Discounting India

The country upgrades also celebrate cash transfers, which would loosen the control of the ruling party on government finances

By Mohan Sule

Current stock prices are supposed to factor in about a year’s forward earning. A stock that may look expensive on trailing 12-month earning could be a bargain pick based on next fiscal’s outlook. Yet this conventional wisdom is being severely tested of late. Guidance by companies acts as a trigger to accumulate or exit from the counter without waiting for the actual figures to roll in. Meeting the forecast or exceeding expectation is a signal to book profit. The opposite is considered a signal for value buying. Consider the current run-up of the market despite the stubborn persistence of inflation, plummeting GDP, slowing industrial production and a weakening currency on the inevitably of cut in policy rates. Companies would be able to borrow cheaply and restructure their debt, kick-start stalled projects or undertake fresh expansion. Besides, the rabi crop is also supposed to blunt food-supply shortages. All this could cool price indices in the medium to long run. In the short run, however, softer rates could inflame prices, whose recent rise has been contributed by delayed southwest monsoon and slashing of fuel subsidies. This means the market is running ahead by discounting the imminent tamping of inflation. There could be a sell-off when the central bank actually comes out with data showing the good results of its tight money policy. Similarly, a series of measures by the government to bolster capital inflow has triggered re-rating of India despite the frightening obstacles in execution and percolation.

The increase in the FDI cap in the capital-intensive multi-brand retail to 51% and aviation to 49% was long overdue. Organised retail creates jobs and eliminates tax evasion. Suppliers get assured market. Consumers benefit, too: the responsibility of stocking quality goods at bargin prices is shared by the retailer as well as the producers. Nonetheless, MNCs are worried about issues of dilution of brand equity due to quota for local sourcing. Most states ruled by non-Congress parties are not cooperating in order to protect mom-and-pop shops. The aviation industry is making losses worldwide. If at all a foreign investor shows interest in the Indian space, he will require patience to navigate bureaucracy and negotiating skills to make the airline shed staff. The restructuring package for state electricity boards and distribution companies calls for tariff hikes, when free electricity is the norm. Besides, the transmission and distribution sector will need many years to shake off its debt. Even if the National Investment Board, another remedy to fast-track big-ticket infra projects, does its job speedily, getting environment clearance and acquiring land face formidable hurdles including approval of parliament to make the process painless. The 2-G spectrum auction, which could have made a major impact on fiscal reduction, collected only 25% of its objective. PSU stake sell-off also makes foreign investors happy. The amount mopped up through the offer for sale of Hindustan Copper’s equity, however, is not even 3% of this financial year’s target. The problem is with the low floating stock, which make efficient price discovery difficult. The lukewarm reception is no deterrence due to the cushion of financial institutions. In short, shares of one state-owned entity are transferred to another at a hefty price.

The cash transfer scheme is another move that has impressed foreign investors. The move could indeed be a game-changer but not in the sense the UPA II government is hoping. It is not a giveaway like other welfare schemes, the most significant being the rural employment scheme guaranteeing 100 days of wages to one member of every family. Subsidy will be credited to the account of the beneficiary to buy the product at market rate. So far, PSU oil exploration and marketing companies had to bear the bill. In return, the government compensated them with bonds, which did not fully bridge the gap between production cost and selling price. Now the government has to take the entire burden on its balance sheet. With their bleeding staunched, PSU upstream and downstream oil companies will be able to raise funds to expand, benefiting their shareholders, employers and customers. On the other hand, the higher subsidy bill may force the finance minister to cut down on expenditure. For instance, the proposed food security bill and other welfare measures could be watered down, if not axed. By backing cash transfers, the ruling dynasty has unwittingly, or on fear of getting the country dubbed as junk, let go its hold on government’s finances, used to consolidate its reign. No wonder, rating agency Moody’s and investment banks Goldman Sachs and Morgan Stanley are bullish on India. The next upgrade would be on loosening of government control over bank lending.

Disruptive force

Companies should engage with anti-corruption activists as both depend on the same constituency: the middle class

By Mohan Sule

Countries, industries and companies often have to confront with disruptive forces that challenge the existing equation. Outsourcing has wiped out thousands of blue- and white-collar jobs in the developed world, especially in the US. Brick-and-mortar businesses are fighting the onslaught of e-commerce as the penetration of Internet becomes pervasive. The CEO of Nokia, which till recently was the world’s largest seller of mobile phones, likened the situation his company is facing to an oil rig up in flames as smartphones and tablets upended its dominance. Closer home, Bajaj Auto had to jettison assembling scooters as new entrant Hero Honda’s motorcycles cornered a larger market share. The automobile industry in the US is in a decline since the 1973 oil shock after it did not embrace buyers’ preference for fuel-efficient imports. The labor-intensive textile sector in India is still on life support for failing to adapt to new technology and tastes. Once-upon-a-time leader in the watch segment PSU HMT was slow in responding to changes in consumer preference to viewing watches as feel-good accessories from merely functional timepieces. On the other side, some companies are displaying flexibility to catch the tailwinds. IBM got out of personal computing to focus on the big picture. The domestic drug industry is tapping the outsourcing segment to bypass stiff domestic regulations. The HCL group has successfully made the transition from a computer hardware producer to a leading software services provider.

A typical reaction to disruptive forces is to hunker down, hoping the storm will pass. In the aftermath, companies undergo the three classical symptoms of loss: denial, anger and, finally, acceptance. At the global level, the changes are more profound with the entire edifice of capitalism, of choice, of personal well being put on the block for review. The US electorate has cautiously but surely backed government’s role in determining the way healthcare is going to reach patients, in bailing out sick units like General Motors and Chrysler and Wall Street banks, and in responding to natural disasters like hurricanes. Right now, the Indian political class is in the second stage, after realising that their denial of charges of corruption and crony capitalism leveled by the civil society, led by Arvind Kejriwal, is not convincing the electorate to shrug off the muck-raking as inconsequential. The current strategy seems to discredit the accusers as unreliable and accusations as without substance, and credit unnamed ‘vested interests’ for the campaign of calumny. After pointing to the rot at the top of Congress and BJP, the anti-graft activists’ target of late has encompassed companies, too. Reliance Industries Chairman Mukesh Ambani is supposed to be holding the levers of power in India to the extent of influencing gas pricing and cabinet posts and HSBC is alleged to have acted as a conduit for black money into Swiss accounts. Both the companies predictably have dismissed the charges as baseless. What is surprising is the reaction of some other corporate bosses. Infosys co-founder-turned-philanthropist N R Narayan Murthy sought to put himself at arm’s length from the widening scope of the agitation by noting his charitable giveaway was to help Kejriwal’s apolitical NGO to raise awareness about the Right to Information Act. Contrary to Murthy’s assertion, the Tata group has denied that its social welfare trust gave any donation.

The attempt of Corporate India to distance itself from the anti-corruption campaign demonstrates that company bosses still believe caution is the best defence. It is essential that they engage with Kejriwal as his soon-to-be-formed political party might even hold the balance of power after the next election. Promoters should impress upon him the difficulties of doing business in an environment that encourages party leaders and their relatives to act as facilitators. They should probe the crusader-turn-politician’s views on the economy. Does he want to go back to the past when everything was rationed and subsidised and PSUs were the major job creators? Companies have to recognise that he represents the same constituency that they woo to sell products and services and raise funds: the middle class, whose size is going to explode as India rapidly urbanises. The contradiction should be emphasised: the middle class, which is propelling the ongoing wave of anger against the politician-business nexus, is the biggest beneficiary of the opening of the economy by gradual elimination of the role of government. At the same time, Kejriwal should heed to the advice Secretary of State Colin Powell gave to President George W Bush in 2001 on why the US should not invade Iraq: “You break (the system), you own it.”

Unintended consequence

High interest rates could accelerate the flow of foreign funds from low-yielding developed nations

By Mohan Sule
The market expressed its disapproval of the Reserve Bank of India’s steadfast refusal late last month to lower interest rates. The annoyance was understandable. Besides keeping the bank rate steady, the central bank increased the capital for banks’ restructured standard assets and downward revised the GDP growth forecast for the current fiscal for the second time. Perhaps the apparent contradiction in these positions has escaped the central bank. Low interest rates fuel growth and so also restructuring of loss-making companies, whose numbers increase during a downturn. How can the economy grow if obstacles are raised in the path of these contributors? From the policy composition, it is apparent that Mint Road believes that the major trigger has to come from the Central government and it can at best play a supporting rather than a leading role in scripting the growth story. The finance minister has to share the blame for the RBI’s obsession with inflation, particularly so with polls looming around the corner. His intention to nearly halve the fiscal deficit from the current level in another four years is fine as along the details of the roadmap are spelt out. Not a single rupee was collected from PSU divestment in the last seven months. Yet the market is supposed to trust the government in meeting the Rs 30000-crore target in the remaining period. The other three options — of trimming subsidies further, hiking taxes, and cutting spending — do not look feasible at this juncture. The recent increase in prices of fuels resulted in the walkout of UPA-II ally TMC and renewed attacks from opposition and civil society on the issue of corruption. There is the danger of the economy slipping into recession if indirect taxes are bumped up amid a slowdown. Instead of going down, spending tends to increase on the eve of election.

