Open Letters in Response to the Budget

  

As mentioned in my post on the Union Budget FY 2013, I would like to share these 2 Open Letters, addressed to Mr. Finance Minister, in response to the Budget. The reason I picked these two is that they offer very different vantage points; one is from the perspective of a student, and the other is from the perspective of a tech-entrepreneur. Both letters provide good insight on the kind of impact the Budget's proposals would have on everyone, and how this Budget, just like all its predecessors, is not a proactive one.

1. Why I didn’t like the budget: A student’s view of Budget 2012 

Dear Finance Minister,

I hated hearing that long budget speech of yours. Who wants to know if there was an increase in the paddy yield? All I cared about was going to the US, getting a foreign degree and making some money. But do you care?

You are now giving my parents second thoughts about sending me abroad. So what if there’s no service tax on pre-school and high school education? That’s in India. Of course I am not bothered!

You increased the service taxes on all other things from 10 percent to 12 percent. This obviously means my father has to pay more for my GRE tuition and TOEFL tuitions.

For all you know, he might just decide to keep his money in his savings account for it to grow; as you announced that will give him higher income tax exemptions on it and maybe he’ll send me to a college in India. That’s not what I want.

He’s already talking about reducing my pocket money and now you have given him good reason to do that.

The education loan I would take to study abroad won’t come cheap. On top of that, eight years is all I have to repay back the loan. Eight, just eight? Couldn’t you, our finance minister, increase it to 10 years, at least?

Yes, I know you are allocating funds to research centres in India, but I still want to go abroad to study.

You promised to ensure better flow of credit to us, by proposing a Credit Guarantee Fund. But when will that be set up? I want to go abroad the next year as soon as my I am done with high school, but this ‘credit thing’, I am sure, will not be set up so soon. The way India functions it will take another five years. Can you promise you will set it up this year?

You also proposed to set up more schools in rural areas. Ok, I understand development. But what about women’s development? Girl child education and all that? Nothing.

No easy loans even for the girls, while the interest rates will continue to remain at par with the boys.

And even if I forget education abroad for a moment, what about that bike that my father was supposed to give me next month? You’ve made that expensive too. And now that will have to wait too.

Sincerely patient,

A student who did not like your budget

 

2. Mr. FM, why don't you ever think of entrepreneurs?

Dear FM,

I looked you up on Facebook but found a cold 'page'. I checked on Twitter, but came across some fake ids. I searched on Linkedin but you don't seem to be there. I gathered that I can't hang out with you on these internet-mobile places I hang out in, because you probably don't visit them!

Let me come to the point. I read your budget speech with interest (all 14,234 words of it). Amidst your Pacific Ocean of words, I found:

The word 'Startup' mentioned 0 times.

The word 'Internet' mentioned 0 times.

The word 'Mobile' mentioned 2 times.

The word 'Entrepreneur' mentioned 3 times.

Now, the word 'Farm' is mentioned 16 times and the word 'Agriculture' is mentioned 18 times. Sir, let me share with you some interesting trivia. In another country, a couple of years ago, an entrepreneur created a new agricultural community that invited farmers from all over the world.

The address of the farm was the Internet. The place was 'Farmville'. Believe it or not, this Farmville 'thingy' generated `300 crore of revenue in the first year. About 5 crore farmer 'players' signed up! When the Haiti earthquake struck, this community actually garnered money and sent it to Haiti. To cap it all, the company, Zynga (that started this virtual agricultural business), is actually listed on the stock exchanges and is currently worth Rs 5,000+ crore!

Sir, just pause and think if Zynga was created in India. You, sir, would have earned juicy service taxes, revenues from corporate taxes, even would have a nice new age listed company on our otherwise boring bourse. The point I am making, is that new age businesses of the internet and new age entrepreneurs like myself, deserve a bit more attention from you. Because we attract venture capital, we employ people, we generate revenue, we pay our taxes and sometimes, even sell our companies and bring the money home!

Sir, I don't like wearing suits and ties; or coming to meet you in Delhi. But I can request you to help us in a few critical issues, on behalf of the Internet, entrepreneurial community.

