companies also right by not abiding by all the rules and regulations? Ms. Manners: Most of the times the companies lose their competitive edge. But, if they use their competitive edge for the wrong reasons, which is what invariably ends up happening, the results can be shocking. As far as transparency is concerned, every publicly listed company needs to be transparent and there can be no two ways about that. Today, it’s not so much about what you have, it’s more about what you use it for.

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CEO, SME,Janalakshmi Financial Services Pvt. Ltd Mr. K. S. Ramdas is a senior professional banker with over three decades of experience in Indian and international financial markets. His areas of expertise cover emerging growth companies, mid-corporates, international trading companies and debt financing of global projects. He has a proven track record in starting de novo business verticals for banking majors and growing them into profitable and self-sustaining lines of business. Niveshak: As a professional banker with over 30 years of experience, do you think that financial inclusion is feasible?

also don’t take into account how many of them have fallen back to the world of poverty, which is equally important to be measured.

Mr. Ramdas: The answer is an emphatic ‘yes’. In my opinion, it is not only feasible, but inevitable, even in the society where the open market principles hold true. The reason for that is that financial inclusion is not a deterrent. In fact, on the contrary, it can provide you diversification in your portfolio, can be anti-cyclical and it can mitigate risk. Like other things, the choices you make as to whom you provide your services and how you do it is very important. And that’s why I think that when you provide credit, you need to be smart about it and you can’t get carried away by those altruistic principles.

Niveshak: Do

Niveshak: Sir, if 5-7 years down the line Janalakshmi Financial Services is asked how much financial inclusion it has achieved, then what are the primary factors that you will take into account to compute that financial inclusion?

Mr. Ramdas: Well, it is a very good point and a difficult challenge. I will like to tell you that even we have not figured out the answer. But, it is a question we have asked ourselves and a lot of work is being done, both from a data analytics point of view to partnering with the hot leaders in the field. Anirudh Krishna, Duke University has done some pioneering work in the area of poverty alleviation and the basic issue he addresses is that not many companies measure when they have taken somebody out of poverty and they say “It’s done”. They

you think government should play

a major role in promoting credit bureau checks?

Mr. Ramdas: The role of government is very minimal. It is much more focused on the role of individuals and role of institutions, the government is only an enabler. I think the Reserve Bank of India has done a lot and can continue to do more and I believe institutions like banks and Micro-financial institutions should make it a hygiene factor to do credit bureau checks. There are a number of lenders who don’t do these checks because of various factors like extra time that needs to put in or cost considerations, as they don’t want to pass the extra costs to customers. Most often this is due to competitive reason; you try to overlook it for example you may think that I know this customer why should I unnecessarily perform a credit check on him. But in many cases the institutions doesn’t know the exact credit worthiness of their customers. As we all know that past performance is no guarantee for future performance, it is important to do a credit check. Regulatory bodies like SEBI, IRDA or any other associations can make institution perform credit bureau checks as a norm.

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Mr. K. S. Ramdas

He Speaketh

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Dr. Gautam Naresh, Public Financial Management Advisor, PwC India, in a candid discussion with Team Niveshak talks about implementation of GST in India and various issue associated with it.

August 2012

Dr. Gautam Naresh

Public Financial Management Advisor, PricewaterhouseCoopers Dr. Gautam Naresh is a full-time retainer with the Public Finance & Public Enterprise reforms practice of the Government Reforms and Infrastructure Development (GRID), PwC, India. . He has been the senior economist at National Institute of Public Finance and Policy (NIPFP), New Delhi which is an autonomous Institute of Ministry of Finance, Government of India. He has participated and conducted various training courses for senior officers of Government of India, state officials and local government officials on the broad areas of taxation, expenditure management, public financial management, revenue administration, urban finance and property tax reform and fiscal policies. Disclaimer by Dr. Gautam Naresh: The views expressed in this interview are my sole responsibility and not of the company I belong to. However, there may be coincidental similarities in the views. Niveshak: Keeping Oil keeping net of

Gas secGST is like

and

tor out of the purview of

30% indirect tax out of the GST. How effective will this

be keeping in mind that the tax credit for the same will not be available for set off?

sale of their finished products. Similarly, distributors would also be able to pass on the duty burden to their customers. This would ensure that there is no cascading effect of taxes and would result in a reduction in the cost of doing business.

Mr. Gautam: The Constitution provided for the entire regulation of petroleum sector under Union government. The recent bill of amendment to the Constitution allowing for the introduction of a GST inter alia exempted this sector from the purview of the GST. There are pros and cons of its rationality and attracted a debate on this issue. Yes, the Indian oil and gas sector is the largest revenue earner for the central and state governments as it accounts for nearly 1/3rd of indirect taxes.

Currently and in future too, on the group of commodities under discussion, the tax credit would not be applicable and the tax would be retained by the producing state. This may create cascading impact on the consuming state and would therefore effect the final price to consumers. This situation needs correction. Apart from the oil and gas sector, other industries that consume petroleum products will also be adversely affected by the exclusion.

Conceptually, under GST, manufacturers would be entitled to input tax credit of all inputs and capital goods purchased, including service taxes, from within the state as well as interstate, from a registered dealer for setting off the output tax liability on the

state governments about the implemen-

Niveshak: How

should the govern-

ment go ahead with convincing the tation of

GST?

Mr. Gautam: GST is a major indirect tax reform in India. Its structure, constitutional amendments and legislation is still a work-in-progress and would be settled soon. The Central Sales Tax

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Constitution of India provides for fiscal autonomy in which tax rates may be decided by each state. This has led to adoption of dual GST system in India, which is a unique experiment. If there is scope of rate war among states, it may be injurious for trade and consumers too. If India is to be treated as single market, the minimum variation The states have in general demanded that (i) Non of tax rates is good. implementation of GST from 1-4-2010 should not be taken as a ground to stop the CST compensa- By inclusive growth we may mean an equitable tion and the Government of India has to provide allocation of resources with benefits incurred to compensation till GST is introduced as the rev- every section of the society. This consideration is enue loss suffered by the states is substantial and not state specific but keeping in mind a citizen of permanent. (ii) Revision of VAT rate from 4% to 5% India. This task is performed as a joint venture by should not be linked to the CST compensation for all levels of governments in the federation. Institu2010-2011 as it was not part of the original com- tions like Planning Commission and Finance Compensation package and the VAT revision had noth- mission also intervene in a big way. It may also be ing to do with the CST. And (iii) If further delay is interesting to note that fiscally, in the annual budexpected in implementing GST, then the CST rate get, which includes all activities, total own source must be restored immediately to the original 4%. receipts finance the state expenditures to the extent of 50 percent of total revenue expenditure Manufacturing states like Maharashtra, Gujarat, and capital outlays, whereas recently only about Tamil Nadu and Andhra Pradesh see major loss 12 percent to the total capital disbursement and while a consuming state like Bihar is not going revenue expenditure are financed by own source to incur any major loss. These concerns are not receipts. The implementation of a standard tax impossible to be redressed and need to be ad- rates across all states will be beneficial to India’s dressed until stability is restored. mandate of inclusive growth and not detrimental Niveshak: India is like a combination of 28 differ- to the development prospects of relatively underent countries, each with different levels of devel- developed states. opment and economic activity, something which is similar to USA which for that matter does not have a GST regime. Do

you think that implementation of a standard

tax rates across all states will be beneficial to India’s mandate of inclusive growth and not detrimental to the development prospects of relatively underdeveloped states?

