Shivasharana@REVA

Business Cycles: Meaning, Phases, Features and

Business Cycles: Meaning, Phases, Features and Theories of Business Cycle!

Meaning:

Many free enterprise capitalist countries such as USA and Great Britain have registered rapid

economic growth during the last two centuries. But economic growth in these countries has not followed steady and smooth upward trend. There has been a long-run upward trend in Gross

National Product (GNP), but periodically there have been large short-run fluctuations in economic activity, that is, changes in output, income, employment and prices around this long- term trend.

The period of high income, output and employment has been called the period of expansion, upswing or prosperity, and the period of low income, output and employment has been described

as contraction, recession, downswing or depression. The economic history of the free market capitalist countries has shown that the period of economic prosperity or expansion alternates

with the period of contraction or recession.

These alternating periods of expansion and contraction in economic activity has been called

business cycles. They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages with periods of bad trade characterised by falling prices and high unemployment

percentages.”

A noteworthy feature about these fluctuations in economic activity is that they are recurrent and

have been occurring periodically in a more or less regular fashion. Therefore, these fluctuations have been called business cycles. It may be noted that calling these fluctuations as ‘cycles’ mean they are periodic and occur regularly, though perfect regularity has not been observed.

The duration of a business cycle has not been of the same length; it has varied from a minimum of two years to a maximum of ten to twelve years, though in the past it was often assumed that

fluctuations of output and other economic indicators around the trend showed repetitive and regular pattern of alternating periods of expansion and contraction.

However, actually there has been no clear evidence of very regular cycles of the same definite duration. Some business cycles have been very short lasting for only two to three years, while

others have lasted for several years. Further, in some cycles there have been large swings away from trend and in others these swings have been of moderate nature.

A significant point worth noting about business cycles is that they have been very costly in the economic sense of the word. During a period of recession or depression many workers lose their

jobs and as a result large-scale unemployment, which causes loss of output that could have been produced with full-employment of resources, come to prevail in the economy.

Besides, during depression many businessmen go bankrupt and suffer huge losses. Depression causes a lot of human sufferings and lowers the levels of living of the people. Fluctuations in

economic activity create a lot of uncertainty in the economy which causes anxiety to the individuals about their future income and employment opportunities and involve a great risk for

long-run investment in projects.

Who does not remember the great havoc caused by the great depression of the early thirties of

the present century? Even boom when it is accompanied by inflation has its social costs. Inflation erodes the real incomes of the people and makes life miserable for the poor people.

Inflation distorts allocation of resources by drawing away scarce resources from productive uses to unproductive ones. Inflation redistributes income in favour of the richer actions and also when inflation rate is high, it impedes economic growth.

About the harmful effects of the business cycles Crowther writes, “On the one hand, there is the misery and shame of unemployment with all the individual poverty and social disturbances that it

may create. On the other hand, there is the loss of wealth represented by so much wasted and idle labour and capital.”

Phases of Business Cycles:

Business cycles have shown distinct phases the study of which is useful to understand their underlying causes. These phases nave been called by different names by different economists.

Generally, the following phases of business cycles have been distinguished:

1. Expansion (Boom, Upswing or Prosperity)

2. Peak (upper turning point)

3. Contraction (Downswing, Recession or Depression)

4. Trough (lower turning point)

The four phases of business cycles have been shown in Fig. 27.1 where we start from trough or depression when the level of economic activity i.e., level of production and employment is at the lowest level. With the revival of economic activity the economy moves into the expansion phase,

but due to the causes explained below, the expansion cannot continue indefinitely, and after reaching peak, contraction or downswing starts. When the contraction gathers momentum, we

have a depression. The downswing continues till the lowest turning point which is also called trough is reached. In this

way cycle is complete. However, after remaining at the trough for some time the economy revives and again the new cycle starts.

Haberler in his important work on business cycles has named the four phases of business

cycles as:

(1) Upswing,

(2) Upper turning point,

(3) Downswing, and

(4) Lower turning point.

There are two types of patterns of cyclic changes. One pattern is shown in Fig. 27.1 where fluctuations occur around a stable equilibrium position as shown by the horizontal line. It is a

case of dynamic stability which depicts change but without growth or trend.

The second pattern of cyclical fluctuations is shown in Fig. 27.2 where cyclical changes in

economic activity take place around a growth path (i.e., rising trend). J.R. Hicks in his model of business cycles explains such a pattern of fluctuations with long-run rising trend in economic activity by imposing factors such as autonomous investment due to population growth and

technological progress causing economic growth on the otherwise stationary state. We briefly

explain below various phases of business cycles.

Expansion and Prosperity: In its expansion phase, both output and employment increase till we have full-employment of

resources and production is at the highest possible level with the given productive resources. There is no involuntary unemployment and whatever unemployment prevails is only of frictional and structural types.

Thus, when expansion gathers momentum and we have prosperity, the gap between potential GNP and actual GNP is zero, that is, the level of production is at the maximum production level.

A good amount of net investment is occurring and demand for durable consumer goods is also high. Prices also generally rise during the expansion phase but due to high level of economic

activity people enjoy a high standard of living.