Consider These Two Examples:

A month ago, a team of four young entrepreneurs came to meet me. In a couple of minutes, I figured two things about them:

i) They came from families that a decade ago, would have never dreamt that their children would be graduates, speak fluent English and earn more money than their fathers ever did, all at a young age.

ii) This quartet was smart. I mean really smart. Smarter than anyone I had ever met!

This was a goosebumpy moment for me. It signalled that the 'Indian Dream' was working. Despite all our odds, we were producing local 'chaap' Einsteins! These four friends told me that they were quitting their jobs and becoming Internet entrepreneurs. And they presented an idea to me that blew my mind. They wanted me to mentor them, and I readily accepted. I felt it was a 'Googlesque' moment (what may have transpired when Google started up).

A week later, I got an SOS from one of them. They wanted to acquire a web domain (a site name) that was available on a foreign auction site since it was critical to their business. They requested I help them. I readily agreed. What transpired is something I want to bring to your attention.

To buy the domain, I needed to transfer about $1,000 to a German company. They accept only 'PayPal' payments, but PayPal is not available in India. When I wrote to the Germans they were flabbergasted! They said, "PayPal 'is' the global payment platform for small transactions".

But I had to tell them the Indian government had severe restrictions in letting them operate here. I begged them to allow me to wire the money to them. They agreed. When I started the transfer, I realised that it was 'impossible' for a startup to manage the process using the Indian banking processes! I had to sign some 8 forms, get my CFO and his team to 'solve some major paperwork crosswords' and also pay for certification charges.

Finally, I did get the domain, but trust me, on their own, this hot start up would never have made it. The over-regulated and complicated banking laws of India would have killed this 'google' in-the-making even before they started up.

After many years, I was able to woo a senior gaming expert in the US to join me. All he wanted was independence and esops. I gave him independence on day one, but the procedures to carve out esops for a foreign national to be employed by an Indian company became a mystery that would make even Dan Brown's Da Vinci Code look like an amateur essay! It took a good four months to solve the riddle, and I went through hell to keep Mr Gaming Rockstar motivated. He liked me and hung on, but now he is really nervous about India and its laws.

Sir, the number of do's, don'ts, regulations, forms, certifications, validations, permissions, etc that small, startup internet companies require to comply with, kill our energy, excitement and enthusiasm to grow. We need special treatment.

Let me say, that we are like delicate flowers. We need special farming rules to grow. Give us those, and I promise you, when we bloom, your treasury will be full. Not just with revenues but also the scent of a new and fresh Indian Industry!

(The writer is a digital entrepreneur)

India's Union Budget FY 2013

 

The run-up to the Union Budget has seen a plethora of ‘experts’ (bankers, corporate executives, investors, economists, journalists, etc.) voicing their opinion of what the Union Budget FY2013 should look like. The Union Budget is probably the most hyped up event in the economic calendar. From being a simple event of the government declaring the profit and loss account of the public finances, it has undergone a metamorphosis, whereby the government now provides a snapshot of the nitty-gritties of the economy, policy ingredients, and guidance for the next fiscal year. Nobody gains from this parliamentary Budget session as much as the media. In fact, judging by the past few years, the Budget has been more of the TRP (Television Rating Point) event than a GDP (Gross Domestic Product) event.

 

Budget Day in India is somewhat of a close follower of the British counterpart. For many years in Britain, the Chancellor of the Exchequer ceremonially enters the House of Commons with a Victorian-era ‘budget box’ briefcase. In similar fashion, Indian Finance Minister Pranab Mukherjee clutched his red leather briefcase as he entered the Indian Parliament building. Mr. Mukherjee presented India’s 81^st annual Budget on March 16^th; Individually, it was his seventh, the second highest by any Finance Minister in India. Several ‘experts’ were hoping the budget would introduce the much-awaited reforms that would spur economic growth, and bring back the investor confidence. The key reforms anticipated by the markets included:

1. A revamp of Tax-structure by introducing Goods and Service Tax (GST) and a Direct Tax Code (DTC)
2. Allowing Foreign Direct Investment (FDI) in sectors such as Aviation, Retail, and Insurance
3. Trimming the fiscal deficit
4. Removing infrastructure bottlenecks
5. Breakup of the state-run Coal monopoly
6. Cutting back on subsidies (Fuel, Fertilizer, and Food)
7. Maybe even some tax relief for the middle class

