SECOND GENERATION ECONOMIC REFORMS IN INDIA

BACKGROUND FOR 2ND GENERATION REFORMS

First Attempt made in 1966 by Indira Gandhi Second Attempt under Rajiv Gandhi in 1985-87 But in 1991 India launch Its Market-Oriented Economic Reforms Since 1991, economic reform has been based on Market Liberalization & a Large Role of Private Enterprise PRESSURE OF ECONOMIC CRISES BALANCE OF PAYMENT & HIGH RATE OF INFLATION- MAJOR REASON FOR 2ND GENERATION ECONOMIC REFORMS. 2ND GENERATION ECONOMIC REFORMS CATEGORIZED UNDER TWO BROAD AREA > Major macro-economic management reforms > Structural sector-specific economic reforms.

Action Plane

Change
Progress report

Objectives of Economic reforms

Increase in the rate of Economic growth Increase in competitiveness of industrial sector Reduction in Poverty and Inequality Increase in Efficiency of public sector Control over Fiscal deficit Promoting FDI Decline in Deficit of BOPs

CORPORATE GOVERNANCE

Brief history Mandated CG Guidelines and Disclosures How does India measure up with Sarbanes-Oxley New corporate governance moves that are expected

CG Brief History

Unlike South-East and East Asia, the corporate governance initiative in India was not triggered by any serious nationwide financial, banking and economic collapse Also, unlike most OECD countries, the initiative in India was initially driven by an industry association, the Confederation of Indian Industry In December 1995, CII set up a task force to design a voluntary code of corporate governance The final draft of this code was widely circulated in 1997 In April 1998, the code was released. It was called Desirable Corporate Governance: A Code Between 1998 and 2000, over 25 leading companies voluntarily followed the code: Bajaj Auto, Hindalco, Infosys, Dr. Reddys Laboratories, Nicholas Piramal, Bharat Forge, BSES, HDFC, ICICI and many others Following CIIs initiative, the Securities and Exchange Board of India (SEBI) set up a committee under Kumar Mangalam Birla to design a mandatory-cumrecommendatory code for listed companies The Birla Committee Report was approved by SEBI in December 2000

Cont

Became mandatory for listed companies through the listing agreement, and implemented according to a rollout plan: 2000-01: All Group A companies of the BSE or those in the S&P CNX Nifty index 80% of market cap 2001-02: All companies with paid-up capital of Rs.100 million or more or net worth of Rs.250 million or more 2002-03: All companies with paid-up capital of Rs.30 million or more Following CII and SEBI, the Department of Company Affairs (DCA) modified the Companies Act, 1956 to incorporate specific corporate governance provisions regarding independent directors and audit committees In 2001-02, certain accounting standards were modified to further improve financial disclosures. These were: Disclosure of related party transactions Disclosure of segment income: revenues, profits and capital employed Deferred tax liabilities or assets Consolidation of accounts Initiatives are being taken to (i) account for ESOPs, (ii) further increase disclosures, and (iii) put in place systems that can further strengthen auditors independence

CG Mandated Guidelines & Disclosures

Board of Directors: frequency of meetings and composition

Board must meet at least at least four times a year, with a maximum time gap of four months between two successive meetings If the chairman of the Company is a non-executive then one-third of the board should consist of independent directors, and 50% otherwise Independent defined as those directors who, apart from receiving directors remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, management or subsidiaries, which in the view of the board may affect independence of judgments. This definition may be soon strengthened The frequency of board meetings and board committee meetings, with their dates, must be fully disclosed to shareholders in the annual report of the company The attendance record of all directors in board meetings and board committee meetings must be fully disclosed to shareholders in the annual report of the company Full and detailed remuneration of each director (salary, sitting fees, commissions, stock options and perquisites) must be fully disclosed to shareholders in the annual report of the company Loans given to executive directors are capped (no loans permitted to non-executives), and must be fully disclosed to shareholders in the annual report of the company