The inescapable conclusion is that the government is hoping for a gush of foreign funds into retail and aviation and inflows from auction of the second-generation spectrum to balance its spending spree. Why would foreign direct investors want to invest in a country that risks being slapped with a junk credit rating if it does not speedily reform seems to be beyond the comprehension of the policy makers. Against this backdrop, the RBI’s caution looks prudent. The stubborn stand, however, could backfire and create more harm than good. If inflation is the central bank’s core concern, the higher cost of money compared with other major economies, which are holding down interest rates to spur growth, could act as a magnet for hot money searching for better yields and release more liquidity. The silver lining is that high interest rates could achieve what the government has not been able to so far: foreign funds could revitalize the stock markets, boost business confidence to take up stalled expansion, and breathe life into failing companies. This means the Indian economy will no longer act in tandem with the global economy. The decoupling that did not happen post 2008 credit crisis in spite of the domestic orientation of the economy could be in the making now as a consequence of India’s reluctance to fully integrate with the rest of the globe by softening its lending rates.

There are two reasons for this unintended series of developments. First, India imported inflation along with foreign capital during the 2003-07 bull-run, which raised the affluence level. The wholesale price index more than doubled in September 2008 from five years ago. The heating of the economy was largely contributed by the surging prices of commodities. However, inflation in India did not cool down even though the collapse of Lehman Brothers halved it for OECD countries by September 2012. As a result, the gap between the middle class and the poor in India widened, spurring the launch of many welfare programs and preventing policy makers from correcting the fiscal imbalance by reducing subsidies. Together, these developments contributed to more than doubling the fiscal deficit in the four years to FY 2012. The consequence of higher interest rates and increased dollar inflows will strengthen the rupee, making imports and the cost of borrowing for Indian companies cheaper but also boost asset prices, and, in the process, squeeze the government to act. Cutting subsidies is going to fuel inflation in the short term before the impact of narrowing fiscal deficit allows the central bank to reduce interest rates. How long this period will be will depend on to what extent the government goes in slashing expenditure. Chances of the US economic recovery gaining momentum are bright after the presidential elections, providing a fillip to exports and helping in easing the pain of transition to a cleaner balance sheet. So the market should look at the current developments as half glass full.

Double standards

Companies should have to adhere to the same rigorous criteria for borrowing as an education- or a home-loan consumer

By Mohan Sule
Why is that success of some companies trigger skepticism, cynicism and even derision but the failure of some others evoke a feeling of shock, sadness and even sympathy? The first category comprises companies whose dizzying rise is largely due to crony capitalism rather than due to display of gut and daring, which are more likely to be the hallmarks of the second. It almost seems a travesty that the lot that has political patronage seems to be thriving merely because of the fact that the promoters have been lucky enough to be born in well-connected families, who flourished during the licence-raj regime and were favored while granting entry into the emerging sectors. Most of them hold a controlling stake, using government financial institutions and the small investors as supporting actors, to fuel their wealth, ambition and image. On the other hand are the entrepreneurs who are venturing into an uncertain landscape not to burn their cash reserves but to translate a dream into reality by circumventing government regulations, surmounting bureaucratic obstacles, convincing hardnosed private and institutional equity participants, and inspiring the small investors and consumers. Of late, both types of companies are in the news due to the renewed focus on the nexus between politicians and the corporate sector and the torturous deterioration in the health of two companies that were among the showpieces of the post-reforms era.

The hurdles encountered in the rehabilitation of Kingfisher Airlines and Suzlon Energy could compete with any Hollywood thriller for the twists and turns. After each hopeless turn of event, there appears a glimmer of hope that the two companies will get a second shot at survival, only to be dashed by complications arising from global economic slowdown and the resultant volatility in foreign exchange. The problems of the airline and the wind turbine producer can be traced to their accumulation of too much debt to grow. In hindsight, they erred not for aiming too high but in doing so on a shaky base. Though not a first-generation entrepreneur, Vijay Mallya entered the Rajya Sabha to beat the system. His high-cost, all-frills airline indeed filled up a space that arose from the rapidly expanding middle class. Tulsi Tanti set to harvest wind energy as an alternative to the pricey crude oil. Their initial success spurred them to embark on bigger gambles. Mallya’s acquisition of Air Deccan in 2007 was essential as the aviation space was undergoing consolidation to increase market share so as to gain pricing power. By then the dynamics of the industry had changed. The liquidity crunch of 2008 brought renewed focus on the bottom line of the aviation industry that was recovering from the blow of the terrorist attacks on the US in September 2001. As luxury airlines closed or were acquired in the aftermath, low-cost airlines became fashionable. Flyers changed their priority from comfort to convenience. Compounding the problem was the surging prices of aviation turbine fuel, receiving a fillip from China’s growth juggernaut. Soon after Suzlon took on cumulative debt for over US$2 billion to buy two European companies, one in 2006 and another in 2007, to achieve scale, liquidity dried up on the seizure of global financial institutions, with the euro zone particularly hit hard. Acquisitions that seemed sensible became albatrosses.

Should the two companies be allowed to fail? The licence of Kingfisher has been suspended and foreign lenders early October rebuffed Suzlon’s request for extension to redeem their bonds. It would be a pity indeed if they are not extended some sort of life-support system till the global economy turns around. In the meantime, it is time to examine how companies’ ambition to become sizeable players in their market can be tempered with reality. At the outset it is important to impress on promoters that they cannot turn their companies into world-class entities while retaining more than 51% ownership. They have to turn minority shareholders to enable institutional investors to have a greater say in capital expenditure as well as cost trimming on adverse turn of events. Any plan to raise debt more than two times sales or net profit should be approved by at least 50% of the non-promoter shareholders. The Reserve Bank of India needs to set a up a separate cell to monitor the foreign debt of companies as well as domestic lending institutions’ exposure and alert them of worrisome trends that would impact repayment. Importantly, promoters issuing debt should have adequate backup of assets or have a consortium of lenders to throw a lifeline. If the home of an ordinary borrower has to be mortgaged with the housing finance company and an education loan comes only with a collateral of equivalent value, why not create a level-playing field for companies, too?

Sense and sensibility

A two-tier market could strike a balance between growth and social obligations

By Mohan Sule

The Supreme Court’s recent assertion that making policies is the domain of the legislature should go to scotch the increasing concern over judicial overreach. Hopefully, the government would stop abdicating its responsibility of taking unpopular decisions by letting the judiciary take a call. However, the rider that the government’s actions should be motivated by “public good” is open to interpretation. Past experience forms the basis of most laws rather than anticipation of future developments. Regulation to discourage dividend stripping was formulated after its rampant prevalence. Take a recent case that has raised lot of heat. Vodafone of the UK has contended it is not liable to pay capital gain tax on purchase of the shares of Hutchison of Hongkong in the telecom services joint venture with the Essar group as the agreement was executed outside India. The income tax department expected the British company to deduct tax at source while paying the seller. The Supreme Court upheld Vodafone’s argument, thereby sticking to the letter but undermining the spirit of the law formulated to tax gain on sale of Indian assets. The loophole was subsequently plugged by amending the Income Tax Act, 1961, to include earlier deals. Foreign investors raised a storm, forcing a government desperate for capital inflows to rethink the legislation. The proposal to tax entities registered in tax havens has been postponed for a year. This has given rise to two contradictory scenarios. Revision in law was essential to avoid India being viewed as a tax haven and also to tax transactions that had escaped the net. At the same time, retraction from the stand to make the rule effective retrospectively was also necessary to avoid giving the impression that India was a banana republic that tinkered with laws depending on current circumstances rather than to impart stability. Both the stands taken by the government were for the good of public.

Leaving the formulation of the methodology to the discretion of the government, the apex court also ruled that auctions is not always the best method to dispose of natural resources, a nod to the argument that the high price to win gets embedded into the end service or product. In 2008, the winning bids for second-generation spectrum were determined as per a cutoff date, rather than solely on the criterion of financial standing and the value of bid followed in the earlier process. The restriction on number of players per circle was removed. In retrospect, this arrangement seemed to serve the purpose of intensifying competition and pushing down tariffs, which can be said to be for the good of public. Initiating an auction would have limited the number of players. Yet, after a transition phase, auction does look a suitable method to award the right to offer connectivity as users make a leap to the next generation of services. The need is for reliable suppliers with a wide coverage rather than providing patchy network at low cost. This means that the concept of public good is not static but evolves as the complexion of the market charges.

Precisely for the fluidity in its characteristic, the idea of public good is troubling. West Bengal chief minister Mamta Banerjee insists that subsidized fuel is in the interest of public, while the aim of Prime Minister Manmohan Sing and Finance Minister P Chidambaram is to puncture the ballooning fiscal deficit, which forces the government to borrow from the market to pay the producers, thereby hindering the Reserve Bank of India’s efforts to reduce interest rates, which is also for public good. Public good also includes employment generation. Jobs are created when companies undertake expansion to meet growing demand. Capital expenditure will be earmarked when the only risk is market perception and not uncertainty in policy making. There is no point for a generator to buy coal at market rates if the price of power is capped or for a pharmaceutical company to spend on research and development if it is unable to earn a decent profit margin. Besides consumers even shareholders form an important part of public. The challenge is how to balance this conflict of interest. By pronouncing that public good rather than maximization of revenue should be the pivotal of any policy to sell natural resources, the Supreme Court has ushered more confusion than clarity. A practical way out would be too create a two-tier market: one by state-run organizations assigned subsidized resources, so that they can provide affordable services and products; and the other consisting of private players competing for raw materials and consumers based on pricing, quality and service.