However, one doesn’t need to be a genius to realize that making everybody happy was impossible. The FY-2013 Budget, like most of its predecessors, stuck to the age-old trend of taxing consumption, raising taxes for existing taxpayers to pay for the handouts given to the impoverished, bail-out ailing sectors, and optimistically talk about reforms to come. The emphasis was on Inclusive Growth, with increased spending on agriculture, healthcare, and education. Little wonder that his choice of literary quote was from Hamlet: “I must be cruel, only to be kind”, compared to Dr. Manmohan Singh citing Victor Hugo in 1991, “a reformed and confident India was an idea whose time had come”.

The FM started his budget speech reminding everyone of the tough global economic environment (high oil prices due to tensions in the Middle East, European Crisis, the usual suspects really). Then he moved on to present India’s economic performance. FY2012 GDP growth rate pegged at 6.9%, compared to 8.4% in the previous year. GDP growth for FY2013 expected to be around 7.6%. Then he moved on to talk about fiscal consolidation, saying that issues regarding public finance – something that investors and the RBI have been demanding for quite some time now – would be addressed. The fiscal deficit, targeted at 4.6% of the GDP, was likely to be around 5.9% for the year ending March 2012. However, factoring in the states’ deficit, and off-balance sheet items, the overall deficit could touch 9%. He announced the target for next fiscal year to be 5.1% (and below 4% in 3 years), which would be achieved on the back of increased service and excise taxes, and subsidy expenditure reduced to 2% of the GDP (and 1.7% in 3 years) from about 2.7% now. It also set a divestment target of Rs 300 billion for FY2013 compared to its FY2012 target of Rs 400 billion, of which it only managed to raise Rs. 139.1 billion (through an FPO of Power Finance Corp. and a 5% stake auction on Oil &Natural Gas Corp.)

He also tried to excite the financial markets by proposing Qualified Foreign Investors (QFIs) access to Indian Corporate Bond Markets; and incentivize greater participation by retail investors in equity markets through Rajiv Gandhi Equity Savings Scheme, which would give them 50% income-tax deduction upto Rs. 50,000. Then he announced that small investors could e-vote in companies. Obviously their e-vote would not be sufficient to stop the Government from looting PSUs (Remember ONGC?). Furthermore, he lowered the Securities Transaction Tax (STT) to just 0.1%.

Mr. Mukherjee then moved on to talk about the bottlenecks in the economy:

• Provided Rs 158.88 billion for recapitalization of public sector banks, regional-rural banks, and other financial institutions like National Bank for Agriculture and Rural Development (NABARD)
• Allowed another Rs. 600 billion worth of tax-free bond issuances to fund infrastructure projects
• Cut customs duty on imported coal to ensure fuel supply for power generation
• Directed Coal India to sign long-term Fuel Supply Agreements (FSAs) with Power plants
• Allowed Airlines to raise more foreign loans (ECBs) for Working Capital
• Allowed ECBs for Capex Requirements of Infrastructure Projects (more specifically, power projects, roads and highway projects)
• Set up a Credit Guarantee Trust Fund and allowed ECBs for Low-Cost Housing Projects to address shortage of affordable housing in many cities
• Provided for Telecom Towers to get viability gap-funding
• Increased funding for National Rural Health Mission (NRHM) to Rs. 20.8 billion
• Announced a “White Paper” is being prepared to deal with on black money (illicit funds) stashed both, at home and abroad
• Increased Defense spending by 17% to Rs. 1.93 trillion
• Provided Rs. 255.55 billion to the Right to Education, a 21.7% yoy increase, and also proposed setting up a Credit Guarantee Fund for students

Finally he spoke about Taxes. On personal taxes, he enhanced the basic limit for tax exemption to Rs. 200,000, and expanded the 20% tax slab upto Rs. 1 million. The new tax slabs is illustrated below. Furthermore, there would be no separate tax slabs for women. Interest-income upto Rs. 10,000 from savings account in banks or post offices would now be tax-free. But custom duty on Gold and Platinum were increased (understandably so, to curb gold imports and to channel that money into more productive areas of the economy). Additionally, Sin tax increased on some tobacco products.

