Higher Oil Prices or Higher EMIs? Take your pick

Vivek Kaul

The petrol prices were raised by Rs 6.28 per litre yesterday. With taxes the total comes to Rs 7.54 per litre. Let’s try and understand what impact this increase in prices will have.
The primary beneficiary of this increase will be the oil marketing companies like Indian Oil, Bharat Petroleum and Hindustan Petroleum. The companies had been losing Rs 6.28 per litre of petrol they sold. Since December, when prices were last raised the companies had lost $830million in total. With the increase in prices the companies will not lose money when they sell petrol.
The increase in price will have no impact on the fiscal deficit of the government. The fiscal deficit is the difference between what the government spends and what it earns. The government does not subsidize the oil marketing companies for the losses they make on selling petrol.
It subsidizes them for losses made on selling diesel, kerosene and LPG, below cost.
The losses on account of this currently run at Rs 512 crore a day. The loss last year to these companies because of selling diesel, kerosene and LPG below cost was at Rs 138,541crore. They were compensated for this loss by the government. Out of this the government got the oil and gas producing companies like ONGC, Oil India Ltd and GAIL to pick up a tab of Rs 55,000 crore. The remaining Rs 83,000 odd crore came from the coffers of the government.
What is interesting that when the budget was presented in March, the oil subsidy bill for the year 2011-2012 (from April 1, 2011 to March 31,2012) was expected to be at around Rs 68,500 crore. The final number was Rs 14,500 crore higher.
The losses for this financial year (from April 1, 2012 to March 31,2012) are expected to be at Rs Rs. 193,880 crore. If the losses are divided between the government and the oil and gas producing companies in the same ratio as last year, then the government will have to compensate the oil marketing companies with around Rs 1,14,000 crore. The remaining money will come from the oil and gas producing companies.
The trouble is in two fronts. It will pull down the earnings of the oil and gas producing companies. But that’s the smaller problem. The bigger problem is it will push up the fiscal deficit. If we look at the assumptions made in the budget for the current financial year, the oil subsidies have been assumed at Rs Rs 43,580 crore. If the government has to compensate the oil marketing companies to the extent of Rs 1,14,000 crore, it means that the fiscal deficit will be pushed up by around Rs 70,000 crore more (Rs 1,14,000crore minus Rs 43,580 crore), assuming all other expenses remain the same.
A higher fiscal deficit would mean that the government would have to borrow more. A higher government borrowing will ‘crowd-out’ the private borrowing and push interest rates higher. This would mean higher equated monthly installments(EMIs) for people who have loans to pay off or are even thinking of borrowing.
The only way of bringing down the interest rates is to bring down the fiscal deficit. The fiscal deficit target for the financial year 2012-2013 has been set at Rs 5,13,590 crore. The government raises this money from the financial system by issuing bonds which pay interest and mature at various points of time. Of this amount that the government will raise, it will spend Rs 3,19,759 crore to pay interest on the debt that it already has. Rs 1,24,302 crore will be spent to payback the debt that was raised in the previous years and matures during the course of the year 2012-2013. Hence a total of Rs 4,44,061 crore or a whopping 86.5% of the fiscal deficit will be spent in paying interest on and paying off previously issued debt. This is an expenditure that cannot be done away with.
The other major expenditure for the government during the course of the year are subsidies. The total cost of subsidies during the course of this year has been estimated to be at Rs Rs 1,90,015 crore. The subsidies are basically of three kinds: oil, food and petroleum. The food subsidy is at Rs 75,000 crore. This is a favourite with Sonia Gandhi and hence cannot be lowered. And more than that there is a humanitarian angle to it as well.
The fertizlier subsidies have been estimated at Rs 60,974 crore. This is a political hot potato and any attempts to cut this in the pst have been unsuccessful and have had to be rolled back. There are other subsidies amounting to Rs 10,461 crore which are minuscule in comparison to the numbers we are talking about.
This leaves us with oil subsidies which have been estimated to be at Rs 43,580 crore. This as we see will be overshot by a huge level, if oil prices continue to be current levels. Even if prices fall a little, the subsidy will not come down by much. .
Hence if the government has to even maintain its deficit (forget bringing it down) the only way out currently is to increase the price of diesel, LPG and kerosene. Diesel is a transport fuel and an increase in its price will push prices inflation in the short term. But maintain the fiscal deficit will at least keep interest rates at their current levels and not push them up from their already high levels.
If the government continues to subsidize diesel, LPG and kerosene, interest rates are bound to go up because it will have to borrow more. This will mean higher EMIs for sure. It would also mean businesses postponing expansion because higher interest rates would mean that projects may not be financially viable. It would also mean people borrowing lesser to buy homes, cars and other things, leading to a further slowdown in a lot of sectors. In turn it would mean lower economic growth.
That’s the choice the government has to make. Does it want the citizens of this country to pay higher fuel and gas prices? Or does it want them to pay higher EMIs? There is no way of providing both.
(The article originally appeared at www.rediff.com on May 24,2012. http://www.rediff.com/business/slide-show/slide-show-1-special-higher-oil-prices-or-higher-emis-take-your-pick/20120524.htm)
(Vivek Kaul is a writer and can be reached at [email protected])

Petrol bomb is a dud: If only Dr Singh had listened…

Vivek Kaul
The Congress led United Progressive Alliance (UPA) government finally acted hoping to halt the fall of the falling rupee, by raising petrol prices by Rs 6.28 per litre, before taxes. Let us try and understand what will be the implications of this move.
