Niveshak Anniversary Issue 2014

Niveshak THE INVESTOR

VOLUME 7 ISSUE 8

August 2014

GEARS OF THE

INDIAN GROWTH ENGINE

CELEBRATING

6 GLORIOUS YEARS OF NIVESHAK

2

JULY 2014

JUNE 2014

MAY 2014

APRIL 2014

MARCH 2014

AUGUST 2013

JANUARY 2014

OCTOBER 2013

DECEMBER 2013 SEPTEMBER 2013

FEBRUARY 2014 NOVEMBER 2013

6th Anniversary Issue

August 2014

6th Anniversary Issue

FROM EDITOR’S DESK Niveshak Volume VII ISSUE VIII August 2014 Faculty Mentor

Prof. P. Saravanan

THE TEAM Editorial Team

Akanksha Gupta Apoorva Sharma Gaurav Bhardwaj Jatin Sethi Kocherlakota Tarun Mohit Gupta Mohnish Khiani Priyadarshi Agarwal S C Chakravarthi V All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

Dear Niveshaks, With this issue, dear readers, Niveshak completes six glorious years of its existence. Niveshak is scaling new heights by introducing a new section every year and this couldn’t have been possible without the constant support and encouragement shown by our esteemed readers. This year, Niveshak has seen several changes with the introduction of new sections such as Finview and Finpact. Monthly updates on Niveshak Investment Fund (NIF) has become a hallmark of the magazine. Your constant feedback is our source of motivation.

Ten years of uneasy calm at Ashoka Road headquarters of BJP has ended as firecrackers burst on May 16, 2014. “Ache din aane wale hai” has been the voice of the country and as expected it was Modi’s government at the centre. With the great hope comes the great responsibility and with this change in government, there are lot of expectations in the new making of India. With the India’s economic reform and liberalization programme running out of steam and growth lingering around 4%, the new prime minister faces an uphill task to turn his manifesto points to effective national policies. Taking a cue from this, at Niveshak, we believe that there has been in shift in the gears of economic progress. And that is why we would like to present you with the “Gears of Indian Growth Engine” as the theme of this anniversary issue.

As you flip through the pages, you can find a rich mix of ideas and opinions by the industry experts and also by the future managers. Both have expressed their critical views on the main drivers of the economy in boosting the Indian economy. One common idea you find is the constant encouragement and optimism in the policies shown with regards to the future of the country. There is a sudden upsurge in stock markets immediately after the formation of the new government and the markets still continue to record new highs. With the fiscal deficit reaching 56.1% of its projected target in the first quarter itself of the financial year, the claim to contain the fiscal deficit at 4.1% of the GDP may sound too utopian but with the plethora of comprehensive efforts laid down that shall pick up in the months to follow, Indians are buoyant and cheering. We expect a balance between the dual objectives of disinflation, which if proceeds as warranted, we can expect interest rate cuts and revival of growth, which is projected at 5.4% in the current fiscal year.

As a precursor to this anniversary, we organized a series of events under the aegis of ‘Celebratio- Celebrating 6 glorious years of Niveshak’. We received enthusiastic participation in all the 3 rounds which were conducted in the last week of July. More than 100 articles were received from top B-schools of India for this anniversary edition of Niveshak. We would take the opportunity to express our heartfelt gratitude for the huge response to our initiatives. As, we warm up for yet another year of learning and exploring the world of finance, may we have the pleasure to have you on board.

We expect that you will keep bestowing your support, encouragement and contribution to your much cherished Niveshak. Together, we will scale new heights and take Niveshak to a whole new level!

Hope you find the issue an interesting read.

www.iims-niveshak.com

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Team Niveshak

3

6th Anniversary Issue

Messages

From the Director...

Located in the green environs of North Eastern part of the country, IIM Shillong in its 7th year of operation remains committed to its already established ethos and promises to continue to bring glory to the nation. It aims to develop into a 21st century center of excellence in management education & research in the national and international arena.

At the outset, I congratulate our Finance Club on completing six years of journey. During this period the club has become one of the highly active student bodies in the B-school circuit of India and its monthly magazine Niveshak has crossed the readership base of 6000 readers. With the support and guidance from industry experts, researchers and experienced faculty members, the magazine covers the entire gamut of business, finance and economics.

It gives me immense pleasure to present to you the sixth anniversary edition of Niveshak, a platform where the future business leaders of our country share their ideas about the country’s financial performance.

I wish the team good luck for its future endeavors and hope that the students of IIM Shillong continue to bring pride to the Institute and the Country.

As they always say, Stay Invested.

Best Regards, Prof Amitabh De Director, IIM Shilong

From the Faculty Mentor...

The idea with which Niveshak is started, predominantly to bridge the gap between theory and practice in the finance domain. It facilitates the readers to apply the theory learned in the class room as well as outside and linking it with the practice by means of connecting with the industry experts. Niveshak has successfully completed six years of publishing the magazine and I whole-heartedly congratulate the team for their seamless effort in keeping the high standard.

The current anniversary issue is focused on the theme “Gears of Indian Growth Engine” which best suited for the current economic scenario. Niveshak is a magazine where one could read articles on emerging issues, views and opinion from people with diverse backgrounds on various interesting topics. Already our magazine have a very strong readership base not only in the business school arena but also in the financial firms.

I wish to record my special thanks to our Director, Prof. Amitabha De and my colleague Prof. Nalini Prava Tripathy for their consistent support in all our activities related to the Niveshak.

I would also like to acknowledge all those who have contributed articles for the anniversary edition.

On behalf of the team, I wish to invite each one of you to join us through your contribution of articles or opinions and consumption of the service provided by us, so that we as a team can help each other in accumulating wealth of financial knowledge to our knowledge bank.

Best Regards, P.Saravanan Associate Professor

4

August 2014

6th Anniversary Issue

TOP FIVE

The CHOSEN ONES

11 Fiscal Deficit: The Like-

06 Infrastructure Sector 07 PSU Banking in India

ly Impact on the Indian Economy

08 Power Sector

18 Dividend Distribution

09 Airlines

Tax: Is the Step by Government taken in the Right Direction?

10 Railways

27 Relaxation in Tax Slab: A

A Tryst With The Experts

34 PSU Banks: What can

Sweet Harbinger or a Death Knell?

15 Mr. Chandra Shekhar Ghosh: Bandhan Financial Services, India

24 Mr. Ashish Sood: Ahli Bank, Oman

Sultanate

of

be a Likely Reversal Growth Story?

40 Goods & Services Tax: Is There Any Fututre?

44 Disinvestment: What does the Future Hold?

50 Glance at Union Budget 31 Mr. Chaitanya Aggarwal: Juvalia & You

2014 - 15

51 Smart Views

38 Mr. Nirakar Pradhan: Fututre Generali India

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

5

TOP Five

6th Anniversary Issue

INFRASTRUCTURE SECTOR From May 15 till date, the Sensex has gained by almost 10%, while the CNX Infrastructure Index increased by 17%. P/E of BSE Sensex is 18.57, while that of CNX Infrastructure Index is 24.57. Out of the 24 companies that make up CNX Index, P/E of 6 companies is above 20. Still, the industry experts feel that these infrastructure companies are fairly priced.

This indicates a lot of scope for infrastructure sector in the years to come. Broadly, infrastructure sector includes real estate, steel and cement companies.

A sum of $1 Trillion was allocated for this sector in 12th five year plan. Roads and bridges occupy a key component in this sector and it is expected to grow at a CAGR of 17.4% over FY12-17. The capacity of ports in India is expected to be doubled by the end of 12th five-year plan (i.e. 2017). This indicates a clear focus of the government on Infra sector which could also be substantiated by the fact that 100% FDI was allowed under automatic route in port development projects. At the same time, there are inherent weaknesses in this sector where a lot of projects pending, this sector has been languishing for a long time and it seems the time has come for this sector to see some capital appreciation.

The recent budget highlights several positive measures pertaining to this sector. One of the key demand by this sector is to have an access to longterm loans and a reduction in cost of financing.

Banks have been encouraged to lend out more loans that will not be considered for CRR and SLR requirements and also a facility of restructuring was offered to the banks in the form of 5:25 initiative.

This 5:25 structure will allow banks to loan money to developers for 25 years, with an option of rewriting the loan or transferring it to another bank after 5 years. But the major problem with this structure is asset-liability mismatch i.e. there may not be enough buyers in the local market. With the government likely to reduce regulatory norms, banks would be able to lend and hence benefitting the infrastructure

6

companies.

In order to make sure, this sector is not straddled with stranded projects, the budget highlighted the need to work on those projects so that it would eliminate the biggest pain point of the infrastructure companies and banks. This would also make the sector more attractive, which would result in more FDI inflows benefitting the economy. Another major initiative was the creation of Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs).

There were a range of tax incentives proposed: Capital gains tax will not be applicable in long-term and short-term capital gains tax would be 15%. The dividend income of the trusts will be subjected to Dividend Distribution Tax on the company that is paying dividend only there by avoiding double taxation i.e. tax being paid by both corporations and individuals. Other initiatives such as investorfriendly environment and predictable Public Private Partnerships (PPPs) that are vital in building largescale projects were proposed in the budget.

Infrastructure sector is the back-bone of any developing economy and it is the right time to concentrate on this sector when there are visible signs of improvement in the economy. Economist Intelligent Unit’s research points out that spending on infrastructure and growth in the middle-class will prop GDP growth over the coming years. It is expected that this sector would have a direct bearing of 70% of the country’s GDP by 2030 (according to McKinsey report). There has been a very clear mandate by the government in the infrastructure sector which would benefit banks, cement companies, construction companies, and project finance institutions. All said and done, implementation of these new measures is the key factor which everyone has to look after and it would take at least a year to see things moving.

August 2014

6th Anniversary Issue

TOP Five

PSU

Banking in India The Indian PSU Banking sector has recently been in the news for all the wrong reasons. Rising bad loans, bad NPA recognition policies, slower credit growth and a few corporate governance issues have tarnished the image of the once conservative sector.

There are a host of reasons why the Indian PSU banking sector puts up such a grim face. But, before analysing these issues, let’s look at the current scenario prevailing in the Indian PSU banking space.

In the entire Indian Banking system, bad loans have risen from Rs. 1, 37,102 cr in 2011-12 to Rs. 2, 45,809 cr 2013-14. Gross NPAs of 22 public sector banks grew by 51% to Rs.1.2 trillion in the March quarter compared to the year-ago quarter. The five banks that rank top among the state-run lenders in terms of gross NPAs are Central Bank of India (6.03%), State Bank of Mysore (5.61%) UCO Bank (5.58%) Punjab National Bank (4.84%) and Allahabad Bank (4.78%).

Indian banks have cumulatively restructured more than Rs.2.5 trillion of loans under the so-called corporate debt restructuring (CDR) mechanism, with a significant portion of this being done by the publicsector banks in recent quarters. Due to these rising NPA levels and slower than industry average credit growth, the bottom lines on these banks has also taken a hit. Another trend that has emerged in state run banks is of a sudden high NPA level whenever a new Managing Director takes over a bank. Whenever a new chairman of State Bank of India announces his (or her) first quarterly result, there is a sharp decline in net profit. Under OP Bhatt, it fell by 35 per cent. Pratip Chaudhuri, his successor, reported a plunge of 99 per cent. The latest to follow the trend is Arundhati Bhattacharya, the incumbent.

In November, when she announced the bank’s earnings for the quarter ended September 30, the profit was down 35 per cent from the same quarter a year earlier. Due to all these issues, these banks have not been able to generate enough capital on their own and are now dependent on the already strained government for the future growth and even for meeting the minimum Capital Adequacy Ratio requirement of Basel 3 norms. The requirement for Basel III Additional Tier I (AT1) capital for banks would be as high as Rs54, 400 crore in FY15 and FY16.

While the larger companies managed to restructure their borrowings by projecting improved prospects in the long-run, the SME and agriculture segments could not do the same and hence this segment of commercial lending causes the highest amount of stress in the lending divisions of the banks. Given the RBI’s estimate that 15 per cent of restructured assets may actually slip into bad loans, the NPAs from restructured loans may add another 90 basis points to the gross NPA of public sector banks. This would take the NPAs to more than 4.1 per cent for public sector banks. The provision coverage (the provisions set aside to minimise the impact on earning in case the NPAs are completely writtenoff) of public sector banks would, thus, fall from 53 per cent to 44 per cent of gross NPAs, increasing the vulnerability of public sector banks. All these issues have led the government to mull over the idea of merging smaller PSU banks with larger ones and have better control over a lesser fragmented industry. The country and the economy require big banks, some international sized banks. However, there should be a strategy and the cultural fit. RBI would have to examine various aspects of the banks and whether the merged entity will be able to serve the objective for which it is being created. If two weak banks merge and you look at the regional angle or the union angle or the asset quality angle, then you don’t reduce problem you create a much bigger problem. Now the question that arises is, can there be a dramatic turnaround in this sector in the coming years. I do not think so that it would be wise to think so, but there could be a few banks that can tighten their credit evaluation processes and speed up their loan recovery process, which can help them reach average level credit growth rates and simultaneously reduce their bad loans substantially. But to even compete with private banks like HDFC Bank and ICICI Bank who have been gaining market share from PSU banks, there have to be many structural changes in this industry like better employee management policies and much more conservative processes to make them leaner and fitter. But this is a long shot that this government and RBI may not be able to achieve even in the next 5 years.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

7

TOP Five

6th Anniversary Issue

Power Sector in India India is the world’s 6th largest consumer of energy accounting for 3.4% of the global consumption. 65% of the electricity consumed in India is generated by thermal power plants, 22% by hydroelectric power plants, 3% by nuclear and 10% from other alternate sources like wind, solar and biomass. The total demand for electricity is expected to cross 950,000 MW by 2030. Indian power sector is one of the most critical components of infrastructure that affects growth and well-being of the nation. But, unfortunately it has been marred by power theft, slack state wise regulatory reforms and politicisation of utility rates amidst fuel shortage and red tape in getting licences like environmental clearance and land acquisition.

The 12th five year plan sets for itself a target of adding a capacity of 89 GW to the current 234.6 GW to total installed power generation capacity. The new government has set out ripples promising revival and with positive market sentiments, distressed projects are finding buyers, companies putting in equity and equipment orders getting finalized. Let us have a sneak peek into what the budget has in store for power sector. The Union budget 2014-15 proposed to extend 10 year tax holiday on all power projects which begin generation, distribution and transmission latest by 31st March, 2017. Tax holiday is a temporary reduction/elimination of tax. This will infuse fresh investor interest in the stalled projects.