 There was no change in corporate tax rates. Broadly, service taxes and general excise duties were hiked to 12%. However, peak excise duty remains unchanged at 10%. This surely would be inflationary as services account for 59% of our GDP. I have compiled a chart to illustrate which goods or services will now cost more and which will cost less.

Overall, Union Budget 2013 was expected to deliver big-bang reforms. But all it had to offer was the traditional mix of more public spending and reshuffled taxes, none of which will be revitalize the stalled engines of economic growth. However, one announcement that was big bang in nature was that of General Anti Avoidance Rules (GAAR), a proposal to amend tax laws to retroactively levy capital gains tax on Indian assets (even on deals that take place abroad by foreign entities). This would apply to transactions as far back as April 1962. It appears that the amendment is principally aimed at taxing Vodafone, but this could well scare off foreign investors – the same people who fund India’s current account deficit; the same people that the Indian Government has been trying to woo.

Brief Background on Vodafone Case:

The British telecom giant bought an Indian operator from Hutchison Telecom of from Hong Kong in an offshore deal in 2007 for $11 billion. However, the Supreme Court of India, in January 2012, ruled that Vodafone should not have to pay a $2.2 billion tax that the Indian government claimed.

Later in the day, Mr. Mukherjee tried to explain that the government was only clarifying the 1962 tax law, and trying to close a loophole that allowed some companies to structure transactions in tax-havens such as Mauritius, purely to avoid paying any capital gains tax. “We are making it very clear that it is the law of the land — this is the intention of the legislature,” he said on NDTV, a news channel.

My Reaction

  

The Union Budget continued with the present Government’s theme of Inclusive Growth. Thankfully however, it refrained from announcing any extremely populist measures, especially considering its poor performance in recent state elections. Instead, it focused on fiscal consolidation. However, no big-ticket reforms were announced either. It seems like whatever additional revenues they’re raising will all be diverted to welfare programs and wasteful subsidies. So in short, our government continues to play Robin Hood.

The government has missed targets before. Furthermore, the last 2 quarters have seen so many revisions that government estimates can no longer be considered a reliable source. There is something really wrong with the way the official statistics are calculated and maintained. Hence pardon my cynicism but I’d take these Budget numbers with a pinch of salt too.

One major takeaway is that the government has missed an opportunity to deliver reforms and jumpstart the productive engines of the economy. I was not expecting the budget to deliver too much, but at least a few reforms were desperately needed. Politics is once again driving the nation at the detriment of economics.

We witnessed this two days ago as well, when a coalition ally Ms. Mamata Bannerjee, populist leader of West Bengal based Trinamool Congress, demanded the Railway Minister (who belongs to her own party) to be fired. 

His crime? Proposing a fractional rise in rail fares to modernize Indian Railways and improve its safety and hygiene. The rail budget was forward-looking, and the fare-hike was very modest, ranging from 2p – 30p per kilometer (or 0.04 – 0.6 cents per km); the fares had not been revised since 8 years. But by proposing this, Rail Minister Mr. Dinesh Trivedi had apparently “gone against the Trinamool Congress Party’s DNA” and that was unacceptable. Imagine their reaction if the government proposed privatizing the railways.

With such obstructing allies, it would be near impossible for the Congress to carry out any significant reforms even if they had a stomach for them. Another problem is that India Inc is a spoilt bunch that loves to sulk; hence business and investment climate will not improve until some policy action from the government. This budget failed to do that. The measures announced were marginal at best. It didn’t help RBI either. The central bank is terrified that inflation would pick up again, reflecting a host of supply-side constraints ranging from agricultural supply chain to inadequate infrastructure.