Some relief for oil companies:
The oil companies like Indian Oil Company (IOC), Bharat Petroleum (BP) and Hindustan Petroleum(HP) had been selling oil at a loss of Rs 6.28 per litre since the last hike in December. That loss will now be eliminated with this increase in prices. The oil companies have lost $830million on selling petrol at below its cost since the prices were last hiked in December last year. If the increase in price stays and is not withdrawn the oil companies will not face any further losses on selling petrol, unless the price of oil goes up and the increase is not passed on to the consumers.
No impact on fiscal deficit:
The government compensates the oil marketing companies like Indian Oil, BP and HP, for selling diesel, LPG gas and kerosene at a loss. Petrol losses are not reimbursed by the government. Hence the move will have no impact on the projected fiscal deficit of Rs 5,13,590 crore. The losses on selling diesel, LPG and kerosene at below cost are much higher at Rs 512 crore a day. For this the companies are compensated for by the government. The companies had lost Rs 138,541 crore during the last financial year i.e.2011-2012 (Between April 1,2011 and March 31,2012).
Of this the government had borne around Rs 83,000 crore and the remaining Rs 55,000 crore came from government owned oil and gas producing companies like ONGC, Oil India Ltd and GAIL.
When the finance minister Pranab Mukherjee presented the budget in March, the oil subsidies for the year 2011-2012 had been expected to be at Rs Rs 68,481 crore. The final bill has turned out to be at around Rs 83,000 crore, this after the oil producing companies owned by the government, were forced to pick up around 40% of the bill.
For the current year the expected losses of the oil companies on selling kerosene, LPG and diesel at below cost is expected to be around Rs 190,000 crore. In the budget, the oil subsidy for the year 2012-2013, has been assumed to be at Rs 43,580 crore. If the government picks up 60% of this bill like it did in the last financial year, it works out to around Rs 114,000 crore. This is around Rs 70,000 crore more than the oil subsidy that the government has budgeted for.
Interest rates will continue to remain high
The difference between what the government earns and what it spends is referred to as the fiscal deficit. The government finances this difference by borrowing. As stated above, the fiscal deficit for the year 2012-2013 is expected to be at Rs 5,13,590 crore. This, when we assume Rs 43,580crore as oil subsidy. But the way things currently are, the government might end up paying Rs 70,000 crore more for oil subsidy, unless the oil prices crash. The amount of Rs 70,000 crore will have to be borrowed from financial markets. This extra borrowing will “crowd-out” the private borrowers in the market even further leading to higher interest rates. At the retail level, this means two things. One EMIs will keep going up. And two, with interest rates being high, investors will prefer to invest in fixed income instruments like fixed deposits, corporate bonds and fixed maturity plans from mutual funds. This in other terms will mean that the money will stay away from the stock market.
The trade deficit
One dollar is worth around Rs 56 now, the reason being that India imports more than it exports. When the difference between exports and imports is negative, the situation is referred to as a trade deficit. This trade deficit is largely on two accounts. We import 80% of our oil requirements and at the same time we have a great fascination for gold. During the last financial year India imported $150billion worth of oil and $60billion worth of gold. This meant that India ran up a huge trade deficit of $185billion during the course of the last financial year. The trend has continued in this financial year. The imports for the month of April 2012 were at $37.9billion, nearly 54.7% more than the exports which stood at $24.5billion.
These imports have to be paid for in dollars. When payments are to be made importers buy dollars and sell rupees. When this happens, the foreign exchange market has an excess supply of rupees and a short fall of dollars. This leads to the rupee losing value against the dollar. In case our exports matched our imports, then exporters who brought in dollars would be converting them into rupees, and thus there would be a balance in the market. Importers would be buying dollars and selling rupees. And exporters would be selling dollars and buying rupees. But that isn’t happening in a balanced way.
What has also not helped is the fact that foreign institutional investors(FIIs) have been selling out of the stock as well as the bond market. Since April 1, the FIIs have sold around $758 million worth of stocks and bonds. When the FIIs repatriate this money they sell rupees and buy dollars, this puts further pressure on the rupee. The impact from this is marginal because $758 million over a period of more than 50 days is not a huge amount.
When it comes to foreign investors, a falling rupee feeds on itself. Lets us try and understand this through an example. When the dollar was worth Rs 50, a foreign investor wanting to repatriate Rs 50 crore would have got $10million. If he wants to repatriate the same amount now he would get only $8.33million. So the fear of the rupee falling further gets foreign investors to sell out, which in turn pushes the rupee down even further.
What could have helped is dollars coming into India through the foreign direct investment route, where multinational companies bring money into India to establish businesses here. But for that the government will have to open up sectors like retail, print media and insurance (from the current 26% cap) more. That hasn’t happened and the way the government is operating currently, it is unlikely to happen.
The Reserve Bank of India does intervene at times to stem the fall of the rupee. This it does by selling dollars and buying rupee to ensure that there is adequate supply of dollars in the market and the excess supply of rupee is sucked out. But the RBI does not have an unlimited supply of dollars and hence cannot keep intervening indefinitely.