Then something may occur, whether banks start reducing credit or profit expectations change

adversely and businessmen become pessimistic about future state of the economy that bring an end to the expansion or prosperity phase.

As shall be explained below, economists differ regarding the possible causes of the end of prosperity and start of downswing in economic activity. Monetarists have argued that contraction in bank credit may cause downswing.

Keynes have argued that sudden collapse of expected rate of profit (which he calls marginal efficiency of capital, MEC) caused by adverse changes in expectations of entrepreneurs lowers

investment in the economy. This fall in investment, according to him, causes downswing in economic activity.

Contraction and Depression:

As stated above, expansion or prosperity is followed by contraction or depression. During contraction, not only there is a fall in GNP but also level of employment is reduced. As a result,

involuntary unemployment appears on a large scale. Investment also decreases causing further fall in consumption of goods and services.

At times of contraction or depression prices also generally fall due to fall in aggregate demand. A significant feature of depression phase is the fall in rate of interest. With lower rate of interest

people’s demand for money holdings increases.

There is a lot of excess capacity as industries producing capital goods and consumer goods work

much below their capacity due to lack of demand. Capital goods and durable consumer goods industries are especially hit hard during depression. Depression, it may be noted, occurs when

there is a severe contraction or recession of economic activities. The depression of 1929-33 is still remembered because of its great intensity which caused a lot of human suffering.

Trough and Revival:

There is a limit to which level of economic activity can fall. The lowest level of economic activity, generally called trough, lasts for some time. Capital stock is allowed to depreciate without replacement. The progress in technology makes the existing capital stock obsolete.

If the banking system starts expanding credit or there is a spurt in investment activity due to the emergence of scarcity of capital as a result of non-replacement of depreciated capital and also

because of new technology coming into existence requiring new types of marines and other capital goods. The stimulation of investment brings about the revival or recovery of the

economy.

The recovery is the turning point from depression into expansion. As investment rises, this

causes induced increase in consumption. As a result industries start producing more and excess capacity is now put into full use due to the revival of aggregate demand. Employment of labour increases and rate of unemployment falls. With this the cycle is complete.

Features of Business Cycles:

Though different business cycles differ in duration and intensity they have some common

features which we explain below:

1. Business cycles occur periodically. Though they do not show same regularity, they have .some

distinct phases such as expansion, peak, contraction or depression and trough. Further the duration of cycles varies a good deal from minimum of two years to a maximum of ten to twelve

years.

2. Secondly, business cycles are Synchronic. That is, they do not cause changes in any single

industry or sector but are of all embracing character. For example, depression or contraction occurs simultaneously in all industries or sectors of the economy. Recession passes from one industry to another and chain reaction continues till the whole economy is in the grip of

recession. Similar process is at work in the expansion phase, prosperity spreads through various linkages of input-output relations or demand relations between various industries, and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of production but also simultaneously in other variables such as employment, investment, consumption, rate of interest

and price level.

4. Another important feature of business cycles is that investment and consumption of durable

consumer goods such as cars, houses, refrigerators are affected most by the cyclical fluctuations. As stressed by J.M. Keynes, investment is greatly volatile and unstable as it depends on profit

expectations of private entrepreneurs. These expectations of entrepreneurs change quite often making investment quite unstable. Since consumption of durable consumer goods can be deferred, it also fluctuates greatly during the course of business cycles.

5. An important feature of business cycles is that consumption of non-durable goods and services does not vary much during different phases of business cycles. Past data of business cycles

reveal that households maintain a great stability in consumption of non-durable goods.

6. The immediate impact of depression and expansion is on the inventories of goods. When

depression sets in, the inventories start accumulating beyond the desired level. This leads to cut in production of goods. On the contrary, when recovery starts, the inventories go below the

desired level. This encourages businessmen to place more orders for goods whose production picks up and stimulates investment in capital goods.

7. Another important feature of business cycles is profits fluctuate more than any other type of income. The occurrence of business cycles causes a lot of uncertainty for businessmen and makes it difficult to forecast the economic conditions. During the depression period profits may

even become negative and many businesses go bankrupt. In a free market economy profits are justified on the ground that they are necessary payments if the entrepreneurs are to be induced to

bear uncertainty.

8. Lastly, business cycles are international in character. That is, once started in one country they

spread to other countries through trade relations between them. For example, if there is a recession in the USA, which is a large importer of goods from other countries, will cause a fall in demand for imports from other countries whose exports would be adversely affected causing

recession in them too. Depression of 1930s in USA and Great Britain engulfed the entire capital world.

This causes industrial recession. Even in USA in the year 1988 a severe drought in the farm belt drove up the food prices around the world. It may be further noted that higher food prices reduce

income available to be spent on industrial goods.

Most economists talk about where the economy is headed – it’s what they do. But in case you

haven’t noticed, many of their predictions are wrong. For example, Ben Bernanke (head of the Federal Reserve) made a prediction in 2007 that the United States was not headed into a

recession. He further claimed that the stock and housing markets would be as strong as ever. As we know now, he was wrong.