So what should the Budget have focused on? Even taking baby-steps, but in the right direction, can go a long way to fixing things. In addition to all that Mr. Finance Minister announced, he should have formed a Priority Group to maneuver the following:

1. Raise diesel prices, incrementally and quietly, but offset that by matching cuts in the tax on diesel. That way, the fiscal hole starts getting plugged, and the consumers don’t feel much of a pinch.
2. Set-up a facility to fast-track land acquisition and environmental clearances. This would kick-start the implementation of stalled projects, which would create employment along with boosting infrastructure, and housing markets, financial markets, and business sentiment – and all this without investing a single new penny.
3. Present a draft on GST and DTC, outlining how the overall economy (include every stakeholder) would benefit from it. Start discussions with an established deadline for the rollout.
4. As of now, India has only 790 diplomats and ambassadors, compared to about 3,000 in Brazil, over 6,000 in China, and well over 20,000 in America. While this may not have much of a direct impact on Indian’s finances (except their payrolls), it does increase India’s presence in different nations. This not only helps in economic ties, but also strategic ties. For a nation trying to strengthen its global footprint, India is severely under-represented on a diplomatic level.

In a separate post, I would like to share 2 open letters addressed to Finance Minister Pranab Mukherjee in response to his budget announcement. They sum up pretty well how some segments of the economy will be affected. A transcript of his BS (I mean Budget Speech) can be found here:

http://indiabudget.nic.in/ub2012-13/bs/bs.pdf

The ONGC Divestment Debacle

Imagine a situation where you are about to buy a product, which costs Rs 100, and the seller is desperate to sell it off. However he is selling it at Rs 120, despite the product having several plaguing issues. Would you still buy it, knowing that the seller is so desperate to sell this product that it may well sell it for Rs 80 a few weeks later? 

I wouldn’t.

Something similar happened at the ONGC’s (Oil and Natural Gas Corp Ltd) share auction on Thursday, March 1^st. For the benefit of some readers, let me start with the backdrop. In the last Union Budget, the government had planned to sell a stake in several state-owned companies, aiming to raise Rs 400 billion, but unfavorable market conditions prevented them from doing so. The only stake-sale that went through successfully was an FPO (Follow on Public Offer) of Power Finance Corp., which fetched the government Rs 11.45 Billion. Simply put, the government only managed to achieve 2.9% of its divestment target for the year. Furthermore, the economic slowdown resulted in tax revenues falling short of expectations. But its expenditure bill on the multiple welfare schemes only ballooned. Hence, hard-pressed for funds, and with the fiscal deficit target getting topped already in 10 months ending January, the government made a desperate attempt to sell some stake in ONGC Ltd through a share auction (the Indian Government seems obsessed about auctions) just weeks before this year’s Union Budget.

The government’s frantic attempt to narrow the budget deficit through an untested divestment method was near disastrous. Up for auction were 428 million shares, at a floor price of Rs 290 per share; this equated to a 5% stake in the nation’s biggest energy explorer, valued at Rs 124 billion. The auction started at 9:15 am, but the lukewarm response was causing concerns among officials and merchant bankers alike. Until 3:20 pm, 10 minutes before the bidding closed, only 14.3 million shares were bid for, which is less than 3.4% of the total offer. To add to the theatrics, the websites of the two main exchanges, Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), stopped updating the bidding activity on their respective websites at 3:20 pm.

Then, in typical Bollywood fashion, the last 10 minutes saw bids for 406 million shares, led by other state-owned entities such as State Bank of India (SBI) and Life Insurance Corp (LIC). Seven hours later, at 10:30pm, Government officials confirmed that the final demand from investors was for 420.3 million shares i.e. 98% of the total offer, and the average price received was Rs 303.67 per share, which was a 4.7% premium on the floor price of Rs 290. The total amount raised was Rs 127.67 billion, of which over 110 billion was coughed out by LIC alone, roughly 87% of the total amount. While the reason behind LIC’s last minute endeavor may be open for debate, the 377 million shares it bought increase its total stake in ONGC to 9.48%.

All said and done, the government only has itself to blame for the debacle. It had not put in adequate work to ensure that the auction process went through without any hiccups. Instead, it rushed through it, aiming to raise some quick cash, and hoping to show a lower fiscal deficit number in its Budget session of the Parliament, due in 2 weeks. However, now that the Divestment Department has established that the auction results were satisfying, and that an auction would be the method of choice for further divestments hence forth, the government can take away some valuable lessons from this episode.

