Dollar should be grovelling by now, but it's not0 commentsThat's mainly because the other currencies aren't doing any better Vivek Kaul. Mumbai The heat was clearly getting to me, as I kept tossing and turning around, unable to sleep. Just then, I heard the door bell ring. "Hello, I am Aruma, your new neighbour. You must be Vivek and I have run out of coffee," she said as I opened the door. I asked her in and went into the kitchen to get some coffee. "You know, so many people have been talking about the US dollar crashing these days. But what has been happening is the exact opposite. Over the last six months, the US dollar has gained value against other currencies, which means other currencies have lost value (see table)," she said, dropping The Economist on the table, as soon I got back with some coffee for her. It felt rather odd to have her in my room at this hour; more so, talking economics. It must be the heat, I thought, trying to waive off the intrusion. "Basically, the US has a debt pile of around $54 trillion and is printing dollars left, right and centre to rescue their biggest financial institutions and to pump-prime the economy by spending on government sponsored projects," I started. "Well then its currency should lose value against other currencies, shouldn't it?" she asked. "But that's not happening." "You are right. The major reason for that is the fact that the financial contagion has spread worldwide. Take the case of United Kingdom, where the government has rescued the biggest banks by printing the pound sterling. Or Japan, where the economy has shrunk 12.1% between October and December. Eastern Europe has borrowed around $1.7 trillion, largely from Western European banks, and needs to repay or roll over around $400 billion this year, which is around one-third of the entire gross domestic product (GDP) of the region. The Austrian banks for one have lent $289 billion to Eastern Europe. A large portion of this lending is in Swiss francs, which these Austrian banks have borrowed from Swiss banks. The Austrian finance minister, Joseph Proll, recently said that even if 10% of this lending goes bad, the Austrian financial system will go broke. Closer home, South Korea has debt of around $194 billion to repay by the end of this year. Currently, its foreign exchange reserves stand at around $201 billion. The country will have a tough time getting anywhere close to repaying all this debt," I said. "So what does that tell us?" "It tells us that investors are now realising the whole world is in trouble and have been moving their investments into securities issued by the US government and thus by default into the US dollar. When they do this, they need to buy the US dollar and sell other currencies, increasing the demand for dollar and thus its value. This has helped the dollar hold up against other currencies. Also, the US dollar is the international reserve currency, and most countries still have a majority of their reserves in it. Thus, the hope is that in spite of the huge debt it has on its hands, the US will survive and so will the dollar." "Is there any other reason?" "Yes. See, the US is the largest importer of goods and services in the world and it is not importing as much as it used to. Now, many countries are dependent on exports. South Korea, for example, gets more than half of its gross domestic product from exports. In January, the country's exports to the US fell by around 22% and to Europe by 47%. This, too, is helping the dollar hold up." "I didn't quite get that," she said. "See, when countries export, they usually get paid in dollars. When they repatriate this money, they sell the dollars and buy their local currency. When you sell a currency and buy another, the value of the currency sold falls and the value of the currency bought goes up. With exports falling big time, dollars are not being sold as before, which is another reason it has held up. Take the case of Mexico. In August, one US dollar was worth around 9.9 Mexican pesos; today it is worth 14 pesos. This is primarily because 85% of Mexico's exports are to the US, and the export volumes are falling. Thus, investors who bet on the peso continuing to go up in value against the US dollar are selling out, leading to a fall in the value of the currency." "Any other major country that's going through this?" "Yeah, Russia too. Energy and metal constitute around fourth-fifths of Russian exports. Alexei Kudrin, the deputy prime minister and finance chief recently said exports can fall by $200 billion from $469 billion this year. This is primarily because the price of oil has fallen from a high of $150 a barrel to around $49 a barrel currently. Confidence in the Russian economy is down because of these reasons and this has led to the rouble crashing against the dollar by 35% since the beginning of October." "What about gold. Why is it rising? I am told the price of gold and the dollar are inversely correlated. I would understand investors moving towards gold if the dollar was perceived as a weak asset. But dollar's holding firm. How come gold is still rising?" "If you look at the prices of gold since October 1, it has risen around 3.5% to $911 an ounce (one troy ounce equals 31.1 grams). However, the dollar has appreciated much more against other currencies. So the theory does hold." "Maybe it does. But where do you think the dollar will go from here?" "Well, once the dust settles down, the dollar should fall and gold continue to rise." "You have a fair sweep of the issue, don't you. I was planning to make some coffee. Want some?" (The example is hypothetical) k_vivek@dnaindia.net References: Gold is a Safe-HavenAmid Global Depression, Gary Dorsh,February 3,2009, www.safehaven.com;US Dollar Shines in a Depression, China buys Metals by Gary Dorsch, www.safehaven.com, March 5, 2009;The whiff of contagion, Economist,February 28th -March 6th, 2009;Articles by Puru Saxenaon www.safehaven.com. Now, Europe has a subprime mess of its own0 commentsLoans extended by banks in Western Europe to consumers in Eastern Europe are in trouble as the economies contract Vivek Kaul. Mumbai Dear V Hey. You can't seem to forget me, eh! Falling in love with me or what? Don't do that. I won't be around forever, you know. Your email was very detailed. Think it rekindled my interest in following the financial crisis. So I thought let me discuss the financial mess, Europe seems to be getting into now. The headline writers are calling it Europe's own subprime. Basically, what has happened is that banks in the more developed Western Europe have lent huge amounts of money to consumers in Eastern Europe. The banks which have lent money belong to countries like Austria, Belgium, Greece, Italy and Sweden. Consumers who have borrowed from these banks belong to countries like Poland, Hungary, Romania, Ukraine and other countries which were a part of the erstwhile Union of Soviet