Because the pundits’ predictions are often unreliable – purposefully so or not – it is important to develop your own understanding of the economy and the factors shaping it. Paying attention to

economic indicators can give you an idea of where the economy is headed so you can plan your finances and even your career accordingly.

There are two types of indicators you need to be aware of:

1. Leading indicators often change prior to large economic adjustments and, as such, can be used to predict future trends.

2. Lagging indicators, however, reflect the economy’s historical performance and changes to these are only identifiable after an economic trend or pattern has already been established.

Leading Indicators

Because leading indicators have the potential to forecast where an economy is headed, fiscal policymakers and governments make use of them to implement or alter programs in order to ward off a recession or other negative economic events. The top leading indicators follow below:

1. Stock Market

Though the stock market is not the most important indicator, it’s the one that most people look to

first. Because stock prices are based in part on what companies are expected to earn, the market can indicate the economy’s direction if earnings estimates are accurate.

For example, a strong market may suggest that earnings estimates are up and therefore that the

overall economy is preparing to thrive. Conversely, a down market may indicate that company earnings are expected to decrease and that the economy is headed toward a recession.

However, there are inherent flaws to relying on the stock market as a leading indicator. First, earnings estimates can be wrong. Second, the stock market is vulnerable to manipulation. For example, the government and Federal Reserve have used quantitative easing, federal stimulus

money, and other strategies to keep markets high in order to keep the public from panicking in the event of an economic crisis.

Moreover, Wall Street traders and corporations can manipulate numbers to inflate stocks via high-volume trades, complex financial derivative strategies, and creative accounting principles (legal and illegal). Since individual stocks and the overall market can be manipulated as such, a

stock or index price is not necessarily a reflection of its true underlying strength or value.

Finally, the stock market is also susceptible to the creation of “bubbles,” which may give a false positive regarding the market’s direction. Market bubbles are created when investors ignore

underlying economic indicators, and mere exuberance leads to unsupported increases in price levels. This can create a “perfect storm” for a market correction, which we saw when the market

crashed in 2008 as a result of overvalued subprime loans and credit default swaps.

2. Manufacturing Activity

Manufacturing activity is another indicator of the state of the economy. This influences the GDP

(gross domestic product) strongly; an increase in which suggests more demand for consumer goods and, in turn, a healthy economy. Moreover, since workers are required to manufacture new

goods, increases in manufacturing activity also boost employment and possibly wages as well.

However, increases in manufacturing activity can also be misleading. For example, sometimes the goods produced do not make it to the end consumer. They may sit in wholesale or retailer

inventory for a while, which increases the cost of holding the assets. Therefore, when looking at manufacturing data, it is also important to look at retail sales data. If both are on the rise, it

indicates there is heightened demand for consumer goods. However, it’s also important to look at inventory levels, which we’ll discuss next.

3. Inventory Levels

High inventory levels can reflect two very different things: either that demand for inventory is expected to increase or that there is a current lack of demand.

In the first scenario, businesses purposely bulk up inventory to prepare for increased consumption in the coming months. If consumer activity increases as expected, businesses with high inventory can meet the demand and thereby increase their profit. Both are good things for

the economy.

In the second scenario, however, high inventories reflect that company supplies exceed demand.

Not only does this cost companies money, but it indicates that retail sales and consumer confidence are both down, which further suggests that tough times are ahead.

4. Retail Sales

Retail sales are particularly important metrics and function hand in hand with inventory levels and manufacturing activity. Most importantly, strong retail sales directly increase GDP, which

also strengthens the home currency. When sales improve, companies can hire more employees to sell and manufacture more product, which in turn puts more money back in the pockets of consumers.

One downside to this metric, though, is that it doesn’t account for how people pay for their purchases. For example, if consumers go into debt to acquire goods, it could signal an impending

recession if the debt becomes too steep to pay off. However, in general, an increase in retail sales indicates an improving economy.

5. Building Permits

Building permits offer foresight into future real estate supply levels. A high volume indicates the

construction industry will be active, which forecasts more jobs and, again, an increase in GDP.

But just like with inventory levels, if more houses are built than consumers are willing to buy, it takes away from the builder’s bottom line. To compensate, housing prices are likely to decline,

which, in turn, devalues the entire real estate market and not just “new” homes.

6. Housing Market

A decline in housing prices can suggest that supply exceeds demand, that existing prices are unaffordable, and/or that housing prices are inflated and need to correct as a result of a housing bubble.

In any scenario, declines in housing have a negative impact on the economy for several key reasons:

1. They decrease homeowner wealth. 2. They reduce the number of construction jobs needed to build new homes, which thereby

increases unemployment.

3. They reduce property taxes, which limits government resources. 4. Homeowners are less able to refinance or sell their homes, which may force them into

foreclosure.

When you look at housing data, look at two things: changes in housing values and changes in sales. When sales decline, it generally indicates that values will also drop. For example, the collapse of the housing bubble in 2007 had dire effects on the economy and is widely blamed for

driving the United States into a recession.