What about the trade deficit?
The trade deficit might come down a little if the increase in price of petrol leads to people consuming less petrol. This in turn would mean lesser import of oil and hence a slightly lower trade deficit. A lower trade deficit would mean lesser pressure on the rupee. But the fact of the matter is that even if the consumption of petrol comes down, its overall impact on the import of oil would not be that much. For the trade deficit to come down the government has to increase prices of kerosene, LPG and diesel. That would have a major impact on the oil imports and thus would push down the demand for the dollar. It would also mean a lower fiscal deficit, which in turn will lead to lower interest rates. Lower interest rates might lead to businesses looking to expand and people borrowing and spending that money, leading to a better economic growth rate. It might also motivate Multi National Companies (MNCs) to increase their investments in India, bringing in more dollars and thus lightening the pressure on the rupee. In the short run an increase in the prices of diesel particularly will lead higher inflation because transportation costs will increase.
Freeing the price
The government had last increased the price of petrol in December before this. For nearly five months it did not do anything and now has gone ahead and increased the price by Rs 6.28 per litre, which after taxes works out to around Rs 7.54 per litre. It need not be said that such a stupendous increase at one go makes it very difficult for the consumers to handle. If a normal market (like it is with vegetables where prices change everyday) was allowed to operate, the price of oil would have risen gradually from December to May and the consumers would have adjusted their consumption of petrol at the same pace. By raising the price suddenly the last person on the mind of the government is the aam aadmi, a term which the UPAwallahs do not stop using time and again.
The other option of course is to continue subsidize diesel, LPG and kerosene. As a known stock bull said on television show a couple of months back, even Saudi Arabia doesn’t sell kerosene at the price at which we do. And that is why a lot of kerosene gets smuggled into neighbouring countries and is used to adulterate diesel and petrol.
If the subsidies continue it is likely that the consumption of the various oil products will not fall. And that in turn would mean oil imports would remain at their current level, meaning that the trade deficit will continue to remain high. It will also mean a higher fiscal deficit and hence high interest rates. The economic growth will remain stagnant, keeping foreign businesses looking to invest in India away.
Manmohan Singh as the finance minister started India’s reform process. On July 24, 1991, he backed his “then” revolutionary proposals of opening up India’s economy by paraphrasing Victor Hugo: “No power on Earth can stop an idea whose time has come.
Good economics is also good politics. That is an idea whose time has come. Now only if Mr Singh were listening. Or should we say be allowed to listen..
(The article originally appeared at www.firstpost.com on May 24,2012. http://www.firstpost.com/economy/petrol-bomb-is-a-dud-if-only-dr-singh-had-listened-319594.html)
(Vivek Kaul is a writer and can be reached at [email protected])

It’s not Greece: Cong policies responsible for rupee crash

Vivek Kaul

All is well in India under the rule of the “Gandhi” family. That’s what the Finance Minister Pranab Mukjerjee has been telling us. And the rupee’s fall against the dollar is primarily because of problems in Greece. And Spain. And Europe. And other parts of the world. As I write this one dollar is worth around Rs 55 (actually Rs 54.965 to be precise, but we can ignore a few decimal points). The rupee has fallen around 22% in value against the dollar in the last one year.
The larger view among analysts and experts who track the foreign exchange market is that a dollar will soon be worth Rs 60. And by then there might be problems in some other part of the world and the rupee’s fall might be blamed on the problems there. As a late professor of mine used to say, with a wry smile on his face “Since we are all born on this mother earth, there is some sort of symbiosis between us.”
So let’s try and understand why the underlying logic to the rupee’s fall against the dollar is not as simple as it is made out to be.
Dollar is the safe haven
As economic problems have come to the fore in Europe (As I have highlighted in If PIIGS have to fly they will have to exit the Euro http://www.firstpost.com/world/if-piigs-have-to-fly-they-will-need-to-exit-the-euro-314589.html) the large institutional investors have moved out of the Euro into the dollar. A year back one dollar was worth €0.71, now it’s worth €0.78. So the dollar has gained against the Euro, no doubt.
But the argument being made is that this is global trend and that dollar has gained in value against lot of other major currencies. Is that true? A year back one dollar was worth 0.88 Swiss Francs, now it is worth 0.93 Swiss Francs. So it has gained in value against the Swiss currency.
What about the British pound? A year back the dollar was worth £0.62, now it’s worth £0.63. Hence the dollar has barely moved against the pound. A dollar was worth around 82 Japanese yen around a year back. Now it’s worth around 79.5yen. It has lost value against the Japanese yen. The dollar has gained in value against the Brazilian Real. It was worth around 1.63real a year back. It is now worth over 2 real. So yes, the dollar has gained in value against the other currencies but not against all currencies.
What is ironic is that the world at large is considering dollar to be a safe haven and moving money into it, by buying bonds issued by the American government. The debt of the US government is now around $14.6trillion, which is almost equal to the US gross domestic product of $15trillion. But since everyone considers it to be a safe haven it has become a safe haven.
But let’s get back to the point at hand. So, not all currencies have lost value against the dollar and those that have lost value, have lost it in varying degrees. This tells us that there are other individual issues at play as well when it comes to currencies losing value against the dollar.
What is happening in India?
