Does Weak currency mean Weak Government?

Author: - Ashish Aggarwal

College: - NMIMS, Mumbai (Capital Markets)

Before answering this million dollar question, I would like to give brief introduction about exchange rates and how they are determined.

Exchange rate is defined as value of a country’s currency in terms of another country’s currency. Exchange rates are determined through forces of demand and supply. For example dollar-rupee exchange rates will depend on how the demand-supply forces moves. When the demand for dollars in India rises and supply does not rise correspondingly, each dollar will cost more rupees to buy.

Important point here to be understood is where this demand/supply does come from?

Sources of Demand: -

Most important source of demand is Importers which needs Dollars (foreign exchange) to buy goods and services.

Other very important source of Demand is Companies / Individuals investing abroad.

Other important sources of Demand include companies sending profits back to their home country.

Sources of Supply:-

Again we can say that most important source is Exporters who sell goods and services and earn Dollars (Foreign exchange)

Other very important source of supply is Companies / Individuals investing into Indian markets.

Other important sources of supply include Indian MNCs sending profits back.

We can see that the factors that contribute to the demand for a currency are mirror images of those that add to their supply.

Rapid increase in value of dollar in recent times

We (India) have witnessed a rapid increase in value of Dollars in recent times which mean there is a change in forces of Demand and supply, obviously demand has outgrown supply of dollars.

There are 2 basic factors that have led to the change in this equation. Firstly, FII’s (Foreign Institutional investors) that have been pumping billions and billions of dollars until few months back, have been desperately pulling money out of India and putting it into safer havens like USA and Germany.

Secondly, Trade deficit gap i.e. gap between values of our Imports and values of our exports has widened i.e. exporters are not able to bring in as much dollars as our importers are giving out and hence demand is more than its supply.

What could have efficient government done to solve the problem?

Solving first problem i.e. of getting FII’s to put money into India. This problem has two dimensions to it, they are

First, FII’s have been pulling money out of India because of financial crisis facing them in their home market. So they are looking for safe heavens and right now with Euro zone’s Euro and Japan’s Yen in a mess there is no other safer and stronger asset than US Dollars.

Second FII’s are pulling out their money from Indian markets because of slowing rate of growth of Indian economy.

It will be totally unfair to say that government can solve or handle the first dimension of this problem as it is a global phenomenon and Indian economy still is not big enough to influence world events.

Looking at second dimension, yes image of India has taken a hit due to following recent events like

·         Retrospective amendments

·         Going back on FDI reforms in Retail and aviation sector

·         Various corruption charges against ministers of central government

·         Increasing Fiscal Deficit

Obviously an efficient government would have tackled it and have saved image of Indian economy.

Question to ask here is that if second dimension of problem is taken care than would it stop FIIs from pulling their money back from India.

Answer is NO, because global crisis is a phenomenon much bigger than then few wrong events occurring in Indian economy. Investors would still have ran towards safe havens and India is not even close to be known as safe haven by  any stretch of imagination. This means money (dollars) would still have flown out of India.

To make my argument more convincing I would like to lay stress on fact that India is expected to grow at 6% to 6.5% this year which is better than almost all the countries of the world but still investors are not willing to take risk in current situation and are running toward safe heavens.

Basically the fact is whenever financial crisis happens investors moves towards safe heavens as risk appetite reduces during financial crisis.

Solving second problem i.e. of Trade deficit gap. This problem has come up due to decreasing growth of values of exports as compared to values of import.

Again this problem can be broken up into two first lower growth in exports and second higher growth in value of Imports.

First part i.e. lower growth in values of export is mainly due to lowering demand in Europe and US which can again be attributed to financial crisis in Europe and doubts about growth of US economy.

Second part i.e. higher growth of imports, basically our Imports depends on price on Crude Oil in international markets and not on strength of government in India.