Socialist Republics (USSR). Stephen Jen, managing director and chief currency economist, Morgan Stanley estimates that Eastern Europe has borrowed around $1.7 trillion and needs to repay or roll over around $400 billion this year, which is around one-third of the entire gross domestic product (GDP) of the region. That's a lot of money to be repaid. But how did it start in the first place? As the stock market and the real estate market boomed across the world, Western European banks saw a huge opportunity in lending in Eastern European countries where the financial system was not very developed. A majority of the lending happened for construction and consumer loans. With real estate prices on their way up, people were happy to go out and borrow. Also, these loans were made primarily in euros or Swiss francs, and not in the local currencies of the countries. These loans were also at a lower rate of interest compared with local currency loans. What also encouraged people to borrow in foreign currencies is something experts are now calling "convergence play." Most Eastern European countries over the next few years were hoping to move to euro as their currency from their current currencies. This encouraged borrowers to borrow in euros, and pay a lower interest rate, rather than borrow in their domestic currencies and pay a higher interest rate. Banks giving out these loans assumed that as these countries moved to the euro currency, the standard of living will also move towards the more developed, Western European countries. And now, it is this foreign currency borrowing that is causing all the problems. Take the case of a country like Poland, where almost 60% of the home loans taken were in Swiss francs. Around one year back, 100 Polish zlotys (the currency of Poland) fetched 45 Swiss francs; today, 100 Polish zlotys are worth 30 Swiss francs. What does that do for a Polish citizen who is earning in zlotys and is expected to repay his loan in Swiss francs? Let us say the equated monthly instalment (EMI) to repay a loan stood at 1,000 Swiss francs a month. Around a year back, he would have needed 2,222 zloty (1000 x 100/45) to buy 1000 Swiss francs. Now, he would need 3,333 zloty (1000 x 100/30) to buy 1000 Swiss francs. This means the EMI has gone up by 1,111 zloty or 50% in just one year. Why has this happened? As I mentioned earlier, most of the loans given out in Eastern European countries were given out as real estate loans and consumer loans. The real estate bubble the world over burst around one and a half years back and since then, prices have been falling. Western European banks obviously saw this, and more or less stopped lending in Eastern European countries. Also, with so much of debt denominated in foreign currencies, there was a mad scramble among the citizens of Eastern European countries to buy and hold foreign currencies like euro and the Swiss franc. When that happened, the demand for the foreign currencies increased, leading to their value against currencies like the Polish zloty going up. This basically meant that people who were earning in zlotys and had borrowed in euros or Swiss francs saw their EMIs go up dramatically. This humongous increase in EMIs does not go down well for economies whose GDP is contracting, which basically means that people are losing jobs and those who have jobs are seeing their incomes come down. This increases the chance of people defaulting on these loans. Take the case of a country like Ukraine, whose economy contracted by 12% in the three months from October to December. This has primarily been on account of steel prices crashing. Steel is a major export for the country. Or take the case of Latvia, whose economy shrank by 10.5% in the December quarter. Most of these Eastern European countries are essentially commodity exporters and as you would know, commodity prices the world over have crashed. On the whole, these countries are expected to contract by 3% this year. So banks which have lent to borrowers in these countries are in huge trouble. Take the case of Austrian banks. Estimates suggest that they have lent $289 billion to Eastern Europe. A large portion of this lending is in Swiss francs, which these Austrian banks have borrowed from Swiss banks. The Austrian finance minister, Joseph Proll, recently said that even if 10% of this lending goes bad, the Austrian financial system will go broke. With much of this money borrowed from the Swiss, the Swiss might also get into some trouble. Now you might ask, why not just rescue these banks, like they have in the United States and the United Kingdom, by simply printing money? The trouble is most of the Western European nations have euro as there currency. For the European Central Bank to print money, it would need each of its 16 members to say "Yes" to the decision. And that, as you would agree, is easier said than done. The other problem is that most of these banks are too big for the countries they are domiciled in. The lending of the Austrian banks to Eastern European banks stands at $289 billion, as I mentioned earlier. This is equivalent to 70% of the Austrian GDP. Given this, it is very difficult for the host countries to rescue these banks. They would need help from larger countries like France and Germany, which are steeped in their own problems, and are not in a mood to oblige. Other than this, most European banks have exposure to all the trouble in the United States. Not a good scene at all. How about the International Monetary Fund (IMF) coming to the rescue of these countries? I guess it's well beyond the IMF as well. The IMF has reserves of around $200 billion. Of this, it has already exhausted a huge amount in rescuing countries such as Belarus, Hungary, Iceland and Ukraine. Most of the Eastern European countries were formerly communist countries and have only recently moved to be being democracies with elected governments. Some experts feel the governments in these countries could pass laws to allow repayment of foreign loans in local currencies, and that would hurt the Western European banks even more. And as if all this was not enough, European banks have given out nearly three-fourth of the loans worth $4.9 trillion given out to the emerging markets. Most emerging markets are in big trouble now. I guess I will leave that for the next email. Or maybe you could tell me about it. That's it for now. I'll try to miss you, as much as you do. Take care. M (The example is hypothetical) k_vivek@dnaindia.net References: Subprime Europe by Liaqut Ahamed, March 7, 2009, www.nytimes.com; US-Dollar Shines in a Depression, China buys Metals by Gary Dorsch, www.safehaven.com, March 5, 2009; Europe's Crisis: Much Bigger Than Subprime, Worse Than U.S., Henry Blodget, www.businessinsider.com, Feb 27, 2009; Poll position, Bill Bonner, www.dailyreckoning.com, March 6, 2009; The whiff of contagion, Economist, February 28-March 6, 2009.