7. Level of New Business Startups

The number of new businesses entering the economy is another indicator of economic health. In fact, some have claimed that small businesses hire more employees than larger corporations and, thereby, contribute more to addressing unemployment.

Moreover, small businesses can contribute significantly to GDP, and they introduce innovative ideas and products that stimulate growth. Therefore, increases in small businesses are an

extremely important indicator of the economic well-being of any capitalist nation.

Lagging Indicators

Unlike leading indicators, lagging indicators shift after the economy changes. Although they do

not typically tell us where the economy is headed, they indicate how the economy changes over time and can help identify long-term trends.

1. Changes in the Gross Domestic Product (GDP)

GDP is typically considered by economists to be the most important measure of the economy’s current health. When GDP increases, it’s a sign the economy is strong. In fact, businesses will

adjust their expenditures on inventory, payroll, and other investments based on GDP output.

However, GDP is also not a flawless indicator. Like the stock market, GDP can be misleading because of programs such as quantitative easing and excessive government spending. For

example, the government has increased GDP by 4% as a result of stimulus spending and the Federal Reserve has pumped approximately $2 trillion into the economy. Both of these attempts

to correct recession fallout are at least partially responsible for GDP growth.

Moreover, as a lagging indicator, some question the true value of the GDP metric. After all, it simply tells us what has already happened, not what is going to happen. Nonetheless, GDP is a

key determinant as to whether or not the United States is entering a recession. The rule of thumb is that when the GDP drops for more than two quarters, a recession is at hand.

2. Income and Wages

If the economy is operating efficiently, earnings should increase regularly to keep up with the average cost of living. When incomes decline, however, it is a sign that employers are either

cutting pay rates, laying workers off, or reducing their hours. Declining incomes can also reflect an environment where investments are not performing as well.

Incomes are broken down by different demographics, such as gender, age, ethnicity, and level of education, and these demographics give insight into how wages change for various groups. This is important because a trend affecting a few outliers may suggest an income problem for the

entire country, rather than just the groups it effects.

3. Unemployment Rate

The unemployment rate is very important and measures the number of people looking for work as a percentage of the total labor force. In a healthy economy, the unemployment rate will be anywhere from 3% to 5%.

When unemployment rates are high, however, consumers have less money to spend, which negatively affects retail stores, GDP, housing markets, and stocks, to name a few. Government

debt can also increase via stimulus spending and assistance programs, such as unemployment benefits and food stamps.

However, like most other indicators, the unemployment rate can be misleading. It only reflects the portion of unemployed who have sought work within the past four weeks and it considers

those with part-time work to be fully employed. Therefore, the official unemployment rate may actually be significantly understated.

One alternative metric is to include as unemployed workers those who are marginally attached to

the workforce (i.e. those who stopped looking but would take a job again if the economy improved) and those who can only find part-time work.

4. Consumer Price Index (Inflation)

The consumer price index (CPI) reflects the increased cost of living, or inflation. The CPI is calculated by measuring the costs of essential goods and services, including vehicles, medical

care, professional services, shelter, clothing, transportation, and electronics. Inflation is then determined by the average increased cost of the total basket of goods over a period of time.

A high rate of inflation may erode the value of the dollar more quickly than the average consumer’s income can compensate. This, thereby, decreases consumer purchasing power, and the average standard of living declines. Moreover, inflation can affect other factors, such as job

growth, and can lead to decreases in the employment rate and GDP.

However, inflation is not entirely a bad thing, especially if it is in line with changes in the

average consumer’s income. Some key benefits to moderate levels of inflation include:

1. It encourages spending and investing, which can help grow an economy. Otherwise, the value of money held in cash would be simply corroded by inflation.

2. It keeps interest rates at a moderately high level, which encourages people to invest their money and provide loans to small businesses and entrepreneurs.

3. It’s not deflation, which can lead to an economic depression.

Deflation is a condition in which the cost of living decreases. Although this sounds like a good thing, it is an indicator that the economy is in very poor shape. Deflation occurs when consumers decide to cut back on spending and is often caused by a reduction in the supply of money. This

forces retailers to lower their prices to meet a lower demand. But as retailers lower their prices, their profits contract considerably. Since they don’t have as much money to pay their employees,

creditors, and suppliers, they have to cut wages, lay off employees, or default on their loans.

These issues cause the supply of money to contract even further, which leads to higher levels of deflation and creates a vicious cycle that may result in an economic depression.

5. Currency Strength

A strong currency increases a country’s purchasing and selling power with other nations. The

country with the stronger currency can sell its products overseas at higher foreign prices and import products more cheaply.

However, there are advantages to having a weak dollar as well. When the dollar is weak, the United States can draw in more tourists and encourage other countries to buy U.S. goods. In fact, as the dollar drops, the demand for American products increases.

6. Interest Rates

Interest rates are another important lagging indicator of economic growth. They represent the

cost of borrowing money and are based around the federal funds rate, which represents the rate at which money is lent from one bank to another and is determined by the Federal Open Market Committee (FOMC). These rates change as a result of economic and market events.