Cont
Board of Directors: information that must be supplied

Annual, quarter, half year operating plans, budgets and updates Quarterly results of company and its business segments Minutes of the audit committee and other board committees Recruitment and remuneration of senior officers Materially important legal notices and claims, as well as any accidents, hazards, pollution issues and labor problems Any actual or expected default in financial obligations Details of joint ventures and collaborations Transactions involving payment towards goodwill, brand equity and intellectual property Any materially significant sale of business and investments Foreign currency and other risks and risk management Any regulatory non-compliance

Cont
Board of Directors: Audit Committee

Audit Committee is mandatory Must have minimum of three members, all non-executive directors, the majority of whom are independent Chairman must be an independent director, and must be present at the annual shareholders meeting to answer audit or finance related questions At least one member must be an expert in finance/accounts Must have at least three meetings per year, including one before finalizations of annual accounts Must meet with statutory auditors and internal auditors; have the powers to seek any financial, legal or operational information from the management; obtain outside legal or professional advice

Board of Directors: Audit Committee functions

Oversight of the companys financial reporting process to ensure that the financial statement is correct, sufficient and credible Appointment / removal of external auditor and fixing of audit fees

Cont

Reviewing with management the annual financial statements before submission to the board, focusing on: Changes in accounting policies and practices Major accounting entries Qualifications in draft audit report Significant adjustments arising out of audit The going concern assumption Compliance with accounting standards, with stock exchange and legal requirements Any related party transactions Adequacy of internal audit and internal control systems, through discussion with internal and statutory auditors as well as management Significant findings, follow-up and action taken reports Discussion with internal and statutory auditors about scope and design of audits Reviewing financial and legal risks and companys risk management policies Examining reasons behind any materially significant default to creditors, bondholders, suppliers and shareholders

Cont
Disclosures to shareholders in addition to balance sheet, P&L and cash flow statement

Board composition (executive, non-exec, independent) Qualifications and experience of directors Number of outside directorships held by each director (capped at director not being a member of more than 10 board-level committees, and Chairman of not more than 5) Attendance record of directors Remuneration of directors Relationship (familial or pecuniary) with other directors Warning against insider trading, with procedures to prevent such acts Details of grievances of shareholders, and how quickly these were addressed Date, time and venue of annual general meeting of shareholders Dates of book closure and dividend payment Details of shareholding pattern Name, address and contact details of registrars and/or share transfer agents Details about the share transfer system Stock price data over the reporting year, and how the companys stock measured up to the index

Cont

Financial effects of stock options Financial effects of any share buyback Financial effects of any warrants that are to be exercised Chapter reporting corporate governance practices Detailed chapter on Management Discussion and Analysis focusing on markets, operations, finances, accounts, risks, opportunities and threats, internal control systems Consolidated financial statement, incorporating accounts of all subsidiaries (over 50% shares held by reporting company) Details of all significant related party transactions Detailed segment reporting (revenues, costs, operating profits and capital employed) Deferred tax liabilities and assets and debit/credit in the P&L for the reporting year

Corporate Governance How does India measure up with Sarbanes-Oxley

The Sarbanes-Oxley Act came into force in July 2002 and introduced major changes to the regulation of corporate governance and financial practice. It is named after Senator Paul Sarbanes and Representative Michael Oxley, who were its main architects, and it set a number of non-negotiable deadlines for compliance.

Sarbanes-Oxley Act
The Sarbanes-Oxley Act is arranged into eleven 'titles'. As far as compliance is concerned, the most important sections within these eleven titles are usually considered to be 302, 401, 404, 409, 802 and 906.

Section 302

Under title III of the act, and pertains to 'Corporate Responsibility for Financial Reports'.

Section 401

Under Title IV of the act (Enhanced Financial Disclosures), and pertains to 'Disclosures in Periodic Reports'.

Section 404

Under title IV of the act (Enhanced Financial Disclosures), and pertains to 'Management Assessment of Internal Controls

Section 409

Under title IV of the act (Enhanced Financial Disclosures), and pertains to 'Real Time Issuer Disclosures'.