Reviewing existing sources of coal and assessing feasibility for rationalizing coal linkages are also underway to optimize transport of coal and reduce cost of power. The government plans to supply 24 x 7 power to all households under the Jyoti Gram Yojna. FICCI has laid down steps to boost renewable energy sector making it independent, facilitating interest rate subsidies and greater funding. ₹ 100 crore has been allocated for preparatory work of clean thermal energy scheme and ₹ 500 crore for ultra-modern solar power projects in Rajasthan and Gujarat, besides giving impetus to implementation

8

of green energy projects. Customs and excise duty cuts on renewable power equipments is proposed with a basic rate of 5%. To keep pace with the rapid urbanization, 100 smart cities will be developed with an outlay of ₹ 7,600 crore and they cannot be envisaged without smart grids where again, power will have a large role in operating of these. Public –private partnerships will be encouraged in the mining operations.

The stimulation has attracted foreign players like Abu Dhabi National Energy Co and GDF Suez to take Indian projects. Soaring stock prices are enticing investors. Although private companies like Tata Power, Reliance Power and Adani Power appear promising, public companies like NTPC, NHPC and other SEBs have yet to overcome the poor financials.

A hurdle which we see is the burden due to subsidies which is estimated to increase by 17% to ₹72,000 crore this year for state utilities. The Industrial production grew by 4.7% in May due to improved performance of manufacturing, mining and power sectors specifically. The reforms aim at reviving this ailing sector. We expect affordable power and penetration of power in remote parts of the country.

Overall, the Budget is lucrative for the power sector but we have yet to see its long term impact and till then here we are, hoping that the Union Budget 2014-15 is just a prelude to the comprehensive efforts the new government shall bestow.

Fig 1: Percentage Contribution towards Electricity Generattion in India

August 2014

6th Anniversary Issue

India is the ninth largest civil aviation market in the world and fourth in terms of domestic passenger volumes. The passenger throughput has increased to 159 MMT (million metric tonnes) at a CAGR of 13% and cargo throughput to 2.19 MMT at CAGR of 10% in FY2013. The Aviation industry currently supports approximately 0.5 percent of the India’s GDP (FY2013). There was an increase of US$ 495.24 in FDI inflows in India during the period FY2000-14 which was observed after UPA government increase the FDI cap to 49%. This led International Carriers like Singapore Airlines and Air Asia to invest in the Indian aviation industry.

In the 12th Five year plan, the center has set aside an investment of 12.1 billion of which US$ 9.3 billion is expected to come from the construction of low cost airports and development of the existing airports

by Indian private players. Additionally, the Ministry of Civil Aviation has also proposed the Essential Air Services Fund (EASF). In the Budget 2014, plans for development of new airports in Tier 1 and Tier 2 cities by the Airports Authority of India or PrivatePublic Partnerships (PPP) and introduction of E-visa

by December 2014(Electronic document obtained online that does not require a visa stamped in the passport prior to arrival in another country for faster clearances) at 9 international airports in India was also announced.

Indian Aviation is a huge industry with numerous opportunities, but it is wrought with high inefficiencies such as irrational pricing, wide fluctuations in exchange rates and unprofessional management that have mired it in losses in the past.

Hence it was expected that taxation on aviation fuel (that consists about 40-45% of the total cost), strict regulations, maintenance, repair and overhaul would be relaxed. These are some of the issues that should have been addressed in the budget, but were not. The government still considers the airlines as a luxury business and accordingly levies humungous taxes at national and state level. This greatly increases the costs for operating the carriers

TOP Five

Airlines

and renders their ability to increase volumes. This is causing the existing players to incur huge losses (USD $1.65 billion in FY2013), and discouraging large investments in the near future.

High taxes (service tax and VAT combining to almost 40% taxes) are levied on the MRO (Maintenance, Repair and Operations) services in India, which make it costlier by 20-30% as compared to the international competitors. This is not just cutting down on one more revenue channel for the aviation players but is also forcing the domestic airlines to turn to the international service providers. Although government has already taken steps to improve this by announcing concessions on import of spare parts in 2013, but to channel proper growth, they must eliminate discriminatory taxation policy for domestic MROs and consider altogether abolishing import duties on the spare parts.

India‘s strategic infrastructure assets such as runways and airspace that have a major impact on the airline efficiency have a low productivity and significant investments must be done to enhance the efficiencies of the Indian airports and the airspace. Indian has a strategic location with respect to the international air traffic that it can leverage to its advantage, but has yet not done so.

The Regulatory Authority can play a major role in reducing the cost-revenue gap of the airlines by considering the application of tax reduction, direct import of fuels, flexible use of airspace between civil and military purposes and proliferation of GAGAN, India’s satellite-based navigation system. These are some of the steps that might help in boosting the Indian Aviation industry in the future.

Fig 1: Fre`ight Traffic in India

Fig 2: Passenger Traffic in India

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

9

6th Anniversary Issue

TOP Five

Railways

India has the 4th largest rail network in the world.

From the time since Indian Railways started it has served to build a modern market economy. It helps in facilitating industrial development by connecting industrial production units with the markets. It provides a link between agricultural production nodes and the markets. It connects places and enables large scale and low cost transportation of people across the entire country. If we compare rail transport with road transport we can see that the Indian Railways with approximately 64000 kms route accounts for most of India’s transport and goods traffic. Goods trains carry around 1 million tonnes of goods and nearly 7500 passenger trains carry 12 million passengers every single day. The Indian Railways accounts for about 1% of the Gross National Product thus contributing significantly towards India’s economic development. It contributes for around 6% of the total employment in the organised sector directly and on top of that an additional 2.5% through its various allied organisations.

Even after having so much importance for India’s growth the condition of Indian Railways is not in a very good state and it requires a lot of major reforms to bring it back on track. It has been more than 150 years since the Indian Railways started its first train but still the speed of Indian trains is very slow as compared to trains of other countries. Even the Shatabdis and Rajdhanis stand nowhere if we see the railways of western countries. If we see the total infrastructure investment achieved in the 11th five year plan, the railways have underachieved by 25% while on the contrary telecom and gas & pipelines

10

overachieved by 25% and 80% respectively. It is not only operations and allied services like the state of the stations that are in disastrous state. Even critical domains like manufacturing and research and development are also in equal state of disarray.

Every new Government in the past has announced new initiatives that automatically halted the projects rolled out by the previous governments. As a result, neither the old initiatives nor the new ones are delivered to the people. The present Government needs to depart from this practice. Instead of going for a large number of new projects they should prioritize the ongoing projects.

The first and foremost need is to win the trust of investors in Indian Railways be it through public private partnership (PPP) or foreign direct investment (FDI). A private investor will invest his money only if he is sure of earning good returns on his investment.

There is a need to first build confidence in them so that they regard railways as a good investment opportunity. In the recent budget, construction of a number of stations has been proposed through the PPP route. It can be awarded on a build operate transfer (BOT) basis. The investor can generate high revenues by running food plazas, hotels, parking spaces, malls etc. It will also help create assets for the railways quickly. To a large extent a country’s image depends on the way it has built its transport infrastructure with a blend of modernity. Every country focuses on technology adoption. We should also try to rub our shoulders with other developing countries. We will fall behind if we allow technology to bypass Indian Railways by saying that we don’t have money. There are a lot of private players and investors such as Japan International Cooperation Agency who are interested to invest in the recently announced bullet train project. We must take their assistance. We should take a portion of the revenue generated and the rest should go to the investor. It will help us achieve two objectives – creation of a world class asset and getting a share of the revenue too. It will be a win-win situation for both the parties.

In the recent budget there was also a proposal for the diamond quadrilateral. The first stretch of the diamond quadrilateral may take about four to five years to come up. Once the first stretch begins the rest will follow quickly. Policy makers should also start to think in new directions. If an implementing agency is unable to implement something, the policy itself should not be immediately changed. Officials even below the Railway Board should be empowered to take decisions. It will help in making things move fast.

August 2014

6th Anniversary Issue

Fiscal Deficit: Likely Impact on the Indian Economy and the Way Forward Udayan Anand

IIM Shillong

In the recently presented budget, Finance Minister Arun Jaitley targeted to reduce the fiscal deficit to 4.1% next FY from 4.5% of GDP this FY and also prepared a roadmap to reduce it to 3.6% of the GDP by 2015-16 and to 3% by 2016-17. Why is the fiscal deficit such a concern for India? Or to begin with, what is fiscal deficit at the first place?

What is Fiscal Deficit?

More than often, the governments can’t balance their budgets in terms of the incoming revenue and the outgoing expenditure. The bulge may go either side – excess of revenue over expenditure or the excess of expenditure over receipts. While the excess of receipts of the government over its expenditure amount is called fiscal surplus, it’s called the Fiscal deficit when it is the other way round - defined as the excess of expenditure of the government to its

revenues.

Fiscal deficit is the amount of borrowed funds required by the government to catch up with its expenditure completely. To get more idea about the fiscal deficit, expenditures and revenues of the government need to be talked about in some detail.

The budget revenues of the government are made up of capital receipts and revenue receipts. Capital receipts include incomes from disinvestment in public undertakings, recovery of loans, borrowings while revenue receipts include tax revenues and non-tax revenues like interest, fines, fees, external aid, profits, and dividends. The expenditures of the government include revenue expenditure and capital expenditure. Revenue expenditure includes salaries, pensions, subsidies while capital expenditure, abbreviated as CapEx, includes

Fig 1: Budget deficits in major economies – Red-deficit, Green-surplusThe darker the hues the greater are the deficits or surpluses

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

11

6th Anniversary Issue

Fig 2: Fiscal deficit in India – A historical view

disbursements on infrastructure, industry etc.

Fiscal deficit is one of the most important indicators of macroeconomic health of an economy along with other macroeconomic variables like nominal GDP, CPI, Money supply (M3), CAD, unemployment rate. Fiscal deficit is used in absolute terms as well as in terms of percentage of the country’s GDP. Other deficits related deficits include primary deficit, revenue deficit. The fiscal deficit in India for the FY 201314 was 4.5 % of the GDP which amounts to over 5lac crore rupees.

Fiscal Deficit Around The World Taking a global picture, while the fiscal deficits of some massive economies like USA, UK have run into double digits recently, the economies of the struggling Eurozone area like Spain, Greece, Poland, France suffer from deficits in the range of 6-8% of their GDPs. However, there are also countries like Kuwait in the Middle East who have budget surpluses of almost 30% of their GDPs. Countries like Norway, Chile, Brazil (however, Brazil slipped into a negative deficit this year) enjoy greater budget receipts than their expenditures and have fiscal surpluses.

Fiscal Deficit In India Indian economy has had a history of persistent uncomfortable fiscal deficits. In the early 1980s, there was an escalation in the fiscal deficit of India due to the excessive fiscal expansion.

Although growth touched unprecedented levels in the mid-1980s but the fiscal deficits continued to touch unsustainable limits along with escalating Current Account Deficit (CAD).

This culminated in the Balance Of Payments crisis of 1991 as the twin deficits of CAD and fiscal deficits climbed to unsustainable limits, 3.5% and 7.8% of the GDP respectively in 1991.

The major aims of the economic reforms in 1991-92 were aimed at reducing the CAD 12

along with the fiscal deficit. The fiscal deficit stubbornly remained over the 5% mark for the next 5-6 years and it was only in 1996-97 that the effects of economic policy change towards liberalization 5 years ago bore fruit as the fiscal deficit shrunk to 4.88 % of the GDP. However, the deficit could not sustain the low levels as the Fifth Pay Commission implemented in 1998 led to sharp uptick in the levels of got salaries and pensions which severely dented the fiscal planning of the government as the deficit shot up to 6.5% of the GDP. Seeing the potentially deteriorating fiscal situation in the economy, the government brought the Fiscal Responsibility and Budget Management (FRBM) Act, 2004 to control the fiscal deficit. The act required the government to reduce the fiscal deficit by 0.3% every year to a level of 3.0% of the GDP and revenue deficit of the government by 0.5% every year to zero by 2008-09. The next 4-5 years witnessed laudable fiscal prudence by the government as the deficit kept plummeting and reached a historic low of 2.54 % in 200708, a year before the target year of 2008-09, as stipulated by the FRBM act.

But the introduction of social welfare schemes like NREGA, farm loan waiver and the implementation of the Sixth Pay Schedule led to enormous increase in public expenditure without corresponding increase in the government receipts. The principles of fiscal prudence seemed to have been abandoned by the government as it embarked on a spending spree. Moreover, the general elections of 2009 also added to the already worsening disproportion of the government budget towards the expenditure side.

It was around this time only that the effects of the global financial crisis also started to hit the India Inc. the Indian government, on the lines of US government, also engaged in massive bailouts of and stimulus packages to Indian companies in sectors like automobile.

This further upset the fiscal health of the economy. The policy of fiscal prudence that the government embarked on in 2003-04 after the FRBM act went haywire and the fiscal deficit again reached to pre FRBM act levels of over 4% of the GDP. The unsustainable public spending on schemes, alleged as populist and politically motivated, caused an upsurge of budget deficits which still continues today and the sustainable levels of fiscal deficits in the Indian economy still remain elusive as the newly elected government battles to reduce the deficit to below 4% level

August 2014

6th Anniversary Issue

Fig 3: Relation between fiscal deficit and inflation levels

of the GDP. Nature Of Fiscal Deficits In India High fiscal deficits are being recorded in USA, UK and Eurozone economies, the deficits in such economies are more cyclical in nature and are likely to disappear as the countries come out of stagnated growth that they are currently trapped into. But the problem of persistently high fiscal deficits in India is more structural than cyclical in nature. The heavy public spending on social welfare programs like NREGA, food subsidy program and subsidies on fuel and fertilizer which do not create any proportionate employment and capital creation do not allow any fiscal recovery and forces the government to fund the deficit domestically or externally. Add to this the poor revenue collection by the government, mainly in the form of tax collections, which further spoils the balance between the income and the expenditure of the government. The spending on social welfare schemes doesn’t lead to any value addition in the economy. Moreover, in the absence of adequate delivery systems corresponding to these schemes, the gigantic chunk of the government expenditure doesn’t contribute to strengthening of the income base of the country’s population, which in turn, deprives the government of its vital tax revenues.

Likely Impacts Of A High Fiscal Deficit In India Keynesian economists believe that a fiscal deficit is a favorable situation for an economy. They argue that increased government expenditure would induce greater production and output in the economy, through a multiplier process. The fiscal deficit financed through borrowing would lead to overall increase in the production capacity of the economy which would create more employment. This may hold true for fiscal deficits within manageable percentage levels of the GDP but for a country like India, who has had a history of fiscal deficits almost constantly

hovering near or above dangerous levels, it poses grave consequences and implications if it is not tamed.

