The Finance & Economics Society of NSIT

presents

CONSILIUM 16
THE NSIT BUSINESS CONCLAVE

Policy Predicament
The Policy Analysis Event

Background Guide
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 2

Letter from the Organizing Committee

Dear Participant,

Congratulations on making it to the second round of Policy Predica-

ment- The Policy Analysis Event.

For the second round, participants have to give a presentation on

the questions given at the end of this background guide, in the col-
lege premises on the day of the event.

The background guide gives a general theme about the agenda at

hand. A few possible areas of research have been given in this back-
ground guide along which the participant can research on. Howev-
er, by no means, is this background guide exhaustive of the entire
agenda at hand. Participants are requested to research extensively
on the given agenda, beyond what is given in this guide, and come
up with the most appropriate answer possible for the questions.

Thank You

Contact the following for any queries:

Nitish Borthakur: (+91) 9868207575
Pranav Sanga: (+91) 9015297333
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 3

US Federal Reserve Interest Rate Hike

Challenges to the Indian Economy

The effect of 2008 financial crisis on US economy

The financial crisis of 200708, is considered by many economists to have been the worst financial
crisissince theGreat Depressionof the 1930s. The crisis played a significant role in the failure of key
businesses, declines in consumer wealth estimated in trillions of U.S. dollars, and a downturn in eco-
nomic activity leading to the20082012 global recession. The US economy, as seen below, went into a
deep crisis.

Income The financial crisis cost the U.S. an estimated $648 billion due to slower economic growth, as
measured by the difference between the Congressional Budget Office (CBO) economic forecast made
in September 2008 and the actual performance of the economy from September 2008 through the end
of 2009. That equates to an average of approximately $5,800 in lost income for each U.S. household.
Government Response Federal government spending to mitigate the financial crisis through the
Troubled Asset Relief Program (TARP) will result in a net cost to taxpayers of $73 billion according to
the CBO. This is approximately $2,050 per U.S. household on average.

Home ValuesThe U.S. lost $3.4 trillion in real estate wealth from July 2008 to March 2009 according
to the Federal Reserve. This is roughly $30,300 per U.S. household. Further, 500,000 additional fore-
closures began during the acute phase of the financial crisis than were expected, based on the Septem-
ber 2008 CBO forecast.

Stock Values The U.S. lost $7.4 trillion in stock wealth from July 2008 to March 2009, according to the
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 4

Federal Reserve. This is roughly $66,200 on average per U.S. household.

Jobs5.5 million more American jobs were lost due to slower economic growth during the financial
crisis than what was predicted by the September 2008 CBO forecast.

Steps taken up by the Federal Reserve of US to boost economy

In December 2008, the Federal Reserve expanded a program of unorthodox lending and securities pur-
chases. It began by reducing its target interest rate -- an overnight bank-lending rate called the feder-
al-funds rate -- from 1%. Another Fed lending rate, the discount rate, will go to half a percentage point,
a level last seen in the 1940s. A number of official borrowing rates -- such as rates on three-month
Treasury bills -- have tumbled to near zero, a level they havent been near since the Great Depression.
Beyond lowering interest rates, the central bank expanded lending programs, including buying of
mortgage-backed securities. The Fed had also started a campaign to lend directly to damaged financial
markets and companies -- nearly anyone with collateral. By such lending, officials had effectively con-
cluded that if banks and financial markets wont extend credit, it will do part of the job for them. The
Fed introduced another program through which they lent as much as $200 billion against highly rated
asset-backed securities backed by car loans, student loans, credit-card debt and small-business loans.

Effect of these steps on US economy

The immediate affects were seen as stocks rallied on the news of the Feds action. The Dow Jones
Industrial Average finished at 8924.14, up 359.61 points, or 4.2%, on the day. Treasury bonds rallied,
sending their yields lower. Yields on 10-year Treasury notes hit 2.269%. The dollar sank against the
euro and the yen.

However, there were many apprehensions at that time regarding these actions of the Federal Reserve.
Those steps by the Fed were being muted then, because many businesses and households are weighed
down by heavy debts. Also, the trouble for Fed officials at that time was that while official borrowing
rates are very low, interest rates for borrowers with even a modicum of risk remain far above levels of
a few months ago, which is squeezing the economy.