The Indian government has been spending much more money than it has been earning over the last few years. In other words the fiscal deficit of the government has been on its way up. For the financial year 2007-2008 (i.e. the period between April 1,2007 and March 31, 2008) the fiscal deficit stood at Rs 1,26,912 crore. This shot up to Rs 5,21,980 crore for the financial year 2011-2012. In a time frame of five years the fiscal deficit has shot up by nearly 312%. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. The fiscal deficit targeted for the current financial year 2012-2013(i.e. between April 1, 2012 and March 31,2013) is a little lower at Rs 5,13,590 crore. The huge increase in fiscal deficit has primarily happened because of the subsidy on food, fertilizer and petroleum.
The tendency to overshoot
Also it is highly likely that the government might overshoot its fiscal deficit target like it did last year. In his budget speech last year Pranab Mukherjee had set the fiscal deficit target for the financial year 2011-2012, at 4.6% of GDP. He missed his target by a huge margin when the real number came in at 5.9% of GDP. The major reason for this was the fact that Mukherjee had underestimated the level of subsidies that the government would have to bear. He had estimated the subsidies at Rs 1,43,750 crore but they ended up costing the government 50.5% more at Rs 2,16,297 crore.
Generally all the three subsidies of food, fertilizer and petroleum are underestimated, but the estimates on the oil subsidies are way off the mark. For the year 2011-2012, oil subsidies were assumed to be at Rs 23,640crore. They came in at Rs 68,481 crore. This has been the case in the past as well. In 2010-2011 (i.e. the period between April 1, 2010 and March 31, 2011) he had estimated the oil subsidies to be at Rs 3108 crore. They finally came in 20 times higher at Rs 62,301 crore. Same was the case in the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010). The estimate was Rs 3109 crore. The real bill came in nearly eight times higher at Rs 25,257 crore (direct subsidies + oil bonds issued to the oil companies).
The increasing fiscal deficit
The fiscal deficit has gone up over the years primarily because an increase in expenditure has not been matched with an increase in revenue. Revenue for the government means various forms of taxes and other forms of revenue like selling stakes in public sector enterprises.
The fact of the matter is that Indians do not like to pay income tax or any other kind of tax. This a throw back from the days of the high income tax rate in the 60s, 70s and the 80s, when a series of Finance Ministers (from C D Deshmukh to Yashwantrao Chavan and bureaucrats like Manmohan Singh) implemented high income tax rates in the hope that taxing the “rich” would solve all of India’s problems.
In the early 1970s the highest marginal rate of tax was 97%. The story goes that JRD Tata sold some property every year to pay taxes (income tax plus wealth tax) which worked out to be more than his yearly income. Of course everybody was not like the great JRD, and because of the high tax rates implemented by various Congress governments over the years, a major part of the Indian economy became black. Dealings were carried out in cash. Transactions were made but they were never recorded, because if they were recorded tax would have to be paid on them.
A series of exemptions were granted to corporate India as well, and companies like Reliance Industries did not pay any income tax for years. As a result of this India and Indians did not and do not like paying tax.
Various lobbies have also emerged which have ensured that those that they represent are not taxed. As Professor Amartya Sen wrote in a column in The Hindu earlier this year “It is worth asking why there is hardly any media discussion about other revenue-involving problems, such as the exemption of diamond and gold from customs duty, which, according to the Ministry of Finance, involves a loss of a much larger amount of revenue (Rs.50,000 crore per year)”.
As he further points out “The total “revenue forgone” under different headings, presented in the Ministry document, an annual publication, is placed at the staggering figure of Rs.511,000 crore per year. This is, of course, a big overestimation of revenue that can be actually obtained (or saved), since many of the revenues allegedly forgone would be difficult to capture — and so I am not accepting that rosy evaluation.”
But even with the overestimation the fact of the matter is that a lot of tax that can be collected from those who can pay is not being collected, and that of course means a higher fiscal deficit.
The twin deficit hypothesis
The hypothesis basically states that as the fiscal deficit of the country goes up its trade deficit (i.e. the difference between its exports and imports) also goes up. Hence when a government of a country spends more than what it earns, the country also ends up importing more than exporting.
But why is that? The fiscal deficit goes up because the increase in expenditure is not matched by an increase in taxes. This leaves people with a greater amount of money in their hands. Some portion of this money is used towards buying goods and services, which might be imported from abroad. This leads to greater imports and thus a higher trade deficit. The situation in India is similar. The government of India has been spending more than it has been earning without matching the increase in income with higher taxes, which in turn has led to increasing incomes and that to some extent has been responsible for an increase in Indian imports. But that could have hardly been responsible for the trade deficit of $185billion that India ran in 2011-2012. The imports for the month of April 2012 were at $37.9billion, nearly 54.7% more than the exports which stood at $24.5billion. So the trend has continued even in this financial year.
The golden oil shock
India exports a major part of its oil needs. On top of that it is obsessed with gold. Last year we imported 1000 tonnes of it. Very little of both these commodities priced in dollars is dug up in India. So we have to import them.