A high deficit would force the Indian government to turn towards the markets for borrowing through issue of securities. This would lead to high debt liabilities on the government and high debt servicing in the next fiscals.

A high debt servicing would imply cut backs on public spending on important sectors like infrastructure, health, education. This was the case in 2009-10 when 37% of the revenues of the government was spent towards debt servicing.

This market borrowing also “crowds out” private investment. As the market starts to lend more and more to the government, it will be left with less money to lend to the private sector.

And with private sector making up the bulk of our GDP (over 75%), this deficit financing from the market finally impedes the growth of the private sector of the country.

To make things worse, as government draws money from the market to finance its deficit, the public is left with lesser money to save, which shrinks the macroeconomic saving level of the economy.

Furthermore, the government would be forced to increase revenues through higher taxation which reduces the incentive to work. A higher fiscal deficit would also imply cut in spending to reduce the expenditures. The cuts may come in important sectors like health, education, defense, social sector, infra.

The government, in order to plug the gap between its expenditures and the revenues may opt for debt monetization - RBI who would print more currency notes to meet the excess expenditure. However, this excess money supply in would lead to inflation. This has been the current scenario as the widening fiscal deficit, which prompted the RBI to print more currency, has kept inflation constantly in the double digit region. It is estimated that to fund a deficit of INR 6 lac crores, the RBI would have to print somewhere around INR 2 lac crore, which makes up for about 15% of our total money supply. To add to this, if we direct another 10-12% from other source, then we’d be expanding our money supply by a fourth every year which is a disastrously high figure.

As inflation sets in it makes the exports costlier and hence, a decrease in the comparative advantage of the country. This threatens the upsetting of the Current Account Deficit as exports fall and the cost of imports increases due to weakening of the rupee.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

13

6th Anniversary Issue High deficits can be tragic, as was the lesson learnt from the experience of Eurozone economies like Portugal and Greece, where, as mentioned above, reckless government spending led to massive fiscal deficits that kept mounting every year until they reached levels so high, that the countries had to be bailed out by the other Eurozone countries.

Fiscal deficits also forces the government to borrow from external markets. This risks down gradation of the sovereign rating of the country. It would also create pressure on exchange rate of the currency which would have negative impact on the exports and imports of the country. Recently, the credit rating agency Moody’s said that India’s deficit, which is higher than most other similarly rated countries, makes it vulnerable to risks and shocks. The dismal fiscal state already made S&P to downgrade India’s outlook to negative in 2012.

Fix The Fisc Borrowing, domestically or externally, seems to be the easier option out. However, heavy borrowing leads to a series of unfavorable situations for the economy as discussed above.

A right step towards containment of fiscal deficit would be through legislation dictating fiscal responsibility measures which define limits on borrowing, especially exogenous borrowings by the government. The FRBM Act of 2004 was a step in this direction by the government which was successful in managing the fiscal deficit.

But the later years of the decade witnessed massive disregard for the legislation as the government indulged in reckless spending which deteriorated the fiscal health of the country. Today, what we need is another legislation which bounds the government to embark on fiscal prudence to bring the deficit back on track. A good example is provided by the Maastricht treaty, which led to the creation of the European Union, which legally stipulates the member countries to follow two conditions • The country’s fiscal deficit must be below 3% of its GDP, and this limit is not to be exceeded under “normal “economic downturns.

• The country’s total public debt must remain at or below 60% of the GDP of the country.

Although the recent Eurozone crisis led to massive escalation in the fiscal deficits and public debts in Europe (public debt in Greece rose to abysmally high levels of 177% of the GDP) but the Maastricht treaty provides a 14

good framework that the Indian government can mimic to form a legislation aimed at fiscal control.

Due to a history of lack of co-ordination between the government and the RBI in India, the fiscal policy and the monetary policy of the country have not been in tandem. In light of the fiscal deficit reaching grave levels, the RBI and the government would have to change their tussling stance and work in coordination with each other to tame the deficit.

For example, government can cut its spending and borrowing, and this will give the RBI more freedom to continue using low interest rates and other techniques such as Quantitative Easing (QE) and other bond buying programs to promote growth and recovery.

Moreover, the fiscal deficit of India is seen as structural rather than cyclical. The social welfare schemes like National Food Subsidy Scheme and other subsidies like fuel subsidy, fertilizer subsidy entail gargantuan expenditures, in the absence of corresponding revenues makes the budget heavily lopsided towards the expenditure and creates high fiscal deficit.

As Moody’s recent report “Frequently Asked Questions On India’s Fiscal Position and the Forthcoming Budget” points to, the low income levels limit the tax collections while the sociopolitical pressure lead to heavy spending on social sector which imbalances the government budget. So the need of the hour for the Indian government is to cut the profligate spending on social sector. This doesn’t mean putting a plug on the social expenditure but reducing them from their current excessively high levels. The government should rather focus on developing proper delivery channels and systems instead to make sure the social spending actually reaches the desired target population.

Fiscal deficit is one of the most important macroeconomic index of the economy and Fiscal Deficit being favorable for an economy may be debatable but a high fiscal deficit is unanimously and unequivocally a threat to any economy. Indian government must now take charge and catch hold of this runaway figure of the deficit. The government must make sure that its commitment to reduce the fiscal deficit to 3% of the GDP by 2016-17 is more than a mere lip service, because any talk of India becoming an economic superpower in the future will remain a farce unless basic gears of the Indian growth engine like fiscal deficit are brought under control.

August 2014

6th Anniversary Issue

A TRYST WITH THE EXPERTS

MR. CHANDRA SHEKHAR GHOSH Chairman & Managing Director, Bandhan Financial Services

What was your inspiration to go for a new banking license?

Bandhan started its journey in 2001 and the inspiration to go for the license came in 2009 when we were a NBFC and at that time a lot of negative sentiments were emerging for the NBFCs. I learnt that the people have not yet understood the needs of the poor people. I felt dejected and thought that I would not be able to continue this service, for the poor people, any further. I even felt that I was risking the future of my staff, since due to the negative publicity, the growth of NBFC sector might get hampered in the future. Hence I contemplated on how we could overcome this risk. I had multiple discussions with the RBI and they suggested that the only way for you to settle these issue was to obtain a banking license and we decided to pursue this path, if given the opportunity. In March 2010 the applications for the new banking license were opened and, fortunately, it was also announced that the NBFCs could apply.

Even though it was not clear that who would get the license, we remained determined and prepared ourselves in the best manner according to what would be required if we got the banking license. They declared a draft guideline, asking for our opinions on certain issues, which we gave. Then they asked for the final applications and we got the license.

Your commitments for triple bottom values had led Bandhan towards success. We would like to know that which are the areas in India that you are going to focus at.

Approximately 60% of people in India still do not have a bank account, these are the people we will be focusing on for how to serve. We would compete for the people already having bank accounts. We would primarily target on those that are not being served

yet. The second target would be the set of people who have an account but do not use it. For their economical development, people need to have an access to basic financial service and a bank account and they must also make use of this account. Till they would not use, there would not be any creation of value. It’s a great challenge to make the people, who do not use their accounts, aware about the importance of the banking services and educate them about how it can be beneficial for them. There is a lot of demand and we would like to target this sector. We are ready to serve all the sections of the society, in all income levels, but we already have an expertise in providing credit facilities to the poor, who generally do not have high deposits. Secondly, financial inclusion was a major agenda during the issue of the new bank license, where even we would like to focus. Out of whole India, most of the financially excluded people live in North Eastesrn and Eastern region. Only 7% people in North East and 8% in the Eastern region are getting the credit services. Hence these areas must be of the primary focus, along with the rest of the India. Thirdly, 70% of the population is living in the East and the North zone. Hence to provide the economic support to the people, these regions must be focused. This is where we are currently working. 75% of our operations are in Eastern region, including North East. We have operations in North and a little bit in Western and Central India. We would first like to fill up the gap of financial exclusion and then gradually we would go to the other places.

In past, Bandhan has focused on women empowerment. In future, what are your plans for the education, health and employment opportunities for women.

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

15

6th Anniversary Issue Women have still remained deprived in our society and women head very few families. But the women raise the next generation. The mother takes care of all the needs of the children like food, medicine, education, etc. To develop the future of the country, you need to develop the future of the children and for that you would have to empower women, which would come from their economic independence so that they can fulfill small demands of their children and would not have to always depend on men. Currently most of the decisions like sending the child to which school and to be taught by which teacher, is taken by fathers since in most of the families,the father is the earner. So if women become independent, then she also would be able to take these decisions and be a part of these decisions. The issue is more about the feeling of how the women can be empowered. If they have a little of their own money to command, they would feel empowered. Lastly, when the women come to my group meetings for taking loans, they get to interact with other people for taking the loans and get access to important information which helps her to grow intellectualy. Hence, we would not say that we are focusing only on women empowerment, but their empowerment forms a major part of our vision.

What is your opinion about the fact that micro finance institutions must be allowed to take the deposits?

I have, in past, taken a stand to support this and raised this point with the RBI and the ministry.

But, there are many issues associated with this, since NBFCs have different compliance rules and regulations. Banks have one registration whereas microfinance institutions are registered under different registrations. Some one might register under the Section 25 in the company’s act, some under NBFC, some under cooperative, etc. There is no single controller for all these, and hence there is a fear with the regulator on how to preserve the rights of the depositor. So they have not taken the risk of letting NBFCs take the deposits and even I partly agree to this point. Suppose if in future any company becomes an NGO and applies for the NBFC license and it is given the permission to take deposits, then it would create problems in the future if the depositor’s money are kept at such high risk as we have seen some of chit fund scams in past. This will create negative perception about microfinance institutions in the minds of public.

16

SME financing will play a big role in future for poverty alleviation and employment generation. What are your plans for SME lending and what are the gaps that you plan to Fill.

I would rather say that we would address MSMEs (below SME) that are 29.8 million in our country, that employ approximately 3 crores of the population. Out of total MSME only 1.8 million have been registered.

That means that nearly 28 million are unregistered which banks have till now not addressed. There is a big gap here that we are likely to cater. We would promote them to get the registrations, provide banking services and gradually increase their business and create new jobs. But this is going to take some time and can’t be archived immediately.

In MSME, there are different sectors like Agriculture, Manufacturing etc. But we find that most of the banks are focusing on manufacturing. So, is there any specific preference for your bank? If so what?

Till now there has been one fear in the country.

Whether it is MSME or SME, the NPA rate is very high. There is no doubt about it. Once upon a time everybody said that in this sector NPA would be high.

But, we proved it wrong and have shown others that comparatively NPA will be better. Every area or sector in MSME has potential. In any area of the MSME we would like to start in a small way but think in a big way. Gradually, when we get established it we would be able to build capacity and growth will automatically happen. But one should not start right away in a big way which is a great risk. So, think big for the future, but start small. There is another fear in the country that till now fear of lending in agriculture sector. This is because government can anytime waive off the entire lending that has been made to the agriculture sector and the recovery of this money from government will take a long time. So, this risk should not be taken by a new bank. We know that in Andhra Pradesh, on the very first day, post elections, the CM waived off the agriculture lending which is not very good for banks and ultimately to the country and the economy. This is demoralizing to a banker and hence would not like to lend to this type of segments. That must be stopped. Hence we focused on small agriculture like fisheries, piggeries, milking cows & goats, vegetable cultivation etc. where there are no such issues.

Bandhan is currently maintaining a Capital Adequacy Ratio of around 21% and RBI requires a minimum of 13%. So is this a strategic decision on your part?

August 2014

6th Anniversary Issue No, it’s not like that. The Capital Adequacy Ratio for a bank and an NBFC are different and hence, it was like that. We do not like to keep that levels of capital as a bank. It is not very good for an institution and its efficiency. If our efficiency is good, then why not leverage the money! Then people will also invest in us. Otherwise, they might express fear about it.

Sir, in less than 18 months , you will form the bank. So, what are the actions you are taking currently and what is exactly the agenda you are contemplating on how to establish yourself as a bank completely?

Currently, we are working hard on the processes.

These include identifying the branch areas, setting up the branch infrastructure like IT, regulatory and compliance arrangements, designing products and services like that of the liability products etc. These are the things that are now going on.

What interest rates and minimum loan amount are you planning to give to the rural poor now who are being exploited by moneylenders? What will be the floor for deposits that you will accept from them?

The lending rate is not an issue now. The bank borrowing completely depends on the bank borrowing costs. I can set up my base rate and accordingly lend. Until my deposits don’t increase, I cannot comment on how much I can increase or decrease the rates. The rates must be decided on this basis only. Coming to the floor on the deposits, we have to take a decision based on the costs we incur. We will also make sure that it will be reasonable to the customer.

As you have spoken about transaction costs that you may incur, you know that implementing IT infrastructure and facilities like net banking in rural areas is very difFicult. So setting up ATMs might also get difFicult there and people might need to come to banks to transact money. So how are you planning to tackle this and what steps are you taking to reduce the transaction costs?

We are a 2,75,000 group. Every week we are conducting the group meeting, collecting the installments and disbursing the loans. And this 2,75,000 collection points, we can use for ATMs. Rather we can say that HTM which stands for Human Transfer Money.

It can help in reducing the cost. Small amounts can be taken as well. They will carry a machine and for

whatever money has been received, the customer will get a receipt and this money will be deposited.

This is how we want to go to the poor people and serve them. Coming to middle class, they will use the ATM or the branches, whatever they like to.

Sir, while addressing the MCCI members, you said you would lend the poor based on the cash flows and not based on the collateral.

So how are you planning to execute it?

As you see, the poor people do not have any assets. So I cannot ask them for any collateral.

Secondly, for say a lending of INR 50, 000, I cannot ask for a collateral of INR 5, 00,000 from them. If you see all the big lending have happened on the basis of assets as collateral. The same is the case with Kingfisher as well. So then why are we not able to collect anything from them today? So asset is not important. Money will be returned back on the basis of its utilization. Hence, the focus must be on the utilization and the cash flows.

We also design our products in such a way that businesses get benefited from them according to their requirements.

Sir, what according to you is the best way to achieve financial inclusion currently in India?

Firstly, we have to educate the people and serve them at their doorstep. Do not ask them to come to your bank branch. So we educate and simultaneously we keep the services also. There is no value to the education if service does not go in tandem with it.

If you want to go further on country development, I suggest you all to create a vision to work in a rural area and not in a metro city. Until the fresh Graduates go to rural willingly, financial inclusion is not possible. Rural is the best place to start with in order to establish a market in the future. That is why rural banking has great importance. The ones who sacrifices his life in the beginning will enjoy in the future.

Any advice to the budding management graduates of the country?