Section 802

Within Title VIII of the act (Corporate and Criminal Fraud Accountability), and pertains to 'Criminal Penalties for Altering Documents'

Sarbanes-Oxley Act
.
Section 302 - This section is of course listed under Title III of the act, and pertains to 'Corporate Responsibility for Financial Reports. Periodic statutory financial reports are to include certifications that:
The signing officers have reviewed the report The report does not contain any material untrue statements or material omission or be considered misleading The financial statements and related information fairly present the financial condition and the results in all material respects The signing officers are responsible for internal controls and have evaluated these internal controls within the previous ninety days and have reported on their findings A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities Any significant changes in internal controls or related factors that could have a negative impact on the internal controls

CONT
Section 401 : This section is of course listed under Title IV of the act (Enhanced Financial Disclosures), and pertains to 'Disclosures in Periodic Reports'.

Financial statements are published by issuers are required to be accurate and presented in a manner that does not contain incorrect statements or admit to state material information. These financial statements shall also include all material off-balance sheet liabilities, obligations or transactions. The Commission was required to study and report on the extent of offbalance transactions resulting transparent reporting. The Commission is also required to determine whether generally accepted accounting principals or other regulations result in open and meaningful reporting by issuers

CONT
Section 404 This section is listed under Title IV of the act (Enhanced Financial Disclosures), and pertains to 'Management Assessment of Internal Controls'.

Issuers are required to publish information in their annual reports concerning the scope and adequacy of the internal control structure and procedures for financial reporting. This statement shall also assess the effectiveness of such internal controls and procedures. The registered accounting firm shall, in the same report, attest to and report on the assessment on the effectiveness of the internal control structure and procedures for financial reporting.

CONT
Section 409 This section is listed within Title IV of the act (Enhanced Financial Disclosures), and pertains to 'Real Time Issuer Disclosures'.

Issuers are required to disclose to the public, on an urgent basis, information on material changes in their financial condition or operations. These disclosures are to be presented in terms that are easy to understand supported by trend and qualitative information of graphic presentations as appropriate.

CONT
Section 802 This section is listed within Title VIII of the act (Corporate and Criminal Fraud Accountability), and pertains to 'Criminal Penalties for Altering Documents

This section imposes penalties of fines and/or up to 20 years imprisonment for altering, destroying, mutilating, concealing, falsifying records, documents or tangible objects with the intent to obstruct, impede or influence a legal investigation. This section also imposes penalties of fines and/or imprisonment up to 10 years on any accountant who knowingly and willfully violates the requirements of maintenance of all audit or review papers for a period of 5 years

CG How does India measure up

with Sarbanes-Oxley
Sarbanes-Oxley Indian situation What might be needed

Certification of annual accounts by CEO, CFO

Fully independent audit committees Disgorgement of CEO/CFO compensation in event of restatement Prohibition of insider trading Prohibition of insider loans to directors

At least two directors must sign, of whom one must be the Managing Director
Fully non-executive, majority independent audit committees Accounts and profits once published cannot be re-stated

Need to change to have MD/CEO plus Finance Director/CFO to sign

Need to consider (i) fully independent (ii) tighter definition of independence Need to see if ESOP payments need to be disgorged if there is a restatement Nothing is needed Caps are stringent enough to prevent insider abuse

Prohibits insider trading Strict cap on insider loans to directors; requires prior government approval

Sarbanes-Oxley

Indian situation

What might be needed

Real time disclosure concerning changes in financials and operations

Mandatory periodic review of companys filings once every three years Auditors prohibited from nine types of non-audit services to audit clients Auditors to report to Audit Committee on critical accounting policies Rotation of audit partners every five years Up to 20 years in prison for fraud and destruction of records

Listing agreement mandates Nothing is needed companies to report quarterly results and material changes
No such provision Need to consider how this can be done without creating administrative hassles Nothing is needed

These services are already prohibited in India Mandated by the listing agreement and the Companies Act amendments No such provision exists

Nothing is needed

A committee is considering such a change Need to consider tougher penalties, including longer imprisonment

No such provision

CG - New corporate governance moves that are expected

There are five reasons why one doesnt expect the corporate sector in India to exhibit the excesses that occurred in the US
1. 2.

3. 4. 5.