This pushes up our imports and makes them greater than our exports. These imports have to be paid for in dollar. When payments are to be made importers buy dollars and sell rupees. When this happens, the foreign exchange market has an excess supply of rupees and a short fall of dollars. This leads to rupee losing value against the dollar. In case our exports matched our imports, then exporters who brought in dollars would be converting them into rupees, and thus there would be a balance in the market. Importers would be buying dollars and selling rupees. And exporters would be selling dollars and buying rupees. But that isn’t happening in a balanced way.
This to some extent explains the current rupee dollar rate of $1 = Rs 55. The Reserve Bank of India does intervene at times to stem the fall of the rupee. This it does by selling dollars and buying rupee. But the RBI does not have an unlimited supply of dollars and hence cannot keep intervening indefinitely.
As mentioned earlier the major part of the trade deficit is because of the fact that we need to import oil. Oil prices have been high for the last few years, though recently they have fallen. Oil is sold in dollars. Hence when India needs to buy oil it needs to pay in dollars. But with the rupee constantly losing value against the dollar, it means that Indian companies have to more per barrel of oil in rupees.
The government of India does not pass on a major part of the increase in the price of oil to the end consumer and hence subsidizes the prices of diesel, LPG, kerosene etc. This means that the oil companies have to sell these products at a loss to the consumer. The government in turn compensates these companies for the loss. This leads to the expenditure of the government going up and hence it incurs a higher fiscal deficit.
No passing the buck
If the government had not subsidized prices of oil products and passed them onto the end consumer, their consumption would have come down. With prices of oil products not rising as much as they should people have not adjusted their consumption accordingly. An increase in price typically leads to a fall in demand. If the increased price of oil had been passed onto the end consumer, the demand for oil would have come down. This would have meant that a fewer number of dollars would have been required to pay for the oil being imported, in turn leading to a lower trade deficit and hence lesser pressure on the rupee-dollar rate.
So let me summarise the argument I am making. The higher fiscal deficit in the form of subsidies has pushed up the trade deficit which in turn has led to rupee losing value against the dollar. The solution is to get consumers to pay the “right” price. With this the fiscal deficit can be brought down to some extent. If these products are priced correctly, their consumption is likely to come down as well in the near future, given that their prices will go up. Lower consumption is likely to lead to lower imports and thus a lower trade deficit. A lower trade deficit would also mean that the fall of the rupee against the dollar may stop. This in turn would mean a lower price for the oil we import in rupee terms and that in turn help overall economic growth. A lower fiscal deficit will lead to lower government borrowing and hence lesser “crowding out” and so lower interest rates, which might get corporates and individuals interested in borrowing again.
The long term solution
What has been suggested above is a short term solution, which given the way the Congress led UPA government operates is unlikely to be implemented. The main problem is that while it’s quite a noble idea to provide subsidies in the form of food, fertilizer, kerosene etc to the India’s poor, it has to be matched with an increase in taxes. An increase in income taxes rates isn’t going to help much because only a minuscule portion of India pays income tax (basically the salaried class).
What is needed is to get larger number of people to pay tax to pay for all the subsidies that are doled out. This can be done by simplifying the income tax act. This was tried when the government tried to come up with the Direct Taxes Code(DTC), which was very simple and straightforward and had done away with most exemptions. In its original form the DTC was a pleasure to read. But of course if it had been implemented scores of people who do not pay income tax would have to pay income tax. In its current form the DTC is another version of Income Tax Act.
Another way is to target specific communities of people who do not pay income tax even though they earn a huge amount of money, but all in “black”. For starters the targeting property dealers that line up almost every street in Delhi might be a good idea. Once, people see that the government is serious about collecting taxes, they are more likely to pay up than not. And there is no better way than starting with the capital.
(The article originally appeared at www.firstpost.com on May 23,2012. http://www.firstpost.com/economy/dont-blame-greece-cong-policies-responsible-for-rupees-crash-318280.html)
(Vivek Kaul is a writer and he can be reached at [email protected])

Facebook is a bubble and it will burst

Vivek Kaul

So let me be a killjoy this Monday morning and say that Facebook is a bubble. And like all bubbles it will burst.
The price of the Facebook share closed at $38.23 at the close of trading on Friday. At this price the company was worth around $104.6billion.The basic question that crops up here is that whether Facebook deserves such a high price? “It’s exceedingly dangerous to pay a $100 billion valuation for a company that hasn’t figured out a way to make money,” Aswath Damodaran, a professor at Stern Business School at New York University told Barrons Online. Damodaran is one of the world’s premier experts on valuation.
Facebook versus Google
Facebook earned 43 cents per share in 2011. At its Friday closing price of $38.23, the company has a price to earnings ratio of around 88.4 ($38.23/43cents). Now compare this to Google, which is the closest comparison we can make with a stock like Facebook. Google had an earnings per share of $33 in 2011. The market price of the company closed at $600.4 on Friday, implying a price to earnings ratio of 18.2 ($600.14/$33). This makes Facebook around five times as expensively priced as Google (88.4/18.2). Price to earnings ratio is equal to the latest market price of the share of the company divided by its earnings per share.
Even if we were to look at the expected earnings for the current year, Facebook is expensively priced. Analysts expected Facebook to earn around 50 cents per share in 2012. This means that the forward price to earnings ratio of the company is at 76.5($38.23/50cents). Google’s forward price to earnings ratio for 2012 works out to 14, making Facebook more than five times as expensive as Google.