Price declines would help many consumers in the short run, but there were fears that a longer-run
bout of falling consumer prices could be dangerous, giving households even more incentive to slow
spending and hoard cash. The approach also carried several risks. It could eventually lead to the oppo-
site of the current problem: higher inflation.

In the long term, the US witnessed a steady rate of growth. By reducing interest rates, the Fed helped
spur business spending on capital goodswhich also helped the economys long-term performance
and helped spur household expenditures on homes or consumer durables like automobiles. For exam-
ple, home sales are generally higher when mortgage rates are 5 percent than when they are 10 percent.
A second benefit of low interest rates was improving bank balance sheets and banks capacity to lend.
During the financial crisis, many banks, particularly some of the largest banks, were found to have too
little capital, which limited their ability to make loans during the initial stages of the recovery.

Low interest rates also raised asset prices. When the Fed increased the money supply, the public found
itself with more money balances than it wanted to hold. In response, people used these excess bal-
ances to increase their purchases of goods and services and of assets like houses or corporate equities.
Increased demand for these assets, all else equal, raised their price.
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Effects on emerging economies

The ultra-loose US monetary policy that started in 2008 drove capital flows into emerging markets by
investors looking for yield. This resulted in upward pressure on emerging countries currencies, rising
equity and bond prices and falling interest rates. Lower interest rates, both external and domestic, in
turn boosted borrowing and economic growth. This time around, it was mainly companies in emerg-
ing markets, particularly in the energy and construction sectors, that have increased their borrowing
in this period of cheap money. Most borrowing has been domestically in local currency, but also from
foreign banks, and increasingly from the international capital market.

Why is the Federal Reserve increasing the interest rates now?

TheFederal Reserve,on 16th December 2015, raised short-term interest rates for the first time since the
financial crisis, a decision it described as a vote of confidence in the American economy even as much
of the rest of the world struggles. The Feds announcement came exactly seven years to the day after
the central bank cut its benchmark rate nearly to zero. The Fed cited strong job growth, and the broad-
er backdrop of a moderate but steady economic expansion, as evidence that the economy no longer
needed quite as much of its help.

The Fed is trying to tiptoe between two kinds of danger. It wants to raise rates to improve its defens-
es against future risks, including higher inflation or another economic downturn. But if it moves too
quickly, it risks undermining the current recovery.

It faces the additional challenge of increasing domestic rates while other central banks are holding
rates down.

Effect on emerging economies

Emerging markets are under pressure from slowing growth in China, falling exports, lower commodity
prices and depreciating currencies. Concerns about the creditworthiness of companies in emerging
markets especially is a rising concern because they have borrowed heavily over the past decade. In-
creasing business failures are therefore to be expected. Even though a large-scale crisis due to the
interest rate hike is not expected, markets will remain unsettled due to uncertainty about the pace and
scope of the normalization of US monetary policy and the strength of the US economy. Most vulnerable
are countries with high external financing needs, high foreign currency debt, a questionable monetary
policy and external low buffers.

The taper turbulence of 2013 was a period of great exchange rate volatility caused by the announce-
ment that the Fed would gradually buy less securities and which affected emerging markets in partic-
ular Capital flows shifted, but now in the direction of the United States and away from emerging mar-
kets: resulting in downward pressure on currency, falling share and bond prices and higher domestic
interest rates in emerging economies

Such a process of capital outflows makes financing of foreign debt more difficult and more expensive,
the latter due to depreciation and higher interest rates. Therefore, it leads to a decline in creditworthi-
ness of borrowers in emerging countries. Particularly disruptive are sudden stops in capital flows,
which in the past have often been associated with US interest rate hikes. As a result of such sudden
stops, rate hikes have often been accompanied by a balance of payments crisis: a financial crisis or
default by the government in emerging economies.
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 6

IS INDIA PREPARED?
Current Scenario
Banking Sector
The Indian banking sector consists of 26 public sector banks, 20 private sector banks and 43 foreign
banks along with 61 Regional Rural Banks (RRBs) and more than 90,000 credit cooperatives.Banking
sector provides much needed funding to industries and cooperates. Indian banks are not known to
give big loans where as foreign banks are able to make it. If Indian banks are able to provide enough
capital for domestic industries, then there will be a decline in reliance on foreign investors.

The major problem related to Indian banking system is bad loans.