Mr. Gautam: India is a Union of States. The taxation system of transaction of goods in the USA is retail sales tax, which is an ideal form unlike the Indian case of mix of origin-based and destinationbased system. The VAT system took over from this archaic system here but this is a half journey. I think our similarity may be compared with the European Union in some way from the view of integrated market and adoption of GST, and Brazil and Canada may also be considered. The states or sub-national identities in a federation can never be identical in terms of economic development. Inter-regional disparities are bound to exist. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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(CST) has been biggest bone of contention ever since switching over to VAT because of the accruals from it have been quite handsome. The apprehension of the states is mainly because the experience of getting CST loss compensation from the Centre has not been very good.

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Financial Inclusion: Feasible in a Capitalist Economy?

Soumya Iyer

IIM Shillong

Financial inclusion is the delivery of financial services at affordable costs to sections of disadvantaged and low income segments of society. Access to sustainable financial services in the form of credit, insurance and savings to the unbanked sections of the society to bring them into the mainstream economy by increasing their standards of living is the objective of almost all the central banks of the world. The degree of financial inclusion is measured with the help of two basic parameters: • The current account(no-frills bank account) penetration within the population • The formal loan accessed/availed by the population from organized sources The two representations in Fig. 1 below show the % of population in the world having access to formal credit and bank accounts respectively indicating the low levels of credit availed in Asia Pacific and Africa. Reasons for financial exclusion The reasons can be classified as stemming from demand side and supply side. Demand side de-

terrents include lack of awareness, low incomes/ assets, social exclusion and illiteracy whereas supply side deterrents include distance from branch, branch timings, cumbersome documentation and procedures, unsuitable products, language and staff attitudes. A study of the demographics of the worldwide unbanked people by World Bank highlights the wide gap existing between the “haves” and “have-nots” of the world. The Findex Report (Fig. 2) highlights the gaps across demographic variables which points out the need for financial inclusion services for the youth in the rural areas. Financial Inclusion and Capitalist Economy In a capitalist economy which functions as per the market mechanism principle of maximum profit, financial inclusion is an anomaly with its social objectives clashing with the economic objectives of the free market operations which are mainly profitdriven. Since 2000s, there has been a worldwide debate regarding the feasibility of the lofty objective of inclusion of the economically disadvantaged sections of the people into the mainstream fabric

Fig. 1: Representation of % of population in the world having access to formal credit and bank accounts respectively

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Fig. 2: World Bank Findex Report, 2011

of economic soundness. While this problem does not seem much gigantic in the developed countries, it is one of the most burning problems facing the developing countries wherein a wide chasm of economic inequality dividing the capitalist and the labour class often results into “class-conflicts” hampering economic efficiency along with undesirable political and social consequences. The need of the hour is to evolve an integrated economic system which ensures “Progress of All”. But the question is “Is it feasible to provide financial inclusion to the poor?” and “Are there profitable methods to do the same?” Arguments for feasibility of financial inclusion Financial Inclusion as a socially desirable objective can be achieved by building for-profit models which suit the needs of a capitalist economy. It is said that the best way to support an argument is to provide objective and realistic observations. Here, in Table 1 we analyse some of the real-time experiments in various countries in the area of financial inclusions which have been successful and are financially sustainable. An emerging model in the field of financial inclusion is the Polylateral Development which focuses on supporting systematic and sustainable lateral flows of knowledge and resources among developing countries to promote socio-economic growth and development. A good example of Polylateral Development is the Alliance for Financial Inclusion (AFI). AFI is a knowledge sharing network of de-

veloping nations focused on expanding access to the formal financial sector. The financial intermediaries of developing nations can draw inspiration and assistance from this organization and can form networks for sharing information and resources to deliver their services profitably. Financial inclusion presents an undeniable opportunity for investors. With 35 million customers in India alone, MFIs have only begun their business in the pioneering stage. As the next phase of economic growth moves into smaller towns and villages, hundreds of millions of people will come into the financial mainstream. They will save their extra income, borrow for agriculture, business and consumption and transfer money between one another. MFIs today have a combined portfolio of more than INR 33000 crore. Norms require a capital of 20-22 per cent of loans. This means a capital base of INR 6600 crore at present. As the industry doubles and quadruples in size, MFIs will have to raise money through equity to support that growth. A study by the World Bank shows that the unbanked sections have a huge demand for credit for the purpose of housing and community services. Innovative business models based on technology can be used to reduce uncertainties and the cost of doing business. Quality certification can play a key role in channelling funds for community infrastructure projects. A commercial bank business model can be adopted wherein central banks can provide partial guarantees for credit to MFIs which further lend-on to the low-income households. This would help in enhancing the size of the transaction and

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Country

Financial Inclusion Model/ Measure

Impact Branch–led business model although expensive is able to leverage on economies of scope by catering to different needs of the same target group. It also set up a money-market mutual fund with required minimum investment of INR 100 in collaboration with ICICI Bank to provide an investment and savings avenue to the rural people

India

Kshetriya Gramin Financial Services: Focus on what the customer wants and prescribe financial solutions that suit their needs

Kenya

Bank without a Bank: Instead of Safaricom-Vodafone launched M-PESA in 2007 creating this using a bank account, use of mo- parallel banking ecosystem. The transactions, capped at $500, bile phones as a conduit for keep- happen in real time through a wide network of around 17,000 agents. It has reached a penetration level of 20% ing and transacting money

India

Branchless Banking: Allowing people to transact money quickly and conveniently at kiosk points established for the same

Financial Inclusion Network & Operations (FINO), a financial technology company, runs the Dharavi kiosk in an alliance with Union Bank of India and attracts more than 500 customers each day. FINO’s smart-card and finger-printing technology comes in handy while recording the identity of a customer and linking him to a bank account

Mexico

Super-Efficient Lending Mission: Banco Compartamos serves 1.5 million clients and in 2007 Micro-credit and allied services came up with an IPO of $400 million. An excellent combination provided with private capital to of innovation and efficiency capture economies of scale

India

SBI has appointed a banking correspondent called Eko to take Banking Correspondents: Agents financial services to the migrants through a combination of who propagate financial services mobile phone technology and the ubiquitous presence of on behalf of the bank providing neighbourhood provision stores. Today, Eko has a network of Doorstep Banking 700 customers a day

Guatemala

El Banco and BANRURAL came up with a bank which emulated Full-Fledged Rural Bank: Provision the “corner style” buildings of the rural areas instead of the of remittances, credit and ATM fa- traditional stately ones. Language and picture options were provided to help customers in easy and convenient transaccilities in a user friendly way tions Table 1: Some innovative models of financial inclusion

to build on extensive knowledge and networks of organizations that have interactive relations with the client base by including them in the business chain. Studies state that MFIs have grown at a CAGR of around 65% since the last 5 years and provide an ROA of 6% per annum. Financial inclusion measures can help banks in better Asset and Liabilities Management (ALM) by procuring low cost funds with a low churn rate from large sections of low-income people by including them in the banking system. Even the Current and Savings Account (CASA) ratio can be improved by spreading the business risks and protecting the margins. As Prof. C.K. Prahlad had pointed out, the fortune lies at the bottom of the pyramid for financial institutions providing inclusionary services. To achieve this aim, banks can offer a package of services like insurance, credit, government payments and savings account to help attract customers which would help generate

August 2012

transaction values. Adequate credit facilities can be made accessible and a user friendly pay-per-use business model for transactionary purposes can be implemented considering the fact that much of the demand of this segment is for consumption purpose. Lessons can be learnt from the informal sector and innovations in product and service levels on the same lines can help in generating robust demand. An area where financial inclusion services would have a great demand includes the small and medium enterprises in the rural and semi-urban areas. If we take the case of India alone, there are over 2.6 crore micro and small enterprises. Share of bank loans to MEs and MSEs show increasing trend, but is still way behind where it needs to be. Share of bank loans to MEs was 6.5% in 2011. The demand for loans in the INR 1 to 10 lakh range is estimated at Rs.80, 000 crores (about $16 billion).The services specially designed to cater to the needs of these