Mohan Sule

The countdown begins

It will not be premature elections but the health of the euro zone and the US economy that will drive the domestic market

By Mohan Sule

The UPA-II government’s rapid-fire reforms last fortnight will hasten its end. Even without any major policy initiative, foreign investors had started coming back to India since the beginning of this fiscal, lifting the broad market by nearly 19% till 14 September. Suspension of the General Anti-Avoidance Rules that aimed to tax foreign investors registered in tax havens for one year had improved sentiments. Liquidity injection by the European Central Bank and the US Federal Reserve had boosted global markets. As such the government could have just focused on day-to-day survival without shaking off its policy paralysis. Yet, unpalatable prescriptions such as increasing prices of fuels and opening up sensitive sectors for foreign direct investment were revived. The question is why now when any reform would have exposed fissures among coalition partners at a vulnerable time, with the government under attack for corruption. The first reason could be that the Commonwealth Games and the 2G spectrum and coal block allotment scams have pulled the stock of the UPA-II government to a bottom and nothing else could inflict any more damage. Second, various welfare programs including the rural employment guarantee scheme have boosted income in the hinterlands, as testified by the contribution of these regions to the top line of Indian Inc in the first quarter of the current fiscal, and increased their capacity to absorb small doses of hike in prices of diesel and LPG. Third, by dithering over opening of multi-brand retail to FDI, the Congress was unwittingly protecting the interest of mom-and-pop shops, which constitute the vote bank of BJP. Fourth, two of its supporters, the TMC and Samajwadi Party, have emerged from state elections recently and would not be in a position to fight mid-term polls now due to fatigue, depleted war chest, and a very short window for their policies to percolate to the grassroots.

In the meantime, the feel-good factor unleashed by the structural repairs could even be consolidated, providing Congress a chance to kick the winning goal. By then the various scams would be a distant memory for the voters just as the Bofors payoff did not deter them from giving Congress two consecutive terms. The euphoric reaction of the market has emboldened the government to dust off PSU divestment, another controversial measure, whose suspension was bolstering the constituency of CPM, which had withdrawn support to the UPA-I government after the signing of the US-India nuclear deal three years ago. Meeting the mop-up target of Rs 30000 crore would add fuel to the rally as the government would not have to divert funds from other sources to meet its welfare schemes, thereby reducing fiscal deficit. The success of the first batch of PSUs could also encourage the Reserve Bank of India, which retained the repo rate but reduced the cash reserve ratio last fortnight, to loosen up some more, thereby providing another boost to the stock markets, a winning combination indeed. But at hindsight, the risky gamble looks more like a self-inflicted wound by Congress rather than a masterstroke.

First, the positive impact of employment generation due to increasing the cap in retail and opening of the aviation sector to FDI could be visible over the long term. On the contrary, the adverse effect of hike in some petroleum products would be felt immediately. Second, it would be tempting for the allies of the Congress to distance themselves from the UPA government and covertly co-opt the opposition to precipitate elections before they become closely identified with unpopular but necessary decisions to bring the economy back into shape. In fact, by undertaking the bitterly contested reforms Congress has handed a gift to the opposition, who would be in a position to ride the discontent and at the same time saved from taking these very steps that would have become necessary if they were to form a government after the next elections. Does this mean that all the gains that the market has notched up would be wiped out if polls were to be announced before schedule? Not likely. Even a Third Front government with a regional leader at the helm will find its flexibility for posturing severely limited in the face on high interest rates and slow growth. More than domestic events, the availability of liquidity with foreign funds will dictate market trends. Another favorable indicator is the uncertainty in China. Its export-oriented economy is slowing down with unresponsive Europe and the US. This should keep prices of commodities down for India, with a little help from the appreciating rupee. For all the show of strength, history would judge Manmohan Singh as a reluctant warrior who picked up the gauntlet too late.

Mohan Sule

Tomorrow’s payout

Locking funds in dividend-yield stocks could result in missed opportunities to ride on capital appreciation during a bull run

By Mohan Sule

A slowdown is a suitable time to revisit many conventional theories that drive the market. Many times, themes that seemed logical for the market to assign higher discounting during a bull phase go out of fashion during a downturn. Companies unveiling capital expenditure plans are greeted with enthusiasm by investors as these symbolize confidence about future. Capacity expansion is expected to result in higher output. The spurt in the top line is assumed to pull up the bottom line, too. Turn the page, and fall in capacity utilization haunts shareholders. The squeeze in cash-flow not only affects equity ratios but also the ability to service the debt taken up for organic or inorganic growth. Suzlon Energy typifies the incredible rise and fall of companies accompanying the cycles of the market. At the other end is Wockhardt, which is enjoying a second lease of life following the promoters’ relentless cost-cutting initiatives. The lesson is what is good for a company during a market upturn may prove to be its undoing during a bear phase. Take another favorite investment path propounded when the market has caught the cold: scoop dividend-paying companies as they offer comfort during a period when scope for capital appreciation is limited. Besides, the steady steam of income is tax-free. There are two major pitfalls involved with this strategy. The yield decreases if investors, anticipating a dividend, flock to the counter. Those who go by past record to enter a stock may have to wait till the end of the quarter or fiscal year to pluck the dividend. Second, there is no guarantee that these companies would be able to maintain their operating profit as they are present in mature markets, where gaining share can come at the expense of margin. This is what happened to FMCG companies in the last fiscal.

The absence of expansion and diversification limits the attraction of dividend payers during an upturn. Such companies are in the danger of becoming relics. Apple, the most valuable company in the world, announced its intention to pay dividend for the first time and buy back shares in March 2012. Coming soon after the death of its charismatic founder, the market took the move as an indication that the growth machine had run out of innovative products to launch rather than the company’s desire to return some of the cash pile lying idle. Many big FMCG companies outsource chunks of the manufacturing process to retain flexibility during demand push and slump. The suppliers have to sacrifice on margin as their high-volume clients drive a hard bargain. So there is a strange scenario of big manufacturers accumulating cash to pay dividends while the ancillaries face pricing pressure from the end users as well as rising cost of raw materials. In the process, the smaller units may not be in a position to pay dividends. To ensure that investors get a fair deal, companies in safe-haven sectors should invest in their raw material and intermediate suppliers in sectors such as paper and packing, plastic products, glass, printing, and even metals on one hand and in the distribution chain of wholesalers and retailers on the other. This would ensure that satellite producers benefit from the dividend distribution of their large shareholders, who in turn benefit from the growth prospects of their smaller-size suppliers as the capital infusion would enable to update their technology as well as ensure attention and guidance from their shareholders-cum-customers.

Not only investors, even government loves dividend payers. It collects 16.22% dividend distribution tax, an important source of revenue when dwindling volumes and share prices cause a dent in the securities transaction tax and, importantly, tax on corporate profit. This should be small comfort when capital-intensive companies are unable to service their debt and the queue for debt restructuring lengthens. For a country talking of reaping the demographic dividend of more than half the population below 25 years of age, better to have a universe of companies providing employment opportunities and thus creating a consumer class rather a smallish segment distributing dividends. Supporters of dividends argue that the dividend income is a welcome flow of cash in the hands of investors to splurge on consumption. On the contrary, during uncertain times, investors prefer to lock up cash in debt instruments that offer the security of capital protection and high interest rates due to the strain on liquidity despite inefficient post-tax returns. For companies, repaying debt is much more constraining than raising resources through equity issuance. Time perhaps for government, companies and investors to re-look at the issue of dividends to ensure that the cash utilization is efficient and productive.

Mohan Sule

Puzzling obsession

The fall in demand for gold is the best lesson for the finance minister to stop directing banks on how to conduct their business

By Mohan Sule

In the end, the government did nothing to discourage its consumption. Nor was there any patriotic fervor behind users’ waning interest. Rather high prices contributed to the fall in demand for gold by 20% in India in the June 2012 quarter over a year ago. Continuation of this trend could have a beneficial impact on the country’s current account deficit, easing the pressure on the rupee and, thus, interest rates. The reversal demonstrates how market forces are the best levelers rather than artificial efforts to suppress prices or discourage usage. Taken together with the low tariffs in the telecom services space, it should embolden the government to free prices of natural gas, power, coal, and fuel. This could be the signal for the market to break out rather than cosmetic tinkering with the minimum retail subscription for IPOs, which was recently raised by Sebi to attract serious investors and ensure allotment. This is despite increasing the cap for this category of investors to Rs 2 lakh from Rs one lakh producing no noticeable surge in participation by the small investors. Small investors’ disinterest stems from issuers pricing their offerings richly, leaving little scope for post listing appreciation. Inability to get allotment is due to the large portion (65%) allocated to institutional investors. Prohibiting big-ticket investors from withdrawing their bids would make them choosy and increase the selling expenses of issuers, and prompt them to opt for private placement, preferential allotment or tap the cheap overseas markets.

The flattening of gold consumption should also be a lesson for the finance minister from interfering with companies’ administrative affairs. P Chidambaram has suggested that banks reduce their interest rates on loans for consumer durables and automobiles. According to his reckoning, the resultant demand-push would accelerate GDP growth. As the largest shareholder of PSU banks, the government does have a right to opine on operational matters of state enterprises. So are funds with exposure to listed entities entitled to oppose any move that would hurt minority shareholders’ interest. The brawl between the largest institutional investor in Coal India and the Centre over capping prices of coal is still fresh. Second, the finance minister’s advice amounts to abutting into the Reserve Bank of India’s job of carefully weighing growth and inflation indicators to determine the credit policy. It is perhaps the outcome of the government’s frustration at the central bank’s stubbornness over easing interest rates. Unwittingly, the advisory indicates that the lawmakers believe that the monetary authority has the finger on the trigger for economic growth, unwilling to concede that they too have some responsibility for the slowdown. The bump that the equity markets around the world are receiving at the prospect of a third round of quantitative easing by the US Federal Reserve could have also encouraged the finance minister to think that lower interest rates could move the wheels of the economy. But the demand unleashed by soft lending rates will be temporary and could release inflationary pressures. Consumer durables manufacturers can produce more if raw materials and finished goods can be transported quickly and there is adequate power to run their facilities. A transparent and uniform tax structure will enable them to buy inputs and price their goods efficiently. There is no dearth of capital. The obstacle is the inability of the government to implement policies that would facilitate this environment.

