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Sequestration: What it really means

The real problem with the sequestration for both politicians and investors is that the cuts will be phased in over time without an immediate impact. No one is really sure what its effect will be. It is doubtful that either party will feel the need to compromise until there is a consequence either from the markets or from the voters

Three months ago as most Americans were getting ready for the annual holiday insanity, the news outlets were adding to the hysteria with threats of a fiscal Armageddon. The fiscal cliff was coming! The fiscal cliff was coming! As of 1 January 2013 taxes for all US taxpayers would rise and government spending would be drastically cut. This would result in an immediate recession. Markets would crash. Corporate and consumer spending would cease. But a funny thing happened. Nothing! Nothing happened.

 

After a number of dramatic late night telephone calls, all-night meetings and even a rare session on New Year’s Day, a holiday in the US, at the last minute the US Congress got together and passed a Bill that raised taxes on a very small percentage of Americans and reinstated pension charges on everyone else. The spending cuts were delayed for two months until Friday 1st March. Markets seemed to anticipate this and continued to rise throughout December and have been flirting with multi-years highs ever since. What is interesting is that the markets do not seem to have priced in the second part of the fiscal cliff, the cut in government spending known as the sequester.

 

In contrast to the fiscal cliff, sequestration has been met with a universal yawn. Compared with the disaster of the Italian election, it seems that nothing much has happened. But if you listen to president Obama, disaster is just around the corner. For the last two weeks the White House has been listing the effects of sequestration. These include the loss of nutrition support for 600,000 poor women and children, cascading flight delays, and a hit to the US military readiness as up to 800,000 civilian employees of the military will go without pay for a short period. Still the American public is almost unanimously apathetic.  Polls have shown that although more voters blame the Republicans rather than the president, only half the population has a clue that there is something going on. They dislike the way the government is going about the spending cuts, but the cuts themselves are generally popular, unless the cut is to your favourite programme.

 

Last December, before the fiscal cliff, there were all sorts of businessmen and CEOs lobbying to prevent it. But now most seem to believe that the cuts would do little harm. The fiscal cliff entailed something all businesses hate with a passion: higher taxes. The sequester is something much more benign: cuts in government spending. Even better those cuts phase in gradually over time. So, unlike a tax hike which would affect people immediately, the cuts may or may not be noticeable.

 

The sequester started as a compromise in the summer of 2011. It was a compromise to insure that the US could continue to borrow money and stand behind its obligations. It was basically a bet by both parties that they would come out with the upper hand at the next election. Sadly the electorate again split down the middle and neither party gained any advantage.

 

The two aspects of it were unequal though in their repugnance to a particular constituency. The idea was to find a solution to America’s $16 trillion deficit, which is approaching 100% of GDP. The Republicans wanted to solve America’s growing deficit with spending cuts. The Democrats wanted to solve it with higher taxes on the rich. The fiscal cliff contained both cuts and taxes, but the Republicans outmanoeuvred the Democrats. They came up with a deal at the last minute that raised a few taxes on a very small number people earning over $450,000 a year, a very small number of individuals. But they delayed the cuts until 1st March. With the taxes out of the way, the Republicans felt no need to compromise on spending cuts. There are Republicans who dislike the military cuts especially in districts with military installations. For every one of those, there are Democrats who like the idea of taming a bloated military.  Still the vast majority of citizens will probably not notice at all. President Obama basically admitted this on Friday. He toned down the scare tactics and said that sequestration would not result in a collapse.

 

The economic effects of the cuts in government spending are hotly debated. Some Democratic tinged economists feel that the cuts of $85 billion this year and $1.2 trillion over 10 years will result in a loss of almost 1% of GDP. In December the US economy grew at only 0.1% and the forecasts are for not more than 2%. The Republican economists are more benign. They point out that the cuts account for only 2.3% of total spending and that the government should easily be able to cut this amount since government agency budgets have been growing by an average of 17% in the previous five years. Their projections are for an impact on the economy of as little as 0.3% although unemployment could tick up from the present 7.9% to 8%.

 

This week in his testimony the Federal Reserve chairman, Ben Bernanke promised continued monetary stimulus in the form of QE3. But he admitted that the stimulus would not be sufficient to overcome the effects of the budget cuts. Bernanke’s promise may not be sufficient, because there are rising doubts about the risks of his programme both in Congress and more importantly among his own Committee. In the minutes recently released ‘many’ of the 19 officials who attend the rate-setting Federal Open Market Committee “expressed some concerns about potential costs and risks arising from further asset purchases”.