Following two charts will illustrate this fact

Chart 1: Value of Oil Imports of India

 Chart 2: Value of Crude Oil in international market

Source: - International Monetary Fund – 2011 World Economic Outlook

 Let us look at the trend after 2002 because that is when India rapidly industrialized.

During the period 2003 to 2008 there was increase in prices of crude oil from 26$ per barrel to 140$ per barrel similar trend is visible in value of Oil import by India.

Also we can see that slope of both the curves are in coherence.

After 2008 till 2010 we can see Crude prices falling from 140$ per barrel to around 75$ per barrel similar trend is seen in value of Oil import by India

From this we can easily see that value of our oil imports depends heavily on price of crude oil in international market.

Now since 70% of our import bill is Oil imports that mean our imports are heavily dependent on price of crude oil.

Hence above argument proves that Increase in trade deficit in current conditions in case of India is due to global phenomenon and not because of ineffective government.

So far the discussion put forward has been India specific; now let’s talk about various other reasons why we can’t say that weak currency is an indicator of weak government.

Following are some of the reasons:-

·     Many strong countries want weak currency: - Two prominent examples for such countries are Japan and China. This is because it keeps prices of their export lower so that its products and services become attractive for consumers in other countries. This helps them increase production which creates more jobs and also gets foreign currency which ultimately leads to overall growth of economy of the country.

·     Role of Speculations: - In any market, expectations and speculation play an important role. For example, when there is an expectation that the dollar will rise against the rupee, exporters tend to hold back their earnings in the hope of getting a higher rate.

Similarly, importers will try and buy as much as they can today, adding to the current demand and making the dollar rise even more.

All this skews the supply-demand equation even further and thus setting off a vicious cycle.

 Does weak government means weak currency?

Again we need to see how can weak government affect demand supply equations?

Following are some of the adverse effect of weak government: -

Loss of investor’s confidence: - perhaps the most adverse effect of political instability is on investor confidence. There may be certain policies that may not be in the interest of business or government may not be working in larger interest of economy, government may not be strong enough to take unpopular but necessary decision like increase in fares of public transport or increase in fuel prices or reduction in subsidies, All these can lead to lack of investor’s confidence in future growth of country making him pull out his money from the market of that country.

Poor business environment: - Poor business environment means high taxes, unclear tax regime, poor law and order, difficulties in setting up new business, lack of infrastructure like lack of roads and electricity etc all this results in lesser production for domestic companies which results in lesser revenues also it discourages foreign companies to invest in the country leading to lesser inflow of foreign exchange in form of foreign direct investment again adversely affecting demand and supply situation.

Poor Fiscal Management: - Generally it is seen that ineffective government are unable to keep their expenditure under check and there is excess of expenditure over revenues. As such governments have to borrow more and more money which increases their borrowing cost and country with fiscal deficit needs to pay more for each dollar they borrow.

Uncontrolled Inflation: - High inflation may persist in such countries because of supply side problems. High inflation is dangerous for overall health of economy as it may lead to lack of savings and more of spending which further increases inflation, as a result Interest rates are higher in such countries leading to increased cost of borrowing and hampering the growth of business.

All of these may or may not occur simultaneously but all of them are harmful for growth and development of an economy.

Cause	effect on Supply of dollar (Foreign Exchange)	effect on Demand of Dollar(Foreign exchange)	Effect on currency (Weakens or strengthens)
Loss of investor’s confidence	Reduced	No Direct impact	Weakens
Poor business environment	Reduced	No Direct impact	Weakens
Poor Fiscal Management	No Direct impact	Increases	Weakens
Uncontrolled Inflation	Reduced	Increased	Weakens

Above table summarizes ill effects of weak and inefficient government and we can see that weak government does leads to weak currency.

Conclusion

From the above argument it can be concluded that weak currency does not necessarily means weak government, just by looking at state of currency we cannot say much whether the government is weak or not, we need to carefully analyze causes for weakness in the currency to determine whether it is due to some global phenomenon or whether country has intentionally kept its currency weak or whether it is due to weak government.