The Price – Setting the floor price for the auction at Rs 290 per share was the government’s first mistake. Usually, when a firm tries to sell a stake to public, be it in the form of an IPO or an FPO (or an auction as in this case), they issue the shares at a discount. This is attractive, especially for the retail investors as it leaves some money on the table for them by giving them an opportunity to sell the stock in the secondary markets. When the floor price of Rs 290 was formally announced on Feb 29^th, it was at a 1.1% discount from the previous day’s closing price of 293.2.

ONGC Shares, up 14% in 2012 - A misleading benchmark perhaps?

However, what the government (or their advisors) failed to factor in was the wave of liquidity around the world in the last 2 months, which saw foreign investors pour in $7.2 billion (Rs 360 billion) in Indian equity markets, and another $4.8 billion (Rs 240 billion) in the debt markets. Such large inflows caused the ONGC stock to climb 14%. Hence, a more appropriate price would have been somewhere between Rs 260 - 270, the average price in the last few months, thereby offering an attractive discount from the previous trading day’s closing price. Just for the record, the share price as I write this piece is Rs 283 i.e. Rs 7 lost on every share from the auction’s floor price overnight. I wonder how LIC feels about its loss.

The Risks – Another reason why it would have been more prudent on the government’s part to auction at a discount is the operational risk underlying ONGC. In any economy, the nation’s largest energy explorer would be the darling of the investors. However, the case is slightly different in India; on one hand, over 80% of its oil is imported, but on the other hand, the government subsidizes the price of fuel. The problem (not to mention the current account deficit) for investors is that ONGC, being a state-run company, is forced to share a portion of the government’s subsidy burden. In fact recently, the government increased ONGC’s share of burden, and with oil prices edging higher (already above $125 per barrel), chances are that this ratio will increase much further.

 

In addition to the impact on costs and earnings, investors have also been worried about the ad hoc nature of the subsidy sharing arrangement. According to the Economic Times, the company’s subsidy burden for the first 2 quarters of FY12 was close to 30% of the oil marketing companies’ under-recoveries. However, in the third quarter (ending December 2011), the methodology was changed and the burden was calculated to be $56 per barrel, rising from 33% to 38% for the entire 9-month period, April - December. As a result, there was a steep rise of 47% in burden in a single quarter, and no assurances that the methodology wouldn’t change again in the future. Hence, with such uncertainty over issues that have a direct bearing on its profitability, a floor price of Rs 290 was totally unjustified vis-à-vis the underlying risk.

The Timing – The government has been teasing the markets with the idea of an ONGC FPO since December 2010. While the offering was postponed several times, a mere discussion about it stagnated the share price as investors were anticipating a discounted offering. So much so that the stock did not even react to developments such as a bonus issue and a stock split (both of which would otherwise cause a significant rally) in February 2011.

However, when the time finally did come, the government rushed through the process, in order to fill its coffers before the financial year ended. They neither gave themselves and their bankers enough time to market the auction, nor did they give the markets enough time to arrange liquidity to participate. The auction was held barely 48 hours after an official announcement. For a market where the average IPO size ranges between Rs 30 billion to Rs 50 billion, a much greater effort was required by brokers and investment bankers to sell an auction worth Rs 124 billion. Therefore, the government should have been more diligent and given themselves and the market about 8-10 days to prepare for the auction. Alternatively, they could have carried it out in multiple steps, for example, 4 auctions of Rs 30 billion each. This would have calmed some jittery nerves among investors, who fundamentally remain very bearish and indecisive due to several domestic and international overhangs (European Crisis, Slowing GDP, etc.)

All in all, I can see why the government tried to rush through the auction. I can also see why they set the floor price at Rs 290. In the grand scheme of things, ONGC is still undervalued at Rs 290; therefore longer-term investors wouldn’t mind the price too much. However, it is important that the lessons are learnt from this experience. I am convinced that we are living in a world where sentiments control stock prices (at least in the short term), and government interventions drive the economy. Hence the single most critical factor one should evaluate is the underlying risk – risk of a bad investment; risk of mismanaging a stake sale; risk of making a wrong decision. Come to think about it, it’s a life lesson isn’t it?

