Impossible Trinity - A Macro-economic Policy Conflict!

Introduction

This article discusses the theorem of Impossible Trinity, choices in front of any Central Bank and consequences of its actions. An attempt has been made to highlight an important macroeconomic policy challenge faced by the Central Banks and Reserve Bank of India’s (RBI) steps towards handling this challenge.

The Theorem

The theory of impossible trinity states that it is impossible simultaneously to have full capital mobility, fixed exchange rate and an independent monetary policy.

Here, capital mobility refers to freedom given by a country with respect to inbound and outbound capital flows i.e. no quantitative or qualitative restrictions. All the entities and individuals within the country are allowed to invest/remit money abroad and foreign residents can do so in the host country. Fixity in exchange rate results whenever RBI intervenes in the foreign exchange market in order to control unnecessary deviation in the market exchange rate from the standard, desirable from the economy’s fundamentals point of view. A monetary policy can be said to be independent only, when it is used to regulate growth of the economy. This means, reducing/increasing the interest rates with the sole purpose of accelerating/decelerating the economy growth rate. For example, a decrease in interest rate is warranted in order to push industrial growth after the recent recession.

Application

Now, I would like to discuss the importance of this theorem taking 3 cases, considering a situation where the Indian economy is having in the midst of strong economic growth phase:

· If RBI goes with free capital mobility and fixed exchange rate

This means that there are no restrictions on the incoming and outgoing movement of funds. Also, RBI commits to keep Rupee exchange rate fixed with reference to a foreign currency, say US Dollar (USD).

Now, suppose strong economic growth results in huge capital inflows into the country. These inflows will increase the supply of USD and demand for Rupee which will cause the Rs/$ exchange rate to appreciate. In such a case, if RBI wants to keep exchange rate fixed, it will have to intervene in the foreign exchange market and start buying USD (thereby selling Rupee), so as to depreciate Rupee. This process will increase money supply. If this money supply is normal, there is no worry, but if it is excess, will result in inflation. Such consequent inflation will prevent RBI from intervening in the foreign exchange market, as it hurts Indian economy growth. RBI had faced such a situation in 2008 when it had decided not to intervene in the market due to concerns of inflation.

So, rather than intervening through foreign exchange market, another option available before it is to cut interest rates, so that foreign capital inflows decrease and exchange rate is restored to its earlier value. But in this process, RBI looses its monetary independence and interest rate autonomy, as reduction in interest rate has come to regulate exchange rate, which was unwarranted as the country is already in strong growth phase. Such, reductions may lead to ‘overheating’ in the economy.

· If RBI goes with free capital mobility and desires monetary independence

As explained earlier, increase in capital inflows results in appreciation of the Rs/$ exchange rate. Since, RBI desires monetary independence; it cannot reduce interest rate to discourage capital inflows. So, only tool available is intervention in the foreign exchange market, but this will result in inflation. To avoid inflation, RBI has to let exchange rate determination to market forces.

· If RBI wants monetary independence with a fixed exchange rate regime

Continuing with the previous example, now interest rate reduction is rule out. Intervention in foreign exchange market is also not possible due to fear of inflation. So, to regulate exchange rate, the only option before RBI to is curb capital inflows/mobility as this itself was the cause of initial Rs/$ exchange rate appreciation.

These scenarios can also be looked into from the point of view of a country with weak economic growth.

India’s Case

In India, RBI’s efforts have always been towards inflation-controlled economic growth. Such an approach requires interest rate autonomy. Thus, what RBI has to choose is either fixed exchange rate regime or free capital mobility.

A temporary depreciation in the Rs/$ exchange rate has generally been taken favorable in India because of economic significance and lobbying by exporters. But it has also resulted in increase in the Balance of Trade deficit due to India’s excessive reliance on oil imports, causing further depreciation.