When the federal funds rate increases, banks and other lenders have to pay higher interest rates to obtain money. They, in turn, lend money to borrowers at higher rates to compensate, which

thereby makes borrowers more reluctant to take out loans. This discourages businesses from expanding and consumers from taking on debt. As a result, GDP growth becomes stagnant.

On the other hand, rates that are too low can lead to an increased demand for money and raise the

likelihood of inflation, which as we’ve discussed above, can distort the economy and the value of its currency. Current interest rates are thus indicative of the economy’s current condition and can

further suggest where it might be headed as well.

7. Corporate Profits

Strong corporate profits are correlated with a rise in GDP because they reflect an increase in

sales and therefore encourage job growth. They also increase stock market performance as investors look for places to invest income. That said, growth in profits does not always reflect a

healthy economy.

For example, in the recession that began in 2008, companies enjoyed increased profits largely as a result of excessive outsourcing and downsizing (including major job cuts). Since both activities

took jobs out of the economy, this indicator falsely suggested a strong economy.

8. Balance of Trade

The balance of trade is the net difference between the value of exports and imports and shows whether there is a trade surplus (more money coming into the country) or a trade deficit (more money going out of the country).

Trade surpluses are generally desirable, but if the trade surplus is too high, a country may not be taking full advantage of the opportunity to purchase other countries’ products. That is, in a global

economy, nations specialize in manufacturing specific products while taking advantage of the goods other nations produce at a cheaper, more efficient rate.

Trade deficits, however, can lead to significant domestic debt. Over the long term, a trade deficit can result in a devaluation of the local currency as foreign debt increases. This increase in debt will reduce the credibility of the local currency, which will inevitably lower the demand for it

and thereby the value. Moreover, significant debt will likely lead to a major financial burden for future generations who will be forced to pay it off.

9. Value of Commodity Substitutes to U.S. Dollar

Gold and silver are often viewed as substitutes to the U.S. dollar. When the economy suffers or the value of the U.S. dollar declines, these commodities increase in price because more people

buy them as a measure of protection. They are viewed to have inherent value that does not decline.

Furthermore, because these metals are priced in U.S. dollars, any deterioration or projected decline in the value of the dollar must logically lead to an increase in the price of the metal. Thus, precious metal prices can act as a reflection of consumer sentiment towards the U.S. dollar

and its future. For example, consider the record-high price of gold at $1,900 an ounce in 2011 as the value of the U.S. dollar deteriorated.

Introduction

Investment and disinvestment are two sides of the same coin. When we deal with the

investment management, it automatically encompasses, disinvestment also, as what is

investment for one is disinvestment for another, particularly in the secondary market. It investment is an art and science, the more so is the disinvestment process.

What is Disinvestment

Investment refers to conversion of money or cash into securities, debentures, bonds or any

other claims on money. At the same time, disinvestment involves the conversion of money claims or securities into money or cash.

Objectives of the study

The study of disinvestment of public sector undertakings is aimed at examining the

following :

1. To analyse the objectives of disinvestment process in India.

2. To study the disinvestment process followed in India till date.

3. To examine the timing of disinvestment

4. To bring out the significance of disinvestment proceeds vis-à-vis budget deficit. 5. To bring out the findings of the study.

Disinvestment of Public sector undertakings

Disinvestment is a wider term extending from dilution of the stake of the government to a

level where there is no change in the control to dilution that results in the transfer of

management. The transfer of ownership may occur when in an enterprise the dilution of

government ownership is beyond 51 percent. The disinvestment implies that the

government will sell to public or private enterprises / public institutes part of its holding in public sector enterprises.

Reasons for disinvestment

The public sector in India at present is at cross roads. The new economic policy initiated in

July – 1991, clearly indicated that the public sector undertakings have shown a very

negative rate of return on capital employed. On account of this phenomenon many public

sector undertakings have become burden to the government. They are infact turning out to be liabilities to the government rather than being assets.

This is a sector which the government clearly wants to get rid off. In this direction the

government has adopted a new approach to reform and improve the public sector

undertakings performance i.e 'Disinvestment policy'. This has gained lot of importance

especially in latter part of 90s. At present the government seriously perceives the

disinvestment policy as an active tool to reduce the burden to financing the public sector

undertakings.

Problems of Public sector undertakings

The most important criticism levied against public sector undertakings has been that in

relation to the capital employed, the level of profits has been too low. Even the government

has crticised the public sector undertakings on this count. Of the various factors responsible

for low profits in the public sector undertakings, the following are particularly important :-

i. Price policy of public sector undertakings

ii. Under – utilization of capacity

iii. Problem related to planning and construction of projects

iv. Problems of labour, personnel and management v. Lack of autonomy

The government in order to put an end to these problems, decided to disinvest its stake in

the PSUs. The companies traditionally established as pillars of growth have now become a

burden on the economy. Except few mighty oil and petroleum companies, almost all other

PSUs are incurring losses. The national gross domestic product and gross national savings

are also adversely effected by low returns from PSUs. About 10 to 15 % of the total gross domestic savings are reduced on account of low savings from PSUs.