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which cater to the varied needs of a fragmented section does not provide the needed financial incentive for big institutions to enter the market. Financially, the sector leaves much to be desired in terms of operating margins as tight regulations in the sector often bring down the interest rates of micro-loans which are a major chunk of revenue in the gamut of inclusionary services provided. It is estimated that for every 1% drop in the interest rates, a 500 branch MFI loses its valuation by around Rs.150 crores. Hence, the risk involved in the business is quite high without adequate return potential compensating the same. Another feature over-shadowing the sector is the political interventions by means of populist measures which are often unfair, unjust and uncertain making it almost unviable for corporates to deliver the services. In developing countries with huge unbanked and rural populations, the governments often implement crackdown measures against the corporates to gain vote-bank shares by playing to the gallery. This results in very few players entering the market which in turn results in oligopolistic markets and give firms the power to dictate their own terms for doing business. Capitalist markets always value efficiency but the political and regulatory environments in the developing countries do not provide the congenial atmosphere for smooth functioning of the market mechanism. Also, financial inclusion requires doing away with an “all-for-profit” motive and has a strong culture of social responsibility which is not extensively present in a capitalistic society. Companies with holistic innovative models which can accept low but sustainable profits with an unwavering intention to aid the development of the unbanked sections are the essentials in the financial inclusion sector which are but rare in the corporate-driven capitalist economies. Financial inclusion represents a sector wherein sharp business acumen coupled with a sense of social justice and equity is required. Capitalist

Fig. 3: GDP contribution by sector in low and high income countries in 2010 & 2020 respectively

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segments is popularly called Enterprise Financial Services whose goal is to deliver a complete suite of asset-liability products and fee based services to micro and small enterprise. The Fig. 3 represents the growth potential of SME sector which is poised to contribute about 51% of the GDP in 2020 from about 16% in 2010 thus providing an opportunity for the banks to provide the sectors with adequate liquidity. Arguments against feasibility of financial inclusion One of the major roadblocks which render financial inclusion difficult to implement is the lack of proper regulatory frameworks in place in most of the developing countries allowing the business corporates to resort to complex and usurious models for generating profit. Often in a capitalist market driven by profit-motive, financial inclusion just becomes a garb under which the most unethical and exploitative practices flourish. Financial inclusion in India is often closely connected to the aggressive microcredit policies that were introduced without the appropriate regulatory surveillance or consumer education policies. The result was consumers becoming quickly over-indebted to the point of committing suicide and lending institutions saw repayment rates collapse after politicians in one of the country’s largest states called on borrowers to stop paying back their loans, threatening the existence of the entire 4 billion a year Indian microcredit industry. Lack of financial literacy among the low-income sections is one of the most potent reasons for exploitation by corporates. Consumer literacy drives often provide half-baked knowledge without giving the people an all-round and clear perspective for taking decisions regarding credit. Financial planning suited to the requirements of the unbanked people is lacking often driving them to overlook the debt-trap they get into unintentionally. A “one-size fits all” approach often does not work in a sector like micro-finance and devising different products

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Fig. 4: Prof. Rangarajan’s Schema for Financial Inclusion

countries with strong lobbies for financial incentives may not be conducive to its propagation and development. Corruption is also a major factor deterring the growth in this sector. The role of the big corporate houses in influencing state policies to suit their needs is not uncommon in capitalist countries which ultimately mar the purpose and essence of financial inclusion. Lastly, the main cause behind the incongruity of financial inclusion in a capitalistic economy is the venal attitude that is deeply ingrained in the culture of such a society. People measure success based on just monetary parameters. To change the culture of materialism which so engulfs a capitalist state would be very onerous task. Powerful enterprises pose a big challenge in cleansing the overall economic environment of the nation. The recent financial crisis of 2008 is an example in this case wherein the big and powerful financial institutions colluded within themselves and came up with complex products making a lot of money for themselves but pulling down the entire economy in a whirlwind of monetary imbalance. Conclusion As The Committee on Financial Inclusion, 2008 defines it: “The process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at an affordable cost”, financial inclusion represents tremendous opportunities for the banks and financial institutions in a capitalist economy to tap the potential that lies in the unbanked sector with innovative and profitable business models. Technology can help a long way in achieving this goal. Considering both the sides of the coin, we can come to the conclusion that financial services for the unbanked can be a lucrative sector only if robust regulatory frameworks with adequate room for autonomy are

August 2012

put in place. The governments have to play a facilitating role providing a healthy environment for the corporates to function with proper check and balance measures in place without creating rigid policies which hamper companies and institutions from entering the sector. The Rangarajan framework enlists all the possibilities that can be accommodated in the package of services to be provided to the unbanked sector. Out of the three broad sectors of contingency planning, credit, income and wealth creation, credit sector would represent the highest demand in the years to come. Financial Institutions can help bring the unbanked sector under its cover by firstly providing contingency planning services in the form of insurance and remittances to them and then helping them with loans and other financial products. Thus, financial inclusion can be made feasible and possible in a capitalist economy albeit with a sustainable and moderate profit margin. Transaction volumes provide the key to revenue growth which can be tapped by the corporates providing integrated and collaborative services. But a caveat in this regard would be a gestation period of about 3-5 years which would be required for the growth in this sector to propel fully. Feasibility of this business depends upon the creativity and out-of-the-box solutions which can come up regardless of kind of economy but which requires an environment which fosters and encourages passion and innovation to drive change and a culture which is flexible and open to new ideas rejecting concentration of power. Care needs to be taken not to just focus on the monetary aspects of this business but to consider the social implications which have the power to transform and enrich the lives of billions of financially vulnerable groups achieving ultimate and holistic aim of “Empowerment of All”.

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Should we promote more integration (Fiscal Union) or push for increased country level autonomy Shuv Aritra Sengupta

IIM Shillong A monetary union encompasses multiple countries ceding control over the money supply to a common authority. The formation of the monetary union is one of the final stages in the formation of an economic union. The steps of economic integration that lead to the formation of an economic union can be divided into six major stages: 1. Preferential trading area- This involves reduced customs tariffs between certain countries 2. Free trade area- Having an area with no internal tariffs on goods between participating countries 3. Customs union- This stage involves having the same external customs tariffs for third countries and a common trade policy 4. Single market- Single market involves adoption of common product regulations along with free movement of goods, labour, capital and services 5. Economic and monetary union- This stage results in formation of a single market with a common currency and monetary policy 6. Complete economic integration-This is achieved when all of the above have been completed as well as harmonized fiscal and other economic policies put in place The monetary unions are more present than ever, even with the Eurozone crisis that has shown that all is not rosy when countries decide to go in for the formation of a Monetary Union. Despite the Eurozone crisis, the states of southern Africa have set the objective of adopting a common currency by the year 2018. This shows that despite the crisis in Europe, the idea of economic integration is something that countries are willing to adopt. The euro has been introduced into a zone that contains many disparities and differences and despite the differences, the benefits of the Euro is something that the Eurozone members have been reaping since long. Moreover, under the 1992 Maastricht Treaty, which set the ball rolling for the formation of the European Union, there were four

convergence criteria specified, which included tough restrictions on inflation, fiscal deficits, interest rates and public debt. By the time the euro came into being in 1999, most of the members of the European Union (EU) were adjudged to have met the Maastricht conditions or at least to have made significant progress towards achieving them. The only exception, Greece, was eventually allowed to join the monetary union two years later. Therefore, there is the argument that the creation of a single market with a single currency will generate forces of convergence. BENEFITS OF THE MONETARY UNION While going for the adoption of a common currency, there are a number of costs involved in the whole process. Adopting a common currency brings several benefits, but these benefits must be higher than the costs. One of the major advantages in the formation of a monetary union is that governments participating might find it a little easier to promote the market share of a single currency as compared with the task of trying to defend the separate national brands. But therein also lay the main disadvantage - since pooling necessarily implies some measures of collective action with regard to the issue and the management of money. An alliance requires allies, other states with similar choices and a disposition to act cooperatively. In practice, the willing partners among sovereign states are just not all that plentiful. One of the primary aims of a monetary union is to improve the market position of its member states so as to create a single joint currency which, when compared to the weakly competitive national currencies, will generate more appeal to the market actors. With the greater appeal of the new currency, there will be more benefits of monopoly, which eroded at the national level, will be replicated at the group level. On the positive side, partners can anticipate a reduction of transaction costs and make efficiency savings