Merger tax-neutral for RPL shareholders0 commentsRecord date for 1:16 swap yetto be announced, though merger is effective April 1, 2008 sandeep shanbhag The merger of Reliance Pertroleum (RPL) with Reliance Industries (RIL) is the latest in a long string of amalgamations and mergers that have taken place over time in the Reliance group. As per the arrangement announced by RIL, RPL shareholders of RPL will get one share of RIL for every 16 RPL shares held by them. Though the merger is effective April 1, 2008, the record date, i.e. the actual date when the shares will be swapped, hasn’t been announced yet. When the announcement does come in, RPL shareholders will own RIL shares in lieu of their RPL shares. Would such a share swap entail any tax consequences? Is capital gains tax payable? What about cost of acquisition and period of holding? This week’s article examines these and other related issues. First and foremost, from the tax point of view, RPL will be the amalgamating company, while RIL will be the amalgamated company. As per the provisions of Sec. 47(vii) read with Sec. 49(2), any transfer by a shareholder in a scheme of amalgamation of shares held by him in the amalgamating company shall not be regarded as transfer if- a. transfer is made in consideration of allotment to him of shares in the amalgamated company ; and b. amalgamated company is an Indian company. What this means is that any exchange of shares held in the amalgamating company (RPL) will not be considered as a sale and consequently there will be no capital gains/ loss as long as the transfer is made in consideration for being allotted shares in the amalgamated company (RIL). Moreover, the cost of shares of RPL will be considered as the cost of shares of the new shares allotted of RIL. Readers would know that in order for shares to qualify as long-term assets and consequently as long-term capital gains upon sale, they have to be held for over 12 months. Now, in this case, to ascertain whether the freshly allotted RIL shares are long-term or not, the period of holding of RPL shares would also be considered. Indexation however, will start from the date of allotment of RIL shares. Let’s understand all this in terms of an example. Let’s say Vishal has acquired 400 shares in RPL on December 15, 2008 @Rs 90 per share. Therefore, his total cost is Rs 36,000 (Rs 90 X 400 shares). Now, on the record date, his holding of 400 shares in RPL will be converted into 25 RIL shares (400/ 16). His total cost remains the same, i.e. Rs 36,000, yielding a net cost per RIL share of Rs 1,440 (Rs 36,000/ 25 RIL shares). Let’s say, going forward, Vishal sells his holding of 25 RIL shares on December 31, 2009 at Rs 1,600 per share. He would get Rs 40,000 on selling the shares. The capital gain earned would be Rs 4,000 (Rs 40,000 less Rs 36,000). Also, though he has technically held the RIL shares for less than 12 months (from record date which will be on or after April 1, 2009 till December 31, 2009), since the period of holding of the erstwhile RPL shares has to be aggregated, this capital gain would be long-term in nature and hence free of tax. In the above illustration, the example of a shareholder who holds RPL shares that are an exact multiple of 16 has been used for ease of understanding,. But in real life, this may not be so. What if one holds only 15 shares or perhaps 200 or even 300 — in short a number that is not exactly divisible by 16 such that you get a precise round figure of RIL shares. Though it is not clear from the terms so far, in all probability RIL would compensate for the fractional shareholding in cash. In this regard, in the case of Gautam Sarabhai Trust, 173 ITR 216 the Gujarat High Court held that if besides shares, the shareholders of the amalgamating company are allotted something more in exchange like say bonds or cash, etc., then the swap will not get the benefit of exemption from capital gains. However, experts are of the opinion that the above ruling is applicable only in cases where the offer for shares plus cash / bonds is a part and parcel of the terms of the merger itself and not where the cash comes into the picture only to account for fractional ownership. For example, if the offer were one RIL share plus say Rs. 50 in cash for every 16 shares of RPL, the swap would be considered as a transfer and capital gains tax would apply. But since the offer is of one RIL share only (and nothing else) for every 16 shares held and cash, if at all, comes into play because fractional shares cannot be offered, the spirit of the law isn’t revoked and hence there would be no capital gain. Conclusion? The RIL-RPL merger will be completely tax neutral for all shareholders of RPL.
Printing notes is no way out of trouble0 commentsDebasement of currency will only bring on a bigger financial crisis, a la Zimbabwe Vivek Kaul. Mumbai In fact, central banks will continue to print money until the world runs out of trees. —Puru Saxena Dear M, Hey, I miss discussing the financial crisis with you. Tried calling, but couldn’t get through. So this email. L The times are getting even more interesting, you know. Several hallowed American companies are going down the drain, literally. American International Group (AIG) recently announced that in the three months from October to December they made a loss of $61.7 billion. Now that is a lot of money to lose, Rs 3,17,755 crore to be very precise (assuming $1 = Rs 51.5). The US government had given $133 billion to AIG in the past, but that doesn’t seem to have helped. So, AIG is getting another $30 billion. General Motors (GM), which reported losses of $31 billion on sales of $149 billion, has seen sales fall to a 27 year low. GM got a $13.4 billion bailout from the government, and now wants $16 billion more. Citigroup isn’t in good shape either. So are Fannie Mae, Freddie Mac and all those big financial institutions, which have had to be rescued by the government. This is not the case with the US alone. Various countries in Europe have gone around rescuing their once hallowed financial institutions, too. But neither in the US nor in Europe has any of these rescue efforts borne fruit so far. The losses keep piling up, questioning the very basis of bailing out the financial institutions in the first place. Should the market be allowed to work, and these institutions allowed to fade away? I wish I had an answer to that. And I need not tell you where all this money is coming from. Various governments are printing all the money they need. Okay, I can see you raising an eyebrow. How do I know this? Oh, it’s rather simple. When a government wants to borrow, it has to issue bonds. Investors like banks and other financial institutions invest in those bonds and thus the government gets the money. Basically, the money the government borrows comes from the money supply already available. In the recent past, the US government has injected nearly $300 billion into the financial system, without there being a similar increase in the bonds issued by it. Basically, therefore, all this money is being created out of thin air — it is being printed. And the US isn’t alone. European countries such as the United Kingdom are also doing this. The money being printed is used to keep the weak financial institutions, which would otherwise have gone bust, up and running. It is also being used by governments to spend on what are being referred to as “shovel ready projects.” The idea, as I have explained in the past, is to get the banks to start lending again so people borrow and spend it. This will lead to the moribund economy growing again. The “shovel ready projects” are expected to put people who have lost employment back on job and earning again. Earning is likely to lead to spending and hopefully, this will revive the economy. But all that is theory. Will it practically work out the way, as politicians and economists have been saying it would? Highly unlikely, if history is anything to go by. Money printing only leads to more money printing. Okay, don’t you raise that eyebrow again. I’ll explain. When a spate of money suddenly hits any economy and people go out and spend, it leads to increased prices. The supply of goods and services they want to buy cannot suddenly expand to keep up with all the newly created “paper” wealth. So suddenly, there is a shortage of goods and services, and this leads to increased prices or inflation, as they call it. When an item is available in abundance, its value tends to go down and vice versa. All this printing of currencies will lead to a situation wherein the purchasing power of currencies will continue to decline. This would mean even more currency will have to be printed, which could lead to