Objectives of Disinvestment

The following are the main objectives of disinvestment policy of the government.

i. To reduce the financial burden on government.

ii. To improve public finances.

iii. To introduce, competition and market discipline.

iv. To find growth.

v. To encourage wider share of ownership. vi. To depoliticise essential services.

The Disinvestment process in India

The following are the three methods adopted by the Government of India for disinvesting

the Public sector undertakings. There are three broad methods involved, which are used in

valuation of shares.

1. Net Asset Method: This will indicate the net assets of the enterprise as shown in the

books of accounts. It shows the historical value of the assets. It is the cost price less

depreciation provided so far on assets. It does not reflect the true position of profitability of

the firm as it overlooks the value of intangibles such as goodwill, brands, distribution

network and customer relationships which are important to determine the intrinsic value of

the enterprise. This model is more suitable in case of liquidation than in case of

disinvestment.

2. Profit Earning Capacity Value Method: The profit earning capacity is generally based

on the profits actually earned or anticipated. It values a company on the basis of the

underlying assets. This method does not consider or project the future cash flow.

3. Discounted Cash Flow Method: In this method the future incremental cash flows are

forecasted and discounted into present value by applying cost of capital rate. The method

indicates the intrinsic value of the firm and this method is considered as superior than other

methods as it projects future cash flows and the earning potential of the firm, takes into

account intangibles such as brand equity, marketing & distribution network, the level of

competition likely to be faced in future, risk factors to which enterprises are exposed as well

as value of its core assets. Out of these three methods the Discounted cash flow method is used widely though it is the most difficult.

Timing of Disinvestment (Through Technical Analysis)

Unless the disinvestment is a distress sale, it has to be well timed to reap the optimum

gain. Such timing can be sought from research analysis of the market trends called

Technical analysis. There are many methods prevailing for finding the significant timing for disinvestment of shares. The most significant method is "Relative Strength Index" method.

Relative Strength Index (RSI) : The most vital method of finding the timing for

disinvestment of shares in RSI, which was developed by 'Wells Wilder'. RSI is calculated for

each scrip to identify the inherent technical

Methods followed by India for Disinvestment so far…

(Table – 3)

Year No. of Companies Method of disinvestment

'91-92 47 Minority shares sold by auction method in bundles of "very good" "good" and

"average" companies

'92-93 35 Bundling of shares abandoned. Shares sold separately for each company by auction

method. '93-94 - Equity of 7 companies sold by open auction but proceeds received in 1994-95

'94-95 13 Sale through auction method, in which NRIs and other persons legally permitted to buy, hold or sell equity, allowed to participate.

'95-96 5 Equities of 4 companies auctioned.

'96-97 1 GDR (VSNL) in international market

'97-98 1 GDR (MTNL) in international market

'98-99 5 GDR (VSNL) / Domestic offerings with the participation of FIIs (CONCOR, GAIL). Cross purchase by 3 oil sector companies i.e. GAIL, ONGC & IOC.

'99-00 2 GDR (GAIL), Domestic issues (VSNL), restructuring BALCO

'00-01 4 Strategic sale of BALCO, LIMC, takeover – KRL (CRL), CPCL (MRL), BRPL

'01-02 10 Strategic sale of CMC (51%), HTL (74%), VSNL(25%), IBP (33.58%), PPL (74%), and sale by other modes (ITDC & HCI).

'02-03 6 Strategic sale of JESSOP (72%), HTL (26%), MFIL (26%), IPCL (25%) and other modes (HCI, Maruthi).

Source: ET Survey, Mar.2003

Fiscal Deficit & Disinvestment proceeds

(Table-4)

Particulars 1991- 1992

1992- 1993

1993- 1994

1994- 1995

1995- 1996

1996- 1997

1997- 1998

1998- 1999

1999- 2000

2000- 2001

2001-2 002

1. Target of Disinvestment 2500 3500 3500 4000 7000 5000 5000 5000 10000 12000 12000

2. Amount realized from disinvestment 3038 1961 1866 5078 357 455 902 5371 1892 2600 5632

3. Amount realized as percentage target 121.5 56.03 53.31 126.9 5.10 9.101 8.04 107.42 18.92 21.67 47

4. Fiscal Deficit 36325 40173 60257 57703 60243 66733 83937 113349 108898 111275

5. Fiscal Deficit as percentage of GDP 5.9 5.7 7.0 5.7 5.1 4.9 5.9 6.4 5.6 5.1 5.1

6. Disinvestment as percentage of Fiscal Deficit

8.36 4.88 3.1 8.8 0.6 0.7 1.0 4.7 1.7 2.3

Source: Annual Report – 2000, RBI Bulletin

Disinvestment Disinvestment is a process in which the public undertaking reduces its portion in equity by disposing its shareholding. “Disinvestment” as per SEBI (substantial acquisition of shares) guideline, means the sale by the central government/state government, of its shares or voting rights and/or control, in PSUs. The disinvestment reduces government participation in the company In India , the new economic policy have given rise to significant focus for privatization of public sector enterprises. Hence, disinvestment is one of the method of privatization, which started in the year 1992. It implies selling of govt. equity shares of public sector units in the market. It is a concrete step towards privatization and liberalization of our economy .