Update: According to news reports, the decline in ONGC’s share price over the last 2 days (post auction) has cost LIC Rs 9 billion.

Ouch !

Greece gets its 2nd Bailout

Greece has been on the brink of its second bailout for weeks. The  130 billion bailout was first delayed because of the terms of the deal, where private bondholders would take a “voluntary haircut” to avoid triggering the Credit Default Swap (CDS) payouts. Then it was the details of the austerity package, where Greek Finance Minister Evangelos Venizelos was battling the “Troika” of rescuers (European Central Bank, the IMF, and the European Commission) over the details of  3.3 billion of spending cuts. Finally, the Troika wanted the leaders of all political parties to give written assurances that they will not renege on the deal after elections (penciled for April 8^th). 

According to an IMF report published in October last year, a 50% write-down on private sector bonds, stringent targets set by the EU summit, along with  130 in additional low interest financing would give Greece a decent chance to trim its public debt to 120% of the GDP by 2020, from 160% at present. However, since then, Greece's economy has been in much worse shape; it’s already in its fifth year of recession. Naturally, its rescuers – especially Germany – did not want to plug in the bigger financial hole because Greek politicians had already broken several promises on introducing economic reforms in the past. The implications were dire. If there had been no deal by March 20, when a big repayment of  14.4 billion was due (expiration of sovereign bonds), Greece would have no choice but to default. This would trigger a series of CDS payments (the quantum of which are unknown), and that could cause chaos across the entire financial system. Greece could well even be ejected from the Euro (inevitable in my opinion) since the European governments have failed to build a “firewall” around other high debt-ridden nations such as Portugal, Italy and Spain.

Background

For 30 years, the Greeks lived lavishly. Public spending bloated as cheap funding from the US and the EU seeped in, and as citizens incessantly cheated the system, and routinely avoided taxes. The last 3 years have seen Greeks humiliated and forced to endure hardship. Since the first bailout ( 110 billion) in May 2010, the government has imposed austerity and increased the taxes (not a very bright idea for a culture notoriously renowned for evading taxes). Taxes on restaurants more than doubled from 11% to 23%. Property prices and rents have plummeted but property taxes have tripled. An increase in taxes on cars prompted many drivers to hand in their license plates.

Protests against Austerity in Athens

The middle class has been driven into poverty. Many of the small-to-medium sized family businesses (50 employees or less), which make up of about 99% of Greece’s enterprises and 75% of its private sector workforce have either closed down or have sacked many employees. Big businesses aren’t faring much better either. Close to 470,000 private sector jobs have been lost since 2008. In contrast, the (bloated) public sector has seen not even a single job-loss. The civil sector has had a small pay-cut and a minor reduction in benefits, but no job losses. 
 

As a result, the GDP has contracted 12.5% since 2008, and is expected to fall by another 4% this year. Unemployment rate is at 19%, but youth unemployment is close to 50%. Those who do have jobs are over-qualified, underpaid, and overtaxed. In their frustration, they have taken to the streets in protest. Not surprisingly, both, crime rate and homelessness have been surging while investments have practically halted. 

Brinkmanship

Official Handover from Papandreou to Papadamos in November

The leadership battle started in Greece after George Papandreou stepped down halfway through his 4-year term, handing the power to Lucas Papademos. Mr. Papademos, a former ECB vice-president, has already suggested that he will not run; he is expected to take an academic post in America. So the current finance minister Evangelos Venizelos is the socialist party’s front-runner to succeed Papandreou. But preoccupied by the bailout and debt restructuring process, he has hardly been able to campaign. Little wonder that many observers believe that he may have to spend some time in Opposition first.

Evangelos Venizelos (Panhellenic Socialist Movement)

Antonis Samaras (New Democracy)

On the other hand, there is the leader of the conservative New Democracy (ND) party, Antonis Samaras. In opinion polls, his party has an unassailable lead with 33% of the vote, however that is not enough for a clear majority. Hence, the most likely outcome is for Greece to have a coalition party rule. However, a major concern remains the discontent among citizens, many of whom may not even bother to vote at all. They blame not only the New Democracy who was a reckless borrower when in power, but also the Panhellenic Socialist Movement (PASOK) failed to clean up the mess. Also another crucial concern is that without the calm leadership of Papademos, the coalition of populists may not fare well for reforms. Further street unrest could test politicians' commitment to cuts in wages, pensions and jobs. Hence, one cannot blame the Triorka for its lack of trust in Greek politicians, and the reluctance to bail them out.