Let us get into little more detail here. Both Google and Facebook have around 900million users. “There isn’t much scope for growth here, really – we’re beginning to run out of connected adults on the planet,” points out venture capitalist Mahesh Murthy on his Facebook page.
Google had sales of $39.98billion with a profit of $10.83billion. From almost a similar number of users Facebook had sales of $3.71billion and profits of $1billion. Hence Google makes average revenue of around $44per user. At the same time Facebook makes average revenue of around $4 per user. It is rather ironic that even though Google has average revenue per user 11 times that of Facebook and also earned a profit which was nearly 11times, the price to earnings ratio of Facebook is 5 times that of Google.
So what are investors paying for?
Investors are essentially paying for the future growth of Facebook. As Kevin Landis chief investment officer at Firsthand Capital, a Facebook holder told Barrons Online “The investment thesis is pretty simple. Facebook knows more things about more people than does Google, and those people have stronger emotional connections and loyalty because that’s where their friends are…So given a few years to figure it out, Facebook could end up being worth more than Google, which has a market value of $200 billion.
One advantage with more user data is that Facebook can help advertisers reach their targeted audience better. When companies advertise in mass market mediums like newspapers or television channels they have no clue of whether they are reaching their target audience. But with Facebook they can be sure.
At least the story being bandied around by analysts who are bullish on the stock. But companies aren’t buying this yet. In fact General Motors, a company with one of the largest advertising budgets in the United States, recently pulled its ads from Facebook, cancelling its $10million Facebook advertising budget.
As Matthew Yeomans wrote in a recent column on www.guardian.co.uk “GM clearly believes Facebook users aren’t engaging in banner and targeted advertising and, in that analysis, the company is probably right. Frankly I’ve never met a single person (apart from those who work in the digital advertising industry) who believe online banner ads are effective”.
This is something I totally agree with. What makes it even worse on Facebook is its cluttered look. In fact I only realised that my homepage on Facebook page has ads when I went looking for them. In comparison the Google.com page has a very clean look and with a white background the targeted ads are easily available.
Given this Facebook might find it a little difficult to grow its revenues. As Murthy puts it “This (the valuation of Facebook) might make sense if there was room for Facebook to grow. Where is that? More ads per user? Would we really like that? More charges per ad? Advertisers are already smarting at FB’s rates. Will you pay for apps on their store? Will you pay for premium listings? Not many will, I believe. The point is that FB will find it hard to grow its revenues per user – which is around $4 per year now.
In fact the revenue growth of Facebook is slowing. Its revenues for the first quarter of 2012 stood at $1.06billion in comparison to $1.13billion in the fourth quarter of 2011. The primary reason for the same is the fact that more and more users are accessing Facebook from their smartphones. And smartsphone screens do not lend themselves well to advertising. Facebook admitted to this in a recent filing with the Securities and Exchange Commission, the stock market regulator in the United States, where it said “we do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.”
The bubble signs
Other than the basic doubt on the business model (i.e. how does the company plan to make money) of Facebook, there are other signs also of why the company is in bubbly territory. Too many analysts are bullish on it.
Towards the end of the dotcom bubble in 1999, even though the stock market had gone up too soon too fast, most the stock recommendations from the analysts remained a buy i.e. the analysts of Wall Street were commending investors to buy stocks even at very high levels.
According to data from Zack Investment Research only about 1% of the recommendations on some 6000 companies were sell recommendations. The remaining 99% was divided between 69.5% buy recommendations and 29.9%hold recommendations(i.e. don’t buy more shares but don’t sell what you already have).
Analysts typically do not like issuing sell recommendations (or in the case of Facebook asking investors not to buy the stock) because that did not put them in the good books of the company involved. This would mean that the company would stop sharing information and deny the analyst access to its top people. And what good is an analyst who has no access to information on the company he is covering.
Henry Blodget one of the premier analysts during the days of the dotcom boom is quoted as saying in Andy Kessler’s Wall Street Meat “You’ve got to understand. If I stop recommending stock and the shares keep going up, there is hell to pay. Brokers call you up and yell to you for missing more of the upside. Bankers yell at you for messing up their relationships. There is just too much risk in not recommending these stocks.
Facebook is in a similar situation. Analysts are predicting that Facebook will grow its profits by 38% and its revenues by 35% on an average over the course of the next three years. This is groupthink at its worst.
Another thing that happened during dotcom bubble was the fact that the valuations of the dotcom companies with no business models were worth much more than companies which had genuine businesses in place which had been generating revenue for years. Priceline.com sold its shares at $16 and ended its first day of trading at $69. The website basically resold airline tickets and did not own any airplanes, but was worth more than the entire tangible airline industry put together.
Valuations had reached crazy levels. eToys a tiny seller of toys on the web with revenues of $25million was listed on the stock exchanges at a market capitalization of three times the value of Toys “R” Us, a company with tangible business and stores throughout the United States generating a revenue of $11billion.
While the situation is nowhere as crazy now as it was back then but it is a tad similar. At its current market capitalization of around $104.6billion, Facebook is worth as much as PepsiCo, a company which has been in the business for years. PepsiCo has a sales of $67billion with profits of around $6billion. While people may call PepsiCo an old economy stock but it can be pointed out that the company still has huge scope to expand across large parts of Asia and Africa where the annual per capita consumption of cold drinks continues to remain low.
