Please control the deficit Mr. Finance Minister - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Please control the deficit Mr. Finance Minister 

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In this issue:
» RBI proposes new law for bank insolvency
» Diesel car demand falls with rising diesel prices
» Why Warren Buffet won't jump on the buyback bandwagon
» The IMF calls for greater central bank cooperation
» And more!

Narendra Modi is to be sworn in as India's Prime Minister today. At the ceremony, his council of ministers will also take oath. From the economy's and the stock market's point of view, the most important individual in the cabinet is the Finance Minister. His job will not be easy. India's new FM will have no choice but to hit the ground running from day one. The new government has inherited a whole host of problems from the UPA. High inflation, youth unemployment, bureaucratic hurdles and a complicated tax structure, just to name a few. While these are all very serious issues, the most urgent one is, without a doubt, the government's own finances.

If news reports are to be believed, then the new government will present the full budget for FY15 by June end or by the first week of July. This will not give the new FM much time for preparation. Given the serious mess that the economy is in, he will have to tackle multiple issues at the same time. However, his most important task will be to stabilse the iscal deficit. Why is the fiscal deficit so important? Allow us to explain. The fiscal deficit represents the difference between the amount that the government spends and the amount it receives. The government usually covers the fiscal deficit by borrowing money from the bond markets. This excess spending provides a boost to the economy by stimulating consumption. But this artificially created demand also stokes inflation. It must be kept in mind there is a limit to how much the government can borrow. If the government borrows too much, then it will lead to higher interest rates. This will slow down consumption as well as investment and bring down GDP growth.

This is what has happened over the last few years. For FY14 the fiscal deficit is estimated to be 4.9% of GDP. However this is an illusion as over Rs 1,000 bn of unpaid subsidy bills have been rolled over to FY15. Excessive spending by the previous government on wasteful subsidies is to blame. If the new Finance Minister desires to boost long term GDP growth and bring down inflation sustainably, then his number one focus should be to bring down the fiscal deficit. This is not done. It can be achieved by reducing the money being spent on various subsidies. Over half of the government's subsidy bill, is due to the subsidies given to petroleum products like diesel and LPG. This is an unnecessary subsidy as the benefit that it offers the poor is limited. If these are done away then the government's finances will improve and the amount of government borrowing will reduce. Lower amounts of borrowing will mean that the bond markets will not be flooded with government debt as it is now. Thus there will be more money available for corporates to borrow at lower long-term interest rates. This will encourage corporates to invest more and create more capacity. Higher corporate investment will create jobs leading to higher income levels. This virtuous cycle can only be realized if the government controls its own expenditure. This will be the most urgent task before the new Finance Minister when he presents the next budget.

This government has received a decisive mandate. It must now move decisively on the serious economic issues facing the country. While there are many important issues that have to be dealt with, it would be heartening if the government would begin by putting its own house in order. Controlling the fiscal deficit, we believe, should be right on top of the list.

Do you think that that new government will be able to control the fiscal deficit? Let us know in the Equitymaster Club or share your comments below.

01:45  Chart of the day
Million dollar salaries and bonuses seem to be making a comeback. Well, we are not talking about US here but our very own India. As per a leading daily, it's beefing up time for major investment banks in India. They are hopeful that the new Government would bring in reforms and thus drive up fund raising as well as M&A activities across the corporate spectrum. It should be noted that this buoyancy is coming after a three year lull where lot of investment banks had to trim staff in order to survive and stay profitable. However, with the veil of uncertainty lifting, they have sounded out head hunters so that they have enough bankers when the deal making season begins.

It is certainly ironical that the best times to do deals are when the sentiments are weak. Because this is when valuations are cheap. However, due to the quirks of the human nature, most deals tend to happen when markets are in cheerful mood. This then tends to push up the valuations, making M&A's on an average, a loss making rather than a profit making exercise for the acquirers.

Falling domestic M&A activity

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Even as the public sector banks in the country struggle to save their net worth from loan write-offs, there is some good news for depositors. All this while the depositors in Indian banks took solace from the fact that hardly any went bankrupt. Even in cases like Global Trust Bank (GTB) which was acquired by Oriental Bank of Commerce (OBC), the interest of the depositors was safeguarded. It was the shareholders of both GTB and OBC who had to bear the losses. Thus the RBI's focus on prioritizing depositor interest is well known. However, a new set of regulations may keep the depositors insulated even in case of bankruptcy filed by the bank.