The amount of stock options to be granted to employees is strictly limited. Expensing options (if adopted) will create a further natural limit In general, companies are controlled by a sizeable shareholder, typically owning over 35% of stocks. This tends to limit agency costs of dispersed ownership The variable compensation package is much more linked to profits and/or EVA, than stock prices or P/E Much greater importance is given to accumulating cash. Profit is an opinion; cash is fact For better or for worse, most Indian companies still dont have to give forward looking earnings estimates

CONT

ESOP: Employee stock ownership plans can be used to keep plan participants focused on company performance and share price appreciation. By giving plan participants an interest in seeing that the company's stock performs well, these plans are believed to encourage participants to do what's best for shareholders, since the participants themselves are shareholders Read more: http://www.investopedia.com/terms/e/esop.asp#ixzz1XRVI7lbW

EVA: Economic Value Added is an estimate of the amount by which earnings exceeds or falls short of the required rate of return for shareholders or lenders at comparable rates.

CG - New corporate governance moves that are expected

After the US crises, there have been some initiatives:

1.

2.

3.

4.

A committee has been set up to examine stock options, including expensing them Another committee has been set up to recommend tighter enforcement by DCA and stiffer penalties, including longer prison terms A third committee has been set up to examine auditor-company relationships and the role of independent audit committees A fourth committee is examining what additional disclosures and accounting standards are needed to have even better corporate governance

CORPORATE SOCIAL RESPONSIBILITIES

CSR focus - People, Planet and Profit (Triple Bottom-line )

Stakeholders in a business - customers, employees, shareholders, communities and environment Sustainable development and profits are inter-related Corporate profits need to be analyzed in conjunction with social prosperity

CSR IN INDIA THE INITIAL STEPS

Evolved through the concept of giving an integral part of Indian culture Philanthropy Religious donations Modern connotation Gandhian concept of Trusteeship

Bombay Plan (1944-45) First initiative by leading business houses (Tata, Bajaj, Birla group through FICCI)

Individual initiatives by individual corporate

CSR IN INDIA FOCUS AREAS

Traditional Education Health Contemporary Capacity Building skill development, training Sustainable Development environmental protection Community Development education, health, poverty alleviation Social Challenges women's empowerment, girl child

CSR - INTERNAL vs. EXTERNAL

Internal (carried out within the organisation) viz. o Energy and water conservation o Employee welfare training, healthcare o Affirmative action employment of backward sections o Corporate governance External (within vicinity or for society at large), viz. o Community development o Capacity building o Environmental protection o Healthcare o Creating awareness - education, health, social issues o E-initiatives Online Information, education, etc.

CSR - Benefits

Positive public image Retaining staff, enhancing employee morale Higher productivity, reduction in costs and increase in profitability Positive engagement with government In-house CSR activities treated as a business expense Contributions to registered Non Profit Organizations eligible for benefits under Indian Income tax laws (Sections 80G, 35AC) Contributions to NGOs 100% deduction if NGO promotes social and economic welfare 125% deduction if NGO engaged in research in sciences/social sciences and statistical research

EXTERNAL SECTORS

After 1991, the liberalization of the external sector was gradual, in consideration of the domestic and external situation. The strategy in 1991 shifted from import substitution to export promotion and the reach of export incentives was broadened to cover numerous non-traditional items. The strategy for external sector reforms had the following key elements: (a) sufficiency of reserves (b) stability in the foreign exchange market (c) prudent external debt management The share of Indias imports in world trade increased from 0.6 per cent in 1993 to 0.9 per cent in 2003, while that of the exports increased from 0.6 per cent to 0.8 per cent.

CONT

BALANCE OF PAYMENTS AND EXTERNAL DEBT - A number of measures have been initiated since 1991 to liberalize capital inflows. Foreign investment policy also underwent a radical change to encourage foreign direct investment to India Convertibility of foreign direct investment was extended to portfolio investments by foreign institutional investors in Indian stock exchanges. Indian corporations were allowed access to overseas financial markets in the form of Global/American Depository Receipts and Foreign Currency Convertible Bonds FOREIGN EXCHANGE RESERVES - India's foreign exchange reserves, as a result of measures initiated since 1991, have continued to record a healthy growth due to moderation in the trade deficit and strong capital and other inflows India's foreign exchange reserves, as a result of measures initiated since 1991, have continued to record a healthy growth due to moderation in the trade deficit and strong capital and other inflows. The increase in reserves has been facilitated by Foreign Direct investment ($129 million in 1991-92 to $ 4.5 billion in 2003-04) and net invisibles ($1.6 billion in 1991-92 to $25.4 billion in 2003-04). Inward workers remittances have increased from $2.1 billion in 1990-91 to $19.2 billion in 2003-04 while software exports have increased from $0.7 billion in 1995-96 to 12.2 billion in 2003-04. EXCHANGE RATE - Despite these regular adjustments, the exchange rate was overvalued and resulted in erosion of international competitiveness by 1990-91.Therefore, it was adjusted downward in two stages on July 01 and 03, 1991 to effect about 18 percent reduction in the external value of the rupee