In case of rate appreciation, RBI has generally adopted a managed exchange rate regime with selective intervention to support exports. Such an approach has always resulted in an excessive money supply and resulting inflation. This brings Government into picture, which issues bonds under Market Stabilization Scheme (MSS) to absorb the excess liquidity, so as to curtail inflation. But problem doesn’t end here. These bonds do carry interest payments, which in turn increase revenue and fiscal deficit, cause Government finances in bad shape and downgrading in country’s credit rating. Corporate world feels pinch as their interest rates on foreign financing increases. We are not left untouched as Government has to reduce its spending on social initiatives and if it desires to maintain or increase such spending, it increases tax rates.

Also, any RBI intervention of buying USD leaves it with increased reserves of it. These reserves have to be invested in financial securities abroad (mainly US bonds), which offer meager return. So, total cost of these interventions should be seen as a sum of several above mentioned factors.

What happens when RBI opts for free capital mobility? This issue has been widely debated at all the forums – conferences, print and electronic media, but in the name – full Capital Account Convertibility (CAC). Tarapore committee has given recommendations on implementation of full CAC in India and the issue is still under consideration. But an adoption of such a regime has to result in the free float of exchange rate. But for India, macroeconomic consequences of such an act can be huge as if the volatility is excess, export oriented companies will be unsure about their future revenues and will also result in wide fluctuations in Balance of Trade. Ultimately, RBI will be forced to play with the interest rate and thereby loose monetary independence.

Conclusion

India’s action to tackle impossible trinity has been of adopting a mixture of partial interest rate autonomy, managed exchange rate regime and limited capital mobility. Though in first two aspects, RBI and Government have considerable freedom, there is an increasing world pressure on India, to relax capital controls in this financially integrated world.

It is indeed a macroeconomic policy conflict, which needs to be tackled by RBI and the Union Government.

References:

·Joshi, Vijay, “India and the Impossible Trinity,” World Economy, Vol. 26,

pp. 555-583, April 2003

·Gulzar Natarajan’s blog

(http://gulzar05.blogspot.com/2007/11/impossible-trinity-and-central-banks.html)

·Several recent articles from The Hindu Business Line website

(http://www.thehindubusinessline.com/cgi-bin/bl.pl?subclass=518)

(http://www.thehindubusinessline.com/cgi-bin/bl.pl?subclass=033)

(This article was originally published on www.iimconnect.com - a networking website for IIM students,

alumni and faculty)

Sad but necessary

Rahul Dravid's omission from the one-day side

Everybody is bound to be surprised and there will be hues and cries whenever any senior is dropped from the side. However, what we should remember that if we have to find another Sachin, Sourav or Rahul, we have to pick the youngsters in their prime years. Remember, if Sachin had not been picked up for a tough tour for Pakistan when he was just 16, we would not have discovered India's greatest batsman. If you don't pick the youngsters right now, they may be disheartened and loose their intensity. Change is always painful but we need to accept it, keeping in mind the future particularly because big 3 will definitely not be there for 2011 World Cup.

(Published in Letters to the Editor, The Hindustan Times, Mumbai, 30th October 2007)

Depreciating Rupee: Does it really help exporters?

Abstract

Exchange rates and exports have always been discussed in tandem. Whenever Rupee depreciates, Government become alert as any strengthening of rupee makes the exports costly because of which they loose their competitiveness. Reason given is that this has an adverse affect on the country’s Balance of Payments Surplus and it pulls down the economic growth. Lobby of the exporters also stands up and tries to make its voice heard in the corridors of the Union Government. Hence, this paper has been written with the objective of finding whether there is any relationship between the growth in exports and the depreciating Rupee.

Introduction

In last few days, several articles have been written about the appreciation of Rupee and its effect on the competitiveness of the Indian exports.