It is time policy makers give up their obsession with interest rates. Heating up of prices is a characteristic of a growing economy and so also high interest rates. It would be surprising if they were not. Instead of trying to choke up inflation by tightening and increasing the cost of money supply, it would be interesting to examine the factors influencing inflation. The two biggest contributors in recent time have been crude and food items. The flow of both is beyond government’s control. Availability of oil depends on the growth of global economy and tensions in the producing regions. Food grains’ output is dependent on monsoon. The predictable response to surging oil prices is to ramp up interest rates in a vain bid to suppress consumption. The collateral damage is increase in the capex cost of companies as investors flee from equities to debt. The minimum support price is hiked to incentivise farmers to grow more and also to ensure that they do not suffer in case of glut. In the process the share of food items in the wholesale price index goes up. This means using interest rates to counter rising prices can prove counterproductive for a growing economy. Instead allowing the market to even out demand-supply, as demonstrated by gold, would ensure flow of investment in the right direction and at the same time keep prices in check.

Mohan Sule

The big bang reform

Growth will hinge on the policy to sell natural resources rather than merely opening up the economy to more FDI


By Mohan Sule

Is more foreign direct investment the only solution to place India in the 9% growth orbit? Not only Indian commentators but even US President Barak Obama has weighed in on this subject. Opening the Indian economy further will bring in the much-needed capital and technology required to match the pace of supply with the growing demand, so goes the reasoning. Infrastructure has been replaced with multi-brand retail, banking and insurance as sectors that could trigger an explosive expansion of GDP. Opponents fear that this would hurt the indigenous industry and proponents cite the many benefits including better access to providers of goods and services. Yet looking at the experience of opening of the infrastructure sectors, it is doubtful if mere FDI is going to boost the economy. Telecom and power are two glaring examples that demonstrate that ultimately it is policies and regulations that would determine India’s growth and not only foreign capital. The telecom sector attracted plenty of FDI till the implosion of the second-generation spectrum allotment scam of 2008. Canceling of the licenses by the Supreme Court and a stiff base price prescribed by the goverment for a new auction on fears that anything less rigorous would invite more controversy have scared foreign investors already apprehensive of India’s red tape and endemic corruption. Thus, a sector that was a showcase of India’s growth potential has unwittingly become an example of what is wrong with India’s reform program.

The two-day blackout in the northern and eastern parts of the country has also shone a light on how Indian policy makers’ balancing act of keeping prices of essentials low so as not to affect the poor and at the same time inviting investment to increase output has failed to bridge the demand-supply imbalance. Investors who want to set up power generation plants not only have to grapple with pricing of the end service and recovery of dues but also contend with securing raw material. This strange situation is due to selective opening up of the supply chain to private investors. Production of coal is controlled by a public enterprise monopoly, while the last-mile connectivity is predominantly in the hands of state-owned distributors. India’s first experiment with FDI in the power generation sector, Enron, was grounded before it could start running, as it fought a two-pronged attack from NGOs accusing it of profiteering by pricing power more than the cost of production and also slamming it for likely damage to the environment. Posco could rank next to Enron to illustrate how political compulsions can derail sound policy decisions. Foreign investors can gauge the investment climate in the country when no less than the prime minister-in-waiting Rahul Gandhi descends into Orissa to anoint himself the representative of the ethnic tribes that were to be displaced by the South Korean steel maker. In fact, the inability of the government to pass a balanced land acquisition bill has done more to hurt FDI than its reluctance to open up the services sector.

The most famous battle for putting a price tag on commodities of late is over natural gas, with the government alleging that RIL is keeping output from its Krishna-Godavari block low and the company indicating that further investment at current pricing is unviable. This must indeed sound familiar to foreign investors in the power generation sector facing coal shortage due to Coal India’s inability to undertake more investment because of price control. In the telecom sector, the scenario is reverse. Very high spectrum prices will mean there will be few operators, depriving users the benefit of low prices that arise from competition. As long as the government was controlling the supply chain of essentials, it could afford to regulate pricing, taking the subsidy on its balance sheet. But the listing of some of the public sector suppliers of scarce resources has disrupted the cozy equation, with big investors voicing their frustration at the government’s interference with market forces. Even if the economy is opened further, foreign investors will come in only if they can make profit. This is possible if producers are given operational flexibility. The rush of players in the telecom sector despite competition spawning discount pricing was in anticipation of eventual selloffs to rivals. The banking sector, which is artificially being restrained (by putting a cap on voting rights) from achieving economies of scale, is in need of capital. Removing restrictions on mergers and acquisitions will turn these two sectors engines of growth. Hiking the sectoral FDI cap is not the answer to economic slowdown. For durability, the solution is releasing the entire value chain from pricing controls and allowing industry consolidation.

Mohan Sule

Keeping faith

Despite lack of reforms and looming drought, the market is not ready to write off the India Growth story


By Mohan Sule

  The contrast could not be more striking. Even as China, the euro-zone countries, and the US Federal Reserve are scrambling to get their economies back in shape by cutting interest rates, putting together a bailout package, and easing liquidity, the attention of the UPA-II government is focused on survival by writing off debt of states ruled by its mercurial allies, putting on hold reforms like FDI in multi-brand retail, or dithering over reducing fuel subsidy. So any hopes of restoration of our fiscal health, which would ease pressure on interest rates and spur investment, have been dashed. No wonder the Reserve Bank of India refused to relent last fortnight. In fact, the first thing that our new president did was to order an austerity drive in his mansion. Perhaps locking up the grounds and shifting to a more modest abode would produce better results. The staff could be dispatched to rural regions for 100 days of guaranteed employment. Pranabda’s symbolic act also illustrates that our policy makers have still not shed the mindset of the 60s era, when industries making profit were viewed with suspicion instead of being encouraged due to their potential to create jobs, stringent curbs were placed on foreign exchange usage to conserve reserves instead of boosting exports by providing a nurturing business environment, and crackdown on public distribution outlets was considered necessary to ensure availability instead of removing mandatory quotas. In fact, some of the quick-fix solutions have proved to be counterproductive. Increasing the minimum support prices for agriculturists every year irrespective of surplus or deficit benefits the FMCG and consumer durables players but incorporates inflation in food prices.

The story is similar in other sectors like energy and fuel. In the absence of freedom to price electricity, investment in power generation is not a lucrative proposition, resulting in chronic outages: The national grid in the north tripped for two consecutive days end of last month allegedly due to excess withdrawal by some states. Many industrial users have circumvented the shortages by spending on captive generation, thereby locking up investment in an activity that is not their core business. Private refiners prefer to export rather than sell to the domestic market at administered prices, leaving PSU oil marketing companies to take on the subsidy and thereby making no dent on usage. Policy makers who cut their teeth in the socialist era need to realise that the solution to shortages in not capping demand but permitting producers to sell at competitive prices, which would boost investment and supply. The issue of putting the country’s finances in order is assuming urgency in view of the famine conditions in four states: Maharashtra, Gujarat, Karnataka, and Andhra Pradesh. The chorus for drought relief will widen the fiscal deficit. The surge in prices of cotton, sugar, edible oils, coffee and rice could blunt the positive effect of cooling crude oil due to tapering of global demand. A prominent casualty will be the banking sector. Not only will paucity of kharif crop stem any softening of interest rates and thereby hurt banks’ treasury income, there will be pressure to write off farm loans or make available cheap credit to farmers.

Besides India will be importing inflation if it buys food grains from overseas, whose prices will reflect the fall in the country’s output. To make matters worse, even the US is bracing for drought, which has triggered increase in prices of corn and livestocks. The rising prosperity in the emerging markets as reflected in demand for protein-rich food was the main contributor to the worldwide spurt in food prices last year. Principal adviser to the Planning Commission Pronab Sen has said rate cuts are not the remedy for India’s growth slowdown. Weak confidence in the economy, and not a shortage of credit, is hurting growth. Many Indian companies are sitting on piles of cash. Some are borrowing cheaply from international markets. Right now the government should be facilitating companies to carry on capital expenditure. What is needed is a stable climate with no surprises. The bizarre happening at Suzuki’s Manesar facility in Haryana is a setback. Perhaps this could be the fallout of the current turmoil going on in the country due to slowdown in economy, resulting in dwindling job opportunities and cooling wages on one hand and heating inflation due to inadequate supply of essentials on the other. Social programs of the government have increased demand for goods and services. The silver lining is the market is holding steady. The BSE Sensex is up 12% in the first seven months of 2012. What it is waiting for is decisive action by the government to break out.