Criteria for disinvestment The decision regarding disinvestment or liquidation viewed in the light of following criteria: a) Whether the objectives of the company are achieved b) Whether there is decrease in number of beneficiaries c) Whether serving the national interest will be affected because of disinvestment d) Whether private sector can efficiently operate and manage the undertaking. e) Whether the original rate of return targeted could not be possible to achieve. f) Whether socio-economic objectives lots its purpose Merits of disinvestment In Private Sector, the decision making process is quick and decisions are linked with the competitive market changes. The disinvestment process would bring in better corporate governance, exposure to competitive, corporate responsibility, improvement in work environment etc. The market participation in capital of PSUs through stock exchanges would enable the market to discover the latent worth of PSUs. The Loss making PSUs can be successfully revived by asking the strategic partner to infuse fresh capital and exercising excellent management control over sick PSUs Demerits of disinvestment Selling of profit-making and dividend paying PSU would result in loss of regular source of income to the government. There would be chances of ‘asset stripping’ by the strategic partner. Most of the PSUs have valuable assets in the shape of plant and machinery, land and buildings etc. The Government’s Policy or disinvestment includes the disposal of both profit making, as well potentially viable PSUs. Privatization and Disinvestment Privatization implies a change in ownership, resulting in a change in management. The privatization of public sector enterprises will occur only when govt. sells more than 51% of its ownership to private entrepreneurs. Disinvestment on the other hand, has a much wider connotation as it could either involve dilution of govt. stake to a level that result in a transfer of management or could also be limited to such a level as would permit govt. to retain control over the organization. Disinvestment beyond 50% involves transfer of management, where as disinvestment below 50% would result in the govt. continuing to have a major say in the undertaking Background of Disinvestment The Indian economy had virtually embraced bankruptcy during the period of 1980-92. In 1991, there was 236 operating public sector undertakings, of which only 123 were profit making. The top 20 profit making PSU’s were responsible for 80 percent of profits. The return on public sector investment for the year 1990-91 was just over 2 percent. The basic charges against the public sector for its

Poor performance are as follows: Low rate of return on Investment Declining contribution to national savings Poor capacity utilization Overstaffing, bureaucratization leading to excessive delays and wastage of scares resources. On account of these phenomenon, many public sector enterprises have become more a burden than an asset to the government. Process of Disinvestment The govt. in July 1991 initiated the disinvestment process in India, while launching the New Economic Policy (NEP The govt. had appointed the Krishnamurthy committee in 1991 and Rangarajan committee in 1992 to look after the disinvestment process. Both the committees have recommended disinvestments to fulfill objectives of modernization of the PSE’s through: Strengthening R &D Initiating diversification/expansion programme Retaining and reemployment of employees Funding genuine needs of expansion Mitigating fiscal deficit of the government . These committees also distinguished between the short term and long term goals of the disinvestment and advised the govt. not to sacrifice the long term goals for the sake of fulfilling the short term objectives. The govt. has announced in its NEP that mitigating the fiscal deficits is the only objective of disinvestment. The crucial shift in govt. policy for disinvestment of PSU’s was mainly attributed to poor performance of these enterprises and burden of financing their requirements through budget allocation. Further in 1996, the govt. constituted a five member public sector disinvestment commission under the chairmanship of G.K.Ramakrshna for drawing a long term disinvestment programme for the PSU’s. The committee submitted its report covering 58 enterprises, out of 70 enterprises referred to it by the govt. recommendations ranged from strategic sales in various proportions to disinvestments ant various level. This committee was ultimately abolished in 1999. The govt. set up a new Department of Disinvestment in 1991 to establish a systematic policy approach to disinvestment and to give fresh impetus to the programme of disinvestment, which will increasingly emphasize strategic sales of identified PSU’s In 2001, the govt. reconstituted the disinvestment commission with R.H.Patil as its chairman. The govt. has decided to refer all ‘non-strategic’ PSU’s and their subsidiaries, excluding IOC, ONGC, and GAIL to the commission for its independent advice. Objectives of Disinvestment: The following are the main objectives of the disinvestment policy of the government: To reduce financial burden on the government