 

The sequestration is not the only budget issue. Congress has not been able to pass a budget due to the continuing polarization. To keep the government running, they use a device called “a continuing resolution” that funds programs at prior levels less the sequester cuts. It there is no budget by 27th March, the government shuts down. Finally the debt ceiling ran out in the beginning of February. To avoid the really harsh and immediate economic impact it was extended, but only until May. No doubt these deadlines will be an excuse for more sniping and possible delay, but to go past either deadline has an immediate effect which is probably untenable for either party.

 

The real problem with the sequestration for both politicians and investors is that the cuts will be phased in over time without an immediate impact. So no one is really sure what its effect will be. It is doubtful that either party will feel the need to compromise until there is a consequence either from the markets or from the voters. Right now neither seems to be interested. So nothing will be done.

 

What is clear is that the period of unlimited monetary and fiscal stimulus in the US is coming to an end. This will be difficult for both politicians and central bankers. It is far more fun and popular to hand out money than to take it back. The problem for investors though is not the US tightening. The American economy has recently shown signs of resilience especially in the housing market. It appears that the employment situation is getting better, which will change with sequestration. Recent numbers from manufacturers are hopeful. So there will probably not be a US recession, but neither will there be anything but marginal growth.

 

The problem is that tightening in the US appears to be part of the global tightening. The best thing that can be said about the European numbers is that they are not as bad as they were. The EU remains in recession and the political turmoil in Italy and other countries will not help the situation with the Euro.

 

China has been floating on a flood of cash from the unleashing of its shadow banking system since last year. This will end. The People’s Bank of China recently announced new regulations aimed at controlling these off balance sheet transactions. The state council has announced further restrictions on real estate. The experiments with real estate taxes will be continued and expanded, which will increase carrying costs for the millions of empty apartments. The real estate issue is so bad that even Rui Chenggang, the patriotic anchor of a prime-time business news programme on China Central Television, the state-run broadcaster, opined that “There is a huge real estate bubble in third and fourth-tier cities in China. Sales of homes have slowed significantly, to the point that supply seriously exceeds demand.” Only Japan seems interested in more free money.

 

The combination of a more optimistic outlook in all the major economies and loose fiscal and monetary policy has encouraged speculators around the world to increase their risk exposure and look for yield in every possible place. Markets have been driven to all-time highs in many countries. After a recession a certain amount of stimulus is good, but after four years there may be distortions in the global economy that central bankers did not predict, government policy makers did not foresee and investors may find more painful than any effects of the sequestration.

 

Other stories from William Gamble

 

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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COMMENTS

Vinay Joshi

4 years ago

Hello William,

History shows the second term Prez in US rarely bothers, not many have bothered, Obama bothers for Dems reputation.

The sequester is going to hurt but when else the US will summon the seriousness to cut?

Will it be a hatchet or a scalpel?
What about defences?

What is the reason for US debt?
Per capita debt of $ 52,812 [16.6 trn, GDP 15.7 trn], globally 700+Bn$ assets & operations sold by commercial banks, overseas operation are about 350+Bn.

Will Obama decide to his [Dems] political advantage? 41% GDP government spending.

Italy STARK 'eye opener'. High taxes, VAT 22%, 47% wages of employees fund social protection schemes, employers no better off, unions grip, high taxes.

US wants to follow the path?

Regards,


Infrastructure Debt Funds to accelerate the growth of infrastructure sector

The better rating of Infra companies through credit enhancement will ensure participation of insurance funds and pension funds in providing cost-effective infra funding. The balance sheet of banks loaded with long term infra loans will be off-loaded with the help of take-out finance

The Finance Bill, 2013, has several amendments with respect to investment in the infrastructure sector. Going with the past trend and stressing upon the importance of the infrastructure development, finance minister, P Chidambaram while presenting the Budget for 2013-14, has focused on the need for infrastructure development. To quote him: “While every sector can absorb new investment, it is the infrastructure sector that needs large volumes of investment. The 12th Plan projects an investment of $1 trillion or Rs55,00,000 crore in infrastructure. The Plan envisages that the private sector will share 47% of the investment. Besides, we need new and innovative instruments to mobilise funds for this order of investment.”
 