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Monetary Union:

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on all exchanges and investments within the group. Moreover, what is given up at the national level is recouped at the monetary union level. Authority is not surrendered but it is pooled & delegated to the joint institutions of currency partnership, to be shared and in some manner, to be managed by all the countries involved. Each partner’s loss, therefore, is also simultaneous to each other’s gain. The individual state no longer has much latitude to act unilaterally, but every government retains its voice in decision making process for the total group as a whole. Thus by joining together, governments will be better positioned to resist the market pressures. Together they will be better suited to guide macroeconomic performance, generate seigniorage revenue, avoid external dependence, and promote a sense of community. They are all, in this sense, gainers. The benefits of the monetary union can be listed as under the following heads as follows1) The formation of the monetary union is seen as a symbol of strength and so it gives hope that it will provide support for political integration. 2) Monetary unification is perceived as a way for perfecting a single market and especially for countries belonging to regional trading blocs. 3) Elimination of transaction costs is one of the major benefits. Currently firms in UK spend around £1.5 billion a year for buying and selling foreign currencies in order to do business in the EU. 4) Price transparency is another perceived benefit of joining the monetary union. As per the economic theory, the prices should act as a mechanism for allocating resources in an optimal way, so as to improve overall economic efficiency. There is a greater chance of this happening in an economic union rather than in individual economies. The adoption of a common currency can improve the structural characteristics of the concerned economies thereby increasing trade integration and business cycle correlation thus enhancing the credibility of the macroeconomic policies. The structural characteristics in question mainly focus on three main areas: a) Analysis of the nature of shocks affecting the economies concerned. b) Assessment of the degree of correlations of movements of real exchange rates and the terms of trade among the economies c) Analysis of co-movements in cyclical real growth rates among the economies. A reason for focusing on each of these three areas is the assumption that countries facing a high degree of symmetry of shocks or high correlations of cyclical movements of real output or real exchange rates do not need country-specific monetary and exchange-rate policies.

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Also from the macroeconomic theories we see that the differences among the countries regarding the preferences for inflation and unemployment do not constitute a major obstacle in achieving a monetary union, as, on a long term, the authorities cannot choose an optimum combination between inflation and unemployment. There has also been an incentive of undervaluing the domestic currency for providing a boost to the nation’s exports and this has been a constant driving force for policy makers across the world. The debt crisis in the Eurozone led to investors dumping the Euro for alternative currencies and this in turn led to the Euro getting depreciated. The much needed depreciation of the Euro happened without the accompanying pain that depreciations normally bring. The cheaper Euro made exports competitive in international markets and helped improve the deteriorating trade balances. Such depreciation of the Euro would have been quite hard to imagine given the policies of China of keeping its currency artificially low through pegging and had individual currencies existed in place of the Euro then for them it would have been extremely difficult in such a scenario. This is another benefit which a common currency can bring about. COSTS OF FORMING THE MONETARY UNION The integration of the economies has ensured that the ripples of economic activities are no longer confined to a specific geography but rather its impact is felt worldwide. This has been recently brought to light by the European debt crisis that has led to a huge turmoil in the global markets. The costs, the most important of them are placed at a macroeconomic level and they occur as a result of giving up the independence of the monetary policy. The most important costs of joining a monetary union at a macroeconomic level can be listed as1) Loss of sovereignty - The countries, when taking part in a monetary union loses important tools of their economic policy specially those which are specific to the monetary policy namely the handling of the interest charge and the exchange rate. 2) Seigniorage - Seigniorage is defined as the excess of the nominal value of a currency over its cost of production; and can be understood to be an alternative source of revenue for the country beyond what can be raised through taxes or by borrowing from financial markets. The central bank of the country can no longer change the exchange rate of its own currency and it cannot determine the quantity of national currency in the economy and states with lower influence may perceive this as a negative situation. Sacrifice of the seigniorage privilege should also be compared against the gains from a monetary union.

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Figure 1: Phillipâ&#x20AC;&#x2122;s Curve

3) Deflationary Tendencies - Another major effect is the deflationary tendencies the participating countries tend to experience. With the deflationary tendencies the unemployment also tends to increase. Balancing this trade-off between inflation and unemployment is one of the major challenges that governments face. This tends to happen because individual local economies tend to suffer because of policy decisions taken by a central authority. 4) Differences between countries in terms of inflation & unemployment - According to the macroeconomic theory, the Phillips curve (Figure1) tends to be vertical on a long term, and the intersection between the long term Phillips curve and the horizontal axis shows the natural rate of unemployment. Thus, in other words, on a longer term, the unemployment in a country is determined by the natural rate of unemployment which depends on inflation, and so the authorities can no longer make a choice between inflation and unemployment. Thus, on a longer term,

At the micro level there are two major cost heads which should be considered: a) Operational costs, which are necessary for adjusting the systems to the new currency, and b) Strategic costs, which consist of re-defining competition and in the occurrence of specific risks. Such risks may be caused by an unfavorable exchange rate of a country which joins the monetary union. When the country in question joins the union with a depreciated currency, it is bound to discover increased competition. According to the optimum currency areas theory, in most of the cases, the countries have tools available which are alternatives to the rate of exchange. But joining a monetary union is not desirable as long as its costs are higher than the benefits, and the differences among the countries are big, thus making the objective of minimizing the costs difficult. There are significant differences among the countries, which do not disappear in a monetary union. Giving up the exchange rate tool may be considered a cost of the monetary union. And changing the rate

Figure 2: Perceived minus actual inflation difference pre and post Euro

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for the case of a monetary union, two participating countries can equalize their inflation rates by establishing a fixed rate of exchange between currency x and y, without any costs in terms of unemployment; taking into account the fact that, at least on a short term, the inflation-unemployment trade-off exists, we may say that, for the countries recording high inflation rates, joining a monetary union suppose, on a short term, the acceptance of a higher unemployment.

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Figure 3: Coefficients

Figure 4: ANOVA

of exchange is a strong tool which is available to the countries which desire to eliminate the major macroeconomic unbalances, with lower costs in terms of output and unemployment. Arguments For the Topic 1) Political Integration 2) Perfecting of Single Market 3) Elimination of transaction costs 4) Price transparency Arguments Against the Topic 1) Loss of sovereignty 2) Seigniorage 3) Deflationary Tendencies 4) Differences between countries in terms of inflation & unemployment CONCLUSION Why, then, do we not see many more monetary unions sprouting up all around the globe? Despite the numerous potential advantages, the number of monetary unions remains inexplicably few. Sadly in the contemporary record, there’s only one new monetary union-Europe’s European Monetary Union which offers few direct clues. Historical sample of the currency unions, including those that have failed eventually as well as those that survived provides enough evidence to make clear why an alliance of this sort can be so challenging. The difﬁculty of defending the uncompetitive national currencies is certainly growing. But for most governments, the disadvantages of monetary union still continue to look quite formidable. A few states share enough group loyalty to make the required sacriﬁces of making a monetary sovereignty seem acceptable but that is still not a norm. Full mon-

August 2012

etary union is not the only option. Less demanding forms of alliance strategy are also possible, requiring something short of a complete pooling of monetary sovereignty. Indeed, much room exists for variation in the degree of formal authority to be delegated to joint institutions to accommodate the interests of individual countries. Apart from this the example of the European Union and the problems associated with the formation of a monetary union are for all to see. In spite of this we see that the Southern African Nations are pushing towards the formation of a common currency by 2018. So, despite this the formation of more monetary unions on the scale of the European Union seems difficult. The probability of a lesser form of monetary alliance is much more. Based on the Data of Table 1 of Flash Eurobarometer 307 of December 2010, a confidence model has been developed to show how the general public feels about the Euro and whether the euro is a good thing or bad thing for Europe. The result, shown in Figures 3, 4 shows the results of ANOVA and the F test shows that the null hypothesis of Eurozone breakup should be rejected. Thus, although the formation of many monetary unions is less likely, the citizen in these countries that are a part of the monetary union feel that the monetary union is beneficial for them. The total number of currencies around the world is not going to shrink dramatically. The monetary map of the world may include an increasing number of limited alliances but few are likely to transform into new joint currencies like the euro. The formation of monetary unions is not inevitable. In fact, it is quite the contrary.