Vice Versa, i.e. if we have weak government at centre than surely currency of the country is going to be weak.

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All About Commodities Market

By: Shipra Jha , NMIMS , MBA Capital Markets

WHAT ARE COMMODITIES?

Commodities are one of the most volatile asset classes available to investors .They are interchangeable products which, as a consequence, share a common price. Examples for commodities are goods such as grains, livestock, oil, cotton, or even financial products like currencies, bonds, and stock market indices.

ABOUT COMMODITIES MARKET:

The commodities market has emerged during the modern era as an important player in the way people invest and speculate. The two most-watched commodities by far are crude oil and gold: oil because it is the primary form of energy commodities market use to power international transportation and trade ,  and gold because it is viewed by financial markets as a hedge against rising inflation. Daily price swings in commodities of all kinds can be violent and due to the use of leverage, investors can lose more than their initial investment.

PROCESS :

Prices in the commodities market are determined by the motives of the buyers and sellers, who together make up the market.

TYPES OF COMMODITY MARKET :

A commodities market can be a : Cash market or futures market.

 In the case of a cash market, again it could be either a spot or forward market. In case of a spot market, you get immediate physical delivery of a commodity, whereas in the forward market, you tend to get your commodity delivered at a specific date in future. Both spot markets and forward markets are together known as actuals since actual delivery has to be made in either of the types.

A futures contract is a special type of forward contract. They are designed to reduce risks and increase flexibility of forward contracts. The contract, for instance, may specify delivery points and price variations for discrepancies in the quality of the commodity being shipped.

HOW  VULNERABLE ARE COMMODITY PRICES ?

The recent decline in commodity prices attests to the possibility that commodity prices are vulnerable to a deterioration of the global outlook.

HOW BENEFICIAL HAS QE3 BEEN TO COMMODITIES ?

As the Fed embarked on a third round of quantitative easing, risky assets are rallying hard. Commodities were among the biggest gainers of any asset class following the announcement of QE2.Are commodities poised for similar gains this time round?

Conditions in the macro economy are much less supportive, commodity prices are higher and the impact of successive waves of QE is reduced each time. China’s big build is maturing as capacity catches up with demand and that is beginning to backfire through parts of the global commodities supply chain that has fed China for the past decade. Markets are concerned that with business confidence low, growth faltering and export demand poor, weakness in China’s commodity imports will become more pervasive, especially with high inventories overhanging sectors such as copper and steel. With the dollar weakening and the debate over fiat currency debasement now likely to retake centre stage, QE3 is likely to unleash enough physical and futures market buying to bring to an end to gold’s position as one of the weakest commodity markets in 2012 so far. In terms of current market positioning, base metals look likely to benefit most from better sentiment in the short term, as hedge funds look severely underweight, especially in copper.

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Informed Investor – an asset to the company

Author : Charchit Joshi, NMIMS, MBA Capital Markets

In the past few years the relationship between the corporate managers and investors has gone for a beating. Investors lost money in the turbulent markets. Their disinterest in the scribes brought down the stock prices. And this added to the woes of decision makers and top management of the public companies. Many corporate houses started believing that managers should not take care of the capital market. Managers should do their business, do well and investors will follow the success story. They have forgotten that it is a mutually beneficial relationship which if respected in an honest and transparent way can prove to be a win-win situation for both the involved parties.

Giving true and relevant information to the investors is generally a good business. But doing it in a detailed and unambiguous way is rather more important. Providing investors with something more than just quarterly and annual results can help in maintaining this mutually beneficial relationship between the two.