In comparison there is not much scope for Facebook to grow from its current levels as far as number of users is concerned.
To conclude:
Warren Buffett one of the greatest investors of our times did not invest in any of the dotcom stocks in the late 1990s. His returns fell for a few years and he was also the laughing stock of the market. But when the bubble burst and billions of dollars of investor money were lost, Buffett was the last man standing. What he wrote in his annual letter to the shareholders of Berkshire Hathaway for the year 2000 after the dotcom bubble burst is worth repeating here:
By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

And for all we know Facebook might just be a passing fad. I would like to conclude with something a gentleman by the name of Marc Effron, the President of The Talent Strategy Group, and author of One Page Talent Management, told me a few months back, when I asked him if Facebook was just a passing fad. “The first thing that comes to my mind when you say Facebook is MySpace,” he replied.
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/investing/facebook-is-a-bubble-and-it-will-burst-316100.html)
(Vivek Kaul is a writer and can be reached at [email protected])

If PIIGS have to fly, they will need to exit the euro

Vivek Kaul

I’ve long said that capitalism without bankruptcy is like Christianity without hell. – Frank Borman
If you have been following the business newspapers lately, you would have probably come to the conclusion by now that a break-up of the euro will lead to a huge catastrophe in Europe as well as the rest of the world.
Yes, there will be problems. But the world will be a much better place if the countries like Portugal, Ireland, Italy, Greece and Spain opt out of the euro. To know why read on.
How it all started
The European Coal and Steel Community was an economic organisation formed by six European nations in 1958. This gradually evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The EU introduced the euro on 1 January 1999. On this day, 11 member countries of the EU started using euro as their currency. Before the euro came into being the German currency deutschemark used to be the premier currency of Europe. The euro inherited the strength of the deutschemark. The world looked at the euro as the new deutschemark.
The move to euro benefitted countries such as Portugal, Italy , Ireland , Greece and Spain (together now known as the PIIGS). Before these countries started to use euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the Euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU.
Easy money and the borrowing binge
With interest rates being low, the PIIGS countries as well as their citizens went on a borrowing binge. Greece took the lead among these countries. The Greek politicians launched a large social spending programme which subsidised most of the key public services. In fact a few years back, the finance minister of Greece claimed that he could save more money shutting down the Railways and driving people around in taxies. In 2009, Greece railways revenues were at around $250 million and the losses of around $1.36billion. All this extravagance has was financed through borrowing.
Greece was not the only country indulging in this extravagance, other PIIGS nations had also joined in. Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest being charged on loans.
As John Mauldin and Jonathan Tepper write in Endgame – The End of the Debt Supercycle and How it Changes Everything “In plain English, that means that if the borrowing rate is 3 percent while inflation is 4 percent you’re effectively borrowing for 1 percent less than inflation. You’re being paid to borrow. And borrow they did. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros.”
This was because loans were being made by German, French and British banks who were able to raise deposits at much lower interest rates in their respective countries and offer it at a slightly higher rate in the PIIGS countries.
The citizens of Spain borrowed big time to speculate in real estate. All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. Currently Spain has as many homes unsold as the United States (US), though the US is six times bigger than Spain. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP, are in trouble.
The accumulated debt in Spain is largely in the private sector. On the other hand the Italian government debt stands at $2.6trillion, the fourth largest in the world. The debt works out to around 125% of the Italian gross domestic product (GDP). As a recent report titled A Primer on Euro Breakup brought out by Variant Perception points out “Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level.” Debt as we all know needs to be repaid, and that’s where all the problems are. But before we come to that we need to understand the German role in the entire crisis.
The German connection
Germany became the largest exporter in the world on the strength of the euro. Before euro became a common currency across Europe, German exports stood at around €487billion in 1995. In 1999, the first year of euro being used as a currency the exports were at €469billion euros. Next year they increased to €548billion euros. And now they stand at more than a trillion euros. Germany is the biggest exporter in the world even bigger than China.
With euro as a common currency took away the cost of dealing with multiple currencies and thus helped Germany expand its exports to its European neighbours big time. Also with a common currency at play exchange rate fluctuations which play an important part in the export game no longer mattered and what really mattered was the cost of production.
Germany was more productive than the other members of the European Union given it an edge when it came to exports. As Mauldin and Tepper point out “since the beginning of the Euro in 1999, Germany has become some 30 per cent more productive than Greece. Very roughly, that means it costs 30 per cent more to produce the same amount of goods in Greece than in Germany. That is why Greece imports $64 billion and exports only $21 billion.”
German banks also had a role to play in helping increasing German exports. They were more than happy to lend to citizens, governments and firms in PIIGS countries. So the way it worked was that German banks lent to other countries in Europe at low interest rates, and they in turn bought German goods and services which are extremely competitively priced as well as of good quality. Hence German exports went up.
The PIIGS countries owe a lot of money to German banks. Greece needs to repay $45billion. Spain owes around $238billion to Germany. Italy, Ireland and Portugal owe $190billion, $184 billion and $47billion respectively.
Inability to repay
When the going is good and everything is looking good there is a tendency to borrow more than one has the ability to repay, in the hope that things will continue to remain good in the days to come. But good times do not last forever and when that happens the borrower is in no position to repay the loan taken on.