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Anoop Sharma C N

IMT Nagpur GAAR abbreviation stands for general-anti-avoidance rules. In the environment of moderate tax rates, according to the government it is necessary that the correct tax base be subject to tax in the face of aggressive tax planning and use of opaque low tax jurisdictions for residence as well as for sourcing capital. It is important to highlight the distinction between Tax Evasion and Tax Avoidance. Tax evasion v. Tax avoidance The Organization for Economic Cooperation and Development (OECD) has defined tax evasion as “A term that is used to mean illegal arrangements where liability to tax is hidden or ignored i.e. the tax payer pays less tax than he is legally obligated to pay by hiding income or information from tax authorities”. In case of tax evasion deliberate steps are taken by the tax payer in order to reduce the tax liability by illegal or fraudulent means. Example – Mr. B sells his products for cash and does not bank the cash. Tax avoidance, on the other hand is defined by the OECD as “term used to describe an arrangement of a tax payer’s affairs that is intended to reduce his liability and that although the arrangement could be strictly legal it is usually in contradiction with the intent of the law it purports to follow”. The key distinction being that in tax avoidance the key facts or details are not hidden by the tax payer but are on record. Example – Mr. A forms a company to sell his products. The company pays 25% tax, but if he himself sold the products he would pay 30%. With the increasing globalization of economies and growth in cross border transactions, some countries have introduced legislation which has empowered the Revenue Authorities to question transactions and arrangements and disregard their

form to deny tax benefit unless the taxpayer can establish the commercial legitimacy of the transaction. It may be noted that the GAAR is not an antidote for ‘tax evasion’, but for ‘tax avoidance’. The GAAR cannot deal with tax evasion since it cannot deal with what is not reported. The Government has recognized that the GAAR is meant for tackling tax avoidance. Need for general anti-avoidance rule (GAAR): Pro GAAR or General Anti-Avoidance Rule is aimed at preventing deals or income that is structured only to avoid paying taxes. Tax avoidance, like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner. Sectors that provide a greater opportunity for tax avoidance tends to cause distortions in the allocation of resources. Since the better-off sections are more endowed to resort to such practices, tax avoidance also leads to cross-subsidization of the rich. Also the taxpayer would avoid distribution of profits to evade dividend distribution tax; and repatriates such profits by way of buyback of shares from a shareholder in a jurisdiction that does not result into taxation of capital gains. Also there might be an arrangement involving finalizing loan from one country and assigning it to another country to avoid withholding provisions is a tax avoidance arrangement. Also A foreign company can interpose another company for investing in India to take advantage of treaty benefit by direct transfer of shares by the foreign company would have attracted capital gains in India. The case is similar to the Bombay High Court decision in the case of Aditya Birla Nuvo Ltd. Also An Indian Company can voluntarily get liqui-

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GAAR Boon or bane for developing economies

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dated and its assets are transferred to its holding companies in a jurisdiction that levies lower tax on capital gains. Also there might be an arrangement involving borrowing of money for investment in a connected party at a significantly higher premium, such capital which was then moved back to another connected party of the lender, and then the investment was sold off at a loss to claim set off of losses, is lacking commercial substance. Also in Stock market transaction entered into between related parties or between unrelated parties through a broker, for exchange of losses with gains, is an impermissible avoidance. Also Disguising business transactions conducted in a taxable jurisdiction as being undertaken in a low tax jurisdiction so as to avoid taxation, is a transaction lacking commercial substance. Also A foreign company routes funds in India through a country ‘X’ where capital gains are taxed at a beneficial rate and India- X tax treaty provides for residence based taxation of capital gains. Here there is routing of funds through Country X, payment of capital gains tax is avoided and the company does not have substantive commercial substance in Country ‘X’ Also there might be routing of investments by a resident of one country through the other country ‘X’ back to one’s own country. An Indian resident investing directly in the shares of Indian company would have to pay capital gain taxes. This is referred as ‘Round Tripping’ or ‘Treaty Shopping’, majorly done using this way. If we take India w.r.t GAAR, Mauritius gains importance because Mauritius treaty on Double Tax Avoidance Agreements (DTAAs), has no domestic level tax on capital gains, thus making it exempt. Thus if anyone routes his investments through an entity incorporated in Mauritius, the tax can be avoided under a Double taxation avoidance treaty (DTAA) between the two countries. A DTAA is a bilateral treaty signed between governments to prevent companies from paying taxes both in their country of origin as well as in the country where they are doing business. This has made Mauritius an attractive route for the purpose of ..

investment in India. The ‘Mauritius’ route is an interesting facet of the Indian tax system which involves the arrangement relating to the residence rule of taxation. According to the treaty the gains derived by a resident of a contracting State shall be taxable only in that State. The Indian law taxes gains derived from the sale of shares irrespective of whether the shareholder is a resident or nonresident. Under India’s tax treaty with Mauritius, gains derived by a resident of Mauritius from the sale of shares in an Indian company are taxable only in Mauritius and as it does not tax capital gains, the transaction escapes tax in both countries. Foreign investors have been using the Mauritius holding company structure to make investments in India right from the early 1990s. Following the liberalization of the Indian economy, the Indo-Mauritius DTAA, was “discovered” as an effective mechanism to avoid capital gains tax on sale of shares in Indian companies. A Foreign enterprise can set up a subsidiary in Mauritius, and use it to derive capital gains from acquisition and sale of shares. Although India follows the source rule for taxation of non-residents, which makes this transaction taxable under the Income Tax Act, 1961, Article 13(4) of the DTAA gives Mauritius the right to tax this transaction. Since such gains are exempt from tax in Mauritius, the transaction becomes completely tax exempt, resulting in double non-taxation. As a result, much of the Mauritian investment into India is actually round tripping by Indian companies setting up a Mauritian entity to avoid capital gains tax in India. Therefore, there is a strong general presumption on tax policy that all tax avoidance, like tax evasion, is economically undesirable and inequitable. On considerations of economic efficiency and fiscal justice, a taxpayer should not be allowed to use legal constructions or transactions to violate horizontal equity. In the past, the response to tax avoidance has been the introduction of legislative amendments to deal with specific instances of tax avoidance. Since the liberalization of the Indian economy, increasingly sophisticated forms of tax avoidance are being adopted by the taxpayers and their advisers. The problem has been further com-

If we take India w.r.t GAAR, Mauritius gains importance because Mauritius treaty on Double Tax Avoidance Agreements (DTAAs), has no domestic level tax on capital gains