As per the economic theory of information asymmetry – When one party in a transaction knows more than the other, someone suffers – and it is not whom you might think of. If the seller has more information than the buyer, the sellers are the primary losers, as a suspicious buyer can bring down prices or can quit the market altogether (George Akerlof won Nobel Prize for this). No one would buy a car without inspecting it. Same theory applies to share market as well. By providing the necessary information about the company’s plans and estimates in future a manager can avoid falling share prices, weakening demand, high volatility, higher cost of capital, etc. Such practice if followed by a company eliminates suspicion in investor’s mind. It further helps a company to hold an investor with the company’s stocks for longer period of time and to attract new investors to invest in the company.

To make this practice of information sharing, working, companies should know their investors well. They should dig deep to know what investors want from them. According to a misconception, very prevalent amongst the corporate managers today, those who buy and sell stocks are jumpy and myopic in nature. But it is the other way around. Market is usually dominated by the investors who are more concerned about long term investments rather than short term or intraday investments. Though short term news, fluctuates the market. But the impact of long term forecast revisions and financial reports of the companies have much stronger impact on companies’ share prices. Actually investors suffer from what organizational researchers call, limited attention. It is the inability or rather restricted ability of human brain to process and analyze vast information. Hence investors react to the news that captures the headlines of the News Papers. This causes knee jerk reactions, even from the long term investors, who would have never paid much heed to such news ahead of the forecasted financials of the company.

Hence companies should not only provide its investors with the information about the present financials, but also a detailed report of the future projects, estimated financials , possible threats , opportunities, etc. They should highlight the key points of such detailed information. This will not only help investors to be well informed about the main features of the company’s current and future operations but also help company in safeguarding against the knee jerk reactions to the short term news.

As I said earlier the company investor relationship is a two way bond where interacting with the investor does not always mean giving information. The movements in share prices speak a lot. Capital Market’s response after the announcement of financial results reveals the investors’ expectations and faith on the current management. Knee jerk reactions and sudden short sales often signal some serious trouble with operations of the company that needs to be fixed.

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GAAR REPORT – A tax reform or a Shenanigan?

Author : Chakshu Aggarwal,NMIMS

                 
The confusion over the General Anti Avoidance Rule (GAAR) cropped up when on 21^st January, 2012 Supreme Court ruling went in favor of hutch-vodafone deal on grounds that the deal between two companies was incorporated outside India and thus exempted Vodafone from tax of $2.5 billion. This led to series of events which resulted in weakening of investor sentiments and thus goaded the government in July to set up a 4 member panel to look into the concerns of foreign investors in GAAR. 

DEVELOPMENTS IN GAAR TILL JUNE,2012 AND ITS IMPLICATIONS

• The Supreme Court ruling in favor of Vodafone led to introduction of a retrospective clarification to Income Tax act 1961 thus amending the law to tax cross border transactions such as Hutch-Vodafone deal.

• The new provision in Income Tax act stated that any company situated outside India shall be deemed to be situated in India if it derives its value or shares from the assets located in India.

• The provision was disclosed in the Union budget of 2012 by then finance minister Pranab Mukherjee. Post inclusion of this provision it was estimated that it could earn the exchequer Rs 35000-40000 Crores in back dated revenues.

• INCOME TAX department filed a petition in SC in March, 2012 for reversal of its earlier decision on back of the retrospective clarification in Income Tax act.

• The amendment to Income Tax act did not bring any gains to Income Tax department and petition was turned down by Supreme Court.

• The argument given by government for introduction of GAAR in form of change in Income Tax  act was that it will come into action where in particular transaction tax avoidance is one of the motives.

• This led to a lot of uncertainty as foreign investors feared that this provision will bring the past transactions under the purview of Income Tax act that were completed in last five years since 2007 when hutch-vodafone deal happened and will tax them retrospectively

• This took the foreign investors by shock leading to erosion of investor sentiment and Prime minister Manmohan Singh had to reign in by forming a 4 panel committee headed by Dr. Parthasarthi Shome to look into concerns of foreign investors in GAAR.