The Bailout Arrangement

At 5 AM local time (0400 GMT), after 13 long hours of discussion, the Eurogroup of Finance Ministers, chaired by Luxembourg’s Prime Minister Jean-Claude Juncker, finally agreed on the second bailout package for Greece. In return, Athens had to commit unpopular and painful cuts, and private bondholders had to take even bigger losses. The deal still leaves doubts about Greece’s ability to recover, and avoid the default in the long term; but it does buy the 17-nation currency bloc to buy some time to strengthen their ‘firewalls’. The response to this was very dull as expectations of an agreement had been largely priced into financial markets.

As mentioned already, one of the biggest concerns of the deal is the pain that private bondholders have to bear. They will be offered new government bonds with only 31.5% of the principal value, at lower yields and maturities ranging between 11 and 30 years. They will receive another 15% in short-term bonds back by the Eurozone’s temporary bailout fund. The resulting loss of 53.5% is higher than the 50% that was agreed upon in October, but it was necessary to give Greece a fighting chance. This could cause problems in the future as private investors may stay away from Eurozone nations (such as Portugal or Spain) that may need a bailout later.

The Euro zone central banks will also play their part. According to a Eurogroup statement, the ECB would pass up profits it made from buying discounted Greek bonds (over the past two years) to the national central banks so that their respective governments can further pass it on to Athens. This would “further improve the sustainability of Greece's public debt.” The ECB has bought Greek bonds with Face Value of  50 billion on a 24% discount (i.e. for only  38 billion).

Usage of the Bailout Funds

The bond-swapping process for private bondholders, expected to take 3 days, will start on 8^th March. This means that the  14.4 billion bond-repayment, due on March 20^th, will be restructured and Greece will avoid a chaotic default. While a vast majority of the bailout money will be used to finance the bond-swap, some  30 billion will be needed for “sweeteners” to convince private bondholders to sign-up. The remaining funds will be used to cover the budget deficit, recapitalize Greek banks, and finance a bond-buyback. At the end, almost nothing will be left to actually stimulate the Greek economy.

Growth in Austerity

The highlight of the bailout is the demand for austerity from Greece. While it may sound only fair that the Greek Government tightens up its purse strings, it may not exactly be the best approach as it could well lead to a downward debt spiral. Some of the features of the austerity package include a 22% reduction in minimum wage, another round of pension cuts, and 15,000 public-sector job cuts. Mr. Venilezos called these demands “unrealistic” and “farcical” before giving in. Spending cuts are also demanded are in the sectors of defense and healthcare, and to scrap the habit of paying “holiday bonus”. All in all, Greece has been asked to make further cuts in Government spending of 1.5% of GDP. Furthermore, from 2013 Greece is supposed to sustain “primary” budget surpluses (i.e. excluding interest payments). To do this, the government has been considering privatization of national assets such as land, utitilities, ports, mines, etc. 

German finance minister Wolfgang Schäuble suggested that the Greek elections be postponed and a small technocratic government be set up like Italy’s for the next two years to carry out reforms. But the Greeks have now grown resentful of what they regard as German high-headedness.

In such an environment of social upheaval, political uncertainty, insufficient capital, it is not hard to see why Greece has been Eurozone’s most troublesome child; couple that with Eurozone’s out of sync monetary policy, and lack of fiscal unity, and what you get is a system designed to collapse under its own weight. Many economists doubt that Greece will ever be able to pay off even a reduced debt burden, and hint that the bailout has only pushed the can down the road, and Greece will eventually default. After all a return to economic growth could take well over a decade. Little wonder that rating agencies have downgraded Greece and several other Eurozone economies. Yields on Greek bonds have been above 30%, compared to less than 3% on German bonds. However, Considering that Germany has the highest exposure to Greek debt after France, they find themselves stuck in a Catch-22 situation.