August 2012

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pounded by tax avoidance arrangements spanning across several tax jurisdictions. This has led to severe erosion of the tax base. Further, appellate authorities and courts have been placing a heavy onus on the Revenue when dealing with matters of tax avoidance even though the relevant facts are in the exclusive knowledge of the taxpayer and he chooses not to reveal them. In view of the above, it is necessary and desirable to introduce a general anti-avoidance rule which will serve as a deterrent against such practices. This is also consistent with the international trend. GAAR is tax regulation is generally intended as a catch-all to close loopholes in the income and profit tax laws. That will in general apply to the whole; a step or a part of the arrangement has been entered with the objective of obtaining tax benefit, and the arrangement. There are many countries which are considered as tax heavens including India. Figure 1 shows the Top 10 Tax Havens of the World as per Tax Justice Networks, (Financial Secrecy Index) 2011 Why and what are Criticisms against GAAR? GAAR affects almost anybody and everybody. Well the problem with a GAAR is that it creates a massive amount of uncertainty about how a transaction will be taxed. GAAR is called a Disaster- because it provides a wide discretion and authority to tax authority

On considerations of economic efficiency and fiscal justice, a taxpayer should not be allowed to use legal constructions or transactions to violate horizontal equity

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Figure 1: Top 10 Tax Havens of the World

and to the tax administration, which at times is prone to be misused. GAAR allows the tax authorities to call a business arrangement or a transaction impermissible avoidance arrangement if they feel it has been primarily entered into avoid taxes. Once an arrangement is ruled impermissible then the tax authorities can deny tax benefits for individual or for an organization. The rule can apply on domestic as well as overseas transactions. GAAR is very broad based provision and can easily be applied to most tax saving arrangements. Many feel that the provision would give unbridled powers to tax officers, allowing them to question any tax-saving deal. For an Individual For example, if anyone has taken a loan from your spouse for whom you are paying an interest, the tax department can conclude that you have structured the loan from a family member only to claim a tax deduction on the interest paid. Your spouse, on the other hand, will pay a lower tax on the interest earned. This may be seen as violating GAAR. At large it is affecting big organizations and foreign investors. For Big Organizations like A large corporate company creates a service company to manage its noncore business. Service Company charges each company on a cost plus basis. But tax authorities can misuse it by invoking GAAR under s Transfer Pricing Provisions which has actually not happened, but which would harass the company. With FII’s Government is thriving on hubris as Foreign institutional Investors are worried that their investments routed through other countries majorly Mauritius and could be denied tax benefits enjoyed by them under the Indo-Mauritius tax treaty. But with Indian investors have no choice but to live with the arbitrary policies of the Government, the foreign investors are not subject to any such limitation. They don’t want to take any chances. There are a number of countries wooing the foreign investors and they will be forced to abandon India en masse and migrate to foreign countries if they get disillusioned with India The Implication to this was Net FIIs have been

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illustrating an inflow since December, 2011. Net FII inflows peaked to $7 bn in February, 2012. However, foreign institutional investments have declined post the announcement of GAAR on 16thMarch, 2012. March saw a net inflow of mere $0.4 bn while April registered an outflow of $8 bn. This clearly indicates that the adoption of GAAR by India was not found to be favorable by foreign investors.

Also the guidelines state that GAAR will not apply to tax mitigation cases but only in case of tax avoidance. However, there is a thin line that demarcates the two, leaving the tax payer in a state of uncertainty about the interpretation of the tax authorities. Further, considering the history of tax litigation in India, there is likely to be increase in burden of tax compliance on the tax payer Also if we consider in the case of Azadi Bachao Andolan, the Honorable Supreme Court has endorsed the right of a tax payer to ‘plan’ his transactions to mitigate tax liability and upheld that tax planning cannot be questioned only because it is ‘tax-advantageous’ provided ‘economic substance’ is demonstrated. So with this we can say to what extent India will succeed in invoking GAAR in treaty abuse situations will ultimately be tested before the courts. So from the above we have seen many problems with this GAAR So These vital aspect, therefore, needs to be kept in mind while formulating any GAAR regime. Summary: GAAR is being both considered as a boon and a bane in a different context. To consider it as a boon it a very progressive move in so far as tax policy as concerned by introducing anti avoidance measures which will address major flaws like • The foreign company used to take advantage by interposing another company for investing in India by direct transfer of shares by the foreign company would have attracted capital gains in India. • Also the company used to take advantage by Disguising business transactions conducted in a taxable jurisdiction as being undertaken in a low tax jurisdiction so as to avoid taxation • Thirdly, majorly by be routing of investments by a resident of one country through the other country ‘X’ back to one’s own country. To consider it as a bane as the law is making a big blunder by mistaking change for progress and mindlessly churning out ill-thought out amendments to the Income-tax Act year after

Figure 2: Daily movement of FII flows in India

Figure 2 illustrates daily movement of FII flows in India from 16th March, 2012 when the Finance Minister announced the implementation of GAAR. It can be observed there has been an outflow of dollars to the effect of $ 1 bn during this period. This has also had an impact on the exchange rate which has depreciated from Rs 50.31 on March 16th, 2012 to Rs 51.16 on Marchend and further to Rs 52.51 and Rs 53.72 on April end and May 4th, 2012 respectively. This was notwithstanding the fact that forex reserves had remained largely stable, increasing from $ 294.8 bn on March 16thto $ 295.4 bn on April 27th. Clearly the sentiment was affected which drove the rupee down further. Also GAAR is called as arrogant government policies that have created an uncertain and arbitrary environment. This has resulted in three international rating agencies downgrading India’s status as an investment destination. To substantiate this, Late last month, Standard & Poor’s cut the outlook for India’s credit rating to negative, putting Asia’s third-largest economy in danger of losing its investment grade status. This would have a spiraling effect of again investment stagnation or slow down, in turn affect our growth and pull back the country to 19th century. ..

GAAR is called a Disaster- because it provides a wide discretion and authority to tax authority and to the tax administration, which at times is prone to be misused

August 2012

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Considering the long drawn litigation process, over-burdened courts and pro-litigation mindset of both, the Revenue and the tax payers, GAAR could trigger more hardship and defeat the objective of the Code to simplify the tax regime and bring in more certainty. The detailed rules on safe harbors could help in bringing in some level of certainty. As far as the objective of stopping treaty abuse is concerned, the correct approach ought to be to amend the tax treaties and introduce limitation to benefits provisions and not to let the domestic laws override the tax treaties. With India as concerned in the view of these problems the government has postponed GAAR to the next financial year which was proposed in this year financial budget 2012-13 and was suppose to come into effect by April1, 2012. So this will allow the government time to frame clear rules after consultations with stakeholders. Also By delaying the introduction of GAAR, the Government has provided a nine month window to the tax payer to introspect & analyze the existing business structures in light of these guidelines. The Finance Minster (former Mr. Mukerjee) also had clarified that the onus to prove that an arrangement is impermissible will lie with the tax department. The GAAR Panel, the final body will decide on the applicability of the law, will include an independent member. More than 30 countries have introduced GAAR provisions in their respective tax codes to check evasion. Further, more specifically GAAR has been in force in Australia (1981), Canada (1988), Singapore (1988), South Africa (2006) and China (2008) according to a study compiled by Deloitte. UK is considering it in 2013 while USA is also working towards it. India though had proposed to introduce anti avoidance measures in domestic tax laws by amending Direct tax Code bill, 2010 was pushed from pressures. The proposed GAAR in Indian context are premised broadly in line with the internationally accepted standards of anti-avoidance measures, though deviating in some aspects.