 NEED FOR GAAR COMMITTEE AND HOW DID THE COMMITTEE GO ABOUT IT

The investor sentiment already dented by policy paralysis, decelerating growth, spiraling inflation and high interest rates was being further impacted adversely by the clouds of retrospective taxation that was hinted upon by the retrospective clarification in Income Tax act and the first GAAR Draft guidelines issued on june 28, 2012. This impact was significant in the erosion of FIIs from Indian capital market as foreign investors saw lots of ambiguity in Indian investment climate. Anticipating the detrimental effect of the draft guidelines, On june 29,2012 PMO came out with a statement that guidelines posted have been put out for receiving feedback and discussion purposes. Furthermore, PMO stated that these guidelines have not been seen by PM and will be finalized after its approval. A day later it was announced that PM has approved the constitution of 4 member committee headed by Dr. Parthasarthi Shome to undertake stakeholder’s feedback and finalize the guidelines. The series of events followed by posting of first Draft guidelines clearly suggested that was a difference of opinion between PMO and finance ministry.

Dr. Parthasarthi Shome had major task at his hands as these final guidelines would determine the fate of FIIs and hence the investor sentiment in the Indian capital market. A roadmap was laid down to go about the task at hand and the main highlights of the roadmap were:

• Record comments from the stakeholders and the general public on the first draft guidelines that have been published on government website and complete this task by end-July 2012

• Rework the guidelines based on this feedback and formulate second draft of guidelines and publish it for comments and consultations by 31^st august 2012

• Undertake consultations on the second draft guidelines

• Finalize the GAAR guidelines based on the consultations and prepare the implementation plan and submit it to government

HIGHLIGHTS OF SECOND DRAFT OF GAAR GUIDELINES SUBMITTED BY GAAR COMMITTEE

• GAAR delayed by 3 years and will be applicable from assessment year 2017-2018
• Approving panel of GAAR will have 5 members including a retired HC judge and two from outside government in contrast to 3 members ( all from government) recommended by first draft
• Abolition of tax on transfer of listed securities for resident as well as non-resident Indians.Prospective positive impact of this provision: Earlier short term capital gain (less than 1 year holding) used to be taxed at 15% and short term business gain used to be taxed at 30% and to prevent the tax foreigners used to invest via Mauritius route which is a tax haven. This move will make the Mauritius route redundant and will facilitate pooling of funds directly in India.
• Limit of Rs 3 crore has been kept for tax benefit exceeding which GAAR will be applied in contrast to the first draft where this limit was not certain
• Investors from Singapore and Mauritius have been spared from GAAR. The rationale given behind this provision is that these places already have limit of tax benefit in their treaties and so GAAR should not be applied as they already have tax avoidance rule
• GAAR will be invoked only when tax benefit is the main purpose in contrast to earlier draft which stated that GAAR to be invoked where tax benefit is one of the main purposes.
• There will be no retrospective taxation on transactions that happened in past

After taking a glance at the guidelines submitted by GAAR committee, provisions look encouraging and one would think that it would do enough to revive investor sentiment. The main motive of government behind setting up of GAAR committee was to clean up the mess created by the earlier finance minister Mr Pranab Mukherjee who introduced the provision of retrospectively taxing the transactions which made the investment environment ambiguous and shocked the foreign investors. The government sees latest GAAR guidelines as tool to placate the volatility in the investor sentiment. The move aimed at discounting the trade and fiscal deficit woes to some extent by revamping the investor sentiment through GAAR report. But it was not to be as share market in turn discounted GAAR and Sensex fell 0.26
% on the day subsequent to publishing the guidelines of GAAR. Market sees policy inaction and want of reforms as more important issues than GAAR . Also, there is lots of skepticism about delaying the GAAR by 3 years and it questions the government’s effort of GAAR as serious tax reform. It is yet to be seen that whether GAAR will prove to be a positive tax reform or just a shenanigan by Government to improve the investment environment which has been worsened by their inaction.

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