hyperinflation — a situation where prices go totally out of control, as the currency rapidly loses value. Take the case of Zimbabwe, which has been printing Zimbabwean dollars for sometime now. Economists estimate that the rate of inflation is currently at 5,000,000,000,000,000,000,000 (five sextillion) per cent. The country recently even printed a 100 trillion Zimbabwean dollar note, which was just about good enough to buy a loaf of bread. Basically then, the Zimbabwean dollar as a currency has totally collapsed. And this phenomenon gets repeated time and again. As Puru Saxena, a Hong Kong-based wealth manager writes, “In fact, a remarkable study confirms that only 23% of paper currencies ever issued have survived the test of time.” And why isn’t all the money being printed in the US and Europe not showing up in inflation? It is primarily because the banks are not ready to lend now, as they don’t have enough confidence in the ability of borrowers to repay in such an economic environment. But you need to remember that gradually most banks are being nationalised. Take the case of Citigroup, up to 36% of it is owned by the US government. A lot of banks in Europe have been nationalised or are in the process of being nationalised. Once the government takes over, it will ensure that the banks actually go out in the market and lend all that money that has been printed up. If that happens, inflation is going to go through the roof. By printing all this money, the US can hope to inflate away all its debt. The US currently has a total debt of $54 trillion, which it cannot repay in the normal scheme of things. “In other words, either the US will default (highly unlikely in my view) or it will print and inflate so that this huge mountain of debt feels much smaller in the future due to the loss of its purchasing power,” writes Saxena. And who loses out in such a situation? Countries like China, Japan and the oil producing nations who have a lot of their foreign exchange reserves invested in bonds issued by the American government. If all this printing continues, economies are likely to see hyperinflation in the day to come and their currencies will be in trouble. “As the jokers in Washington continue to ‘save’ the US economy (i.e. bail out their rich friends on Wall Street), the US dollar will eventually become worthless or it may be replaced by another currency.” Hope I haven’t scared you too much. Such are the times. Take care. V Wary of equities? Try ELSS for long-term gains0 commentsGiven the reasonable valuations going, capital appreciation can be huge ICRA Online Research Desk It’s that time of the year again. Everyone is scurrying to save tax before March 31. But, the only difference this time is that the confidence levels of the average investor are low. There are many investors who are hesitant to invest in any type of equity instrument, even if it amounts to saving a large sum in taxes. Until recently, very few investors looked beyond insurance and equity linked savings schemes (ELSS), but today the average investor wants to know whether there are safer alternatives to tax planning. To some extent, this is also ironical, because before January 2008, all we heard was that Indian markets were overpriced; we were floating in a five-year long inflated bubble (which commenced in 2002), which could burst anytime. In spite of such noise, investors pooled in money in ELSS without batting an eyelid. However, today when the markets look more reasonably priced with possibilities of gaining phenomenally from capital appreciation, we are thinking twice. While this is human tendency, as better informed investors, we must not fall prey to such predispositions. If you are a disciplined and regular investor who has a minimum investment horizon of three to five years, then you stand to gain much from investing in equity tax planning mutual funds. ELSS funds have been positioned essentially as diversified equity schemes, and very few of them have a style bias towards a particular market segment. There is one open-ended index-based ELSS fund floated by Franklin Investments. Apart from this, there are a few theme-based ELSS funds floated by asset management companies. However, these are closed-ended in nature and hence do not accept fresh applications. There is no doubt that the figures for the past year have been very discouraging. The average 48% loss for the one-year period ending March 3, 2009 is enough to scare investors. But, what we were interested in assessing was the performance of the average tax planning scheme in the two different bear phases. The pertinent question is whether fund management has matured at all or are we back in the same scenario of under performing the large indices. A look at the table shows that in a bull phase asset management companies manage to comfortably out-perform the key benchmarks, but in bear phases they very clearly leave much to be desired. Having said that, there have been about six schemes that have lost less than the Nifty over 2008. However, this still amounts to a minimum 47% loss through the year. But a quick analysis reveals that one way to reduce these losses is possible through a systematic investment plan. For the period — January 1, 2008 to January 1, 2009 — possibly the worst phase of the current crisis, a systematic investment in an average performing plan would limit your losses to 34%. Coping with the loss So, what has the average equity tax planning scheme done to combat the current slump? Many have reduced their equity allocation, much like the average diversified equity fund. Schemes, which are not yet three years old and hence do not face a redemption pressure, are also playing it safe and keeping more money in cash. In the current scenario one can easily divide the universe of open-ended ELSS schemes amongst those that have decided to stick to their primary mandate of staying invested in equities and those which are currently holding large amounts in cash. The immediate question that crops up is whether a low equity allocation shields you from losses. Well, the answer to this is no. While some schemes such as Sundaram BNP Paribas Taxsaver have managed to limit losses to 40% (for a one-year period ending January 31, 2009 on the back of an average 78% exposure to equity schemes for a 12-month period ending January 31, 2009) there are others such as Escorts Tax Plan which have lost as much as 55% in spite of a low 51% average exposure to equity instruments. A low equity holding is not the way out to contain losses and this has been exemplified by the fund management at Franklin India Taxshield and Fidelity Tax Advantage. These funds have lost 43% on the base of a 90-94% allocation to equity instruments over the one year period ending January 31, 2009. In addition to this the strategy of an index-based ELSS fund has also worked in the current slump where Franklin India Index Fund has managed to emerge amongst the best performing ELSS funds. Other than this, there has been a discernible reduction in the exposure to the mid- and small-cap companies. During the current bearish phase, ELSS schemes have on an average allocated 19.50% of their net assets for mid cap stocks. In the bullish phase, ELSS schemes on an average have invested 25% of the net assets into mid-cap stocks. Also the fallout of the slump has been that the concentration to top holdings has gone up and not down. Fund managers prefer sticking to safer options, by investing large sums in seemingly robust companies such as Reliance Industries. Till about February 2008 it was not unusual to find companies such as Areva T&D, Jaiprakash Associates being held as top holdings. In addition to this, there has been a drastic change in the allocation to different sectors over the past year. While the banking and oil & gas sectors continue to remain the most popular amongst fund managers, the allocations to realty, engineering, industrial machinery and auto sectors have given way to pharmaceuticals, technology and financial services. Way out There is one caveat to the three-year lock-in period. An investor can hope to receive some cash flow in the form of dividends, which again are tax free. This is true only for the dividend payout option and not the re-investment option. Schemes have not restricted dividend payouts only to their dividend options, but have declared dividends even under growth plans. Until recently, the dividend history of some of the schemes has been quite robust. Investors who are uncomfortable with the strict three-year lock in can consider the dividend payout option under the ELSS category. Also to limit losses and to capture the bottom of the current slump, systematic investments are highly recommended.