Mohan Sule

In a flux

Apart from economic and industry- and company-specific developments, the market is sensitive to policy makers

By Mohan Sule

Never before has the outlook been so uncertain. Integration with the global economy has boosted liquidity and valuations but also made the market vulnerable to volatility not restricted to domestic events. If the low interest rates in the developed world saw unprecedented foreign portfolio investment during the boom period of 2003-09, the global credit crunch, slow recovery of the US economy, and the fluctuations in the future of the euro zone have turned the market range-bound. The variables affecting stock movements have increased. Besides company-specific projections capable of impacting market performance, earning estimates based on economic growth calculations also contribute to the flux. Projection of hardening of interest rates prompt investors to reduce exposure to automobile and consumer durables stocks, while a depreciating rupee spells opportunities in export-related stocks. Capital goods stocks slip with a slowing economy, which proves to be a boon to the FMCG sector. This cycle has predictability in its occurrence and also the response. Heating up of the economy, as indicated by inflation, stock market indices, and commodity prices, is required to be cooled by ramping up the cost of money, tightening money injection, and even imposing some sort of barriers to control the entry of overseas capital.

The market second-guesses how the central bank would act. Yields on government securities goes up in anticipation and valuations of interest-rate sensitive stocks plateau off. Institutional investors hedge their positions by taking contra bets in the derivatives market to cushion any price weakness in the cash segment. Companies implementing capital expenditure plans suffer on signs of recession in the form of four consecutive quarters of falling growth. Increasingly, the role of central banks around the world has assumed critical importance in investors’ decision making. The Federal Reserve’s resolve to keep interest rates near static till 2014 signalled the timeframe for the US economy’s recovery. Recent rate cuts by the European Central Bank and China’s central bank were a reaction to the slowing global economy, evident from the fall in prices of copper and other commodities including crude oil. Another source of stress in India is budget making. Every year the market displays nervousness or excitement in the run-up, depending on its expectation. It is a mystery why the government has to wait for one year to make major policy announcements when the annual exercise should be restricted to recalibrating tax rates. Instead, the presidential speech can spell out the agenda for the ensuing session. Even the tax rate can be kept stable and uniform for a longer period. The Direct Taxes Code, requiring three-fourth votes for any alteration in rates instead of a simple majority necessary to pass the finance bill, and the Good and Services Tax would have achieved this feat.

Not only economic indicators, the market also factors in expected political developments. Investors display withdrawal symptoms if polls suggest election of a populist government. The expected win of a socialist candidate in France’s presidential election and left-of-the-center party in Greece caused a temporary liquidity freeze around the world. As if these routine disturbances do not make the already complex life of an investor more confusing, there is a new kind of uncertainty. It stems from abrupt changes in policies, applying brakes to the reform process, or reversing some of the entrenched decisions. The unexpected springing up of the General Anti-Avoidance Rule in the last budget and retrospective amendment in income tax laws on transfer of foreign companies’ Indian assets, rolling back 51% FDI in multibrand retail, and the Supreme Court’s decision to cancel 2G licences allotted in 2008 and the inability of the government to take a call on the base price for the 2G spectrum auction could be included in this category. Similarly, the eruption of the scandal involving about 20 banks in the US, Europe, Australia and Japan in rigging the London Inter-Bank Offer Rate used to borrow dollars for three months, threatens to shake up the foundation of the financial services industry, which has been recovering from government bailouts after the collapse of Lehman Brothers in September 2008. The most wrenching aspect is the alleged involvement of the British government, which wanted to keep interest rates low, in brining pressure on Bank of England. Increasingly, investors not only would have to be bothered about promoters diluting their stakes or equity but also the shift of ministers in the cabinet as was evident by the market’s spurt after the resignation of presidential candidate Pranab Mukherjee as finance minister.

Mohan Sule

On the menu

The new finance minister has to revisit the subject of IPO selling and PSU divestment to revive investor sentiment

By Mohan Sule

All the fat-cat US CEOs sacked for non-performance must be looking at the presidential election in India with shock and awe. Only if their boards were as compassionate as Congress party’s High Command to factor in the woes of the euro zone or the slow recovery of the domestic economy for their under-performance. Pranab Mukherjee’s promotion or golden handshake, depending on how his shift from the North Block is viewed, is as astounding as his appointment as finance minister. Even US Secretary of State Hillary Clinton had wondered then: To which industrial group is he beholdened? His legacy is a heated economy (inflation 8.1% per annum end of March 2012 as against 3.8% in 2009-10, the year he took charge), a cooling IIP (down to 2.83% from 5.29%), a weak rupee (losing around 20%), slowing growth (GDP expanded 6.5% last fiscal from 8.4%), and sparse presence of foreign portfolio investors (with FII net equity investment nearly halving). The President-in-waiting also undermined the autonomy of various regulators by setting up an umbrella body, chaired by him, apparently for better coordination but probably to keep a cap on activist bosses like C B Bhave, who doggedly followed the stock market trail even to big companies and tamed an unruly mutual fund industry. Under his watch, a high-ranking official of the Securities and Exchange Board of India had to seek the prime minister’s intervention against the finance ministry’s interference, unwittingly shining a light on the working of the capital market watchdog. The bottom line, however, is the finance minister can be as good or bad as the government he represents.

There is no better way for Manmohan Singh to ride into the sunset in 2014 by gifting Sonia Gandhi a healthy economy and, consequently, a majority of her own. The scope for rate cuts and fiscal stimulus is tied to inflation. Withdrawal of fuel subsidiary has to be calibrated so as not to ignite inflation. In the meanwhile, the new finance minister needs take up steps that could restore the faith of foreign investors in the immediate term. The logic that India should not be considered a tax haven is valid. The law to tax capital gain on foreign investors’ assets in India should have been implemented subsequent to the passage of the finance bill. Doing so would pave the way for Vodafone’s India unit to go ahead with its mega IPO, thereby reviving the primary market, which should be the utmost priority of the new dispensation. This can be done by two ways: providing tax-breaks in the secondary market and evolving new rules in the primary market that would be fair to both issuers and investors. The latest budget has scaled down the securities transaction tax by 20% for cash delivery. The STT should be scrapped for small transactions of, say, less than 500 shares per company. This will boost the popularity of the Rajiv Gandhi equity savings scheme, incentivising the small investors to enter the market directly instead of depending on fund managers. Similarly, short-term capital gain tax can be sliced from the present level for small-volume trades.

A debate is on whether a change in the way IPO shares are sold would insulate investors from drubbing. The provocation is the post-listing debacle of Facebook’s IPO, blamed on its lead underwriter Morgan Stanley revising upward the price on the eve of the offer to capitalize on the hype surrounding the social network. The issue is how to bring back retail investors, left out in the cold as book building centers around demand from big-ticket investors. The Dutch auction, where investors bid for shares at prices deemed appropriate by them, is no solution as it gives institutions an upper hand due to the large size of their orders. Discounts to ordinary investors on the price offered to wholesale investors have not proved to be effective as most issuers want to debut in a bull market to stock up their premium reserve. A radical method would be selling retail investors’ quota at a fixed price linked to the book value or networth. Funds should be required to place bids at this floor price. Perhaps the quickest way to revive the market would be to put PSUs on the block. Some15 state-owned enterprises have been identified for divestment this fiscal. The problem is that the basket is not of uniform quality. Some PSUs have other government entities as their major customers, while many are under pressure from market forces to shape up. An alternative would be to create special purpose vehicles to buy shares during divestment instead of seeking bailout by LIC. Listing of the SPVs, representing a mixed bag of underlying assets, would hedge investors from non-performance by a few with gains from those benefiting from the India growth story.

Mohan Sule

The fifth estate

Foreign investors may achieve what the anti-corruption movement has not: forcing this runaway government to become accountable


By Mohan Sule

Foreign portfolio investment is a double-edged sword. For small investors, presence of foreign funds imparts assurance that the company is on the growth path and the transparency levels are high. The management also turns cautious, avoiding taking any step that would antagonize this class of investors. On the flip side, foreign investment pushes up valuations. Many times, events back home influence the decision of these investors to exit from stocks rather than any company-specific reason. They also create an invisible pressure for companies to set ambitious goals, which may not always be possible to attain. In such a case, the punishment is swift, with heavy withdrawals affecting sentiment towards the stock. Before the opening up of the economy early 1990s, LIC and UTI were the movers and shakers of the market and their misuse by government has been extensively documented. But even these state institutions are looking puny in terms of the sheer size and scale of foreign equity inflow into the Indian market. The presence of foreign investors has spread to mid-cap stocks, too. As a result, overseas investors exercise far more influence on the Indian market today than before liberalization. An offshoot has been the government’s diminishing power to influence the market by direct interventions. No doubt, budget, fiscal stimulus or policy rate cuts by the central bank do create an impact. Yet global events tend to overshadow them. The domestic market was affected by the liquidity crisis of September 2008, with the Reserve Bank of India scaling down the growth to 6% for 2009-10 from 8% in 2008-09.

The side-effects of the credit crunch were visible in markets around the world but India was particularly vulnerable because of the shallow retail investor base. Foreign investors are assumed to reward or shun companies that succeed or fail to operate in the environment created by the government. Some sectors and companies are favored or bear the brunt more than the others. A wholesale stampede to enter or exit, however, pivots around government policies rather than across-the-board performance of companies. In fact, correction is viewed as an opportunity to enter long-lusted stocks, thereby offering support to the market. Ramping up of interest rates to control inflation does induce selling and halts the bull-run but does not provoke panic reaction. Attempts to dictate the market by tightening control over inbound or outsource of foreign funds can. The Asian tigers, as these countries were fondly called for their explosive 8%-12% growth, became the target of foreign investors’ ire when Thailand in July 1997 allowed its currency to float to attract overseas funds to service its mounting foreign debt. On the other hand, Brazil in October 2009 announced a 2% tax on foreign purchases of fixed-income securities and stocks to prevent its economy from heating. Both measures resulted in flight of foreign capital. The Far Eastern countries lost the momentum they had acquired, subsequently ceding their hot-button status to emerging economies like China and India.