External Sectors Reforms

OUTCOME OF REFORMS

Merchandise Imports and Exports : There was a healthy growth in the U.S.
dollar value of both merchandise exports and imports other than petroleum, oil and lubricants (POL) for three years 1993-94 to 1995-96 before a subsequent slowdown.

India's Exports in Asian Perspective : Indian export performance in

comparison with that of three rapidly growing East Asian economies (China, South Korea and Taiwan), three South East Asian economies (Indonesia, Thailand and Malaysia) and two of Indias South Asian neighbors (Bangladesh and Pakistan). It is clear that although trade liberalization during the post-1991 period has improved Indias export performance, it is still lagging behind other rapidly growing Asian countries

Cont

Export Shares in Gross Output : When the incentive structure is changed

away from import-substitutes and toward exports as a result of trade liberalization, the consequences are reflected in the increased international competitiveness of the domestic production structure.

Growth in Factory Manufacturing Output and Employment : All the

components of reforms, namely, removal of entry barriers, import tariff reductions, removal of quantitative restrictions on imports of most of the intermediate and capital goods, not only introduced competition both internal and external but also contributed toward more efficient allocation of resources by reducing distortions introduced by the earlier policies. The impact is reflected in a higher growth in real manufacturing output and a faster employment growth in the higher productivity factory segment

Cont

Trends in Total Factor Productivity (TFP) : Prior to reforms of 1991,

given the strait-jacket in which producers were placed through controls on investment, location, technology and input choice, imports of inputs, and foreign investment, and the absence of competitive pressures, it should surprise no one that there was no growth in TFP except in the eighties when the rigors of some of the controls were relaxed.

External Capital Inflows : Until the eighties the two major sources for
external capital for India were bilateral government-to-government foreign aid and borrowing (largely concessional) from international financial institutions. Only in the eighties, when fiscal prudence of the previous three decades gave way to profligacy, the government borrowed from private sources on commercial terms.

Capital Account Convertibility

There is no specific definition of CAPITAL ACCOUNT CONVERTIBILITY. But TaraPore committee defines CAC as the freedom to convert local financial assets into Foreign Financial Assets and Vice-versa at market determined rates of exchange. TaraPore suggestions: Reduction in Gross Fiscal Deficits Mandated rate of Inflation Fully deregulated Interest Rates Reduction of non-Performing Assets But Non of these has been met in its specified time period. There are Limit s to Indian companies borrowing from abroad. Restrictions on Indians sending money abroad that does not have to do with importing goods or services.

Cont

Restrictions on Foreigners investing in India Restriction on foreigners buying shares of Indian companies as only FIIs can hold shares in Indian companies individuals cannot. Restriction on amount that FIIs can hold. Global diversification is practically nonexistent. Components : Merchandise Exports & Imports Invisible Exports & Imports Short Term & Long Term Capital transactions No restriction for Indians (company or individual) talking rupee out or bringing foreign exchange for doing global diversification

CONT

Capital A/C Convertibility desirable o Reduction in cost of capital Foreigners Investing more in India means more money available for Development. o Diversify Portfolios internationally If Indian Household are globally diversified in their portfolios this reduce risk and stabilises the economy o Induces Competition against Indian Finance With convertibility Indian saving will have the choice of moving offshore venues and firms will have choice of Financing Projects offshore. This will have repercussions for Indian GDP growth, since Finance is the BRAIN of the economy o Reduce size of Black Economy If India tries to control on the capital accounts , these are rather easy to evade through various unscrupulous. Pushing for convertibility is about reducing the size of the black market.