Tax-saving investments0 commentsLong-term equity can give you better returns than other avenues are no different from regular ones Sandeep Shanbag Most taxpayers approach their tax-saving investments with the sole objective of saving tax for the current year. As long as investing in the chosen instrument results in getting tax deduction, their immediate purpose is solved. The instrument of choice is more often than not something recommended by a colleague or promoted heavily in the media. And if you are in senior management or a businessman, then you have already been anointed as an HNI (high net worth individual) and assigned a 'relationship manager' whose sole purpose in life is to force-feed you the latest flavours of the season. The result of this is, at the end of the day, you end up tax saving but not tax planning. If you think about it, your tax-saving investments are actually no different than regular investments. The Rs 1-lakh deduction under Section 80C is available in respect of investments made in bank fixed deposits (FDs), post office deposits, senior citizens saving scheme, Public Provident Fund (PPF), insurance and mutual funds etc. These are the very investments that one anyway makes and therefore they need to be integrated into the larger picture in line with one's risk profiles and financial goals. Take for example ELSS (equity-linked saving schemes) or tax saving mutual funds as they are popularly known as. From being all the rage till last year, this time around, investors have been avoiding ELSS and choosing guaranteed return products even for tax-saving investments. However, here's another perspective. No one will argue that equity presents the best option for building wealth over the long term. The problem is no one wants to undertake the risk of capital loss over the short term for the sake of appreciation over the long term. But let's take a step back and think about it. Say you are in the 31% tax bracket (30% + 3% education cess). Now what this means is that the moment you invest Rs 1 lakh in an ELSS fund, you automatically get a return of 31%. Putting it differently, you will not have to pay tax of Rs 31,000 due to your investment of Rs 1 lakh. In other words, you have earned Rs 31,000 the moment you invest Rs 1 lakh. So the capital loss, if any, will only take place if the market (and your investment along with) were to fall by over 31% hereon. As I write this, the Sensex is at 9039. A 31% fall from here would mean a Sensex level of 6237. Therefore, if and only if the Sensex were to fall to a level below 6237 will you actually incur a capital loss. On the other hand, over the next three years, the possibility of the market recovering -- if not to the peak level of 21,000 but at least to a level higher than the present 9039 is more plausible than the other way around. And if this happens, your return would obviously be higher than 31%. Now, the 31% tax saving translates into an immediate return but any ELSS investment has to be held for at least three years. So, the correct way of looking at this will be to spread the 31% over three years. This would assume that the market remains flat throughout, neither does it fall nor does it rise. In such a case, the rate of return for a person in the 31% tax bracket would be 13% and that for a person in the 34% tax bracket would be 14.9% p.a. tax-free. Perhaps your immediate reaction to the above argument would be that this 31% yield due to tax saving is not limited to an ELSS investment only -- one can get the same benefit from any investment that saves taxes like say PPF, bank FDs, or any of the other instruments enumerated earlier. Quite true. However, at this point I will like to take you back to the fact that over the long term, equity has the potential of delivering the highest return. So, say over a five-year period, an ELSS fund will almost certainly give you a much better return than Bank FD or post office deposit. Recycling old investments During an economic downturn like this one, money becomes tighter. Take the case of Ravi, a friend of mine, who is into web design. Ravi's lament was that he was paying tax on income that he had not received. He had over Rs 5 lakh in receivables but customers in general were holding out for higher credit periods. Since our income tax law taxes income on accrual and not on receipt, he had to pay the tax on the Rs 5 lakh not yet received. He was finding it difficult in arranging funds required to pay his employees for the month, so to keep anything aside for tax saving was a long shot. In such cases, one can use another tax planning tool. I call it recycling. Ravi can simply withdraw an earlier investment (say from ELSS or PPF) and redeposit the money, even in the very same instrument. He will get the tax deduction for no additional outlay - in other words, his savings remain the same, but without investing a rupee, he can avail himself of the 31% tax saving. To conclude Tax saving is not an end in itself; it is the means to an end. So, this year don't get seduced by the latest investment product in fashion but instead review your financial goals and asset allocation and then select the tax saving instrument accordingly.