India seems to be facing similar problems. Once tipped to rival China, everything seems to be going wrong now: unmanageable inflation, ballooning expenditure, rising import bill. On top of this, the government annoyed foreign investors with retrospective amendment to tax capital gains on transfer of assets in India and by intending to bring those registered in tax haven Mauritius under the tax net. The rupee nose-dived as foreign investors decamped. The government had to roll back the implementation of the General Anti-Avoidance Rules for one year. The prime minister has decided to focus on infrastructure projects to boost foreign investment. But loosening government hold on the economy and creating a level-playing field to attract long-term foreign investors to help in creation of jobs would balance the negative impact of withdrawal of subsidies. Otherwise, the country has to face social unrest. Street riots forced Indonesia’s President Suharto to step down after 21 years in power a year after the currency turmoil in the region. Therefore, what the anti-corruption movement has not been able to achieve so far, foreign investors are likely to: putting the government on notice that it cannot play with the country’s finance to perpetuate its rule by plundering the nation’s treasure to hand out freebies. If that happens, the country’s sovereign rating is reduced, signaling flight of capital, debasing the nation’s currency, and leaving a big gap in the current account. Thus, foreign investors will be increasingly viewed as the fifth estate after the legislature, executive, judiciary and media, with their ability to force a runaway government to become responsible, thereby taking an important step towards stamping out corruption.

Mohan Sule

Three mistakes

Populism without reforms, failure of PSU divestment, and targeting foreign investors to mop up tax revenue


By Mohan Sule
The more things change, the more they remain the same. Rewind to Indira Gandhi’s Garibi Hato days of loan melas. A ‘foreign hand’ was blamed for the people’s wretched life under the Hindu Growth Rate. The remedy? Nationalisation of banks and increasing government say in running businesses, be it issuing licences for new capacity, determining bosses’ pay or releasing foreign exchange. Unwind to the present day of Sonia Gandhi’s loan write-offs, rural employment guarantee scheme, and the proposed food security bill. Inflation, slowing growth, and debasing of the rupee due to flight of foreign capital and costlier imports are attributed to the euro-zone crisis. After nearly eight years in power, the government notes that petrol is deregulated but forgets to add that it had abandoned the practice of fortnightly price revision, initiated by the NDA government, which resulted in small doses of ups and downs in retail prices. The bottom line is that the nation is paying a heavy price to keep the UPA II government afloat. Looking back, of the many mistakes that the Grand Old Party committed, three stand out. The first is acting on the insecurity that this might be the last chance it has got to govern. As a result, the party that was willing to let its government collapse on the US civilian nuclear deal was afraid of offending its partners on various issues including 51% FDI in multi-brand retail and 49% in insurance, removing the cap on voting rights in banks, and increasing railway tariffs. The land acquisition and mining bills are embedded with anti-business bias in terms of valuation and royalty payment.

The ripple effect of these short-sighted policies is being felt not only on investment in the power sector — problems in buying land to set up plants on one hand and in acquiring coal blocks on the other — but also in the manufacturing sector. In its second term, the Congress is already occupying the left-of-center space vacated by the Left parties, shedding off any pretense of being centrist. Initially, most of the posturing was with an eye to the Uttar Pradesh elections. Hence, the compulsion of coalition politics that Prime Minister Manmohan Singh has bandied about in justification of the scam in allotment of second-generation telecom spectrum in 2008. All these populist stances could have proved to be aberrations and corrected subsequently had the vigorous campaigning of Rahul Gandhi paid off. In fact, the strategy has boomeranged, with the party retaining its miserly seat total in the state and also facing the prospect of increasing dependence on regional satraps to form a government after the 2014 elections. The second error of judgment was the bet that PSU divestment would bail the government out from the fiscal mess caused by increase in spending on social schemes and subsidies to the oil and fertilizer sectors. The calculation was that PSUs would be attractive investment propositions due to their monopoly status. The first blow to the myth was in the form of lukewarm response to the ONGC follow-on offer due to the high price combined with the auction method implemented for the first time since its introduction.

The fact is foreign investors are wary of buying into a company that is sharing the subsidy burden of downstream refineries. The vocal opposition to the Central government’s direction to Coal India to sell its products cheaply to power plants is the beginning of the end of days when big-ticket foreign fund managers would meekly buy into PSU shares. With the divestment proceeds falling short of the target and non-plan expenses ballooning, the finance minister resorted to raising indirect taxes in the budget, contending that these were being restored to their pre-2009 stimulus level. This upward revision would have not caused a flutter if the economy were firmly on the growth path and inflation under control. In a slowing economy, the temptation of increasing taxes to compensate for the fall in revenue due to sluggish industrial activity is always strong. But this proves self-defeating as the move contributes to inflation and further slowdown in sales. Compounding the problem is the third mistake of amending the income tax laws retrospectively to tax capital gain arising to foreign entities on transaction of Indian assets and plugging the tax avoidance loophole exploited by foreign investors by registering in Mauritius. As has been time and again demonstrated, besides hard numbers, the market also runs on sentiment. And the perception is that the UPA government is unable to think out of the box and going back to the days when getting rich was looked at suspiciously and helping the poor meant handouts instead of inviting investments.

Mohan Sule

In search of a theme

Post the timid listing of Facebook, no sector is emerging as a forerunner to catch investors’ fancy

By Mohan Sule

The market runs on sentiments. During every cycle, it latches on to some theme to justify the expensive valuations assigned to certain sectors and companies. Late 1990s, eyeballs rather than cash-flows were used to determine the pricing of dotcom shares. The focus was firmly on India’s back-office tech support services industry following its contribution in the smooth transition to the new century, dispelling apprehension about the global economy coming to a halt due to the Y2K scare. Subsequent to the inability of the dotcoms to live up to the hype, public sector enterprises were the next fad as the NDA government set up a divestment ministry to dispose of these entities through offer for sale or strategic sale. In 2004, the UPA government, propped up by Left parties, promptly disbanded the ministry, signally the end of the PSU story. India, meantime, was discovering mobile telephony and investors were going giddy over the market size. The beginning of the bull phase mid 2003 also triggered real estate companies’ rush to enter the capital market. Forgetting the lessons of the dotcom bust, analysts were measuring land banks to justify the pricey offerings. DLF’s mega IPO and its inclusion in the Sensex left no doubt about the obsession of the market with companies constructing residential and commercial units. Armed with their cash-chests, property developers eyed telecom, hospitality, retail, and other unrelated ventures.

After being shunned for their loose supervision and practices during the securities scam of 1992, banks, particularly in the private space, came back in fashion as they aggressively expanded their balance sheets, lending to the real estate sector on one hand and catering to the needs of the growing middle class by liberally disbursing home and consumer loans and credit cards on the other. Following the opening up the sector to private investment as well as public-private partnership, infrastructure became the flavor of the season, with Reliance Power’s IPO becoming the largest issue in the primary market till then. The going was good, with the market awashed with unprecedented liquidity due to the US Federal Reserve’s loose money policy. The Sensex crossed 21,000, sometimes surging 1,000 points in a few trading sessions. The inflow of foreign investors boosted the Indian rupee to 45 a US dollar, which was considered its fair value. The strength of the currency emboldened many Indian promoters to borrow in foreign currencies and acquire overseas targets. In the euphoria, few noticed the cracks that had started appearing. The first was the drying up of liquidity in the US and Europe as house prices crashed and financial institutions with exposure to mortgage-backed securities discovered a big hole in their balance sheets. Lehman Brothers, the fourth largest investment bank in the US, went into bankruptcy in September 2008. The scam of allotting second-generation spectrum to cronies of the telecom minister at throwaway prices has turned the sector, battered by tariff wars, unattractive. The crash in the value of the rupee offers small solace to the IT sectors, whose margin is being squeezed by the slow recovery of the US economy. Even forays into Europe was not much of help as the region is grappling with the huge debt accumulated by some members.