The RBI has proposed a new framework for the bankruptcy of financial institutions. One that will align the country with international standards. The reason for the same is that the depositors' funds are grossly under insured. Fathom this. As per Economic Times, the Deposit Insurance and Credit Guarantee Corporation of India held Rs 377.7 bn as of September 30 2013. This was barely 1.7% of insured deposits. The Corporation charges an insurance premium of Rs 0.1 per Rs 100 deposited. And not surprisingly, both the premium rate as well as the amount insured was last revised over a decade ago! Thus with such archaic laws, it is only understandable that the central bank should ask for revision in framework. In fact that could also lead to banks getting more proactive in bad loan recoveries.

The development in one sector can have a significant bearing on another. A good example for this is auto sector. Over the years, the sector has been shifting its product portfolio in line with the developments in the energy sector. Few years back, the energy sector witnessed first wave of reforms with deregulation of petrol prices. In June 2010, while petrol prices were decontrolled, the diesel prices still remained fully regulated. In the following years, cheaper diesel became the preferred auto fuel. The distortion in fuel prices was exploited well by auto companies. They responded to price sensitive urban markets by coming up with cars with diesel powered engines. Despite the higher cost and less efficiency than gasoline engines, the diesel engine run vehicles were preferred due to low fuel expenses.

However, in January 2013, energy sector witnessed another key reform when diesel prices were partially deregulated. Since then, the price gap between the two fuels has narrowed. And this is reflected well in the shifting trends in the auto industry. As per Economic Times, diesel car sales have come down by 14% in FY14. With diesel prices coming close to that of petrol, buyers are not willing to pay higher premium for diesel engines. Now that the rupee is appreciating and with a reform oriented Government at the centre, a steep increase in diesel prices cannot be totally ruled out. If that happens, we will not be surprised if diesel engine run vehicles fall out of favour even further.

A buy back is an important signal that management sends to shareholders. It indicates that management perceives its stock to be cheap. And management's perception about its own stock is very critical since they know more about the business than anyone else. Hence, when promoters jump in to buy their own stock, it is perhaps the most important signal of stock undervaluation. Thus, when Warren Buffett recently denied buying back Berkshire Hathaway's common stock, it indicated that the stock was trading expensive. His benchmark for Berkshire is a price to book value of 1.2x while the stock is trading at a premium of 15% now. Hence, he chose to stay away from buying back the stock. Just imagine how the Berkshire price could have reacted to Buffett's buy back considering his stature in the investment industry. However, he chose to stay away due to a 15% difference. And he gave a message to shareholders.

Now let us take a look at the Indian context. There have been multiple buy back announcements in India in the past. However, such announcements were used to mis-guide public rather than anything else. Promoters just announced buy back plans to support the stock price and then later withdrew the offer. Though SEBI has made changes to regulations since then, it explains the intentions of Indian promoters when it comes to being transparent and honest.

Recently an ECB conference was held in Portugal. In this forum, the International Monetary Fund's (IMF) managing director Christine Lagarde proposed that the global central banks should work in a more harmonized manner. As per Lagarde, the potential gains from closer cooperation are enormous especially during the financial crisis. Historically, it is evident that coordinated international efforts have been quite helpful. And thus the central banks should continue to work in closer coordination even after the situation settles down.

The closer coordination of the central banks and the monetary system has been debatable since some time. We too acknowledge that if policymakers from different nations work together, the disruptions will be lower. The central bank's cooperation would help in exchanging better expertise and sharing best practices. However, there is the other side of the coin too. Central banks are currently facing major challenges to foster financial stability in their countries. In such a situation, it will be little difficult for the policymakers to focus on global benefits. Thus in our view, it will be a challenging task for all the policymakers to keep a cooperative approach and work towards the common goal.

The Indian stock markets, continued to surge on strong buying among index heavyweights. At the time of writing, the benchmark BSE-Sensex was up by 307 points (+1.2%). Majority of the sectoral indices were trading in the green led by capital goods and auto. Realty and consumer durables were among the few indices trading in the red today. Most of the Asian Indices were trading in the green with Japan and China being among major gainers. European markets have also opened the day on a firm note.

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1 Responses to "Please control the deficit Mr. Finance Minister"

Rasikbhai Gandhi

May 26, 2014

I donot think the subsidy on diesel should be reduced. Cost of transportation of essential commodities will have to be controlled.And bus services which are used by common men should not be burdened any further.
Can we not find out some device to limit the extraordinary income of managing directors like Mukesh Ambani who can afford a luxurious residence at the cost of shareholders. Just 4 persons who can occupy multistory building with all sorts worldly pleasure. Who pays for their staff and luxury. I think company bears it and for what? There should be some limit to such spendings and extra ordinary salaries of the directors of public limited companies.

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