Economies are in the growing stage, the implications of the same should be studied well, taking into considerations all possible side effects of general anti-avoidance measures

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year with an unstable policy creating problem to different segment of people like • Individuals may fear being troubled by taxmen’s in tax avoidance in managing their needs by monetary adjustment within their family. • Organizations fear that they may be forced to restructure salaries of employees or handling their subsidiaries if taxmen conclude that these were structured only to avoid taxes. •Thirdly and Majorly is Foreign institutional Investors are worried that taxmen’s would consider their investments are routed through other countries majorly Mauritius and could be denied tax benefits enjoyed by them under the Indo-Mauritius tax treaty. Conclusion: By seeing into the positives and the problems of GAAR we can conclude that GAAR is a very broad based provision and can be easily applied to most of the provisions. GAAR is sought to be applied where there is (a) a transaction or a set of transactions that is solely or predominantly aimed at tax avoidance, and (b) if given effect, the object and purpose of the applicable tax law would be violated. With this it has large positives covering major flaws that existed in so far tax policies. It is considered as a very progressive move in our tax policy by introducing major anti avoidance measures. But it has some limitations like many feel that the provision would give unbridled powers to tax officers allowing them to question. Foreign institutional Investors are worried that their investments routed through Mauritius could be denied tax benefits enjoyed by them under the Indo-Mauritius tax treaty. So GAAR cannot be implemented all of sudden in any developing economy. Since these economies are in the growing stage, the implications of the same should be studied well, taking into considerations all possible side effects of general antiavoidance measures is well timed, or whether these measures are still premature given the size of Indian cross-border trade and the state of its administrative and judicial reforms and then has to be implemented.

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Indirect Tax Reforms: Will it boost the industries?

Rahul Ranganathan, ShyamSundar & Prakash Sethu

NITIE

Indirect taxes are basically the taxes levied on the products or services rather than on persons and organizations. These taxes include VAT, Sales tax, Service tax, customs duty, excise duty etc. These tax rates impacts the price of the goods sold and services offered. Currently in India, indirect taxes account to 48% of the revenue. The indirect taxes and their rate vary from state to state. The government of India is in the process of integrating all the indirect taxes under the name of Goods and Services Tax (GST). It has proposed the Central GST and State GST to ensure that both the centre as well as the states earn revenues. The central GST will include the following: • Central Excise Duty • Additional Excise Duty • The Excise Duty levied under Medicinal and toiletries preparation Act • Service Tax • Additional Custom Duty (CVD) • Special Additional Duty • Surcharge • Education Cess and Secondary and Higher Secondary education Cess The state GST will include the following: • VAT/ Sales Tax • Entertainment Tax (unless it is levied by local bodies) • Luxury Tax • Tax on lottery • State Cess and Surcharge related to supply of goods and services. Why GST when there is VAT? India introduced the Value Added Taxes (VAT) in ..

the year 2005. The proposed GST looks similar to VAT. The replacement of VAT by GST is a complicated and a laborious process. Having known that, the government wants to introduce GST for the following reasons: 1. The Central VAT have lot of taxes outside its scope like surcharges, additional customs duties etc. 2. The state VAT doesn’t include the luxury taxes, entertainment taxes etc. 3. Each state has its own rate of VAT. Company producing products in a state and selling them in another state end up paying taxes in each state. This increases the burden of taxes on the company and makes it complicated to run the business. 4. GST is becoming an international standard with a lot of countries implementing it. Hence it becomes all the more important to implement GST so that there is uniformity in the tax systems across countries. 5. VAT involves complexities; everytime the value added is included the next person in the supply chain has to pay more tax. This compounding effect of VAT introduces a lot of complication in the bill keeping and is difficult to follow. 6. Also, the compounding effect of VAT causes the price of goods to be raised at each stage of the supply chain. This causes a dampening effect in the economy. Reforms: Boon for industries and economy GST and the Indian economy Implementation of a comprehensive GST across goods and services is expected to provide gains to India’s GDP in a range of 0.9 to 1.7 per cent approximately. When converted to absolute values, the GDP is expected to be Rs. 42,789 crore and Rs. 83,899 crore, respectively. With our economy reeling at an unrelenting 5.1% fiscal deficit, this boost to

Indirect taxes are basically the taxes levied on the products or services rather than on persons and organizations

August 2012

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Figure 1: Trend in Tax to GDP Ratio in India

the economy in the form of Indirect Tax reforms will reward the economy and thus the industries. The rate of GST is expected to be around 1620%. The tax-rate under the proposed GST would come down but the loss in revenue due to the reduction of tax rate will be compensated by the increase in the number of services to be taxed. In other words, the tax collection is planned to be broad based. GST will bring a change in tax structure by redistributing the burden of taxation equitably between manufacturing and services. The broadening of the tax base and reducing exemptions will lower the tax rates. It will promote a common market across the country. Also, the implementation of GST is expected to increase the income and output in various sectors. This will lead to large scale employment opportunities in various areas of the business. Industries â&#x20AC;&#x201C; their share of the Pie The common rate of GST across the states makes it easier for the companies to produce in a state and sell it in another state. GST simplifies the tax structure. It eases the tax burden on the manufacturers facilitating better tax planning. It also helps in reducing the administrative cost and compliance cost of the company. Further, the products will be priced uniformly in all the states thereby helping the companies to make sales and revenue forecasts with more precisions. This can go a long way in improving the efficiency of operations of the company result-

ing in the gain of factors of production namely land, labour and capital. According to 13th Finance commission 2009, the gains in real returns to land range between 0.42% and 0.82%. Wage rate gains between 0.68% and 1.33% while the real return to capital is expected to be in the range of 0.37% to 0.74%. Currently multiple taxation is increasing the manufacturing cost of most of the products in India. In the proposed GST, the taxes will be levied only at the point of sale. Hence, a transparent and a flawless GST can help in reducing the manufacturing cost by as much as 10%. This will make Indian products more competitive in the global level. Adding to it, the taxes on exports is likely to be reduced. This further provides encouragement for the export driven companies. By the adaptation of GST, the indirect taxation system will be made uniform with the other countries in the world. This will make it easier for the Indian companies to venture into foreign lands and expand their business. The foreign companies trying to expand their business into India will find it easier to start their operations as the indirect taxation system would remain similar to the one existing in their country. Agriculture and real estate industries The GST will also have its impact on the agricultural sector of the country. It is expected to increase the agricultural produce between 0.61% and 1.18% through wider coverage of service taxes, inclusion of several state and central taxes under GST and phasing out Central Sales Tax (CST). The centre has also proposed to provide ..

In the proposed GST, the taxes will be levied only at the point of sale. Hence, a transparent and a flawless GST can help in reducing the manufacturing cost by as much as 10%

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tax benefits for companies investing in warehousing for agricultural produce or cold chain infrastructure. This would encourage a lot of investors in this field and will reduce the wastage of agricultural products due to lack of proper storage. At present, the value of the property constructed form a part of the stamp duty on land and other indirect taxes on inputs. The stamp duty is collected by including these taxes resulting in the increased cost of the property. In the proposed GST, all the taxes on inputs including land will off-set against the tax payable on the constructed property. This will reduce the cost of housing and benefit the poor.

Indirect Tax Reforms: A Bane for the Industries Having discussed all the advantages and the different reasons why Indirect Tax reforms would be a boon for the Industries, it is obvious that GST, as a concept is excellent and it has tremendous chance of structuring the indirect taxes in any nation. However, the proposed GST has some negative impacts on industries as well. The GST will affect the entire supply chain of the company right from procurement of raw materials till sales of the product. Although the additive effect of taxes is negated by GST, it will have an effect on the operations of the industry through increase in import rates or increased taxation for the services offered. The company has to re-examine the strategies and plans to study the effects of the implementation of the GST on its supply chain network. In the supply chain network, companiesâ&#x20AC;&#x2122; ability to get benefits depends on how well their partners comply with the GST. The impact assessment must include the changes in the policies and processes, leverages to suppliers, logistics service providers etc.