This is due to the RBI’s policy of letting Rupee to rise in order to tame the inflation. Till now, whenever Rupee appreciated, RBI intervened by buying the dollars from the market and releasing the equivalent amount of Rupee in the economy which increased the money supply. An increase in the money supply to a particular extent is fine but subsequently it leads to inflation – too much money chasing too few goods. With Indian economy already having a high level of inflation due to supply side constraints, any attempt by the RBI to stem the appreciation of Rupee would have increased the supply of money and hence inflation. That is why; RBI stopped buying dollars which caused appreciation in Rupee.

People have differing views about RBI’s policy. One view is that on account of the appreciating Rupee, our exports will loose their sheen and the trade deficit will increase. Another view is that the appreciating rupee is an indicator of the strong growth of our economy, which has resulted in higher FDI and FII inflows, and there is no harm in what RBI is doing currently. Exporters need to pull on their socks and focus more on cost reduction and quality improvement. In the long run, it is the competitiveness that matters and not the depreciation in Rupee.


Overview

If we observe the trend of Indian exports, India has exported goods and services worth $ 125 bn in the financial year 2006-07 which was just $ 2 bn in 1970-71. Thus exports have grown at a Compounded Annual Growth Rate of approx. 12% p.a. Currently the share of India in the World trade is about 1.5% which is expected to cross 2% in 2009. Similarly, the average exchange rate was Rs. 7.56 per USD in the year 1970-71 which has increased to Rs. 45.25 per USD in 2006-07. The lowest level which the Rupee had touched was in 2002-03 when the average exchange rate was Rs. 48.40 per USD.

Analysis

An important question is that if the Indian exports have grown over the years at a steady rate, has depreciation in Rupee played some role in it. Can the exchange rate explain the variance in the exports?

To find out the answer, investigative studies have been carried out by the author through regression analysis based on data of Rs./$ exchange rate and exports denominated in USD. Dependent variable (Y) is the growth in exports and independent variable (X) is the depreciation in Rupee.

Study I

The period of study was taken as FY 1971-72 to FY 2006-07 i.e. sample size of 36 years.

The results showed that there exists a moderate degree of negative correlation between the depreciation in Rupee and the increasing exports with a correlation of -0.43. Coefficient of determination is 19% which indicates that 19% variation in the growth of exports can be explained by the depreciation in Rupee which means that remaining 81% variation remains unexplained by depreciation in Rupee.

However these results cannot be given much significance as in pre-1990 scenario our economy was not an open one with many trade regulations and exchange controls. It was in the beginning of 1990s that several economic reforms were introduced which involved the deregulation of exports. Also, Rupee was made fully convertible on trade account in February 1993 and on current account in August 1994.


Study II

Keeping in view these facts, another analysis was carried out for the post-reforms period - FY 1993-94 to FY 2006-2007 i.e. sample size of 14 years.

This time the coefficient of correlation is -0.72¸which indicates high degree of negative correlation with 51% of the variation in the growth of exports being explained by the depreciation in Rupee.

The analysis showed that there is negative correlation between the two variables under study however; the extent of explained variation was more in second study. Also, both of these tests have shown significant linear relationship through F Test.

Interpretation and conclusion:

Though both of these studies have got some merits and demerits, we can conclude that that either there is high or moderate degree of negative correlation between the growth in exports and the depreciation in Rupee. It doesn’t matter which study you give importance too, unless the correlation is significantly positive, which hasn’t been proved.

However, as explained earlier, prior to the introduction of economic reforms, our economy was constrained by several rules and regulations and thus the figures of exchange rates and exports may not show us the true picture. In that case, Study II stands out and its results can be considered significant which indicates that there is high degree of negative correlation between the growth in exports and the depreciation in Rupee.

Thus, it can be said that in the long-run, exporters should not get worried whenever Rupee appreciates and, if they keep their thinking hats on they will keep getting better and better and exports are going to increase at a healthy rate.

Further, RBI’s policy of allowing the Rupee to appreciate should be seen in the right perspective. Any appreciation in the Rupee indicates growing strength of the Indian economy with several implications – some positive while some negative. Important thing is whether positives outweigh negatives.