As I already mentioned, one has to develop a vision for the rural. In your age, it is quite possible. If one wants to work at the bottom of the pyramid one has to put one’s heart to work. There is a need for a student to understand his social reality in the country. This would be very helpful for improving the future of the country. Also, students must actively consider their internship assignments in rural areas and imbibe the concepts the sustainability.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

17

6th Anniversary Issue

Dividend DistribuDividend Distribution Tax

tion Tax: Is the step by Government taken in the right direction?

Achintya PR & Hemalkumar Maniar

Abstract The new Government has presented its first Union Budget for FY 2014-15 amidst a lot of high expectations from the corporate and investors alike. PM Modi, who has successfully changed the outlook of Gujarat by bringing in enormous changes in the infrastructure and other related areas, was expected to do the same at Centre.

And the Government has not proved to be a disappointment in this regard. Even though there are no drastic announcements in the budget, there have been several key changes in the policies and the change in the policy pertaining to Dividend Distribution Tax is one among them.

The decision to change the calculation of DDT on ‘Net Distributable Value’ to ‘Gross Distributable Value’ has been aimed at generating greater revenues for the Government. Nevertheless, the corporates have expressed their disappointment over this change. In this article, we have made an attempt to study the positive implications of this change to the corporates, investors and other stakeholders. In an attempt to do so, we have explained the fundamentals of DDT and have taken it to the next level to show the impact on Government’s revenue through an example before explaining the possible implications.

Introduction Decisions about the Dividend pay-out by far have 18

SIBM - Bengaluru

been a subject of great curiosity and interest for the analysts, researchers and academicians for a long time now. The objective of the Dividend Pay-out is to determine the extent to which the company is distributing the ‘dividends’ to its shareholders out of the earnings of the company.

This decision forms an integral part of a corporate action by the company in its financial decisions since it has direct impact on the investments and financing decisions. Corporate taxes have a huge influence on the earnings of a company and they impact the dividend decision in more than one way. On one hand, it influences the net income after tax of the company, which, in turn, determines the capacity of the company to pay the dividends to a greater extent. On the other hand, it may have implications for the net value received by the shareholders. Hence, in this regard, the structure and the rate of tax play an important role in determining the dividend policy.

Earlier in India, an imputation system of taxation was followed with respect to the dividends. As per this, the dividend received by the shareholders was included in their income after being grossed up and the shareholders were granted credit with respect to the amount

August 2014

6th Anniversary Issue deemed to have been paid by the company on their behalf. Thus the part of the corporate earnings which was declared as dividend was taxed only in the hands of the investors.

This system of single taxation was abolished and dividends were taxed for the second time separately in the hands of the shareholders.

Since then, the corporate houses and the investors have been complaining to the Government about the double taxation system of income and the Government eventually reduced the tax on the dividend income in the form of deduction under Section 80L from the year 1968-69.

Both the investors and the corporate houses were expecting the abolition of the double taxation on dividend income ever since the Government of India had initiated financial reforms in 1991. In the budget of 1997, the Finance Minister announced the abolition of tax on dividend income on the hands of the shareholders.

However, the budget also proposed a new tax on the companies when they declared, distributed or p a i d dividend. This new corporate dividend tax was also called as Dividend Distribution Tax (DDT).

The main objective of this was to discourage companies from increasing the dividend outflow significantly leading to lower capital formation. Even though this system exempted investors from paying any direct tax, it required them to pay an indirect tax on the dividend at a prescribed rate.

This new system also ensured that the administration of tax on dividend would be more efficient and effective. The DDT aimed to improve economic growth and flexibility by eliminating the tax bias against equity-financed investments thereby promoting saving and investment. It also aimed at reducing the tax bias against capital gains in the earlier tax system encouraging investment and enhancing the long term growth potential of the economy.

Dividend Distribution Tax (DDT) & Double Taxation: There is a common notion that the dividends are often taxed two times. There is a school of thought that argues for tax exemption for dividend income. The basis of their argument is that the taxation of dividend income amounts to double taxation. The explanation behind this concept is that the corporate profits are subject to corporate tax. Since dividends are paid out of the profit earned which is already taxed, if the dividends are taxed again, it amounts to double taxation.

This logic can be challenged on two grounds: 1. There is a legal distinction between t h e corporation as an entity and the individual shareholders who own the company.

2.Tax rates currently in place were set with the knowledge that there was taxation at the corporate and individual level.

This means that if there is a moral objection to ‘double taxation’, then, the remedial action would also require an increase in the corporate tax rate.

I s it unfair to retail investors?

It’s been over a decade that investors have been arguing that taxing dividend is unfair and it leads to double taxation. The argument is well grounded in a sense that dividend is a source of income for the shareholders and it is distributed after the corporate tax is levied from the gross earning of the firm. Hence, imposition of tax on distribution is injustice to them. However, is it really an injustice to shareholders?

In my opinion, it does not lead to double taxation.

Why? As per our legal system, a company and its owner both are separate entities. Various benefits are accrued to the owners because of this. For example, when a company falls in a crisis situation, its owners are not liable to pay any debt from their pockets. Considering that, when the gross earnings of a firm are taxed it is deemed as an income tax paid by the firm and

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

19

6th Anniversary Issue not by its owners. Moreover, when dividends are taxed, earnings of owners are taxed. Hence, the argument of double taxation is definitely fallacious.

Reforms In Dividend Distribution Tax In The Union Budget 2014 – 15 The reforms brought in by the newly elected government with respect to the direct tax will definitely be a shot in the arm for corporate.

However, the only dampener would be the amendment made in the dividend distribution tax. The amendment made was with respect to section-115O of income tax.

This section was introduced in income tax act in 1997 which made corporates liable to pay DDT while distributing profit to the shareholders. The recent amendment in the act will increase the effective dividend distribution tax as the basis for calculation of tax will be gross distributable surplus rather than net distributable surplus.

The difference can be explained by the following example: Let’s assume, in 2013, Infosys made Rs. 200 Crore profit and it distributed the entire profit to its shareholders. In this case, the DDT that Infosys is subjected to pay would have been as follows: Dividend distribution amount: Rs.200 Crore/1.16995 = Rs.170.95 Crore (The effective rate of 16.995% includes Education cess and surcharge as well) Tax Paid: Rs.170.95*16.995% = Rs.29.05 Crore In contrast, Post amendment, suppose the profit figures are considered to be same for Infosys as per the example above, the tax that Infosys has to pay in 2014 would be, Tax paid: Rs.200 Crore*16.995% = Rs.33.99 Crore Dividend Distribution Amount: Rs.200 – Rs.33.99 = Rs. 166.01 Crore Thus this example shows that a minor tweak in the calculation of DDT can result in high income that the government is going to earn from it.

20

Implications Of Changes In The Dividend Distribution Tax: As soon as the government rolled out its plan to make changes in policies pertaining to dividend distribution tax, newspaper headlines flashed that it will negatively impact the corporates and shareholders as it will increase tax liability to corporates during distribution of dividends.

This might prompt corporates to refrain from distributing the dividends. Consequently, cash flows for shareholders will get delayed and risk associated with that will rise too. Hence, it does give a negative impression at the first sight. However in order to understand the consequences of it at a larger scale, we need to study the consequences of them in more detail.

1 - Impact on corporates: There is an inverse relation between dividend distribution tax and company’s dividend pay-out ratio. When dividend distribution tax is higher, companies prefer to retain most of their earnings for future spending.

Retained earnings can be used to invest in high growth project which will help in following manner: • Need for external financing will be less which will reduce the cost of capital for the firms.

• High growth projects will give an opportunity to firms to earn more profits which will be reflected in their share price in the secondary markets.

• It might also act as a ‘blessing in disguise’ in adverse economic conditions since the cash in the balance sheets will help in surviving through such tough conditions.

2 - Impact on shareholders: Plethora of research has been done on what do small shareholders prefer: capital gain or cash dividends? Majority of them claim that shareholders are more satisfied with capital appreciation than cash dividends. They do not raise any objection if company retains all the earning and invest it in high NPV project as it ultimately affects the share price of the company in secondary market.

August 2014

6th Anniversary Issue Furthermore, if shareholders demand any dividends, firms can distribute stock dividends in lieu of cash dividends. Stock dividends provide many benefits to both shareholder and a firm.

• It doesn’t enforce tax liabilities on shareholders • Firms don’t have to share its earnings and can invest in new projects to expand more.

• Stock dividends provide more liquidity to the stock in the secondary market.

• It also provides an option to the shareholders, who want cash dividend, to sell the additional shares and create artificial cash dividends.

Hence, this proposed change will hardly be a cause of concern for the shareholders.

3 - Social Impact: In India, the participation of retail investors in equity market is just 1.4% of the entire population. The major stock holders are either various institutions or tycoons handling the day to day activities of their businesses. Hence, the burden of increased tax will largely be shared by such investors. Moreover, this will assist the government to streamline its cash flows by imposing tax on these big players who can afford to pay more taxes and these taxes can be used as a plug to compensate the relaxation given to the average salaried employees. For example: An increased exemption limit for personal income tax by Rs. 50000.

4 - Clientele effect: Clientele hypothesis claims that certain type of investors prefer cash dividends since their marginal tax on dividend is less than their income from other sources. It is more prevalent in India as compared to the developed economies. In India, listed companies are largely run by their founders or family members as they hold majority stake in the company.

Their compensation structures are comprised in such a manner that the major chunk comes from dividend income as dividends have less tax liabilities than income tax.

For example: In 2013, the maximum salary that Reliance can give to Mukesh Ambani, as agreed by shareholders, is Rs. 38 crore. But Mukesh Ambani withdrew only 15 crore as a salary. However, the amount he received from cash dividend is massive Rs. 1,240.7 crore. The rationale behind this is that his salary is taxed at 30% while the earnings through dividends

are taxed only at 15%.

Promoter Azim H Premji Mukesh Ambani

Industry Wipro RIL

FY11 (Rs. Cr) 1345.1 1240.7

Rahul Bajaj Anil Agarwal

Bajaj Vedanta

917.4 790.2

Keshub Mahindra

M&M

312.2

Table 1: Dividend earnings of business person in the financial year 2011

This clearly shows the presence of clientele effect. Top managers, who have a final say in dividend policy of the company, have personal advantage in cash dividends which might lead them to incline towards cash dividends.

The proposed change will not limit the gap completely, but will surely reduce the gap.

Conclusion: Tax is one of the main sources of revenues for the Government. Decisions regarding taxes are always given paramount importance during the budget since these decisions set the stage for the economy’s growth during the course of the year. Well aware of these intricacies of taxes, the new government, during its maiden Union Budget has brought in small but effective changes in key policies which would assist in streamlining the cash flows of its treasury.

The small tweak in the calculation of the Dividend Distribution Tax can generate huge revenues to the government. At the first instance, this change gives an impression that it is going to play a spoil sport for the corporates and investors but dwelling deep into this matter, the changes also present an opportunity for the corporates to look out for better growth oriented projects and thereby providing shareholders better returns on their investment by way of capital appreciation. Hence it can be said that in spite of having negative aspects, the positive aspects of the proposed change outweighs the shortcomings of the same.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

21

6th Anniversary Issue A TRYST WITH THE EXPERTS

MR. ASHISH SOOD Deputy CEO, Retail and Private Banking, Ahli Bank, Sultanate of Oman

From the lows in 2008, Assets under Management within Global Wealth Management industry have strongly rebounded across all regions. What has been the growth driver for the MiddleEast nations?

A key factor has been the increase in all process from the lows in 2008 although it has still not reached the peak achieved in the first half of 2008. This has led to increased spending power by the governments; Projects related to infrastructure whether for land or sea, including a first rail track between countries has been announced. With increased spending by the government investor confidence has seen a revival.

Secondly, countries are vying to be promoted as regional hubs given the proximity to Africa, Asia and Europe. Infrastructure is key to the development which countries are investing in, as is hospitality, which is another segment which has seen investment in and is now a key driver for the growth of the nation.

Real estate prices which is on an upward trajectory is also another factor for the investments whether locally, region or from other countries; these however are specific to certain countries and have given a substantial return for investors in the recent past.

Given the above mentioned factors, the region is likely to continue its upward trajectory albeit at a slower pace.

It is assumed that the future will be 24

less about providing standardized products and more about collaboration and providing innovative solutions to clients to meet their objectives and goals. In view of this, what steps Private Wealth Managers are taking to attract clients in emerging market economies?

Absolutely. Given the earlier experiences, in the pre-2008 era, investors have moved away from standardized products and are taking interests in other investable options. However, a large part of investors in the Middle East continue to build and invest in real estate portfolios but directly as owners rather than through the fund route both in emerging as well as developed economies (which has seen sharp price drops ).

In addition clients are now being given options of investment in growing businesses in certain economies; health and education in emerging markets is a safe bet with double digit returns over a sustainable period. Investors no longer want to see themselves as a part of the herd but would rather pay for specialized individual service which is evident from the multiple family offices which have been established; Investments range from buying stakes in high performing companies, investing in hospitality and the digital space as well.

There has been a great deal of reshaping activity as players (private bankers) refocus and restructure their operations to better cater to the needs of the public at large. This was either

August 2014

6th Anniversary Issue

through technological upgradations providing ease of use of the banking services or it was by providing multiple products to the retail customer to fulfill all his needs and act as a one stop financial destination for the general citizen. Keeping these changes in mind, what is the next step that your bank is planning to take to better reach out to the customer?

Banks across the region are moving into a specialized and segmented approach; the concept of one size fits all is no longer the mantra. This is evident from specialized services for segments whether through the relationship management route or through technological changes (different platforms for HNIs).

For being a one stop shop banks it is important to have the right work force – knowledgeable on various aspects of the financial industry, which is one of the places where the banks are investing in (human capital) and we are no different.

Institutes continue to focus on enhancing their touch points – easy access with reduction of customer pain points for which technology plays and important role. Investments are being made in enhancing existing platforms and limiting human intervention – key is for customers to have easy access to their money ; I-banking platforms are key to this – whether it is for interacting digitally with the RM or self -service models.

“Rise of state directed capitalism” Nation-states are seeking to better control their financial systems and the institutions within their borders, as they learn that a global banking system becomes local in a crisis. What approach has been followed by Middle-East banks to deal such situations (with reference to recent Iraq crisis)?

Middle –East banks too have learned from the crises like the rest. Post the 2008 crash , regulators (Central banks and other industry watch dogs) have worked hard at ensuring that a stable environment is followed and put

in place; whether through enhancing capital adequacy ratios , lending ratios, industry specific exposure monitoring (real estate as a percentage of overall portfolio) retail to corporate ratios amongst others. Regulators have also put in place tougher lending norms thus controlling the actual flow of money. In addition, flow of money into the economy is monitored through various measures which has been effective and has had a calming effect on the economy.