Recession? The US is in a Depression0 commentsEven the new $787 billion plan maynot rescue the economy Vivek Kaul. Mumbai The cure for a depression is a depression. The situation won’t return to ‘normal’ until this crisis has been able to do its work — Bill Bonner “It’s all in your mind, V. They can take away your job, but they can’t take away that brain you have inside your head,” she told me, trying to pacify my fears of being fired. “I guess, you are right,” I replied. “But to tell you frankly, it is not looking good. The US has come up with another rescue plan. This time, the big round number is $787 billion. So if we add the earlier two rescue efforts, the bigger round number is more than $2 trillion. One of the biggest items in this new plan is a $400 payroll tax cut for individuals and $800 for couples. Some others like retirees, war veterans etc who do not pay payroll taxes will get a $250 payment from the government. The idea is that the beneficiaries will spend all this money, which will help revive a contracting economy and, in turn, save jobs. But I don’t think all this is going to make much of a difference,” she said, puncturing all the pacification she had just indulged in. “Why do you say that?” I asked. “I don’t think all the efforts being put in by the US government to get its citizens to start spending will bear much fruit. Private debt is usually around 80% of the gross domestic product (GDP), but right now in the US it is 140% of the GDP. In money terms, private debt in the US is now around $6 trillion and this is after nearly $1 trillion was written off in the last two years. Now, I need not tell you, that is a hell of a lot of money. People realise that unless they save, they won’t be able to pay off all the debt that they have accumulated. People have also lost nearly $30 trillion in value from their homes and investments over the last few years. This has led to a huge change in psychological attitude when it comes to spending. With real estate prices falling and incomes either stagnant or falling, it is natural that people want to hold on to all their cash. Savings as a percentage of income currently stands at around 2%. Now, that rate has to increase if people are to pay off all the debt that has been accumulated. So, basically, people want to save even though the government wants them to spend in order to revive the economy. Get that?” “Yup, I do. You seem to be getting better and better,” I commented. “You know, David Rosenberg, an economist at Merrill Lynch, has opined that the US economy is not in a recession, but in a depression,” she said. “Depression! But what is the difference between a recession and a depression?” I asked. “Good question. I Googled and found that there is no precise difference between depression and recession. But a depression is essentially an extremely severe recession. And that is why all these attempts by the government to print and spend money — and to get its citizens to spend — to revive the economy just won’t work.” “Hmmm! But why won’t it work? There have been cases in the past when increased government spending has helped revive many economies?” I questioned. “You know this is an exception that proves the rule. The prescribed remedy for a government to get out of any recession is increased government spending that leads to its citizens spending more and hence revival of the economy. But this time it’s different. People just have way too much debt to pay off and, even if they are given tax cuts like they have been offered in this new plan or lower interest rates to borrow and spend, they just won’t spend. All the plans presented till now seek to get people to spend and hence revive consumption. But the economy is in trouble primarily because people borrowed way beyond their capacity and spent too much. As economics and financial writer Mike Shedlock recently put it, ‘Consumers and banks have both been burnt, and attitudes have changed’,” she replied with great confidence. “You explained the consumer part of it. But what about the banks… Why are they not lending? The US government has been helping banks. The increase in lending to American banks as of November 2008 was a staggering $700 billion. Where is all that money going? Even after a lot of government money has been pumped into banks,” “Hmmm! Just imagine if all that money were to hit the economy. What do you feel will happen?” she asked. “Well at a very basic level, such an increase in money supply will lead to a humungous increase in inflation. “Inflation is always a monetary phenomenon,” this is one of the few things that various schools of economics seem to agree on,” I answered. “Right! The fact is that inflation is well under control even with all this increase in money supply. What does that tell you?” she asked. “It means that all that money given to the banks is not coming into the economy… But if it’s not coming into the economy, where is it going?” I asked. “Banks are depositing the money lent to them by the US Fed, back at the US central bank. On this, the US Fed pays them an interest of 0.1%. Other than this, the money that banks raise through depositors is also being deposited with the US Fed. Now why would a bank which pays an interest of around 2% on its fixed deposit, go back and deposit that money to the US Fed at almost zero percent?” she questioned. “It would do that only if it expects to lose more money by lending to people,” I replied, finally getting what she was trying to explain. “But is there a way out of this?” I asked. “There is a way,” she answered. “Economist and investment letter writer Bill Bonner wrote in a recent column, ‘There is about $6 trillion worth of debt that needs to be eliminated before the economy can begin to grow again. Liquidation would do it - quickly and painfully’. He seems to be suggesting that the simplest way to get around all this is to write off the humongous amount of private debt that remains and start afresh.” “So why is it not being done?” I asked nonchalantly. “You know, you can be really stupid at times. If that happens, the US dollar would simply collapse and that of course is not acceptable to the present establishment or for that matter the previous establishment. But I guess the US dollar would collapse anyway. All those dollars that are being printed to rescue the economy will hit the economy sometime, and, when that happens, inflation is going to go through the roof. When inflation goes through the roof, the world at large won’t want to hold on to the humongous amount of securities issued by the US government. They will get out of those securities leading to a crash there. Once they have got the dollars by selling those securities, they will also want to sell off those US dollars and get into other currencies and that my dear, as you have explained in the past, will lead to the US dollar crashing,” came as a long wielding response from her. “So what is the moral of the story?” “Buy gold. With the expected collapse of the US dollar, all the money is going into gold.” (The example is hypothetical) k_vivek@dnaindia.net References: Ben Bernanke’s Wild Ride (and Ours)by Gary North, January 28, 2009,www.lewrockwell.com What We Face Now Is a Depression,by Bill Bonner, February 6, 2009,www.lewrockwell.com Ghost Malls - Coming to Your Townby James Quinn, February 04, 2009,www.dollarcollapse.com