On a lighter note, who would like to buy just a US Dollar by paying 40 Rupees!!

Acknowledgement:

Author is thankful to Dr. Thomas Mathew and Mrs. Jaskiran Arora for valuable help provided during the preparation of this paper.

References:

1. The Economic Survey 2006-07 – www.indiabudget.nic.in
2. Reserve Bank of India’s website – www.rbi.org.in
3. Ministry of Commerce’s website – www.commerce.nic.in
4. “Exports, more than rupee's worth”, Rohit Pandit, Business Line, 25th May 2007

Drivers of Shareholders' Value

“Economic Value Added measures the profitability of a company after taking into account the cost of all capital. It is the post-tax return on capital employed (adjusted for the tax shield on debt) less the cost of capital employed. Companies which earn higher returns than cost of capital create value. Companies which earn lower returns than cost of capital are deemed destroyers of shareholder value.”

- Infosys’s Annual Report (FY 2005-06)


Introduction

The most important objective of Financial Management is the maximization of shareholders’ value. After reading this, the first question which comes to our mind is that how do shareholders know that the company to whom they have entrusted their hard earned money is efficiently utilizing it and thus, creating value for them. We have always read the annual reports of the companies to find out information about their ‘top line’ and ‘bottom line’. We also have various financial ratios for our aid like Return on Capital Employed (ROCE), Return on Net Worth (RONW), Earning per Share (EPS), Dividend per Share (DPS) etc.

In 1890, Alfred Marshall introduced the concept of Residual Income, which can be arrived at by subtracting the charge for the capital employed from the operating profit. In the beginning of the 1990’s, Stern Stewart & Co. came out with a modified way of calculating Residual Income suggesting accounting changes with respect to depreciation, inventory, research and development expenditure etc., for arriving at the figures of operating profit and capital employed. With this, the term – Economic Value Added (EVA) was introduced on which the firm has the copyright.

Many studies have been carried out to find out whether these measures really contribute to the shareholders’ wealth. However, since EVA was introduced as an indicator for shareholders’ wealth maximization, it has been a focal point for majority of the studies. Also, many Indian companies like Infosys, Hindustan Lever, Tata Steel, Godrej etc. have adopted EVA and are mentioning about it in their annual reports.

This paper is another attempt to find out whether EVA really explains the value accretion for the shareholders. Are we better off by removing the focus from EVA and concentrating on traditional measures like ROCE, RONW, EPS, DPS etc.?

Objective

The primary objective of this paper is to find out what drives the shareholders’ value. The study has been conducted to find out the correlation of the measures like ROCE, RONW, EPS, DPS, Cash Flow from Operations and Economic Value Added with Market Value Added (MVA).

EVA and MVA

As the introductory paragraph of this paper suggests, EVA is the surplus profit after accounting for all the expenses including the cost of capital. We have always looked at the figures of Profit after Tax to find out whether a company is performing well or not. However, what we forget is that the shareholders invest money in a company in expectation of some return. So, the basis for evaluation should be whether the company has earned over and above the minimum required rate of return by the investors. If there is surplus after accounting for this opportunity cost of equity, the company is creating value for its shareholders. If not, then it is destroying value. In other words, value is created when return earned by the firm is more than its cost of capital or firm invests in the projects with positive NPV.

EVA can be calculated through any one of the following methods:

· Profit after Tax-(Cost of Equity*Net Worth)
· Operating Profit after Tax-(Weighted Average Cost of Capital*Capital Employed)
· (Return on Capital Employed-Weighted Average Cost of Capital)*Capital Employed


As JHvH de Wat (2005) puts it, EVA is an internal measure of performance that determines MVA, which is an external measure of performance.

MVA can be calculated by subtracting Capital Employed from the Market Value of the firm. Another variant is subtracting Net Worth from the Market Capitalization of the firm. MVA states the value addition at a particular point of time, hence it is a stock variable where as EVA is a flow variable.