Though the figure of $1 trillion was based on the 9% growth target when the 12th Plan was announced, and today, for the current year, the growth estimated is 5.5%. So, the investment target has to be changed. The Planning Commission itself is of opinion that India will not be able to achieve $1 trillion target for investment in the infrastructure sector during the 12th Plan (2012-17) in view of lower economic growth prospects.
 

Still, there is a vast gap and to meet the targets, there is a strong need to infuse investment in the infra sector.
 

With such a high investment target, there is a need to attract huge investment in the infrastructure sector and in harmony with the want of promoting investment in the infrastructure sector, the finance minister has taken steps to encourage new and innovative instruments like Infrastructure Debt Funds (IDFs) for infra funding.

Need for IDFs:

 

  • Infrastructure projects have a long gestation period for which they require sustainable and low cost long-term financing. The lenders, which are mostly banks as insurance and pension funds, do not have the risk appetite for such kind of investment. Further, the fact that the pay-back period for infra projects are too long, banks suffers asset-liability mismatch because of long-term infra funding.

 

  • So, there is a dearth of long-term funds for infra sectors, because of which the cost of projects increases significantly.

 

  • The government had set up the India Infrastructure Finance Company (IIFCL) with the objective of providing long-term debt for infrastructure projects. However, its lending was restricted to about 30% of the project debt, thus the balance 70% were left to be raised mainly from the commercial banks.

 

Click here to read more about fixed income investing

Budget 2011-12 laid down the foundation of IDFs:

 

In the budget for the year 2011-12, the setting up of IDFs was announced to facilitate the flow of long-term debt into infrastructure projects.

 

  • Further, in order to attract foreign funds for financing of infrastructure, the finance minister announced creation of special vehicles in the form of notified IDFs. The interest payments on the borrowings of these funds were subject to a reduced withholding tax rate of 5% instead of rate of 20%.

 

  • The income of the IDF was made exempt from tax u/s 10 (47) of the Income Tax Act (IT Act).

 

  • These initiatives were aimed mainly to lure the investors to invest in infrastructure projects.

    Existing IDFs in India:
     
  • Presently, there are four IDFs registered with the Securities and Exchange Board of India (SEBI) viz. ICICI Prudential Infrastructure Debt Fund, Birla Sunlife Infrastructure Debt Fund, IDBI Infrastructure Debt Fund & IDFC Infrastructure Debt Fund. Further, IL&FS Infrastructure Debt Fund & India Infra Debt (the first Infrastructure Debt Fund under the NBFC Structure) was launched in February 2013.

    What’s in store for IDFs in the Budget 2013-14?
     
  • India Infrastructure Finance Corporation (IIFCL), in partnership with the Asian Development Bank (ADB), will offer credit enhancement to infrastructure companies that wish to access the bond market to tap long-term funds. This credit enhancement will help Infra companies to enhance their rating to AA level and thus making it an eligible instrument for investment by institutions like insurance companies and pension funds.

 

  • During the last financial year, ten infrastructure or infrastructure finance companies, including IIFCL, National Highways Authority of India (NHAI), Housing and Urban Development Corp (Hudco), Power Finance Corporation (PFC) and IRFC, were allowed to issue tax-free bonds. They raised around Rs30,000 crore in 2011-12 and are expected to raise about Rs25,000 crore in 2012-13. In the recent budget, the finance minister has decided to allow some institutions to issue tax-free bonds in 2013-14 up to a total sum of Rs50,000 crore.

 

  • Tax-free infrastructure bonds were proposed by the government to channelize retail and institutional savings into the country’s infra sector through long-term bonds. To make these bonds attractive and widen the investor base, the government has allowed full tax exemptions to interest income from these bonds.

    Infrastructure bonds: Now being eligible for investment by charitable/religious trusts

    Tax amendments for IDFs in the Budget 2013-14:
     
  • The Finance Bill seeks to amend Section 115R of the I-T Act, with effect from 1 June 2013 relating to tax on distributed income to unit holders. A proviso has been inserted after clause (iii) of sub-section (2) of Section 115R to the effect that any income distributed by a mutual fund under an infrastructure debt scheme to a non-resident (other than a company) or a foreign company shall be liable for payment of additional income-tax at the rate of 5% on the income distributed.

 

  • Further, the expression “infrastructure debt fund scheme” has been defined by inserting an explanation under Section 115R of the Income tax Act, to the following effect:-

    “ii) ‘infrastructure debt fund scheme’ shall have the same meaning as assigned to it in clause (1) of regulation 49L of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 made under the Securities and Exchange Board of India Act, 1992.”