Banks have developed remarkably complex and costly business and operating models. Rising customer expectations, increasingly active regulators and stagnant shareholder returns demand for simplification. What re-engineering efforts have been taken by global banks so far to increase profitability?

Banks across the region (and world) have released the need to be innovative and move out of their comfort zone and reach out to consumers. One of the key areas of focus is developing alternate channels, moving from the brick and mortar structure along with centralization of back end operations. However countries differ due to demographics and socio economic factors – certain countries still have greater success in customer experience through branches while others relay on m-banking (mobile, social networking platforms etc). Most banks continue to make investments in non -traditional banking channels and at the same time reducing customer pain points whether it is through instant account, card issuance or reduced and error free processing of transactions.

Regulators on the other hand, while advising caution too are moving into similar directions.

Most of the Middle East regulators are moving to online clearing system – effective, instant cheaper and important safer.

Advances in technology such as digitization, as well as shifting consumer behaviors are disrupting the integrated banking value chain, creating numerous opportunities for innovation and new revenue streams.

For instance, PayPal, Square, and Google

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

25

6th Anniversary Issue

Wallet are challenging traditional card issuers through intuitive solutions that offer unique value. If banks plan to do so, how are they trying to tackle this or are they looking for any partnership opportunities with such players?

Disruption from the norm is the way forward – case in point is Facebook and Twitter .Those who do not innovate have limited survival or shelf life which we have seen in multiple cases; Some of the top companies in the world are fighting for survival in this era of digitalization.

Similarly, banks as well as card issuers / other financial institutes’ world over are partnering with such providers to stay ahead of the game.

Some countries have seen success (mainly those economies which are developed) while it is early days for the others. With the drying up of the earlier revenue streams and low cost of borrowing environment banks have been forced to move to non -interest income streams and fee income is one of the biggest growth for institutes. Traditionally banks have access to a huge amount of customer information and financial health of individual, if mined correctly; these provide immediate access for partners to develop segmented products and higher penetration levels, thus being a win –win situation for both. In future , we will continue to see innovation, multiple new channels of payments and only institutes which adapt and change will continue to survive and thrive.

26

August 2014

6th Anniversary Issue

RELAXATION IN TAX SLAB: A SWEET HARBINGER OR A DEATH KNELL? SWATI PAMNANI & SAKET HAWELIA

IIM Shillong

India is in the midst of the worst economic slowdown since the year of liberalisation, 1991.

The economic growth has been sluggish to say the least and the investor confidence in the Indian economy has taken a nose dive, thanks to the various scams like the 2G Scam, Coalgate scam and the CWG scam which have raised quite a few eyebrows in the international forum with regards to the credibility of the Government of the largest democracy of the world. Add to it, a depreciating currency, rising inflation and a high Current Account Deficit, the Indian economy indeed has hit the trough.

A change was being beckoned and it came in the form of the NDA Government. A lot of hue and cry was raised over the last few months with respect to the new Government and it being pro-industry. Come the month of July, and all eyes were glued to the Union Budget.

The Government had a twin objective, stimulate the savings in the economy and to keep the Government deficit at 4.1 per cent of GDP for 2014-15 and reduce it further to 3 per cent by 2016-17. The expectation of the individual tax payers prior to the budget release was that the

minimum exemption limit on income tax would be raised from Rs. 200,000 to Rs. 300,000 without changing any tax brackets. However, keeping in mind the possible impact of the rise in exemption limit to the probable rise in inflation, the limit was raised to only Rs. 250,000. At the individual level, the exemption is bound to increase the savings of the individuals, however, what would be the impact of such a measure on the Government’s treasury and the twin deficits, calls for a detailed analysis of the measure.

According to The Economic Times, in a population of about 1.2 billion, there are approximately 2.9% of tax payers in India. In other words, there are about 35 million people who pay Income Tax in the country. As mentioned above, the Government of India in the Union Budget of 2014-15 has increased the basic exemption limit from Rs. 200,000 to Rs. 250,000. This implies that from the Assessment Year 2015-16, people in the income range of Rs. 250,000 to Rs. 500,000 shall be taxed at the rate of 10%, increasing the savings of the tax payers by Rs. 5,150 in following manner:

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

27

6th Anniversary Issue

Fig 1: The GDP growth rate of India

Current Year’s Exemption Rs 2,50,000.00 Limit (A) Last year’s Exemption Limit Rs 2,00,000.00 (B) Exemption Benefit (A-B) Rs 50,000.00 10% Tax Rate (C) Sum of education cess 0.3% and secondary and higher education cess (D) Savings ((C+D)*(A-B)) Rs 5,150.00 The savings to the individuals have come at a cost to the Government revenues. Put simply, as a result of the increase in the minimum exemption limit, the loss to the Government revenues for the Financial Year 2014-15 has increased by Rs. 18,025 crores (35 million tax payers * Rs. 5,150 tax saving per individual per annum). The attempt in this analysis is to understand the loss of revenue of the Government merely from the increase in the exemption limit. This loss of revenue is bound to increase if similar mathematics is put behind the following initiatives introduced by the Government to boost the individual savings: • Increase in limit for investment related deduction from Rs. 100,000 to Rs. 150,000 under Section 80C of the Income Tax Act, 1961, and • Hike in Limit for Interest on Housing Loan from Rs. 150,000 to Rs. 200,000 under Section 24 of the Income Tax Act, 1961 Thus to conclude, the Union Government of India stands to lose approximately Rs. 20,000 crores as a result of increase in the tax slab.

The idea of reducing the tax burden on the individual was to increase the individual savings which in turn would lead to an increase in investments as in the ideal case, the savings is equal to the investments.

28

Now, according to the National Income Identity, Y=C+I+G Y = National Income C = Consumption Expenditure I= Investment Expenditure G = Government Expenditure (Y – T – C) + (T-G) = I Or, Private Savings + Public Savings = Investment It is, thus, very clear that on one hand the private savings are going to increase by approximately Rs. 20,000 crores and on the other hand the public savings would decrease by an equivalent amount, bringing about no change at all in the national savings. Thus, using the above model, we repudiate the notion that as a result of the relaxation of the tax slabs, there would be a change at all in the economy as a whole.

Thus, it would not lead to an increase in the investments by an equivalent amount.

At this juncture, it becomes important to understand the significance of the reduction of the public savings in the economy and to ascertain if the increase in private savings can make up for the fall in public savings.

According to the report published by CMIE in

Fig 2: Share of Income Tax in the total tax revenue of the Government for the year 2013-14

August 2014

6th Anniversary Issue

Fig 3: The budget deficit of the Indian Government over the last decade

June, 2014, during the financial year 2013-14, the fiscal deficit of the country stood at a staggering Rs. 508,000 crores! This is equivalent to 4.5 per cent of the GDP (Gross Domestic Product) of India. This means that during the fiscal year 2013-14, the total expenditure of the Government of India exceeded the total revenue (excluding the inflow from borrowings) by Rs. 508,000 crores. The total expenditure of the Government was Rs. 1,560,000 crores, including both the planned and the unplanned expenditure, of which Rs. 1,158,000 crores was financed by the tax revenues generated. What is striking to note here is that the income tax collection had failed to meet its target by approximately Rs. 10,000 crores.

During the current financial year, 2014-15, the Government of India intends to bring down the fiscal deficit to 4.1 per cent of the GDP. Arun Jaitley, in the budget, has set a tax collections target of Rs. 1,364,000 crores (direct tax being Rs. 740,000 crores) for the fiscal 2014-15. The total estimated expenditure for the same period has been set to be close to 1,800,000 crores.

Now, let’s put these figures against the backdrop of Rs. 20,000 crores loss of revenue, as computed earlier, of the Indian Government arising on account of the relaxation in the tax slabs. The following points stand out: • 1.11 per cent (20,000 crores / 1,800,000 crores) of the proposed expenditure could have been financed by that amount lost by the Government • 1.46 per cent (20,000 crores / 1,364,000 crores) of the proposed revenue could have been higher According to the estimates of the World Bank, the Indian economy would grow by 6 per cent in the current fiscal year. This means that the Gross Domestic Product of the country would be USD 1.98 trillion (GDP in the previous fiscal year being USD 1.87 trillion). Assuming that the Government of India would be able to achieve

the fiscal deficit target of 4.1%, it would still need Rs. 480,000 crores to finance the expenditure. In such a scenario, Rs. 20,000 crores of revenue loss would have definitely provided some sort of comfort to the Government. Using the same mathematics, the fiscal deficit of the country could have been 3.9 per cent of the Gross Domestic Product, had no relaxation been made in the tax structure.

India, being a developing country, the 0.2% increase in the fiscal deficit could definitely hurt the economy. A higher fiscal deficit implies high government borrowing to the extent of that 0.2% and a corresponding increase in the debt servicing. This in turn could imply a cut back in Government spending on critical sectors like education, public health and infrastructure.

This would further lead to a reduced growth in human and physical capital, both of which have a long-term impact on economic growth. Large public borrowing also have the potential to lead to crowding out of the private investment, inflation and exchange rate fluctuations thereby impacting the exports of the country.

However, it would be unfair to just look at only one perspective. The other side of the coin would be to have a bottom up approach where we would consider the tax relaxation impact on the economy by aggregating the impact on the individual income earners of the country, who directly stand to gain Rs. 5,150 each.

Now, according to the 2012 Accenture Survey, an average Indian is highly concerned about his financial situation after retirement. This makes him save a considerable amount of his income during his working years. The survey went on to conclude that Indians save 39 per cent of their income annually. This implies that out of Rs. 5,150 increase in his disposable income, an average Indian would actually save about Rs. 2,000 annually; the remaining would go into his expenses.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

29

6th Anniversary Issue

Fig 4: Investment tools used in India

At this point, let’s analyse the significance of this Rs. 2,000 into the Indian economy.

Although, it has been theoretically proved earlier that the aggregate savings in the economy would remain constant as the increase in private savings would be matched by a corresponding decrease in public savings, thereby making the national investments constant; the fact is that more realistically speaking the Government stands to earn a lot more in this case than the original Rs. 5,150. This is because of the multiplier effect that would lead to the multiplication of the savings at each stage and the Government imposing tax at each level.

For example, let’s assume that the individual would put the entire savings of Rs. 2,000 in a commercial bank paying a fixed deposit of 6 per cent per annum. The taxable income of the consumer for the next year would increase by Rs. 120 and that would enable the Government to earn at least Rs. 12 per individual. The total revenue of the Government increasing by Rs. 42 crores. Also, the average net interest margin of an Indian commercial bank is around 3.5 per cent suggests that the profit of commercial banks would rise by Rs. 245 crores.

Fixed Deposit (A) Interest Rate (B) Taxable Income Increase (C=A*B) Tax Rate (D) Government Earning (E=C*D) Total Tax Payers (F) Total Government Earning (G=E*F) Average Net Interest Margin of a bank (H) Profit of Commercial Banks (A*F*H)

30

Rs 2,000.00 6% Rs 120.00 10% Rs 12 Rs 350,00,000.00 Rs 4200,00,000.00 3.5%

The Corporation Tax chargeable would be 30 per cent, bringing an additional revenue of Rs. 73 crores to the Government; increasing the Government revenue by around Rs. 115 crores. (The amount in fact would be more if the salaries of the employees of the bank were to be considered and income tax rates applied to them). This is besides the fact that this would lead to more investments in the economy as the banks would lend the money to corporates facilitating them to increase the future productive capacity of the economy.

Similar calculations could be done for other saving options as well.

Now, as far as the consumption of Rs. 3,150 is concerned, the spending would enable the Government to directly enjoy revenues from indirect taxes such as Value Added Tax (VAT), Sales Tax and Service Tax. Besides, the increased taxable income implies grater purchasing power of the consumers which can be explained in Economics parlance as an increased demand of the consumers, a phenomena where an increased quantity of goods is demand at constant prices. This in turn implies better opportunities for the marketers, especially the FMCG sector, who stands to gain the most. The Government once again stands to enjoy higher corporate tax revenues by charging these FMCG companies.

Now that both the sides of the coin have been thoroughly analysed, one would appreciate that it indeed is a difficult choice to make and to ascertain precisely the impact of this measure on the Indian economy. However, in my opinion the move from the Government was indeed favourable for the economy because no doubt the fiscal deficit could have been reduced had the Government gone for no relaxation in the tax slabs, but considering that India is a developing nation with a considerable number of people belonging to the middle class, the measure would certainly be a sweet harbinger to them, enabling them to better tackle the problem of inflation and price hike. Besides, the increased personal savings and consumption would lead to the creation of greater economic opportunities in the economy, promoting capitalism to say the least. However, only time would say, whether or not, the much hyped “achhe din” is actually around the corner or not.

Rs 24500,00,000.00

August 2014

6th Anniversary Issue

A TRYST WITH THE EXPERTS

MR.CHAITANYA AGGARWAL Founder & CEO, JUVALIA & YOU

Since IPOs in the primary market have dried up in the last few years. So, the exit route for many PE firms has closed apparently. On the other hand there are many startups coming up, which may require lot of funding in the near future. How do you think the current scenario in the IPO market would impact the growth of these firms?

If you look at PE deal flows in the last couple of years, 2013 has been the lowest in terms of deal flows. However, 2014 saw a fair amount of deal flow happening. The largest issue with PE in India is exit and secondly there are two few assets and too many people chasing it. So India became buzzword after 2009. Everyone walked in for the purpose of investment in emerging market but majority of businesses in India is family controlled. PE operates on the premise that they would be able to build the business much faster. That mindset shift diluting control is not happening. Primary markets are more influenced by cyclical behavior and investors are driven by sentiments and there are fools and bigger fools every day. There is no major concern for exits as far as India is concerned because there is appetite for Indian paper. What needs to be seen is that whether the patience plays out? If the view is long term, exit is bound to be there, maybe in the form of PE to PE transaction. VC and startups getting money is a different ball game because risk appetite of Indians are different from that of Americans. In the next two to three years a VC led IPO would be in international space, e.g. Makemytrip, Flipkart, etc. Even in US it took some time for people to understand Amazon.

The online jewelry segment is seeing a lot of action on the ground. Big players like Flipkart, Amazon and Junglee have entered this segment. Also, when Indians make a purchase of such high cost items they would generally want to touch the product. So how are you planning to deal with this perception in India and increase your market share?

Let me divide jewelry into real and imitation.

The touch and feel issue is felt more in the real jewelry segment. In the imitation jewelry space, we have incorporated direct selling or social selling. We have network of over 75,000 stylists. They do style shows like a party wherein touch and feel of products does happen. The customer then can migrate online.