A company can be an EVA and/or MVA positive company by:

· Increasing revenue
· Reducing operating costs
· Efficient utilization of assets
· Raising funds at cheaper cost

Literature Review

Stewart (1991) had carried out a research to find out the relationship between EVA and MVA. This study was done by taking average EVA values for the years 1987 and 1988 of 613 companies in USA and then comparing them with their MVA values for 1988. The study found an r² of 97% between the EVA and MVA values for the companies with positive EVA while this correlation was insignificant for the companies with negative EVA values. Finegan (1991) took a sample of 450 companies in USA and found that average values of EVA could explain 61% of the variance in MVA whereas the similar figure was 44% between the change in EVA and change in MVA. He also observed that this r² was 47% between ROCE and MVA. Dodd and Chen (1992) found ROA as a better driver of shares returns as compared to EVA.

Stern (1993) found out that EVA is the best measure that drives the shareholders’ value with an r² of 50% with MVA. The next important driver was ROE with an r² of 25% with MVA. Lehn and Makhija (1996) also studied the relationship of share returns with ROE, ROA, Return on Sales (ROS), EVA, MVA and CEO turnover. Correlation was found to be highest in case of EVA however, CEO turnover also affected the shares returns. O’Byrne (1996) used measures like capitalized EVA (EVA divided by the cost of capital), NOPAT and free cash flows and correlated with them with market value divided by the invested capital. He found NOPAT as a better indicator with an r² of 33% compared with 31% in case of EVA. However, changes in EVA values explained 74% of the changes in market value over a period of 10 years. Uyemara and others (1996) studied MVA’s correlation with EVA, Net Income, EPS, ROE, and ROA over a period of 10 years. r² was highest in case of EVA (40%) followed by ROA (13%). It was least in case of EPS.

Grant’s (1996 and 1997) study of 983 companies showed that of Standardized EVA (EVA divided by Capital) had an r² of 32% with Standardized MVA (MVA divided by Capital). The data taken was for the year 1993 and he also found that the correlation was higher for positive EVA companies. Milunovich and Tsuei (1996) studied the correlation between EVA and MVA in the US information technology industry for the period 1990-95 and found an r² of 42%. EPS was judged as the second best measure with an r² of 34%. Kramer and Pushner (1997) established that lagged levels of NOPAT explained MVA better as compared to EVA. This correlation was found higher even when changes in NOPAT were correlated with changes in MVA. According to Biddle and others (1999), Net Income was found to be the best measure to explain share returns. Majority of these studies were focused on US companies. Griffith (2004) concluded that an investor or analyst using EVA or MVA measures to forecast performance would have experienced significant losses. Ferguson and others (2005) also doubted that adopting EVA improves stock performance.

JHvH de Wet (2005) analyzed the database of 89 South African companies and observed that the Standardized Cash Flow from Operations (CFO divided by the Invested Capital in the beginning) had an r² of 38% with the Standardized MVA (MVA divided by the Invested Capital in the beginning), which was found to be the best driver as compared to the Standardized EVA (EVA divided by the Invested Capital in the beginning), ROA, ROE, EPS and DPS. He also observed that correlation of EPS and DPS with MVA was insignificant and thus questioned the logic of using EPS and DPS for valuing the shares. Roji George (2005) analyzed the data of 21 Indian banks for the period 1999-2003 and concluded that there is a positive relationship between EVA and productivity and negative relationship between EVA and NPA.
Research Method

This analysis was carried out over a period of 10 years on 25 companies which form part of BSE Sensex. Though Sensex comprises 30 companies, 5 companies were eliminated because of the inadequate information available as these companies were listed post 2001 while the study period was April 1997 – March 2006. The reason for choosing companies from Sensex was its reliability in terms of the selection of the companies as only those companies are selected which have a listing history of at least 3 months with sufficient trading frequency. This helps in efficient discovery of price which in turn helps in calculating an accurate value of MVA, Beta and the Cost of Equity.