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After deep analysis, there are some places where we believe GST can act as a huge curse to the Indian industries. Following are the factors which make GST a bane for the Industries: Proposed reforms: A path to centralization In Indiaâ&#x20AC;&#x2122;s proposed reforms, the basic exemption limit in excise of Rs. 1.5 Crore will be taken away in GST, thereby making the Small Scale Industries slowly go out of the business. A large number of small and medium scale industries in India are able to carry out their business only for one reason that they are not required to pay excise if their turnover does not exceed Rs. 1.5 crore. This had made their products competitive in the market and they were able to sell it at lower rates. In GST regime they will not be getting this benefit and will result in increasing the cost of their products and thereby they will be left to slow death. This would lead to large number of SMEs exiting the business and the people employed in these industries would end up joining the established industries. This results in centralization of control in the big Industries! The majority of the people would be at the mercy of a few number of big business houses. The rich would become richer and poor would be poorer. Huge inequalities in income and wealth would exist resulting in economic disparities. The repercussions will be felt even in the firms which are directly or indirectly working with these SSIs as they would be put to undue hardship resulting in unemployment. Small Scale Industries- The woes continue Another disadvantage is that the services which were charged on receipt basis will be charged on accrual basis. This is an ironic situation where in without even having received the payments for service provided, GST would be required to be paid. Accrual, although a very good concept, is practical only in huge organizations which has enough cash reserves. Implementing the accrual concept in Small Scale Industries, would have a detrimental effect on them. Lack of clarity in GST GST is a concept which is prevalent all over the world! As many as 140 countries follow GST. It is interesting to note that there are over 40 models of GST currently in place, each with its own characteristics. While countries such as Singapore and New Zealand tax virtually everything at a single rate, Indonesia has five positive rates, a zero rate and over 30 categories of exemptions. In China, GST applies only to goods and the provision of repairs, replacement and processing services. It is only re-

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quest, would work with the Central Government to prepare a road map for introduction of GST in India. After nearly 4 years from the date of announcement, there is hardly any sign of GST getting implemented. What’s the reason for this delay? Opposition from States With no concrete revenue sharing methodology proposed by the Centre, majority of the States vehemently oppose the transition to GST. The states, on their part, are trying to make sure they will not be affected (in the form of loss of revenues) by the shift from the current form of taxation to GST. The other major concerns from States against the GST include the fact that in the name of harmonization, the state’s limited authority to levy taxes may be snatched away. In addition, the constitutional mechanisms like the GST Council and the GST Dispute Settlement Authority would impinge on the legislative sovereignty of both the parliament and the state legislatures which is not acceptable. Lessons Learnt from India By analyzing the Indian scenario, it is pretty clear that for a federal democratic country (like India) there is a need for proper management and understanding between the Centre and the

Table of Summary

S.No

For the Topic

Against the topic

GST is going to do away with the basic exUniform taxation policy will ease the tax cise exemption limit of Rs. 1.5 crores which burden on the industries. It will help will have detrimental effects on the Small them in better tax planning Scale Industries

The taxes will be levied only at the point of sale. This will help in reducing the manufacturing cost of the products

Services will be charged and taxed on accrual basis rather than the existing receipt basis. Hence GST needs to be paid before the actual payments are received.

The expansion of the Indian industries into foreign lands and expansion of foreign companies into India will be made easier through a global indirect taxation system, GST

Lack of clarity in the GST model. There are several models of GST adapted by different countries. A wrong model chosen will have a big impact in the negative direction on the economy as a whole.

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coverable on goods used in the production process, and GST on fixed assets is not recoverable. There seems to be no model of GST which can be claimed as the ideal one. It is evident that each country has carved itself a model based on general GST as a concept and built on it to suit its unique situation. The discovery of respective country’s fine balance of structuring of GST is a highly complex job. Thus if a country decides to use GST, it is important that it has to do a proper analysis and roll out a model that is best suited to its unique circumstances. The scale of transition to GST is huge; any mistake in rolling out of the process will end up having negative impact on the whole economy. The Indian Story! In India, the idea of transitioning to GST was proposed in 2008. GST is proposed to replace all indirect taxes levied on goods and services by the Indian Central and State governments. It is aimed at being comprehensive for most goods and services with few tax exemptions. GST was announced by Mr. P.Chidambaram the Union Finance Minister, during the central budget of 2007–2008 that it would be introduced from April 1, 2010 and that the Empowered Committee of State Finance Ministers, on his re-

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NIVESHAK

States. Proper revenue sharing system between the Centre and the States is very critical. It is essential that proper planning is done and that even after a transition of such a huge scale, all the states continue to get the revenues that they are entitled for. The need for Industries to adapt, camouflage So far, most impact assessments of GST have focused on the supply chain and have regarded the reforms as an opportunity to streamline the taxdistorted distribution chain. But a careful review of the GST suggests that it will likely have a major impact on a company’s entire value chain, including sourcing, new product development, pricing and sales. And, while the reforms offer benefits such as relief from the cascading effect of tax upon tax, they could also adversely affect certain operations (e.g., taxation rate for services and imports could increase). To maximize the benefits and minimize the risks of GST, companies need to revisit the planning and management of their business processes and physical assets. At the very least, they need to determine which changes are critical and how to make those changes without adversely affecting current operations. However, companies that go one step further and evaluate the entire value chain holistically can create new sources of competitive advantage. Companies’ ability to realize the benefits of GST depends on how well their partners comply with GST requirements. The impact assessment, as a result, must factor in changes required in policies and processes to better leverage capabilities of suppliers, logistics service providers (LSPs), distribution chain, and service network partners. With services coming under the GST net, decisions related to outsourcing of manufacturing/ engineering services and selection of outsourcing partners should be reconsidered. The assessment must also cover the changes required in customer interaction points and related processes/ policies. Those who align and collaborate with their partners in planning and managing the transition to GST regime will realize greater benefits than others. Conclusion The concept of a Goods & Services Tax is quite appropriate with a centralized tax collection mechanism in place which could greatly simplify the complex process of indirect taxation. This, in turn, would act as a fillip for industrialization in India by obviating the need for specific business mod-

August 2012

els and feasibility analysis for specific locations or specific states. This would offer the opportunity for companies to standardize their internal processes leading to increase in their operational efficiencies thereby contributing to their productivity. Moreover, the additive effects of indirect taxes will be nullified with the implementation of a GST, with taxes being collected only at the point of sale. This, in turn, would lead to lower tax defaults and a resultant increase in tax collections. However, all said and done, the concept of GST and its implementation needs to be tailored to the Indian business scenario. The effect of GST on small and medium enterprises (SMEs) needs to be analysed thoroughly to assess counter effects on their business models. As it stands, India languishes in promoting the development of SMEs with unfriendly economic policies. Any adverse effect of GST on such enterprises could prove to be the last straw that broke the camel’s back. Another key aspect to be taken into account is the revenue sharing model between the state and central governments. In such a scenario, striking a balance between political and economic facets would be the key. A clear and concise policy on revenue sharing would alleviate the concerns of the individual state governments, particularly those ruled by the opposition, and would certainly reinforce the stature of the central government among India’s diaspora.

WINNERS Hawk-Eye Results 1st Prize - INR 4000/-

Kunal Ashok IIM Bangalore

2nd prize - INR 3000/-

Aniket Sagar

VGSOM, IIT Kharagpur

3rd Prize - INR 2000/-

Saumya Iyer IIM Shillong

consolation Prize - INR 1000/- (each team)

Rahul, Shyam and Prakash NITIE, Mumbai &

Shuv Aritra Sengupta IIM Shillong &

Anoop Sharma IMT Nagpur

Team Niveshak invites articles from B-Schools all across India. We are looking for original articles related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month” and would be awarded cash prize of Rs.1000/Instructions »» Please email your article with the file name and the subject as <Title of the Article>_<Institute Name>_<Author’s name/Group’s name> by 12 September 2012. »» For further instructions, please refer to previous editions of Niveshak.

Thanks Team Niveshak www.iims-niveshak.com

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