We have gone to mall, created pop up stores and exhibitions in large formats for the same reason. The philosophy behind the brand is that you will create an experience and a great product. A customer understands what a Juvalia product is. Customers are then confident about brand values and brand ethos. Adoption is an issue because first time buyer wants to test and once he is satisfied, he comes back. In so far is competition is concerned, imitation jewelry has everything right for e-commerce. Sizing is not an issue, great volume to weight ratio and therefore returns are not a problem. What one needs to do is to make sure that one is not an aggregator. Juvalia solved that problem by focusing on the brand and it has come out well.

India being a growth country always trades at higher multiples, which is against the tenets of Value Investing.

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

31

6th Anniversary Issue Also, high quality companies usually trade at significant premium in the Indian market. You being a student of value investing, how do you evaluate Indian companies?

I think you have to think about it in two different ways. Value investing does not believe that high growth cannot be sustained, value investing only questions the multiple you place on the growth. It is trying to separate froth from the real thing. That is what value investing is all about. The India multiple will remain at least for the next decade because all the macros point to that. The issue is it is something like saying good Indian company will grow at twice GDP and great Indian companies are going to grow at 4 times GDP. If we guess GDP to be 6-8% for the next 10 years, we are talking about 1530% growth, which in most developed markets is considered hyper-growth. From the value investing perspective, you have to see how much premium you are placing on that. Forget the multiple, understand the underlying value of the business. Is it a sustainable business?

Is there a pricing power? Those are the tenets of value investing you need to look at. How influential our market dynamics on the business.

You have some fantastic Indian companies that have incredible pricing power, that are almost like a monopoly in their particular markets that are growing at 15-30% Y-o-Y and are completely ignored. Everybody wants to invest in HDFC bank, everybody wants to invest in L&T and everybody wants to invest in the large names and play the India story. As students of value investing, we need to ask ourselves what is the next L&T, what is the next HDFC Bank. Can I find an asset which is today undervalued for no apparent reason which tomorrow when price discovery happens (one of the tenets of value investing), that is when the stock becomes the darling of the market and that is when you exit.

A true student of value investing believes that he/she get out when everybody is getting in. So from value investing perspective, I don’t think India multiple doesn’t make any difference, because that is just saying that every company in India is valued at market p/e. Every company in India is not valued at market P/E of 22-23.

There are some fantastic companies which are 32

trading at 10 P/E. Value investing is like making sure you drill down and play your thesis. Once you understand the thesis, you will be able to find some great companies. There are still some good assets which are valued very cheap.

So, for example after Flipkart got $1 billion of investment, the company was valued at $5 billion. Apart from the revenue growth which they see for the next 10-15 years, what are the other things the investors look into before making an investment, because e-commerce is all about revenues since they don’t have an asset base as such? In such a scenario, how does the valuation happen?

There are multiple factors that are considered and growth is one of them. More than that one has to see what is the thesis behind e-commerce. The thesis is that you are not going to go to mall anymore, you are going to shop at convenience, you are going to shop on the go using mobiles, laptops, tablets. The next generation of shoppers is going online and the market size is going to explode. When the market size explodes, how much of that can Flipkart garner is the question in hand. That is the thesis behind what is going on. Today, from the finance perspective, we are going to ask where is the income statement. How do I value a company with negative cash flows, with negative EBITDA and doesn’t look like it is going to get profitable. The short answer is you have to look at terminal value (from DCF point of view).

The terminal value will make the businesses profitable at scale. In the past 1-1.5 years, the markets exploded. Businesses like Flipkart have seen 3-6 times growth on a revenue basis and they expect that to continue. Two things, one a DNA shift how retail is going to pan out, growth and the last aspect is the ability to leverage the website and to create customers, which is very difficult in comparison to adding stores over and over again. There is no capex, everything that Flipkart is opex (Operating Expenses).We need to look at “What is that I need to deploy today to get at $10 billion of revenue”. The answer is “if average revenue per store is X, then so many 1000 stores should triple the revenue”.

FDI in ecommerce is the next big agenda

August 2014

6th Anniversary Issue

on the government’s plate. This would increase the competition in the market and also enable firms like yours to collaborate with internationally experienced firms. How do you plan to take advantage of this development?

It is a positive news for the entire industry.

Fortunately or unfortunately, it has come with some few strings attached. However, this is just a step in right direction and they will open up with FDI. E-commerce is here to stay and there are a lot of foreign funds and there are foreign names who are interested in this segment. It is positive all the way for industry, you will see new investments coming in and people who earlier did not invest in India because of all the regulations because you are a round investor and you need to do a lot of structuring to get investments. Today, that will become a lot easier.

entrepreneur always has to apply the 80-20 rule to separate material from non-material. Research analyst makes you understand that attention to detail is also important. So, whatever you focus on in the 80, you should focus on till the end.

The experience has been fantastic. It has been awesome 3 years till now.

Don’t you think that more and more investments will dilute the control regarding the decisions related to operations?

I don’t think we can never avoid that. The board always has a say in operations. If you are running a business, you need boards and you need investors. Whether it is a foreign investor or an Indian investor, they are going to have a say. They are going to ask you to do things the way they want. It is going to get a lot of talent, it is going to get a lot of foreign expertise, it is going to get a lot of know-how. So, the investor who is sitting and has done the same thing in 10-20 different companies in the US, he/she is going to come and say the best practices to be adopted. Overall, it is positive for the industry.

What are the changes in mindset and skillset you had to undertake to change from a research analyst in the US to an entrepreneur in India? How did your experience as a research analyst after your MBA help you in setting up Juvalia?

I was always an entrepreneur. Research analyst was a very short stint. I wanted to understand how wall-street works and how the game of finance is played out. As a research analyst, I have learnt about attention to detail. An

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

33

6th Anniversary Issue

PSU banks: What can be a likely reversal growth story?

Prakhar Agrawal

Expectations rise when a pro-growth government is formed in the centre. And when it’s Narendra Modi, the much celebrated former Chief Minister of Gujarat in his new role as Prime Minister of the nation, the expectations are bound to be higher. The word is that industries will see a revival in their fortunes. But can our highly stressed Public Sector banks ride this wave of optimism or will they sink in?

Public Sector Banks And Nationalization Public Sector Banks comprise of 26 banks including SBI and its associates. 14 of these were nationalised by the Indira Gandhi government in 1969 amid calls for a firmer grip over the country’s financial sector by the government.

Indian banking industry had been instrumental in facilitating development of the economy since independence. Moreover, these banks had emerged as one of the largest employers and thus, a debate ensued about nationalizing them. In 1980, 6 more banks were nationalised.

Nationalization had a tremendous impact on the banking industry in the country. Signifying the expansion in banking, the population per branch in the country dropped from 64,000 in 1969 to 14,000 by March 1991. The share of rural branches in total scheduled commercial bank branches rose from 22 per cent in 1969 to 58 per cent in 1990. The share of agricultural credit in total non-food credit rose sharply from 34

IIM Shillong

2 per cent before nationalisation to 21 per cent in the mid-1980s, though it fell to 17 per cent by the end of 1980s. The share of small scale and other priority sector advances in total credit increased from 22 per cent in 1972 to as much as 45 per cent at the end of 1980s. In sum, public ownership, the end of corporate control over banks and the turn to social control over banking resulted in dramatic progress in the direction of social inclusion.

Current Problems Plaguing The PSBs Public Sector Banks (PSB) have proven over the years that they are a critical part of India’s growth story. They led the initial growth since the independence till the 90’s when liberalisation took place. In this respect, it is imperative to point out that the PSU banks have been the pillars of the economy in difficult times. They kept on lending during the recession when the private players were trying to rein in their borrowings. But past seems to catch up with them now.

Public Sector banks are faced with problems of catastrophic proportions. In the boom period before 2008, optimistic lending led to increase in unsecured advances and the asset quality backing these loans degraded. A rise in interest rates along with a general slowdown in the economy put pressure on the repayment by borrowers. NPAs have risen and profitability has taken a hit. The Net NPA ratio in 2012-13 for

August 2014

6th Anniversary Issue

Fig 1: Net NPA Ratio in 2012-13

PSBs was 2.02 as compared to 0.52 for private sector banks. Low recovery coupled with higher provisions is forcing them to sell their stressed assets to ARCs (Asset Reconstruction Companies) at low valuations to clear their balance sheets.

Public Sector Banks also face the constant political pressure of going the extra mile on lending to priority sector. Priority sector lending has been a major drag on their finances due to high non-performing ratios in their loan portfolios. Higher exposure to this sector is especially injurious when the government announces loan waivers and other forms of relief to sectors like agriculture which results in borrowers not servicing their loans even if they are in a position to do so.

Capital adequacy requirements for Basel III which have kicked in and will be completely implemented from 2019 are an additional burden. It has been estimated that PSBs require an additional infusion of Rs. 2.4 lakh crore for compliance. The CAR (Capital Adequacy Ratio) for Basel II in 2012-13 was 12.38 for PSBs as compared to 16.84 for private banks.

PSBs have been slow to adapt to technological changes. This has typically been a result of lack of availability of technically skilled workforce.

Adoption and rapid integration of technological processes within banks has become inevitable, more so because of new processes being introduced such as Cheque Truncation System.

A simple example of the urgency showed by PSBs in technology related issues is the recent phasing out of Windows XP operating system.

Even after early warning from Microsoft against hacking attempts as it ended support to the OS

by April 8, many PSBs continued working on the

OS much after the deadline had passed.

Corporate Governance remains one of the key issues plaguing the PSBs. The effective management of these banks vests with the government and the top management and the board of bank operate merely as functionaries.

The ground reality is that the Government performs simultaneously multiple roles in the PSBs, primarily as the owner, manager and quasiregulator. These issues highlight the importance of giving the boards of banks the desired level of autonomy in order to improve the quality of corporate governance in PSBs. Moreover it has been observed in some large PSBs that there is huge fall in net profits and higher loan loss provisions in the immediate quarterly results after a new chairman takes over the reins. This shows a lack of accountability on the part of the board which weakens the health and image of the bank.

Public Sector Banks also have been constantly blamed for the poor quality of services at their branches mainly attributed to the lax attitude of their employees. This coupled with slow delivery mechanism and negligible efforts in introducing innovative banking products has made PSBs out of favour with the general public.

Gone Are The Days For Minor Tweaks; Need For Dramatic Changes There are a hundred problems plaguing the PSBs. But first of all, PSBs need to deal with the biggest problem facing them: tempering the high number of NPAs, attaining adequate capitalisation for future lending requirements and maintaining CAR. This requires an elaborate strategy on operational as well financial recapitalisation fronts. The first step will be to clear the balance

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

35

6th Anniversary Issue sheets through recognition of NPAs instead of rolling over debt. This may be done by selling assets to asset reconstruction companies (ARC).

This step has already been initiated by many of the large PSBs though there has been subdued response from ARCs. As a matter of fact, there has been little proof to suggest that ARCs will be successful in recovering these bad loans.

Nevertheless, banks have been trying their best to part with these assets given the accounting leeway provided by RBI in terms of reporting losses incurred on such sales to be spread over two years.

Secondly, technological changes need to be implemented to generate early warning systems for better management of NPAs. Technological advances will also help in bringing in the transparency in the system to recognize companies and industries giving better returns which may result in increased business with such sectors.

A first-hand experience in this sector also reveals lack of coordination b e t w e e n different departments and cells of the banks which leads to blocking of flow of crucial information.

Thirdly, risk management systems need to be improved in order to identify the complete risks associated with the asset. This step requires vigilance during pre- as well as post-sanction.

Banks have largely been guided by RBI policies on risk management. But it’s time for banks to develop their own risk management systems based on their own experiences while adhering to suggestive RBI guidelines.

Fourthly, large capitalisation needs can be adhered to by going through equity route though I feel that the control should rest with the government. This can be done by diluting stake to 51% by inviting large institutional players. A more radical method which may allow government to dilute beyond 51% can be the formation of a fund on the lines of Japanese 36

companies INCJ (Innovation Network Corporation of Japan) and Enterprise Turnaround Initiative Corporation of Japan. Indian government will hold 25% of the voting power along with 10-25% contribution in total capital (as per the funding ability of the government). Foreign PE firms as well as sovereign wealth funds such as QIA (Qatar Investment Authority) may be invited to invest in these funds. Working on the model of a PE firm, this fund would invest in public sector banks, thereby, looking at improving the profitability of the bank including changing the management of the company if need arises and exiting at higher valuations, thus earning margins for its investors. This will significantly mend the health of the banks while providing them with much needed cash. The concerns of the bank falling in the hands of private investors will 8area where they can introduce products based on the requirements of the public and companies (mainly SMEs and mid-corporates) operating in that area. This will also result in enhanced coverage of rural areas resulting in financial inclusion which is one of the key objectives of the central bank.

The regional banks will also be in a better position to handle competition from the private sector.

At the same time, larger banks will tend to deal with companies with high turnovers.

A tie up between different banks will help in seamless transactions across the banks thereby benefiting the increasingly mobile workforce of the nation. A major argument against this proposition can be the instability caused in the financial system due to failure of one of the larger banks. This necessitates the introduction of adequate risk management procedures as well as interconnectedness of the whole system through IT enabling them to exchange information in real time.

I believe that with the increasing competition and changing environment, PSBs should be given greater autonomy by giving them freedom to frame their own policies and take decisions which enhance the value of all stakeholders

August 2014

6th Anniversary Issue rather than catering to the interests of the government. In the past, government has been known to extract a large amount of cash through dividend route even though the financial condition of the company is not good. This is particularly paradoxical in nature as on one hand, banks require capital and on the other, they are doling out massive dividends which go into the kitty of the government. Also the issue of corporate governance needs to be resolved in order to ensure proper functioning of the banks and curb creative accounting.

Learnings From Private Sector PSBs need to take lesson out of the functioning of the private sector banks which have been consistently performing above par for the last few years. They have focussed on reducing cost of operations by standardizing procedures and keeping their headcount low while improving their productivity. They have been prudent in lending to enterprises and have employed robust risk management initiatives, thereby, aiming for quality of assets acquired instead of quantity. This is evident from the fact that while their business per employee is Rs. 94.06 million (compared to Rs. 127.47 million for PSBs), their profit per employee is Rs. 1.07 million which is far higher than PSB’s Rs. 0.63 million. They have also been first movers on the technological front.

Private Sector banks have also tried to introduce new products tailored to the requirements of the corporates, hence, establishing long term relationships with them. There is a stark difference in the quality of services provided by private sector banks as compared to PSBs. PSBs also need to work on introducing the e-services to consumers in light of the increasing internet penetration in the country. This will not only reduce hassles for the consumers but also reduce operating costs.