Real estate companies are disposing non-core assets to stay liquid and so are retailers, touted as the next big emerging sector. Banks are confronting rising bad debts and trying to shrink the balance sheet as inflation caused by rising demand for food and inflow of foreign funds forced the Reserve Bank of India to raise interest rates. The additional provisioning of capital to adhere to new global standards will contribute to the sector’s volatility. Investment in private banks is hobbled due to cap on voting rights. The power sector is still to take off due to unavailability of coal and failing health of its key consumer, the distributor, comprising mainly the state electricity boards. PSUs are facing irate foreign shareholders for subsidizing products. On the flip side, the listless market is putting off the government from pursuing an aggressive divestment program. Even large caps are not offering any solace. RIL and the government are engaged in a tussle to determine whether the falling output of gas from the company’s offshore blocks is due to miscalculation or deliberate. For a time, tech companies seemed poised for a comeback. But the post-listing performance of discount web site Groupon, business networker LinkedIn, and particularly of social interactive platform Facebook’s US$104-billion IPO last fortnight appears to have put a premature end to the story. If there is a theme at all for the market today it seems to be pizza chains. No wonder the finance minister has offered tax relief for preventive medical check-ups

Mohan Sule

Pulls and pressures

Foreign investors are demanding consistent growth as well as socially responsible behavior from companies


By Mohan Sule

What do investors want from a stock? Those who are risk-averse would prefer companies in mature industries despite their sluggish growth as against the unknowns. The other category would be of investors not afraid of opting for stocks in the emerging sectors, content in holding the shares for a few years for those bumper gains down the line. Buying low and selling high would be the strategy of those who look for a steady source of income from the stock market. Whatever maybe the appetite, almost all investors would examine the trailing track record of the company, outlook for the sector, how the promoters are going about exploiting opportunities and executing projects in hand, amount of loans, cash-flow and reserves, and payout record. While some may be wary of companies accumulating debt to fund expansion, others would be happy if there is no foreseeable equity dilution. Most would be satisfied as long as the company continues declaring healthy numbers, preferring to sidestep issues such as its role in preserving the environment or absence of any meaningful giveaways to society. Of late, however, an intangible parameter is growing in importance as a measure against which a stock is judged fit for investment. This is a nebulous concept called corporate governance. It comprises a whole gamut of criteria including the number of independent directors, the tenure of auditors, transparency in disclosures, and even social responsibility. For instance, large investors are known to shun certain sectors where bagging of contracts involves much more than just bidding despite the ability of stocks in these high-growth areas tend to outperform the market handsomely during good times.

Aware of the risks and stigma associated in such kind of wheeling-dealing, the US Congress has banned its companies from underhand dealings to secure overseas orders. Walmart shares tumbled on revelation that it had paid bribes to expand business in Mexico. Sometimes activists shame a company to improve its governing practices by launching a vociferous campaign through the social media. A series of critical reports in the US media on the eve of launch of the newest version of its tablet had Apple scurrying to improve employees’ working conditions at its main Chinese component supplier. A few years ago, some western cloth labels were at the receiving end of consumers’ ire for sourcing garments from Indian vendors employing child labor. The US government is currently probing if retailers of digital books in collusion with publishers are keeping prices high. Recently, public sector undertaking Coal India was under pressure as a presidential decree forced it to sign a fuel-supply agreement with power producers to supply coal at subsidized rate, a move not viewed kindly by the largest non-government shareholder, The Children’s Fund of the UK. The fund contended that the company’s decision not to increase coal prices was against the interest of the minority shareholders. This means that what is good for the shareholders of a company need not hold true for its consumers and vice versa.

Of late, even Infosys Technologies has been in a spot of trouble not only because of concern over its outlook due to the slow recovery of the US market, its major revenue stream, but also over the result of the US Department of Homeland Security investigating the company’s alleged misuse of visas. Considering that the software services exporter is held as an example of probity for rest of Corporate India to emulate, the charges are indeed disappointing. Yet, the issue also calls for introspection. Companies increasingly are coming under pressure from institutional investors to notch growth quarter after quarter. Holding too much cash is criticized and pressure is mounted to return it to the shareholders or utilize it to grow. At the same time, taking on debt in the quest for expansion or diversification weighs on valuation. The same set of investors is ready to pounce if companies stray into high-growth areas where there is too much competition or which requires extracurricular skills to pry open. The backlash against real estate developers using their cash pile to venture into telecom, both sectors are tightly controlled by government, to grow as well as a hedge against uncertainty in their main areas of operation, could be held as an example for companies to stick to their core competency. But the Infosys case shows the dangers of this strategy. How companies navigate this era of 24x7 news cycle, Twitter, and Facebook would determine their ability to please all investors all the time.

Mohan Sule

Debasing gold

As surging imports threaten our fiscal health, time to make holding the yellow metal costly



By Mohan Sule


Among the many shocking statements made by the finance minister during the recent budget speech was the revelation that gold imports surged 50% last fiscal, contributing in no small measure to the current-account deficit. Gold imports totalled US$ 60 billion as against US$ 150 billion of crude oil imports in 2011-12. The current-account deficit widened nearly 38% in April-December 2011. As ornaments constitute just 15% of our exports, it is obvious that most of the imports are used for domestic consumption. Yet the budget’s proposals to double customs duty on 99.5% purity gold to 4% and excise on refined gold to 3% to cool down purchases have been met with stiff resistance from jewellers. The finance minister has not only promised a review but has allowed Titan Industries to bring in gold directly instead of routing it through MMTC, the canalizing agency responsible for nearly 25% of India’s gold imports. Thus, there does not seem to be any serious application to discourage local buying. Of late, the yellow metal is being increasingly viewed as an investment option, particularly after the collapse of Lehman Brothers, when investors’ confidence in the dollar got shaken. Also, the quantitative easing that followed the credit-crunch crisis fuelled inflation, depreciating currencies and pushing investors to aggressively corner gold. No wonder gold has appreciated 100% in the three years from September 2008 and nearly 35% in the last fiscal. Capitalising on the fear of an uncertain future are gold exchange traded funds. These schemes have returned around 29% as against the Sensex’s loss of 10.77% in the year to 20 April 2012. Lending institutions are contributing to the gold rush by allowing jewellery as collaterral.

Consequently, gold’s role as a hedge against inflation and a safety net in volatile times is becoming more pronounced. At the same time, the increasing demand is threatening the health of the nation. Money that can be effectively used by the capital market to create liquid wealth and employment opportunities is getting locked in an unproductive asset. It is time to declare a fiscal emergency and tackle this problem head-on. What can be done? The cap on baggage gold was relaxed in 2006. Passengers can sail through 10,000 gm of gold once in six months by paying just Rs 250 per 10 gm. The easy availability has made smuggling unremenurative but not dimmed gold’s luster. On the contrary, consumption has increased as the global economic turmoil has necessitated diversification of portfolio. A radical solution would be to allow duty-free imports. In the short term, there will be spike in landed gold. To stem the outflow of foreign currency, an export commitment of equivalent or double the value of imports could be imposed. The proposal would not only be exchange-neutral but also give rise to a vibrant secondary market for gold credits, boosting export-oriented units’ revenue. This would be similar to polluting companies buying carbon credits from those employing clean technologies. Other measures could include the government buying back gold and issuing tax-free bonds at a coupon 1%-2% below prevailing government security yields. This, however, would open a channel to bring black money into the mainstream.

Postponing income tax on the proceeds of gold sale if they are locked in infrastructure bonds could be a boon to the government. This would be a slight variation on the scheme of diverting the proceeds of long-term gains earned on property held for more than three years into bonds of the NHAI or REC. The cost of buying and holding gold could be made expensive by including the value of gold, which could be the average of the high and low price during the fiscal, held for more than three years in the income. Right now gold and jewellery are clubbed with property and car for attracting wealth tax up to 2% at the highest slab if the value of all these assets is more than Rs 30 lakh. Gold and accessories in excess of 500 gm could be separated for levy of an independent gold-holding tax at the same rate. Doing away with gold exchange traded funds should also be considered seriously as they too are responsible for fuelling gold prices. Even loans against gold should be given at stiff interest rates. A weapon of last resort should be bouts of gold selling by the Reserve Bank of India to ease the demand-supply gap and calm domestic prices. Unfortunately, with China emerging as a major buyer, gold is attracting more attention. The US slowdown and euro-zone recession, too, are enhancing its allure. Nonetheless, it is important to realise that gold is not invincible. Investors who bought into the real estate bubble in the US realised this at a great cost to them and the global economy. To avert another meltdown, it is necessary that governments and central banks around the world undertake periodic debasing of gold.

Mohan Sule

A cruel joke

The finance minister relies on increase in taxes to narrow the fiscal deficit instead of a buoyant economy to boost revenue

By Mohan Sule

Countries respond to slowdown in two ways. The government reduces direct and indirect taxes and the central bank eases liquidity and interest rates. This was what happened after the credit-crunch contagion spread around the world following the collapse of Lehman Brothers in September 2008. These short-term fiscal and monetary measures boost sentiment as the environment allows resumption of risk-taking. How has the budget for 2012-13 fared when measured against these parameters? The finance minister’s challenge was to accelerate growth and at the same time be mindful of inflation. To kickstart the economy, he could have used the budget to roll out a second fiscal stimulus by offering still deeper excise and import duty cuts after those announced in 2009. The resultant expansion in economic activity could have boosted revenue, taking care of fiscal deficit. On the other side, he needed to cap if not trim social spending to tame inflation. Though the allocation to the resource-guzzling rural employment guarantee scheme has been scaled down, there is the food security bill waiting in the wings, Excise and service tax have been revised up 2% points and income tax slabs altered to bring marginal relief. Individual taxpayers will now have to wait for the Direct Taxes Code to kick in for deeper cuts. The is necessary to balance out the higher indirect levies incorporated in the imminent goods and services tax. The desperation in relying on revenue from higher taxes rather than from a buoyant economy is against the backdrop of fiscal deficit climbing upto 5.9% of GDP instead of the budgeted 4.6% in 2011-12.

The twin effect would boost prices of goods and services without a corresponding increase in the purchasing power of consumers, affecting private consumption: hardly the ingredients to revive the growth story. On the other hand, the finance minister kept all pending reforms, which could have attracted capital, created jobs and gone to meet growing demand, outside the purview of the budgetary provisions, mindful of the mercurial allies of the UPA government. A cruel joke, indeed. By doing so, the government has sent out the message that India has reverted to the pre-reforms era, which penalized the rich by higher taxes and viewed foreign investment with suspicion. Instead of lifting more population into the middle class by expanding the market, the government is content in giving subsidised food and fuels. In fact, non-plan expenditure is higher by 8.7% in the current fiscal over the revised estimate of last year mainly on account of subsidies, which would push up government borrowings and put pressure on interest rates, thereby triggering inflation. In a way, inflation could be good for the government. This would increase the nominal value of the GDP and, importantly, erode the debt burden. In fact, some apologists are already patting the UPA government for bringing down the debt to GDP ratio to 50.1 in 2011-12 as against 61.5 in 2004-05, when the first Congress-led coalition government was formed.