It’s time to invest in gilt funds0 commentsWith interest rates easing, the returns have started improving ICRA Online Research Desk Saying 2008 was a tough year would be an understatement, what with the equity markets crashing like a pack of cards and the world at large being heaped with unending financial woes. Investors at large suffered. But one class of funds did exceedingly well during the year — gilt funds. The term ‘gilt’ originated to connote British government certifications that had gilded edges. Going forward, they have come to be defined as mutual funds that predominantly invest in government securities (G-secs). These funds are ideal for retail investors as they allow them an opportunity to invest in government papers, which are otherwise dominated by corporate investors. Gilt funds are possibly the safest class of mutual funds on offer. Indeed, the basic purpose of investing in gilt funds is to generate returns at negligible risk as it is highly unlikely the government will default on the debt raised by it. G-secs include central government dated securities, state government securities and treasury bills. Returns on upcycle Since 2004, the returns from gilt funds had been far from impressive. This was largely because the crescendo of economic boom began building around this time and interest rates were on their way up. Consequently, the return on government bonds began diminishing. With the stock markets booming — the BSE Sensex rose 65% in 2004 — there were more lucrative, albeit more risky, assets to which investors flocked. See table for the gyrations in annual returns delivered by gilt funds. Till 2003, double-digit returns on gilt funds were the norm. However, at the end of 2004, the average longer term gilt fund actually delivered a loss to its investor. These funds can also be quite volatile in terms of returns delivered. The 10-year dated G-sec yield touched a level of as high as 9.46% and dropped to as much as 5.25% over 2008, which gives an indication of volatility in the market. It is no surprise then that gilt funds suffered a tremendous outflow of assets for around four years since 2004. At the beginning of 2004, the assets under management of gilt funds stood at Rs 6,062 crore, which was down to a mere Rs 2,849 crore by January 2008. Year on year, the returns on gilt funds between 2004 and 2007 were also quite dismal. However, things have changed considerably over the past year. Today, the assets managed by gilt funds are at an all-time high of Rs 10,661 crore and we are witnessing double-digit returns again. As of December 31, 2008, the average long-term gilt fund delivered anywhere between 18% and 45% over a one-year time frame. And in just the last three months of 2008, the average long-term gilt fund returned as much as 20%. This is because the Reserve Bank of India (RBI), which over the past four-and-a-half years was relentlessly raising interest rates to curb liquidity in the economy, has done an about turn and started slashing rates. The higher trading volume in the G-secs market has made gilt funds a preferred investment destination. Further, in the last two months there has been strong investor interest in debt funds as a whole due to expectations of interest rates falling further. Not entirely without risk All the same, investors need to keep in mind that investment in gilt funds isn’t all safe. While it is true that risk of default in G-secs, issued as they are by the government, there is always the risk of interest rates changing. When interest rates move up, bond prices move down and vice versa. Bond prices could fall because of other factors as well. For instance, while investors have been optimistic about G-secs and the market has been gung-ho about declining interest rates, gilt funds delivered negative returns during the month of January 2009. The average long-term gilt fund lost 6.27% over the month. Thus, apart from being volatile over the short term, these funds can deliver losses as well. As a lay investor, you could keep a lookout for certain key indicators in newspapers to follow the trends in gilt funds. The cash reserve ratio (CRR) and repurchase rate (repo) are good indicators as an increase in either would bring bond prices down and vice versa. Bond prices are also sensitive to inflation as the central bank is likely to increase the CRR and repo lest inflation spiral out of control. Higher inflation is viewed as a negative and can pull bond prices lower. An increase in government borrowing can also queer the pitch for bonds as traders just hate it. Of late, an increase in government borrowings has been a big dampener to investor confidence. Call rates, which are an indicator of short-term liquidity in the market, influence bond prices indirectly, for if call rates are increasing, traders and banks are likely to sell G-secs held by them, triggering a drop in prices. Also, instead of bond prices, you will find references to the ‘yield’ of a particular instrument. When bond prices fall, the yields increase and vice versa. How to pick gilt funds Selecting a fund that fits in with your risk profile is extremely important. A nervous investor, uncomfortable with negative returns even over the very short term, will invest in a very different sort of gilt fund compared with a more risk-tolerant investor. Next week we will talk about the differences between short-term and long-term gilt funds, and the applicable entry loads as well as expense ratios these funds charge. Should Americans spend now or save? Trickquestion0 commentsOr, how should they spend, yet save, and then save the economy David Leonhardt It’s the American consumer’s fault. Part of it is, anyway. You spent too much money. You bought too much house, took on too much debt and generally lived beyond your means. Your free-spending ways helped cause the worst financial crisis since the Great Depression. And now you’re going to have to do your part to end the crisis. How? By spending. Enough already with the saving that many of you have suddenly begun doing. This very moment, the US congress and president Barack Obama are preparing to send you a tax rebate, to inspire you to stimulate the economy. So go out and stimulate. Spend as if the future of your country depends on it. John Maynard Keynes, the great 20th-century economist, would have appreciated the apparent absurdity in these mixed messages. He coined a phrase, “the paradox of thrift,” to describe the fact that what was rational for an individual during hard times —- saving money —- could be ruinous for an entire economy. Eventually, many of the savers may end up out of work because everyone else is saving, too. It’s enough to make you wonder what exactly you’re supposed to do. At his news conference on Monday night, Obama was asked directly whether people should spend or save their rebate checks. He ducked the question. Fortunately, though, it has an answer. There are, in fact, a few ways to help both your own finances and the country’s. The first involves figuring out how to spend money now to save money later —- which can lift the economy today and help individual households cope with their battered finances in the long run. The second involves realising that Keynes’ paradox isn’t ironclad. In a financial crisis, when banks may need capital as much as retailers or restaurants need business, many people can save without guilt. What follows is a guide to spending and saving, both sensibly and patriotically. Besides developing the most famous prescription for curing downturns, Keynes can also be considered the godfather of behavioural economics. While other economists obsessed over statistical models that treated people as hyper-rational automatons, Keynes wrote about “animal spirits.” He helped explain how psychology shaped economics. Psychology-tinged economics —- that is, behavioural economics —- has taken off over the last two decades, and one of its central findings is that most people do not do a good job of planning for the future. They aren’t nearly as nice to their “future self,” as economists say, as to their “present self.” They eat just one more donut and put off exercising until tomorrow and tomorrow and tomorrow. They fail to set aside enough for retirement. Again and again, they choose a bird in the hand — be it dessert, convenience or a little extra cash — over three or four in the bush. These habits end up causing a lot of trouble. But they also present an opportunity in a time like this. Most people could save themselves a good bit of money by giving proper respect to their future self. They could spend a little now and save a lot later. McKinsey & Co recently analysed household spending on energy, for example, and found enormous waste. People heat their homes when they are not there and, thanks to leaks in their walls and heating ducts, also heat the airspace above their roof. A programmable thermostat, which adjusts the temperature when people are out of the house or asleep, can cost as little as $50. For less than $1,000, people can buy the thermostat, as well as hire a contractor to fix leaks and replace their light bulbs with more efficient