Building For The Future In recent years, PSBs have initiated changes which have started yielding results. There has been a significant investment in technological upgradation of the branches by connecting with the central server. But these steps need to be supplemented by continuous monitoring and review for further changes. There have been significant investments in hiring and training of staff with mandatory training in each year for officer level and above. Few of the larger banks have begun the transition from old risk assessment methodologies to new, sophisticated methods to incorporate a wider range of risks associated with the assets.

Given the present state of the Indian economy, there is ample scope for each PSB to post sound performance. With only 55% of the population in the country having a deposit account and a general perception of safety of deposits associated with public sector, there is a huge opportunity which can be tapped by the PSBs. The renewed push for economic development by the current government by fast tracking clearances and initiating new large scale projects will also see the demand for financing rising drastically.

The public sector banks have been major growth drivers for the Indian economy. They have stood firm in a worsening environment and have been the backbone for the growth of various sectors.

Faced with increasing competition from private sector, they have undergone paradigm shifts in ideologies and functioning to compete with their leaner and fitter counterparts. Yet they need to put in vital efforts to emerge as the future leaders of this critical industry. Having the mandate of fuelling India’s growth, they need to develop themselves in accordance with the expansion of the economy and lead the country into its emergence as the next superpower of the world.

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

37

6th Anniversary Issue

A TRYST WITH THE EXPERTS

MR. NIRAKAR PRADHAN Chief Investment Officer, Future Generali India Life Insurance

What are the most important skills that a Treasury Manager must have? Do you think the current B-School students are adequately equipped with the skills to become good Treasury Managers?

The most important skill of the Treasury Manager is to read market conditions and be able to determine when to minimize or maximize risk in the portfolio. At the end of the day, risk adjusted return of the portfolio measures the ability of a good Treasury Manager.

Current B-School students are well equipped with the theoretical aspects of treasury like measurement of risk and performance of portfolio. Whoever is able to translate the theory into application and adapt to the ever changing and demanding environment of a real treasury will make a good Treasury Manager.

Given the fact that FDI in insurance sector has been raised from 26% to 49% and private players have started making profits only recently, do you think that this move of raising the FDI cap will improve the balance sheet position of the private companies? Will this move have a significant impact in improving the position of health insurance in India?

FDI in insurance sector is a welcome step.

Insurance is a capital intensive industry and it takes a few years for an insurance company to achieve break even. Company needs lot of equity infusion during initial years for business expansion purpose. Higher inflow of foreign capital via FDI will certainly help improve balance sheet position of insurance companies especially for those who have started business a few years back and have not achieved breakeven yet. Also, higher participation of foreign players will bring in global best standards and practices and promote innovation in product, customer service, risk management and corporate 38

governance etc.

Real estate investment trusts (REITs) and Infrastructure Investment Trusts (InvITs) will now be allowed to pass on tax liability to investors. SEBI has put out a draft regulation for the infrastructure investment trusts that would provide easier finance to developers of public works. This is expected to reduce the pressure on the banking sector and make fresh equity available. What is the potential of these trusts in the Indian context and what impact do you think this will make in the coming years?

REIT and InvIT are positive steps for real estate and infrastructure sectors by making availability of capital easier. As per news reports, these instruments have the potential to become $20 billion market in India. Even though, it’s too early to comment on the level of acceptance of these products among investors since REIT, InvITs are 2-3 months away from being launched, the potential is large. Apart from providing a platform for raising capital by infra and real estate companies which are highly leveraged, it also gives an opportunity for retail investors to own real estate/infra assets which are income generating.

The unemployment rate in the US dropped to 6.1 per cent in June against 7.5 per cent in year-ago period. Janet Yellen cautioned to be ready for earlier-than-planned rate hikes if the labor market shows further improvement. Following the comment, global markets have turned bearish. How it will impact the Indian debt and equity markets?

The rate hike in USA is expected to come through sometime in 2015. The initial reaction to the rate hike in Indian debt and equity markets may be

August 2014

6th Anniversary Issue negative as a rising US bond yield and a strong Dollar Index might put pressure on foreign capital flows into Indian markets. However, increase in interest rates should be seen as indication of a stronger US economy which bodes well for everyone. Also, with our improving macro situation like inflation, IIP growth, fiscal consolidation and earnings growth, Indian equity and debt markets are more likely to take cues from domestic economic parameters.

There is no significant secondary market for bond trading in India. According to you what is the reason for undeveloped secondary bond market and what steps can be taken by Government of India to enhance the same?

A few reasons why a significant secondary market for bond trading is missing: •There is no uniform trading platform/exchange for bonds •Unlike equities, FII investment is limited in Indian bond market •As investment in fixed income instruments is not very popular among retail investors, the flow of money into fixed income funds (by mutual funds/insurance cos.) is not large •Low rated instruments usually don’t find any takers because of various investment regulations. So companies with low credit rating prefer to take the bank loan route rather than NCD route.

•Many long term funds like pension funds park the NCDs in HTM (held-to-maturity) book to earn a regular income and prefer not to trade We had an extraordinary first half of this year from an equity performance point of view. How do you see the second half of this year playing out, the period of July to December is a short one, but how do you see the equity markets performance in the near term as well as the long term say the next 3-5 years, keeping in mind the already stretched valuations of the markets ?

Equity markets will take cues from geo-political events across the Globe during the 2nd half of the year. At the same time, domestically, state elections, monsoon situation and trend in growth recovery will influence the equity market performance. After a sharp rally, equity markets might take a breather in the near term but in the medium to long term, outlook on equity markets is very positive due to following reasons.

•Growth - The Union Budget aims at bringing

back GDP growth of 7-8% in next 3-4 years •Corporate Earnings - With capex budgeted to go up by almost 19%, sectors like cement, capital goods, banking will see traction in demand and earnings growth is expected to be more than 15% in FY15 compared to less than 10% in FY14 •Increasing FII interest - A stable Govt. at the Centre, push towards a predictive tax regime and reforms such as hiking FDI limits should boost confidence of global investors. Global liquidity flow to Indian markets is expected to stay benign with net inflow of USD 12 bn to equity market in CY14 so far •Attractive historical return - Sensex has given a CAGR return of more than 18% during last 10 years (between Jun 30, 2004 and Jun 30, 2014) and 17% during last 30 year which is one of the highest returns among all asset classes The insurance industry had introduced an innovative product called ULIP in the pre-2008 era to the general public.

This was for the first time a significant amount of the premium paid by insurers was to be deployed into equities and it was thought to benefit the insurers as equity would give better returns over the longer period of the insurance policy. But the main problem of ULIPs, that was very high management fees and other charges coupled with the equity market meltdown, not only made the product perform poorly but also caused many people to lose their faith in Indian insurance companies. Though now, the charges have been reduced, the product has not been received well by the Indian public. What is Future Generali trying to do to revive this product and prevent mis-selling of such products in India?

Even though equity markets didn’t perform between 2008 and 2013 due to various reasons like global financial crisis and deterioration of domestic macro fundamentals, there has been significant accretion of earnings of many companies during this period. With global growth coming back, India’s GDP growth bottoming out, improvement in domestic macro environment and political stability returning at the Centre, average earnings growth of Nifty companies is expected to go up in FY15. Nifty/Sensex has already given more than 20% in this calendar year and going ahead, we are most likely to achieve average return of 15-20% per annum which might turn retail investors’ interest back to equity linked ULIP products. Also, the recent regulation have reduced charges and made ULIP products attractive for investors.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

39

6th Anniversary Issue

Is there any future ?!

Kamal Nagvani & Ramesh Jaiswal

IIM Shillong “In the interest of the prosperity of the country, a King shall be diligent in foreseeing the possibility of calamities, try to avert them before they arise, overcome those which happen, remove all obstructions to economic activity and prevent loss of revenue to the state” (Quotation of Kautilya quoted by the Hon’ble Finance Minister in Union Budget 2009) Goods and Service tax (GST) is aimed at improving the Indirect Tax Reform System of India. It is proposed to replace the current Tax System i.e. Sales and Service Tax (SST) with single Tax Reform for all goods and services in the country. GST fosters to dismantle the barriers between states, to overcome the current barriers of cascading and compounding effects, transfer pricing and value shifting, discourage vertical integration, administrative difficulties, etc. Indian Taxation System is currently mired in multi-layered taxes levied by the center and state governments at different stages of supply chain such as Central Sales Tax, Exercise Duty or Value Added Tax (VAT). Business thus will not have to deal with multiple taxes but will be able to deal with new system in the easy way. This in turn would incentivize the production, trading and supply of services across the states.

One of the reason why GST is important and is being expected to be pushed by the government 40

at the Centre, is the failure on the government side to exercise control on the inflation by promoting the flow from supply surplus to deficient area.

Some arguments also link the importance to GST as a tool to curb the increasing tax evasion in the arena of indirect taxation and beef up the revenue collection of both the federal and the central government by increasing the taxpayer’s base and reduction in the Tax monitoring cost.

The main feature of the GST is that there is tax credit available at each of the supply chain stages. Thus there is value added at each stage right from the manufacturing stage to the each additional stage but tax is to be paid only on the value added instead of the whole amount.

For Example if there is a tax paid on Rs 10,000 at 15 per cent at the first stage then the tax here will be Rs 1500. At the next stage when the same goods are sold at Rs 15,000 then the tax levied would be Rs 2250 but there is a set off of Rs 1500 available so the actual tax at that stage will come to just Rs 750. Hence cascading effect of tax vanishes under GST. The tax is passed on till the last stage wherein it is the customer of the goods and services who bears the tax. Same is the case for all other indirect taxes but the difference under the GST is that with streamlining of the multiple taxes

August 2014

6th Anniversary Issue the final cost to the customer will come out to be lower on the elimination of double charging in the system.

However, the road ahead is not simple, world history tells any transformation in taxation system is difficult to implement, and in a country like India where the states derive constitutional power and are as powerful as the Centre, problems get compounded.

Issues And Road Ahead The Government decided to introduce the Goods and Service Tax (GST) with was supposed to be implemented from April 1, 2010. There was debate on whether to introduce it as a tax only at central level or both at the center and state level.

Originally the finance ministry had suggested a national level goods and services tax (GST) that should be shared between the Centre and the states. After a long debate there are indications that GST in India may be implemented at a ‘dual level ‘ at least to start with. This would entail Central and State level GST. The federal taxes likely to be summed under GST are Excise duty, federal sales tax and service tax whereas State GST would have VAT and other local taxes. Unlike the current regime Dual GST is expected to give the states concurrent powers to levy service tax on a specified list of services.

A dual GST structure may be most suitable given

India’s quasi-judicial structure and political and socio-economic background. However implementing such a regime can be a challenge since India will not have the luxury of learning from a global experience, as only Brazil and Canada have implemented Dual GST system.

The credibility of GST as a superior indirect tax regime can only be established if an overlap of taxes between the Federal and state governments is avoided. This, in turn, would require elaborate but simple rules for clearly distinguishing between the ambit of Federal and State GST. Similarly, the domain of each state would also need to be defined clearly to help ensure there is no ambiguity between different states regarding taxing the same transaction.

Apart from those there are certain state specific issues as well. For example, Maharashtra, earns more than Rs 13,000 crore annually from octroi.

Gujarat, on the other hand, earns about Rs 5,000 crore from the CST. Agrarian states typically with low manufacturing base such as Punjab and Haryana earn more than Rs 2,000 crore from purchase tax. Each of these states fears that they will lose these revenues once these levies get subsumed under GST. The key issue is the rate of GST and it is for a uniform rate across the country so as to enable a common market in the country. As far as the rate of the GST is concerned, in the interest of

Fig 1: GST Flow

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

41

6th Anniversary Issue

42

Fig 2: GST Supply Chain Example

Fig 3: Infrastructural challenges: a huge deterrent

federal structure of the country the same should not be viewed as a single rate in terms of face value. Uniformity for the constitutional harmony should be viewed as the uniformity in rules, compliance, Tax administration and collection procedure and other mechanisms.

If we take a look at the share of taxes of states from the central government’s gross tax revenue as a percentage of the gross domestic product (GDP) at current prices, it is hovering in the range of 2% to 3%. The net resources flow including grants and loans from center to states is considered, it came down from 6.8% of GDP in 1985-86 to 5.2% in 2011-12.

While the gross tax revenue of the center to GDP also was between 8% and 10%, the states’ own tax revenue was relatively more buoyant, improving from 3.6% of GDP in 197475 to 6% of GDP in 2012-13.Therefore sharing at a single rate for states with manufacturing base and with non- manufacturing base would tilt the growth base and it would be difficult to persuade states with strong manufacturing base on the current discussion on RNR(the rate at which the states have same level of revenue at present) and compensatory package. There is a demand from the states that they should be compensated not only for central sales tax (CST) but till cumulative loss up to 2014-15 (13th Finance Commission report).

The RNR (Revenue Neutral Rate) Issue The rate at which the states shall have the same level of revenue as present is a matter of concern as it would completely depend upon the base of commodities, services that can be taxed , more the base lesser RNR and vice versa . The Memorandum agenda of 14th Finance Commission suggests that differences still remain among states over inclusion of items such as alcohol, coal and subsuming levies like Octroi in the GST. There have been number of attempts on side of government and the constituted agencies to arrive at a formulae and consensus for the Tax Base and RNR. As per the estimates of the Thirteenth Finance Commission, the RNR works out to 11%12% (strongly refuted by states and 14th Finance Commission) .This is practical only if the GST base is large which means that the exempted goods list should be narrow.

The list of exempted goods and services is yet to be finalized and it is therefore required that some discretion should be allowed to states especially the states with low manufacturing base.

We can surely learn the implementation issues from some of 150 countries around the world which includes New Zealand, Australia, Canada, Singapore and South Africa, where GST covers

August 2014

6th Anniversary Issue

a broad base of goods and services and also a single rate but considering the significant rate of disparity it has to be modified in the Indian context. Choosing and inefficient model of GST could cost the government serious losses in terms of matters pending before TAX appellate authorities and the increase in the compliance cost across the country.

Legal Issues And Way Ahead The 115th Constitutional Bill, that proposed an amendment of Article 249, was intended to further empower the Parliament to enact laws in the national interest even though GST is not in the state list. This bill is lapsed after it was sent to the Parliamentary Standing Committee (PSC) on Finance.

The Goods and Services Tax Council stipulated to be set up as a statutory body as proposed under Article 279A of the bill, should be given legal backing in the newer version of the bill.

Administrative Preparedness As the assessment and refunds from the existing tax payers will continue even after the implementation, the tax administration is required to be well-equipped to handle both the systems.