Greece tops this list. It has been rescued several times and the private foreign creditors have already taken a haircut on their debt i.e. they have agreed to the Greek government not returning the full amount of the loan. Between Spain and Italy around €1.5trillion of money needs to be repaid over the next three years. The countries are in no position to repay the debt. It has to be financed by taking on more debt. It remains to be seen whether investors remain ready to continue lending to these countries.
In the past countries which have come under such heavy debt have done one of the following things: a) default on the debt b) inflate the debt c) devalue the currency.
Scores of countries in the past have defaulted on their debt when they have been unable to repay it. A very famous example is that of Russia in 1998. It defaulted both on its national as well as international debt. Oil prices had crashed to $11 per barrel. Oil revenue was the premier source of income for the Russian government and once that fell, there was no way it could continue to repay its debts.
If the country’s debt is in its own currency, all the government needs to do is to print more of it in order to repay it. This has happened time and again over the years all over the world. Every leading developing and developed country has resorted to this at some point of time. The third option is to devalue the currency and export one’s way out of trouble.
Exit the euro
The PIIGS countries cannot print euros and repay their debt. Since they are in a common currency area there is no way that they can devalue the euro. A straight default is ruled out because German and French banks will face huge losses, and Germany being driving force behind the euro, wouldn’t allow that to happen.
So what option do the PIIGS then have? One option that they have is to exit the euro, redominate the foreign debt in their own currency, devalue their currency and hope to export their way out of trouble.
A lot has been written about how you can only enter the euro and not exit it. The situation as is oft repeated is like a line from an old Eagles number Hotel California “You can checkout any time you like / But you can never leave.” A case has also been made as to how it would be disaster for any country leaving the euro.
Let’s try and understand why the situation will not be as bad as it is made out to be. A report titled A Primer on Euro Breakup, about which I briefly talked about a little earlier explains this situation very well.
The first thing to do as per the report is to exit the euro by surprise over a weekend when the markets are closed. Many countries have stopped using one currency and started using another currency in the past. A good example was the division of India and Pakistan. As the report points out “ One example of a currency breakup that went smoothly despite major civil unrest is the separation of India and Pakistan in August 1947. Before the partition of India, the two countries agreed that the Reserve Bank of India (the RBI) would act as the central bank of Pakistan until September 1948….Indian notes overprinted with the inscription “Government of Pakistan” were legal tender. At the end of the transition period, the Government of Pakistan exchanged the non-overprinted Indian notes circulating in Pakistan at par and returned them to India in order to de-monetize them. The overprinted notes would become the liabilities of Pakistan.”
Any country looking to exit Euro could work in a similar way. It will need to have provisions in place to overprint euros and deem them to be their own currency. Then it will have quickly issue new currency and exchange the overprinted notes for the new currency. Capital controls will also have to be put in place for sometime so that the currency does not leave the country.
Despite the fact that there are no exit provisions from the euro, after the creation of the European Central Bank, the individual central banks of countries were not disbanded. And they are still around. “All the euro countries still have fully functioning national central banks, which should greatly facilitate the distribution of bank notes, monetary policy, management of currency reserves, exchange-rate policy, foreign currency exchange, and payment. The mechanics for each central bank remain firmly in place,” the report points out.
Technical default
By applying the legal principle of lex monetae – that a country determines its own currency, the PIIGS countries can re-dominate their debt which they had issued under their local laws into the new currency. As the report points out “Countries may use the principle of lex monetae without problems if the debt contracts were contracted in its territory or under its law. But private and public bonds issued in foreign countries would be ruled on by foreign courts, who would most likely decide that repayment must be in euros.”
The good thing is that in case of Greece, Spain and Portugal, nearly 90% of the bonds issued are governed by local law. While redomination of currencies in their own currencies will legally not be a default, it will be categorized as a default by ratings agencies and international bodies.
Another problem that has brought out is the possibility of bank runs if countries leave the euro. Well bank runs are already happening even when countries are on the euro. (The entire report can be accessed here: http://www.johnmauldin.com/images/uploads/pdf/mwo022712.pdf).
The PIIGS coutnries can devalue their new currencies make themselves export competitive and hope to export their way out of trouble. This is precisely what the countries of South East Asia after the financial crisis of the late 1990s. As the report points out “history shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The best way to promote growth in the periphery, then, is to exit the euro, default and devalue.”
The German export machinery
A breakup of the euro will create problems for the highly competitive export sector that Germany has built up. The PIIGS countries would start competiting with it when it came to exports. Given this they will not let the euro break so easily. As the bestselling author Michael Lewis said in an interview sometime back “German leadership does not want to be labeled as the people who destroyed the euro.”
But as Lewis also said “If you put Germany together with Greece in a single currency, it’s a little like watching an Olympic sprinter and a fat old man running a three-legged race. The Greeks will never be as productive as the Germans, and the Germans will never be as unproductive as the Greeks.” So it’s best for PIIGS countries to exit the euro.
In the end let me quote my favourite economist John Kenneth Galbraith as a disclaimer: “The only function of economic forecasting is to make astrology look respectable.
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/world/if-piigs-have-to-fly-they-will-need-to-exit-the-euro-314589.html)
(Vivek Kaul is a writer and can be reached at [email protected])