 

  • The Finance Bill further amends Section 194LC of the I-T Act with effect from 1 June 2013. As per Section 194LC, a withholding tax of only 5% is required to be deducted by the Specified Indian Company while paying interest on infrastructure bonds or for paying interest on ECBs (external commercial borrowings). One of the requirements under this Section is that the borrowing should be in foreign currency.

    Sub-section (2) of the said Section is amended to provide that where a non-resident or a foreign company has deposited any sum of money in foreign currency in a designated account and such sum (as converted in rupees), is utilized to subscribe to any long-term infrastructure bonds issued by the specified company in India, then, such borrowing for the purposes of Section 194LC shall be deemed to have been made by the specified company in foreign currency.

    Further, the expression “designated account” has been defined by inserting an explanation as clause (a) to the sub-section (2) of Section 194LC, to the following effect:-

    “(a) “designated account” means an account of a person in a bank which has been opened solely for the purpose of deposit of money in foreign currency and utilisation of such money for payment to the specified company for subscription in the long-term infrastructure bonds issued by it.”

    Conclusion

 

The income of an IDF is exempted u/s 10 (47) of the I-T Act. There is a lower withholding tax of 5% on income by way of interest received from IDFs by foreign investors u/s 194LB of the I-T Act. Also, the same withholding tax of 5% is applicable on interest income from infra bonds issued by Indian companies to foreign investors. Further, if the credit enhancement is provided by institutions like IIFCL in collaboration with ADB, we do not see a reason why the infra bond market will not accelerate. The better rating of Infra companies through credit enhancement will also ensure participation of insurance funds and pension funds in providing cost-effective infra funding. The balance sheet of banks loaded with long term infra loans will be off-loaded with the help of take-out finance.

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FM gets tough with tax evaders, rules out amnesty

Chidambaram pointed out that no tax burden had been imposed in the Budget on any category of people, other than a “small burden” of a 10% surcharge on the relatively affluent 42,800 people with incomes of over Rs1 crore a year

In a warning to tax evaders, finance minister P Chidambaram said a huge amount of data has been mined to go after them and ruled out any amnesty scheme.

 

“No. In income-tax, there is no case for amnesty. Because now almost all returns are online except a small category which was exempt. We have a huge amount of data being mined. Therefore, there is no case for amnesty today,” he said on Sunday.

 

“Best case I can make out is to tell people, ‘please don’t hide your income’ Just admit your income and pay tax and be a proud citizen,” he said.

 

Chidambaram pointed out that no tax burden had been imposed in the Budget on any category of people, other than a “small burden” of a 10% surcharge on the relatively affluent 42,800 people with incomes of over Rs1 crore a year.

 

That number was deliberately used to ‘shock’ the nation that there are only 42,800 people who admit an income of over Rs1 crore, he said.

 

Voicing the hope that “other measures” proposed to be taken and the ‘shock’ of the number would persuade more people to declare their true income, Chidambaram said that, based on data mining, notices have been issued to 35,000 people, to be followed by more.

 

“We have the central process cell in Bangalore that processes all income-tax returns using the most advanced software. So, if the information we have from other sources is not matched with the information from I-T returns, that will be thrown up,” he said.

 

To a question, Chidambaram said there are no estimates on the amount of black income and the number who should be in the net but who are not. But, he said, in a country with 125 crore people, excluding 67% of the people under food security risk and elderly people and children, there would be 15 crore people with incomes in various segments.

 

“The top 10% should have large income... I think the number must be several times 42,800 who have high income,” he said, adding they may not be earning Rs1 crore but certainly Rs75 lakh or Rs50 lakh.

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COMMENTS

S BHASKARA NARAYANA

4 years ago

“Best case I can make out is to tell people, ‘please don’t hide your income’ Just admit your income and pay tax and be a proud citizen,” the FM said.

I am feeling proud citizen since the VDIS is introduced in 1992, but no incentive or appreciation from the Govt., who honoured the VDIS assessees, which is unethical.

“No. In income-tax, there is no case for amnesty. Because now almost all returns are online except a small category which was exempt. We have a huge amount of data being mined. Therefore, there is no case for amnesty today,” he added.

If it is true, we all, so called proud citizens will forget the pains, experienced so far, by making up our minds that we have sacrificed for the exchequer of the nation.

ABXPS0727J

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