ones. In either case, the spending often pays for itself in just a year or two. “There is a difference between consuming and investing,” says Ken Ostrowski of McKinsey. “And energy efficiency falls more into the category of investing.” I asked behavioural economists for some other examples, and they helped me come up with a nice little list. Drivers can inflate their tyres, clean their air and fuel filters and start getting better mileage. Book lovers who don’t mind screen reading can buy the new Kindle. It costs $359, but each new book then costs less than $10. Families who shop at rent-to-own stores, which charge ridiculous interest rates, can temporarily pare back and then buy furniture or electronics outright. People who do a lot of laser printing can purchase a printer that uses only a cent or two of ink per page. (Many use far, far more.) In these cases —- and, no doubt, many others — the initial investment tends to pay off quickly, sometimes in mere months. That’s why such spending is perfectly suited to the moment. It will keep people employed or create new jobs when the economy needs the help. But it will also shore up households’ finances. The one big caveat is that some people will feel that they can’t afford to lay out an extra $50 or $100 right now. Millions of workers have already lost their jobs, and many others simply want to cut back. In December, households saved an average of 3.6% of their disposable income, up from about 1% in recent years. In a normal recession, this new saving would have a lot more downside than upside, just as Keynes explained. But this recession is different. It has been caused by a financial crisis. If Americans don’t get their finances in better shape —- if mortgage defaults keep rising and credit card delinquencies soar — banks will remain afraid to lend, and the recession will linger. Even more immediately, banks need to get their own finances in order. That’s the whole aim of the new bailout plan announced by the Treasury Department on Tuesday. Some additional personal savings can only help that effort. “The government is pouring hundreds of billion of dollars into banks,” said Richard Thaler, a University of Chicago economist. “What’s so bad about households pouring some money into banks?” The ideas here don’t apply only to individuals, either. They apply to the stimulus package, too. The federal government is set to spend $800 billion to stimulate the economy. Much of that money will necessarily go to tax rebates, unemployment benefits and other programmes without much long-term benefit. But $800 billion is a lot of money. And the best forms of stimulus are the ones that take effect quickly and bring a long-term payoff. That can mean tax credits for home weatherisation or money to pay for the installation of computerised medical records — two programmes that are still in the stimulus bill. Whenever this recession finally ends, our future selves are going to be facing some very big bills. They can use all the help we can give them.
Lease or let company rent a place for you?0 commentsAccommodation provided by the employer is taxed as a perquisitein the employee’s hands Sandeep Shanbhag The following is an exchange between me and a close friend of mine who recently had to shift to Delhi for a couple of years to execute a project for his company. Since the taxation related issues that he raised apply to taxpayers in general, I am reproducing our dialogue verbatim. Here’s what my friend wrote. Dear Sandeep, As I have been discussing with you, finally it looks like I would have to move to Delhi for around two years. The main issue that concerns me is that of accommodation. Since this is a short-term assignment, I would need to lease a house. My company has very kindly offered me the option of either renting suitable premises on my own or providing me with one. In the former case, I would be paying the lease rent and claiming the house rent allowance (HRA) deduction. On the other hand, if my company were to allot one to me, they would pay the lease rent themselves. Now, my dilemma is to do with the tax impact of selecting either of these options. Upon speaking to a couple of people including my human resources department and doing some research on my own, I confess I am confused between the perquisite value and application of fringe benefit tax (FBT). The following are the different opinions that I have got so far: 1. Perquisite value is 20% of rent paid (and hence FBT is 33.66% of that = 6.73% of rent paid). 2. I should opt for company provided accommodation since the rent paid by the company would be taxed as FBT, which would be 6.73% of the total rent. Even if this FBT is recoverable from me, it would work out much better than paying rent myself and then opting for the HRA deduction. 3. If the employer were to provide me with accommodation, then the perquisite value would be 20% of salary in big cities like Mumbai/ Delhi. Therefore, it is much better to avoid this by leasing the apartment myself and claiming the full lease rent as the HRA deduction. Also, another thought occurs to me. If I were to eventually opt for company provided accommodation, apart from the perquisite value, would the company also need to pay FBT? If so, such FBT may be recovered from me, thereby jacking up my effective rate of tax. Given the above permutations and combinations, could you suggest the most tax optimal course of action? Here’s what I wrote back. Dear Sanjay, It seems to me that you would be better off leasing the place on your own. But before I explain why, there are a couple of concepts that you should be aware of. Firstly, under the system of taxation, there is either perquisite tax payable or FBT but never both. In other words, on any item of expense, if FBT is payable by the employer, the same cannot be charged to tax once again as a perquisite to the employee and vice versa. Secondly, as per a recent amendment, the perquisite value of company provided accommodation has been lowered to 15% of salary from the erstwhile 20%. Now, if you were to opt for employer provided accommodation, the same is taxable as per the provisions of Sec. 17 and Rule 3 as a perquisite in the hands of the employee. The perk value in this regard (that will be added to salary), would be 15% of salary. “Salary” for the aforesaid purposes means basic salary, dearnes allowance (if applicable), bonus, commission, fees and all other taxable allowances (excluding the portions not taxable) and any monetary payment by whatever name called. So basically, almost the entire salary will come into play for calculating the perquisite tax. Therefore, this would be like paying an extra tax of 5.1% (33.99% of 15%) over and above your existing tax payable which would be disastrous. To put the above differently, employer provided accommodation, being a Category I perquisite, is not taxed as FBT in the hands of the employer but as a perquisite in the hands of the employee. Therefore, it would be cheaper (tax wise) to lease the apartment on your own. But here too, note that the entire rent that you pay may not be eligible for tax deduction. The reason for this is that the HRA exemption regulated by rule 2A is the least of the following: 1. An amount equal to 50% of salary, where residential house is situated at Bombay, Calcutta, Delhi or Madras and an amount equal to 40% of salary where residential house is situated at any other place; 2. House rent allowance received by the employee in respect of the period during which rental accommodation is occupied by the employee during the previous year; 3. The excess of rent paid over 10% of salary. “Salary” for the aforesaid purposes means basic salary and includes dearness allowance if terms of employment so provide. Consequently, the entire rent paid may not be deductible. Even so, this deduction will serve to reduce your existing tax rate whereas under the alternative, the additional perk tax will actually increase it. Therefore, it would be best if you pay the rent yourself instead of asking your employer to pay for it on your behalf. The writer is director, Wonderland Consultants, a financial planning firm. He may be reached at sandeep.shanbhag@gmail.com.
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