A major issue in implementation of GST is the administration of tax through various tax authorities present at the state and the center level. The tax administration at both the central and state levels will have to be augmented to deal with the new tax regime as well as the role out of the old tax regime. Preparing the administration to implement the GST would require considerable effort at building capacity

in matters such as the accounting system, forms and procedures, assessment, auditing and computerization. History is evident that our system has performed very poorly at the cost of growth refer little administrative changes that were made when the Central Vat (CENVAT) at the center, and VAT at the state level were introduced. Accounting bodies and professional institutes should also prepare their members in the same direction to handle the transition smoothly. Fast track solutions mechanism for pending disputes before appellate tribunals could be something that will act as a catalyst in the whole transitional process.

Finally, the new GST needs an accounting approach to monitor compliance. This approach is quite different from the control system currently in place for the CENVAT, which is mainly about classification and valuation defining manufactured goods by reference to some nomenclature, imputing a presumptive retail value to them and applying the tax rate.

But under the GST, the tax is proposed to be based on actual, not presumptive, prices and compliance control would be exercised through checks on books of account. Therefore the mechanism built to inspect and collect taxes should be well informed about the verification and inspection procedures.

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

43

6th Anniversary Issue

Disinvestment: What does the future hold?

B Padmalatha & B Sreenivas

IIM Rohtak

Disinvestment is the action of an organization or government selling or liquidating an asset or subsidiary. It is also known as “divestiture”.

Disinvestment as per SEBI (substantial acquisition of shares) guideline means the sale by the central government/state government, of its shares or voting rights and/or control, in PSUs. The government retains partial control with it and disposes its holding to some extent. One side of the coin is selling of government shares while the other side would be the investment in the government shares by the other party investor. Let us look into Disinvestment much deeper.

The new industrial policy provides that “In order to raise resources and encourage wide public participation, a part of the Government share holding in the public sector, would be offered to mutual funds, financial institutes and general public and employees”. During the first five year plans government possessed 5 PSUs with 44

investment of ₹ 29 crores. At the end of the Seventh Plan in 1990, there were 244 PSUs and the investment in them had gone up to ₹. 99,000 crores. The idea of disinvestment first came in 1991-1992. First only a small share of equity was sold till 2000-2001. During 2000-2001, there are 122 profit making enterprises with a net profit of ₹ 19,000 crores. These include NTPC, ONGC, IOC, VSNL etc. 111 companies bore losses with a total loss of ₹ 12,839 crores. These include Hindustan Fertilizers, the Fertilizer Corporation of India (FCI), Bharat Coking Coal etc. But the growing fiscal deficit and current account deficit will not be bearable for longer span of time.

There is immediate need to tame this gap. The only way out is disinvestment of Public Sector Undertakings. It results in efficient use of resources whereby scarce resources like land, capital and machinery are put to more efficient use. The economy as a whole is benefited by increase efficiency of the units and the fiscal mess is reduced by lessening of liabilities.

August 2014

6th Anniversary Issue Inefficient PSU’s were largely responsible for the macro-economic crisis faced by India during 1980’s although they were set up for the purpose of providing employment and the same time generate revenue surplus. But they could not stand upto expectations.

The new economic policy initiated in July 1991 clearly indicated that PSUs had shown a very negative rate of return on capital employed.

Inefficient PSUs had become and were continuing to be a drag on the Government’s Resources turning to be more of liabilities to the Government than being assets. Many undertakings traditionally established as pillars of growth had become a burden on the economy.

The national gross domestic product and gross national savings were also getting adversely affected by low returns from PSUs. About 10 to 15 % of the total gross domestic savings were getting reduced on account of low savings from PSUs. In relation to the capital employed, the levels of profits were too low. Of the various factors responsible for low profits in the PSUs, the following were identified as particularly important: Price policy of public sector undertakings, Under–utilization of capacity, Problems related to planning and construction of projects, Problems of labor, personnel and management and Lack of autonomy.

Hence, the need for the Government to get rid of these units and to concentrate on core activities was identified. Government also took a view that it should move out of noncore businesses, especially the ones where the private sector had now entered in a significant way. Finally, disinvestment was also seen by the Government to raise funds for meeting general/

specific needs. In this direction, the Government adopted the ‘Disinvestment Policy’.

The core objectives of disinvestment are to reduce financial burden on Government, to improve public finances, to introduce, competition and market discipline, to find growth and to encourage wider share of ownership. Presently, the Government has about ₹. 2 lakh crore locked up in PSUs. Disinvestment of the Government stake is, thus, far too significant. The importance of disinvestment lies in utilization of funds for: Financing the increasing fiscal deficit, Financing large-scale infrastructure development, For investing in the economy to encourage spending, For retiring Government debt- Almost 40-45% of the Centre’s revenue receipts go towards repaying public debt/interest, For social programs like health and education.

Disinvestment also assumes significance due to the prevalence of an increasingly competitive environment, which makes it difficult for many PSUs to operate profitably. This leads to a rapid erosion of value of the public assets making it critical to disinvest early to realize a high value.

Now let us move on to the disinvestment in present scenario. The Rangarajan Committee recommended that the government should retain majority equity control in public sector undertakings operating in strategically important areas like defense and atomic energy. In the rest of the public enterprises, the government could disinvest up to any extent. The disinvestment process, which was taken up during UPA-II was deferred twice in 2012 due to volatile market.

With change of guard at the Centre, Union Finance Minister Arun Jaitley told the Lok Sabha recently that the NDA Government would take up RINL disinvestment along with SAIL and HAL. “We are not convinced with the contention that offloading of government shares will be restricted to just 10 per cent. It will subsequently open the floodgates for total privatization,” said All India Steel Workers’ Federation deputy general secretary D. Adinarayana. A RINL official said the Navratna status to RINL would expire on November 16 before which either it had to be listed or the status extended for a year.

Already it has been given two extensions due to uncertainty in the equity market. Sources told that RINL is expected to submit red herring prospectus to market regulator SEBI anytime for notifying .2, 500/- crore IPO. Roadshows will be held both in India and abroad through the merchant bankers mainly to woo institutional investors.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

45

6th Anniversary Issue Need And Rationale Beyond The Disinvestment: Permitting the entry of the private corporate sector in such core sectors as steel, ports, Airlines, Power and Telecommunication. No fresh budgetary support for public sector enterprises.

This will lead to dilution of government: equity is most public enterprises which decide, in for new projects and expansions and no new central public sector undertakings being set up in the country.

Disinvestment was a very bold and important step initiated by the government as a part of its reform measures. But the way it was handled has defeated its very purpose. The challenges before investment in the areas of social, political, environment and legal are as followsSocial Problem: Process of disinvestment is not favored socially as it is against the interest of socially disadvantageous people and society at large. This process will definitely affect the social objectives of the government.

Political Problem: The coalition government at the centre with a number of parties has posed a serious threat to this program.

Conflicting interest has made it difficult to arrive at a national consensus.

E c o n o m i c Problem: Most of the units identified for disinvestment are in a very bad shape which does not offer good returns.

The Government due to paucity of funds is also not in a position to revive it.

Legal Problem: Legality of the disinvestment process has been challenged on a variety of grounds that slowed the sale of public assets.

However, there were two significant judicial rulings that broadly set the boundaries of the

46

Disinvestment process.

Advantages Of Introducing Disinvestment: It would have a beneficial effect on the capital market, the increase in floating stock would give the market more depth and liquidity, give investors easier exit options, help in establishing more accurate benchmarks for valuation and pricing, and facilitate raising of funds by the privatized companies for their projects or expansion, in future. In many areas, for example, the telecom and civil aviation sector, the end of public sector monopoly arid privatization has brought to consumers greater satisfaction by way of more choices as well as cheaper and better quality of products and services. With the quantitative restrictions removed and tariff levels revised owing to opening of world markets/WTO agreements, domestic industry has to compete with cheaper imported goods. It allows new firms to enter into the market and thus increases competition. It brings the low productivity PSUs back on track thereby improving the quality of goods, eliminating e x c e s s i v e m a n p o w e r utilization and enabling high profits.

Direct Participation of Public-Such disinvestments would enable the public, to participate in the equity of PSUs. Encourage E m p l o y e e Ownership-This would encourage the employees to buy shares of PSUs. This may motivate them to work harder and improve the work culture.

Reduction of Bureaucratic Control-This may provide more autonomy to the management of PSUs. Some Of The Drawbacks Of Disinvestment: Disinvestment of oil PSUs can prove to be catastrophic especially when war clouds move around Iraq, which is a major supplier of oil

August 2014

6th Anniversary Issue products to the world at large. Selling profitmaking PSUs would be equivalent to losing regular source of income to the Government. It will result in the loss of public interests since PSUs are resources of the nation. They belong to the people. By selling them to private companies, government is seriously affecting the people’s welfare.

Chances of foreign control like selling equities to foreign companies can result in serious consequences like shifting the nation’s wealth, power and control to outsiders.

Even though the government wants to disinvest, there are actually less number of people who are willing to sell their profit-making and dividend paying PSU shares. There would be chances of ‘asset stripping’ by the strategic partner.

Most of the PSUs have valuable assets in the shape of plant and machinery, land and buildings etc.

Key Suggestions On Disinvestment For Having A Good Effect on Indian Economy: The government has to form a policy framework for the entire disinvestment process. The government should de-link the disinvestment process from the budgetary exercise.

Government should stop setting up of the targets in every year annual budget and should have a long-term plan. A separate fund should be created for disinvestment and it should be kept under the control of president and the fund should be utilized for building infrastructure and developing the social sector. Timing of disinvestment is crucial and the government should follow a specific method or process in order to reap more chunks. The entire exercise of disinvestment should be audited by not less than two reputed auditing firms in order to have a fair and transparent picture of the entire process. Finally, the government should have an ‘Yearly Action Plan’ which should spell out the activities carried out in that particular year and

at the end of the year an ‘Action Taken Report’ has to be submitted.

Some Of The Recommendations To Be Considered: Actually in the case of Disinvestment, there is a huge chance of less knowledgeable people to be a part of Board of directors where effective decisions are to be made and in that particular situation company may be affected in different ways. In order to avoid such scenarios we need to have perfect knowledge of lead players who bought the shares and if felt that such a huge share stock of his/hers hinders the decisions then they can be bought back.

Another most important situation where there can be possibility of wrong decision making happens when most of the IPO shares were bought by the hostile company, so we basically need to have prior knowledge of persons who are interested to buy most quantitative part of stock in IPO. Globalization has affected our Indian economy heavily and because of which there is a drastic change in the income of the middle class and more over mid-part of pyramid is extending enormously. So this has lead to the interest of middle class people to invest in stock market.

By disinvestment procedure they could get an opportunity to take an active role in economy.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

47

6th Anniversary Issue

WINNERS OF 6TH ANNIVERSARY ISSUE 1st Prize (INR 3000) Udayan Anand IIM Shillong 2nd Prize (INR 2000) Hemalkumar Maniar SIBM Bengaluru 3rd Prize (INR 1000) Swati Pamnani & Saket Hawelia IIM Shillong

CELEBRATIO WINNERS Round 1- Quiz 1st Prize (INR 1000) Team Finsters IIM Shillong 2nd Prize (INR 500) Team Grandmasters IMI Delhi

Round 2 – Epsilon

1st Prize (INR 1000) Team Equipo IIM Shillong 2nd Prize (INR 500) Team Thunnez SIBM Bengaluru

Round 3 –Picture Quiz 1st Prize (INR 1000) Team Kehke Lenge IIM Shillong 2nd Prize (INR 500) Team Finsters IIM Shillong

Series Winner (INR 2000) Team Finsters IIM Shillong 48

August 2014

6th Anniversary Issue

TEAM NIVESHAK Front (L to R): Tarun Kocherlakota, Apoorva Sharma, SC Vellanki, Akanksha Gupta, Gaurav Bhardwaj Back (L to R): Mohnish Khiani, Jatin Sethi, Mohit Gupta, Priyadarshi Agarwal

ALL ARE INVITED Team Niveshak invites articles from B-Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puzzles and jokes 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.1500/- along with a certificate.

Instructions »» Please send your articles before 10th September, 2014 to niveshak.iims@gmail.com »» The subject line of the mail must be “Article for Niveshak_<Article Title>” »» Do mention your name, institute name and batch with your article »» Please ensure that the entire document has a wordcount between 1500 - 2000 »» Format: Microsoft WORD File, Font: - Times New Roman, Size: - 12, Line spacing: 1.5 »» Please do NOT send PDF files and kindly stick to the format »» Number of authors is limited to 2 at maximum »» Mention your e-mail id/ blog if you want the readers to contact you for further discussion »» Also certain entries which could not make the cut to the Niveshak will get figured on our Blog in the ‘Specials’ section © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

49

2014 - 15 UNION BUDGET AT A GLANCE

SMART VIEWS

The Budget demonstrates the new governmentâ&#x20AC;&#x2122;s focus on education, skill development and job creation and is expected to create 5-8 million jobs across sectors. The decision to increase FDI in insurance is welcome as it would generate more entry level jobs and ensure more expertise comes into the sector. The young leaders programme and Rs 100 crore start-up programme for rural youth will encourage homebred innovation and empower the youth.

Budget 2014 reinforces the new governmentâ&#x20AC;&#x2122;s claims for tax reforms and clarity in tax legislation. There are enough consumption boosters as well. It reiterates the fact that it is pro-growth. The FM has announced a fiscal deficit target of 3% of the GDP by 2016-17 from current 4.1%, which indicates that government is keen on fiscal consolidation. It plans to do so, not by cutting down on spending, but through increased tax collections, non-tax revenues and disinvestments.

Arshita Kapoor, XLRI

Ankit Agarwal, IIM Shillong

The much anticipated budget presented by Modi Sarkar lacked details on how the govt. will handle subsidies and engineer greater tax collection without raising tax rates. With the fiscal deficit already reaching 46 per cent of the annual target only two months into the fiscal year, a higher deficit target had been widely expected. By keeping it at 4.1 per cent, the government hopes to establish a firm commitment to fiscal consolidation and a reputation for prudent policy that will reignite investment and economic growth.

Growth Oriented Budget made with a long term vision in place to make India globally competitive.

With incentives in place for infrastructure sector and power sector, the budget is directed towards improving country's fundamentals for growth.

Inclusion of rural schemes has made sure that the major chunk of the Indian society is not left behind in the urge for development. Overall an optimistic but prudent budget.

Srishti Srivastava, SPJIMR

Hardik Shah, IIM Shillong

6th Anniversary Issue

COMMENTS/FEEDBACK MAIL TO niveshak.iims@gmail.com http://iims-niveshak.com ALL RIGHTS RESERVED Finance Club Indian Institute of Management, Shillong Mayurbhanj Complex,Nongthymmai Shillong- 793014

52

August 2014