To encourage wider share of ownership To introduce competition and market discipline To help public enterprise upgrade their technology to become competitive To rationalize and retain their workforce To improve efficiency and productivity in public enterprise through new industrial policies. Modalities of Disinvestment: In order to achieve the various objectives and goals of disinvestment many methods have been formulated and implemented. These includes: Public Offer: offering shares of public sector enterprises at a fixed price through a general prospectus, the offer is made to the general public through the medium of recognized market intermediaries. (2) Cross Holding: In the case of cross holding, the govt. would simply sell part of its share of one PSU to one or more PSU’s. (3) Golden Share: in this model, the govt. retains a 26 percent share in the PSU. This 26 percent share will continue to give the govt. the status of majority share holder. 4) Warehousing: Under this model, the govt. owned financial institutions were expected to buy the govt.’s share in select PSU’s and holding them until third buyer emerged. </li></ul><ul><li>(5) Strategic Sale: Under this model, govt. sells a major portion (51% and above) of its stake to the strategic buyer and also gives over the management control. Progress of Disinvestment: Disinvestment has also been undertaken in states. Out for the 222 state level public enterprises identified for disinvestment, the process has been initiated in 124 enterprises. Out of which 30 enterprises have been privatized and 68 have been closed down . The reason for such low proportion of disinvestment proceeds against the target are: The unfavorable market conditions Stringent bureaucratic procedure. The Govt. is not transparent about its approach towards privatization of PSE’s. Suggestion 1. The government has to form a policy framework for the entire disinvestment process. 2. The government should de-link the disinvestment process from the budgetary exercise. 3. Government should stop setting up of the targets in every year annual budget and should have a long-term plan. 4. Timing of disinvestment is crucial and the government should follow a specific method or process in order to reap more chunks. BSNL (TELECOM) The Telecom Commission, the policy-making wing of the, will soon take up the issue of disinvestment in state-run BSNL,DOT Telecom Minister A Raja . Sam Pitroda gave a report that IPO is going to be discussed in the Telecom Commission. Raja had said that the government will refer the issue of disinvestment in BSNL to a GOM, an announcement that brokered peace with employees' unions, who called off an indefinite strike Sam Pitroda with banker Deepak Parekh & telecom secretary JS thomas recommended 30 % disinvestment in BSNL and VR of over 1 lakh staff as part of steps to improve the financial health of the PSU. Sam Pitroda panel was set up by Prime Minister Manmohan Singh to suggest ways to improve BSNL financial health.

BSNL saw profits plummet to Rs 178 crore in 2009-2010 (up to December, 2009) from over Rs 575 crore in 2008-09, as the PSU is rapidly losing market share to new entrants. The PSU has 91 million users, both mobile and landline. </li></ul>

1. 20. PM approves immediate 10% disinvestment of BSNL <ul><li>Prime Minister, attended by BSNL CMD, MTNL CMD, Sam Pitroda and Union Communications Minister A Raja among others arrived at a consensus to offload 10 % stake in BSNL through listing. Effectively it

means the privatization of BSNL. </li></ul><ul><li>BSNL and MTNL two PSUs have been witnessing declining market share month after month even as their private counterparts continue notching up large number of new subscribers. </li></ul><ul><ul><li>Two PSUs have been witnessing declining market share month after month even as their private counterparts continue notching up large number of new subscribers. </li></ul></ul>

2. 21. <ul><li>A Raja also called for exemption of annual licence fee for BSNL which will result in annual savings of about Rs 4,000 crore to the company. As a first step, licence fee for fixedline services in rural areas may be considered for exemption. This move alone can result in savings of about Rs 1,800 crore to the PSU. </li></ul>

3. 22. <ul><li>Unions are opposed to disinvestment in Steel Authority of India Ltd (SAIL), the

government today informed the Rajya Sabha. </li></ul><ul><li>SAIL's 20 per cent share sale plan to mop up about Rs 16,000 crore, earlier planned in October -November this year, already faces some regulatory hurdles. </li></ul><ul><li>Sail unions have resorted to distribution of pamphlets and also staged demonstrations protesting against the decision regarding disinvestment of SAIL,&quot; Minister of State for Steel a Sai Prathap told the Upper House. </li></ul><ul><li>The disinvestment of Government of India's shareholding in SAIL in line with the Government's policy to develop larger people's ownership of CBS Enterprises with Government retaining majority shareholding and control . </li></ul>

4. 23. CONTI…. <ul><li>In April, Govt. announce a proposal to sell 20% equity in the country's largest steelmaker. </li></ul><ul><li>Share sale would see the government offloading 10 %

of its stake in the steel maker, while the company would raise fresh equity in the same proportion. </li></ul><ul><li>On share sale timing, Prathap said the Government has decided to disinvest its shareholding in SAIL besides raising add equity by SAIL, in two discrete tranches to be issued at appropriate times in consideration of SEBI guidelines and prevailing market conditions </li></ul>

5. 24. <ul><li>The government, at present, holds a little over 85 % stake in SAIL and post-FPO, its equity in the company is expected to go down to about 69 %. Steel Minister Virbhadra Singh had said the FPO could fetch Rs 16,000 crore. </li></ul><ul><li>Prathap, said &quot;the actual amount that would be raised through disinvestment as well as from FPO would depend upon a number of factors including inter-alia the prevailing market conditions,

share price and investors' interest.&quot; </li></ul><ul><li> A top government official had last week said that SAIL share sale, earlier scheduled in October-November may not come in 2010 as it is still not SEBI compliant for the FPO </li></ul>

6. 25. <ul><li>The country's largest steelmaker has 12 official directors onboard, besides two independent directors. The company would have to hire at least 10 more independent directors to become SEBI compliant. However, the company has proposed to trim the total board strength to 18, consisting of nine officials and an equal number of independent directors and a nod for restructuring of SAIL Board is awaited from the ACC. </li></ul>