BAD LOANS

Bad loan problem is plaguing the Indian banking system. Loans to the industrial sector account for a
major share of their overall credit portfolio as well as stressed loans, according to the report. There was
a 26.8% rise in non-performing assets (NPAs) over the 12-month period ending September this year.
This is a nearly 10 per cent rise from the 16.9 per cent growth in bad loans over the same period a year
ago, with several projects, especially those in the infrastructure sector, stuck. RBI monetary policy of
2015 states that repo rates will change only if banks are able to curtail on bad loans.
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 7

Due to bad loans problems banks loose a significant amount of their deposits. As a result, the banks are
able to give lesser amount of loans and even if they are able to give, they give it at a higher interest rate,
which the industries dont like and move to other sources of credit which includes foreign investors. As
RBI has made it stand clear that it will reduce repo rates only when the banks reduce their bad loans
percentage. A decrease in repo rate will directly result in cheaper loans and the domestic borrower will
be less reliant on the foreign lenders.

RBI asking various banks to emphasis more on the recovery of bad loans. In fact RBI had brought in
provisions like Strategic Debt Restructuring (SDR) and 5:25 mechanism to give tools to the banks power
of recovery for bad debts.

EXTERNAL COMMERCIAL BORROWING

Indian companies have been increasingly resorting to foreign borrowings to meet their financing
needs. Of Indias total external debt, the government accounts for less than one-fifth of the share, im-
plying that Indian companies are exposed to greater risk from Fed interest rate hike. The proportion of
non-government debt in the countrys external debt has increased from 73.7 per cent towards the end
of December 2007 to 80.5 per cent now.

Indian companies have been increasingly skirting the high cost of borrowing in India by borrowing
overseas at half the interest, mainly due to near-zero rates of interest in many countries.

Foreign investors have invested in real estate, start-ups and unlisted companies through private equity
and venture capital funds but these are long-term investors who are unlikely to churn their assets or
face redemption pressure following a US interest rate hike.

FINANCIAL INCLUSION

In order to decrease its dependence on foreign investors it is necessary to exploit domestic savings to
the fullest. To encourage financial inclusion government has taken some steps:
Household savings Savings provides the means for investments. Typically, investments are primarily
funded through domestic savings and the rest through foreign capital inflows. Domestic savings are
from three sources -- households, private and public sector. Household savings form the largest part
of total savings. As domestic savings contributes the most to capital formation, it can also be a limiting
factor to investments. What is lacking for the optimum utilization of households is its shift away from
capital (financial) markets towards unproductive assets like gold and possibilities of channelization
household savings to investment rather than speculative assets.

DEPENDENCE ON IMPORTS

Indias heavy dependence on imports of commodities like oil and gold, along with technology have
contributed to a large current account deficit over the years. The current low price of oil in the inter-
national market has helped reduce the CAD in recent times. Curbing imports can contribute a lot as
imports have to be paid in dollars and a weakening rupee will harm the importer as India being a net
importer, there is a need to cut import bills. However, the government needs to take long term steps
in reducing its dependence on imports to minimize any serious effects on the economy due to it in the
future. One of the recent steps in this direction has been the launch of the Gold Monetization Scheme
by the government to reduce gold imports. Technology imports is another major contributor to CAD.
Even the Indian mobile companies were increasingly reliant on imports. Government had setup a zone
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 8

in Andhra Pradesh for manufacturing mobile phone in India by making the domestic mobile phone
makers to produce in India and thus avoid importing mobiles. Other essential technology products
include laptops and televisions which are imported in large quantities.

FII (FOREIGN INSTITUTIONAL INVESTOR)

FIIs net investments in Indian equities and debt have touched record highs in the past financial year,
backed by expectations of an economic recovery, falling interest rates and improving earnings outlook.
FIIs have invested a net of US$ 89.5 billion in 2014-15 expected to be their highest investment in any
fiscal year. Of this, a huge amountUS$ 57.2 billionwas invested in debt and it is their record invest-
ment in the asset class, while equities absorbed US$ 32.3 billion.
FII is referred to as Hot Money as it moves in and out very fast. Whenever the Federal Reserve raises
the interest rates, the investors move their money out of emerging markets like India to the United
States of America for better returns.