The regression analysis was done to establish the relationship of MVA with EVA, ROCE, RONW, EPS, DPS and Cash Flow from Operations.

Different measures which were used for the analysis were:

· Standardized Market Value Added (Std. MVA), which is MVA/Avg. Net Worth
· Standardized Economic Value Added (Std. EVA), which is EVA/Avg. Net Worth
· Return on Capital Employed (ROCE)
· Return on Net Worth (RONW)
· Earning per Share (EPS)
· Dividend per Share (DPS)
· Standardized Cash Flow from Operations (Std. CFO), which is CFO/Avg. Capital Employed

Database used was CMIE’s Prowess and Business Beacon from where the values of Avg. Market Capitalization, Avg. Capital Employed, Avg. Net Worth, risk-free return, market return, beta, profit after tax (net of non-recurring transactions), ROCE, RONW, EPS, number of outstanding equity shares, dividends paid and cash flow from operations were taken.

MVA was calculated by subtracting Avg. Net Worth from Avg. Market Capitalization. Value of debt was ignored while calculating MVA because India still doesn’t have a well developed corporate debt market which would have created problems in terms of availability as well as the reliability of the data.
EVA was calculated as follows:

EVA = Profit after Tax – (Cost of Equity*Avg. Net Worth)

where,

Profit after Tax was net of non-recurring transactions.

Cost of Equity was calculated using the Capital Asset Pricing Model, where:

Cost of Equity = Risk-free return + Beta*Market Risk Premium

For calculating risk-free return, average of maximum and minimum yield on 364-days Treasury bill has been used. Beta values have been taken from BSE website and Prowess. Market risk premium has been taken as 7% for the period 2002-05 and 8% for the period 1996-2001, as representative figures being used by some of the companies in Sensex.

Research Results

Analysis establishes that RONW has the strongest correlation (0.59) with Std. MVA with an r² of 34.79%. Standardized EVA comes second with an r² of 28.57% followed by ROCE (r² of 12.92%). Much sought after ratios like EPS and DPS have shown insignificant correlation.

Conclusion

The regression analysis suggests that RONW is the most important variable which explains 34.79% of the variance in MVA, which is not a surprise since shareholders should value an enterprise, based on the return what they are getting on their invested money, which proves that it doesn’t matter whether the company retains or distributed its earnings, so long it is being utilized for productive purposes.

EVA values do have an impact on the MVA of the companies. It takes into account the opportunity cost of capital and it is proved that increase in EVA does add value for the shareholders. ROCE also has some impact, however EPS, DPS and Std. Cash Flow from Operations have shown insignificant relationship.

Thus Return on Net Worth and Economic Value Added emerge as strong drivers of the shareholders’ value.


References:

· Biddle,G.C., Bowen, R.M. & Wallace, J.S., “Evidence on EVA,” Journal of Applied Corporate Finance, Summer 1999, pp 69-79
· Damodaran, Aswath, Corporate Finance (Theory and Practice), John Wiley and Sons Inc., 2nd edition, pp 812-822
· Dodd, J.L. & Chen, S., “EVA: A new panacea?,” B & E review, July – September 1996, pp 26-28
· Durant, Michael W., “Economic Value Added: The Invisible Hand at Work,” Credit Research Foundation
· Ferguson, Robert, Rentzler, Joel and Yu, Susana, “Does EVA improve stock performance profitability?,” Journal of Applied Finance, Fall/Winter 2005, pp 101-113
· Finegan, P.T., “Maximizing shareholder value at the private company,” Journal of Applied Corporate Finance, Spring 1991, pp 30-45
· George, Roji, Prema C. and Kurien Bijo E., “Value Addition at South Indian Bank Ltd.: An EVA Analysis,” Udyog Pragati, Vol. 30, No. 2, April-June, 2006, pp 1-9
· Grant, J.L., “Foundations of Economic Value Added,” 1997, New Hope: Frank & Fabozzi
· Grant, J.L., “Foundations of EVA for investment managers,” The Journal of Portfolio Management, Fall 1996, pp 41-45
· Griffith, John M., “The True Value of EVA,” Journal of Applied Finance, Fall/Winter 2004, Vol. 14, Issue 2, pp 25-29
· Kramer, J.K. and Pushner, G., “An empirical analysis of Economic Value Added as a proxy for Market Value Added,” Financial Practice and Education, Spring/Summer 1997, pp 41-49
· Kramer, J.K. and Peters, J.R., “Economic Value Added and Cost of Capital,” Journal of Applied Corporate Finance
(http://207.36.165.114/Denver/Papers/KramerPetersMFA02.pdf)
· Lehn, K. and Makhija, A.K., “EVA and MVA as performance measures and signals for strategic change,” Strategy & Leadership, May/June 1996, pp 34-38
· Milunovich, S. and Tsuei, A., “EVA in the computer industry,” Journal of Applied Corporate Finance, Spring 1996, pp 104-115
· Myers, Stewart C. and Brealy, Richard A., Principles of Corporate Finance, Tata Mcgraw Hill, 7th edition, pp 322-325
· O’Byrne, S.F., “EVA and market value,” Journal of Applied Corporate Finance, Spring 1996, pp 116-125
· Ross, Stephen A., “Capital Structure and the Cost of Capital,” Journal of Applied Finance, Spring/Summer2005, Vol. 15, Issue 1, p5-23
· Stern, J., “Value and people management,” Corporate Finance, July 1993, pp 35-37
· Stewart, G.B., “The quest for value,” 1991, New York: Harper-Collins
· Uyemura, D.G., Kantor, C.C. & Pettit, J.M., “EVA for banks: value creation, risk management, and profitability measurement,” Journal of Applied Corporate Finance, Summer 1996, pp 94-109
· Weaver, Samuel C, “Measuring Economic Value Added: A Survey of the Practices of EVA Proponents,” Journal of Applied Finance, 2001, Vol. 11, Issue 1, p50
· Wet, JHvH de, “EVA versus traditional accounting measures of performance as drivers of shareholder value – A comparative analysis,” Meditari Accountancy Research, Vol. 13, No. 2, 2005, pp 1-16

Websites:

www.sternstewart.com
ww.financeadvisor.com

Acting affirmatively

Finally, India Inc. has come with the proposal to support affirmative action enlisting steps like paying stipends to students from backward class, imparting training on entrepreneurial skills and imposition of cess on corporate profits to fund elementary education. However, they have made one thing clear that they will not accept any quota of jobs in the private sector. This seems to be a very well thought out strategy as in the absence of these initiatives, Government may force them to reserve jobs for people from backward classes, which may adversely affect their operational efficiency.

This should serve as a food for thought for the elite institutes in India imparting technical and management education particularly IITs and IIMs, who are also opposing the proposed reservation policy of the Government for the students from backward classes. As we know that students desirous of getting admission in these institutes have to clear entrance examinations viz. CAT, IIT-JEE etc. and there is cut-throat competition for achieving this.

What these institutes should do is to be a mean as well as the end. Rather than giving the direct admission to these students from disadvantageous section, with concession in marks secured, these institutes should help them in cracking these entrance examinations. These institutes should organize pre-examination training courses for these students. These courses have to be very similar to what being offered by training institutes like IMS, Brilliant Tutorials, Career Launcher etc. These training institutes provide wholesome training which helps in tackling not only the written examinations but also subsequent selection rounds of Group Discussion and Personal Interview. However, they charge hefty amount which only well-off students can afford to pay and thus, others loose an opportunity to practice well.