Similarly, the move to double the issuance of infrastructure bonds to Rs 60000 crore is a clever way for the government to take on off-balance-sheet debt just as the oil bonds that it issues to PSU refiners to partially compensate their underrecoveries. This will keep its interest payment to GDP ratio down despite higher borrowings from the market. The tax-free status gives these bonds a captive audience. A better way would have been to entice investors to the infrastructure sector by encouraging the mostly PSU issuers to become competitive, introducing transparency in the awarding of projects instead of favoring PSUs, clearing orders and payment quickly, removing restrictions on borrowers’ pricing of their products and services, and plugging leakages of allocations to public utilities. The inability to let go control of PSUs, resulting in increasing impatience of foreign institutional investors, and also the fear that the inflationary proposals in the budget could dim the attraction of equity markets have no doubt contributed to scaling down the divestment target by Rs 10000 crore for the current fiscal. Not that the finance minister has not realised the importance of a vibrant equity market to raise resources. The 50% tax deduction for investment up to Rs 50000 for first-time investors with income below Rs 10 lakh per annum under the Rajiv Gandhi Equity Savings Scheme underscores the government’s acknowledgement. This will create a ready receptacle for PSU share sale. Crucially, it gives investors control over their stock picks instead of relying on fund managers like in the equity-linked savings schemes. What could be a stronger indictment of the mutual fund industry’s failure to live up to the expectation of the small investors?

Mohan Sule

Out of control

Movement of crude oil, currency and real estate will support
or mar budget calculations

By Mohan Sule

The finance minister has made his calculations. Over the next 12 months, the economy could play out as per the bets in the budget or skid as revenue does not pan out as expected or expenses, planned or untold, overshoot estimates. This could be because of internal or external factors. Rollout of reforms could improve sentiments but paralysis in decision making due to compulsions of coalition politics could prove to be a setback. External factors that could cast a positive influence would include a bounceback in the developed economies. Flare-up of geo-political tensions in some hotspots of the world, however, might affect liquidity and inflow of capital. As such the finance minister may have played the best cards available but there is always a joker in the pack to spring up a nasty surprise. Among the three most visible factors that could make or mar the markets in the fiscal ending March 2013, the most important is the movement of crude oil. After crossing US$100 a barrel in 2008 on surge in demand due to the bullishness in global economy, crude is once again testing these levels but not solely in anticipation of global economy’s resurgence. Rather it is due to trade sanctions on Iran, one of the major suppliers of oil to India, China and Europe. How soon the tensions in this region ease will not only determine the speed of recovery worldwide but will also provide a trigger for another spurt in prices. For India, crude is going to play a spoilsport till it dismantles the subsidy regime. Otherwise, expansion will be accompanied by a ballooning fiscal deficit, thereby trapping the country into a periodic cycle of growth-inflation-slowdown.

Of late, the conventional linkage of oil prices to inflation and, in turn, to interest rates is being severely tested. One of the reasons is the world is no longer flat. The bipolar globe consists of the developed and emerging economies. The flow of liquidity favors yields over everything else. Till recently, oil prices were capped by the slowdown in the US and recession in the euro-zone. Yet, India was coping with inflation caused by factors such as increasing consumption of protein-rich food and surging commodities on China’s insatiable appetite. The biggest surprise was India’s inability to attract arbitrageurs despite high interest rates. The attack on the rupee primarily stemmed from the credit crunch in the euro zone and not only from slowdown in growth arising from high interest rates and lack of progress on economic liberalisation. Dollars are flowing once again despite absence of any reforms as the European Central Bank has pumped funds at very cheap rates to lenders in Europe. The US Federal Reserve, too, is determined to keep interest rates at rock bottom for another two years. Foreign direct investment in multi-brand retail, insurance and banks, thus, may not be the keys to open the floodgates for capital inflows. Levelling of economic growth around the world from the present lopsided situation of high-wire and turgid countries would map the movement of funds from one spot to another due to specific reasons and not because of interest-rate differentials. This may take some time to happen. Till then, even deft budgetary juggling will continue to be in the danger of being overshadowed by circumstances beyond the finance minister’s control.

The shock of the the real estate market’s crash in the US, for instance, was not restricted to homebuyers. The contagion spread to Europe and rest of the world quickly as there were many other stakeholders involved ranging from mortgage lenders to financial institutions with exposure to derivatives based on loans of different types and tenures. Earlier, the health of the automobile sector was viewed to determine the well being of the economy due to its capital- and labor-intensive characteristics. Eventually, the industry shrugged off its local flavor to achieve a dispersed personality as supply chains were spread out to the most cost-effective geographies. Ironically, real estate, which should be the most indigenous industry as domestic conditions are supposed to have a bearing on the price tag and availability, has become the most vulnerable component in the global value chain. A boom or a slump transmits benefits or setbacks to different export-oriented sectors including commodities and financial services. Increasingly, its outlook is decided not only by the country’s growth rate but also by the price of oil as it impacts inflation and lending rates. In its endeavor to boost the economy, the budget might fuel real asset prices. This could make the exercise of lowering interest rates tricky for the central bank as it would not want to create asset bubbles. The bottom line is for all the hype and hope pinned on the budget to give a big push to the economy, the exercise has its limitations and comes with an expiry date.

Mohan Sule

Collateral damage

The drive to make the investment space safe has come at a price: marginalisation of retail investors by the issuers


By Mohan Sule

For all the hype about India’s growing middle class being the size of the entire population of the US, the Indian retail market is increasingly looking like a Rubik’s Cube: a tough nut to crack or easy to solve. Even as foreign multi-brand retailers, banks and insurers are lobbying hard to gain access, some of those who have set up shop are looking to exit. Take two recent examples. The Indian arm of Fidelity, US’s second largest mutual fund by assets, is scouting for buyers. Australian group ANZ, which quit India in 2000, reestablished a branch last year but British bank Barclays is pulling out of retail business to concentrate on corporate banking. Yet fast-food chains like McDonalds and Domino’s Pizza are rapidly gaining market share. All these investors are looking at the same middle-class market. Why is that some have been able to tap it while others have flopped? Two reasons are bandied about for this state of affairs. First is India’s boom is fuelled by consumption, at 58% of GDP compared with China’s 48%, rather than government and private sector investment. Demand for automobiles, food, education and travel are the manifestations. This is perplexing considering the domestic savings rate is about 25%, next only to that of China, which is being advised to boost consumption to level the lopsided growth fuelled by state investment and exports. This leads to the second proposition. Compared with real estate, gold or consumer goods, the financial services market is tightly regulated. Sebi’s preference is to create a secure environment even if it comes at the cost of risk-taking.

Ironically, capital market regulations were evolved to attract foreign investors, who wanted a transparent field. It is now becoming clear that the stricter rules have taken care of demand-side issues but not the concerns of suppliers. Compliance is increasing the expenses of intermediaries and issuers. Fidelity has reportedly complained of low entry load and asset management fees, an indictment of Sebi’s reintroduction of entry load as a flat upfront levy, discontinuing the earlier practice of embedding it as a proportion of the subscription amount. Similarly, foreign banks are hobbled by priority sector lending quotas and caps on branches. The Reserve Bank of India came out with a discussion paper on the roadmap for foreign banks early last year in view of India’s commitment to the World Trade Organisation to open up the sector. The recommendations are yet to be translated into policy. The recent freeing of savings rates means costlier retail deposits, the cheapest source of liquidity for banks. Disposing low margin business of retail lending makes sense for foreign banks cleaning their balance sheets and facing higher requirement of risk capital in their home countries following the collapse of Lehman Brothers in September 2008.

The Indian government does not seem to be perturbed by the sparse presence of foreign players in the retail financial services space. This could be for two reasons. First is the skepticism that foreign players share its goal of making banking accessible to all segments. Individual investors would be better off tapping the government’s high-cost borrowings served with the icing of tax deduction. Second could be the desire to ring-fence the small saver from any overseas contagion as well takeovers in the sector. The repercussion of this strategy is marginalisation of retail investors. Issuers are going overseas to raise resources not only for the depth of the subscription pool but also for cost-efficiency. Sebi recently permitted equity dilution through the wholesale route on the bourses to meet the minimum 25% public float requirement, eliminating lock-in of private placement and preferential allotments — a tacit admission that the retail base of investors is inadequate or dispensable. Diminishing chances of allotment in IPOs, increasingly dependent on applying at higher cutoffs and at maximum permissible limit, are also crowding out retail investors. The zero long-term capital gain tax has not emboldened small investors to build up an equity portfolio. Instead there is spurt in day trading as the investment outlook has shortened, with the markets plugged into global bourses. International events rather that domestic happenings influence the benchmark indices. The tortuous euro-zone bailout negotiations have the capability of shaping sentiments. The Supreme Court’s decision to cancel 122 2G telecom licences issued during the second round of spectrum sale had no impact on market movements. Inflows hinge on arbitrage opportunities created by volatility in local currency or interest rates rather than the long-term view of the economy.

Mohan Sule