One of the factors affecting foreign funding is GAAR (General Anti-Avoidance Rule). The regulation al-
lows tax officials to deny tax benefits, if a deal is found without any commercial purpose other than tax
avoidance. It allows tax officials to target participatory notes. Under GAAR, the investor has to prove
that the participatory note was not set to avoid taxes. It also allows officials to deny double taxation
avoidance benefits, if deals made in tax havens like Mauritius were found to be avoiding taxes. Partic-
ipatory Notes commonly known as P-Notes or PNs are instruments issued by registered foreign insti-
tutional investors (FII) to overseas investors, who wish to invest in the Indian stock markets without
registering themselves with the market regulator, the Securities and Exchange Board of India (SEBI).
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 9

FDI (FOREIGN DIRECT INVESTMENT)

Foreign direct investment (FDI) is a major source of non-debt financial resource for the economic de-
velopment of India. Foreign companies invest in India to take advantage of relatively lower wages,
special investment privileges such as tax exemptions, etc. For a country where foreign investments are
being made, it also means achieving technical know-how and generating employment.

Healthy inflow of foreign investments into the country helped Indias balance of payments (Bop) situ-
ation and stabilized the value of rupee.

Government is taking various steps to welcome FDI in various sectors, but there is still reluctance in the
foreign investors to invest in India such as the defense sector.
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 10

As FDI is into fixed assets and FIIs are in bonds and stocks. FII can be moved out of any country easily
than FDIs in the same country. Another major way to boost FDI is through Make in India. However, in
order to achieve that, lots of bureaucratic hurdles have to be removed. The government has been slow
with its reforms such as land acquisition bill, IPR issues and many more. India now ranks 130 out of
189 countries in the ease of doing business, moving up four places from last years adjusted ranking of
134. But if India wants that investors trust India for investments, India will have to make changes that
significantly increase the ease of doing business. In order to give a boost to make in India, government
decided to ease down FDI rules.

FDI IN INSURANCE INDUSTRY

The Indian insurance market is a huge business opportunity waiting to be harnessed. India currently
accounts for less than 1.5 per cent of the worlds total insurance premiums and about 2 per cent of the
worlds life insurance premiums despite being the second most populous nation. The country is the
fifteenth largest insurance market in the world in terms of premium volume, and has the potential to
grow exponentially in the coming years.

Demographic factors such as growing middle class, young insurable population and growing aware-
ness of the need for protection and retirement planning will support the growth of Indian life insurance
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 11

Insurance firms such as LIC plays a huge role in stock markets as it has a big surplus to invest and
many times it is used by the government to salvage PSUs.

FDI in insurance industry can attract foreign players in Indian market and increase competiveness
among the already present competitors. Insurance companies use their money to invest in projects and
bonds, this in turn will provide an effective solution to generate capital locally.

INVESTMENT IN STARTUPS

In India most of the funding of the startups is done by foreign investors (ventures capitalists, angel
investors). India has third largest startup ecosystem in the world. Active investors in India have in-
creased from 220 in 2014 to 490 in 2015, says NASSCOMs report. As of December 2015, eight Indian start-
ups - Flipkart, Snapdeal, Ola, InMobi, Paytm, Quikr, Zomato and MuSigma - form part of the Unicorn
club (startups having valuation greater than a billion dollar). But due to bureaucratic hurdles many
startups shift abroad. As most of the startups find it more easy to operate outside India as opening and
running a company in India is not easy and that is reflected in ease of doing business ranking (India
ranks 130th in the list). The companies move their operations abroad in order to avoid complex taxation
CONSILIUM 16 : THE NSIT BUSINESS CONCLAVE 12

laws in India. As a result, the money that investors invest in these startup is used by these companies
for their operations in India but actually the transaction of that money has taken place outside India.

START UP INDIA
It aims at providing support to entrepreneurs and remove the red tape that previously existed. For ex-
ample: The government has decided to scrap a tax on seed funding provided to start-ups by Indian an-
gel investors in the upcoming Union Budget, to help domestic financiers bankroll new entrepreneurial
ventures under its Start Up India campaign. By this government aims to reduce the foreign holdings in
startup industry which at the present point of time is dependent mainly on foreign investors.

Question to be answered
Give a presentation on short and long term policy recommendations for the Gov-
ernment of India and the Reserve Bank of India to counter possible economic
challenges in the future due to the gradual increase of interest rates by the Fed-
eral Reserve.