IITs, IIMs can utilize their rich experience in the field of education and impart these courses at the cost or even free by leveraging their cash reserves. These courses can be short-term with duration ranging from one month to three months and these being offered at different centres across India, where their entrance examinations are held. In fact similar approach is being followed by majority of the Public Sector Banks during their recruitment for the posts of clerks/probationary officers, with training classes being held before the examinations. Though this will entail additional administrative efforts from these institutes but still it is better than providing reservations at the cost of merit. Further, such an initiative will also be fair to the students from general category, who toil hard to get admissions after spending huge amount.

This will help in creating a level-playing field for all the students irrespective of their caste and economic well-being. Even students from disadvantageous section will support this action as they will be proud of getting admission though their hard work rather than a Government policy. These classes will also help them in their personality development. Also, Government will take this initiative very positively and may not ask these institutes to enforce reservations.

IITs and IIMs should remember that they have been established by Government and they cannot overrule boss’s wishes. What they indeed do is suggesting their boss, various alternatives like these, how are they going to implement them and how is it going to benefit the masses, with a clear message – “We have reservations for meritorious students”.

Profits can improve universities

Apropos the article "Why a university must not go to the market," (Business Line, May 21), a university can really gain a lot of benefits after going public. We all know how infrequently the syllabus is revised in Indian universities. Also, most of them are still running only traditional graduate and post-graduate courses rather than profession-oriented courses of the kind demanded by industry. Once they go public, there will be professional managements looking into these important aspects.

Further, shares can also be issued to the faculty members and administrative staff who will be the owners and thus give their best. And as the focus will be on profits as an entity similar to a company, attractive compensation may be offered to the faculty; this may attract the younger generation towards teaching, as finding committed young people is a major problem faced by the teaching profession.

There should not be any concern with respect to increase in fees too as, with such increases, the number of scholarships can also be increased. Overall, the benefits will definitely outweigh the losses.

Understanding ratios.....!

Often many of us try to fight with the numbers that appear in either the newspapers or the annual reports of various companies. However, we are always dealing with the absolute numbers and hence, the analysis of that company on stand alone basis or comparison with its peers is not possible.

Let me take an example. Recently one of the newspapers carried this information about the performance of the top 10 companies of India and China last year in terms of sales and profits:

Sales ($ bn) Country Net Profit ($ bn)
288 China 40
128 India 10

If we have a look at the absolute numbers of the companies in both the countries, we will arrive at the conclusion that Chinese companies are more efficient. However, by saying this we will be ignoring the fact that Chinese companies are also having higher turnover (sales) which is contributing to their additional profits.

This is where ratios come to our rescue. In this case, if we find a relationship between the Net Profit and Sales, we can observe that Chinese companies are earning a return of 13.89% [(40/288)*100] on their sales whereas Indian companies are earning a return of 7.82% on their sales. So, we can interpret that Chinese companies are earning Rs. 13.89 on every Rs. 100 of sales while the corresponding figure for the Indian companies is only Rs. 7.82.

In other words, Chinese companies are incurring a cost of Rs. 86.11 (100-13.89) for Rs. 100 of sales whereas the corresponding figure for the Indian companies stands at Rs. 92.18. This cost has been incurred with respect to the purchase of raw material, manufacturing, wages and other operating costs. This also proves that Chinese companies are relatively cost efficient as compared to their Indian counterparts which has been substantiated by various reports mentioning about China’s emergence as an effective low cost destination for manufacturing and services.

We have been able to get this insight because of the use of these type of ratios which establish relationship between two absolute numbers so as to enable us to make meaningful analysis and comparison.

Corporate Non-governance

Government's attempt to increase its nominees on the board of Public Sector Banks is a step taken backwards. Earlier, it had directed these banks to go for their board's approval before taking any decision on raising the interest rates. This is unjustified keeping in view the increasing importance of corporate governance. Indian companies have been successful in acquiring the companies and raising large-scale funds from abroad because of the high standards of corporate governance showed by them. Either the Government should rethink its decision or it should also instruct SEBI for ignoring the corporate governance norms.