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1. FINANCIAL ADVISORS: Weigh impact on investors
Stabilise world financial markets: G7 Financial leaders from the world’s richest nations (G7) pledged to work together to stabilise world financial markets shaken by the US housing debacle that is puncturing global economic growth. The Group of Seven finance ministers and central bank chiefs acknowledged that they all had a vested interest in shoring up the global financial system. British finance minister said where coordinated action is found to be necessary to stabilise the world financial markets, we will do all that is needed. We are all after the same thing and this is to restore stability. European Central Bank (ECB) sent a signal that the ECB may soon join the Fed, Bank of England and Bank of Canada in cutting rates. US Treasury Secretary Henry Paulson struck the same theme, urging banks to take losses and raise capital quickly to stave off a credit crunch. The worst thing is if they don’t raise capital; and then restrain their lending. The draft copy of the communiqué vowed to take actions, individually and collectively, in order to secure stability and growth in economies.
2. WEALTH MANAGERS Map out the details to translate into benefits
Frozen demat account Quoting PAN has been made mandatory since 2007 for operating demat accounts, but numerous investors have failed to comply with directive. This had forced the depositories holding securities in electronic form to freeze the demat accounts of several investors. The government is set to act on a proposal to attach the securities lying in frozen demat accounts of lakhs of investors if they do not furnish details of their PAN within a new deadline. If the investor do not come forward and comply with the identification norms, the CBDT plans to invoke the provisions of the Income Tax Act to provisionally attach the securities in the credit of such frozen accounts. The CBDT would write to investors whose demat accounts have been frozen warning them about the consequences of their failure to comply with the norms. At last count, the number of frozen demat accounts was reckoned to be over 20 lakh and the value of securities held by investors in such accounts at least over Rs 1,00,000 crore, which is over 2% of the market capitalisation of companies listed on BSE.
FINANCIAL SECTOR… 2
3. FINANCIAL PLANNERS Value unlocking for investors
Regulation for Art funds In a growing economy, art prices are normally on the rise and funds can pay to investors. But problems may arise when the economy becomes sluggish or slips into a recession. In such cases, redemption pressure on the funds is not difficult to envisage and a regulatory framework is expected to guard investors to some extent from dips in the art market. Regulation of art funds seems to be on the cards. With the Sebi recently taking a stand that art funds, which are dealing in public money, should be registered, it appears that a regulatory framework could transpire soon. The Indian market regulator Sebi said an analysis of the characteristics of the art funds shows that they are collective investment schemes as defined under section 11AA (2) of the Sebi Act, 1992. Since the art and equity markets are different, their performance parameters will vary. According to section 12 (1B) of the Sebi Act, no person can sponsor without obtaining a certificate of registration from the market regulator. Launching/floating art funds or schemes without obtaining registration from Sebi amounts to violation of the Sebi Act and appropriate actions, civil and criminal, under the Sebi Act may be taken against such funds/companies. For a collective investment scheme to raise money from the public, it is prerequisite that the entity must (a) be a company and (b) registered with Sebi as a collective investment management company.
Regulating Venture capital funds Only professionals are likely to be allowed to float venture capital funds (VCF) in future. In what could be a major change in India’s venture capital regulations, no business house, and financial service group or big corporate would be allowed to set up a VCF. The capital market regulator has veered around to this view, possibly driven by instances where large groups have used funds sponsored by them to invest in companies where they have strategic or business interests. Since VCFs operate under a special regime in relation to taxation, foreign capital and investment lock-in, and are meant to encourage new entrepreneurs, the vehicle should not be misused by established players. While no formal guidelines have been issued, the change in regulatory stance on VCFs follows views expressed by an informal panel to look into regulations for venture capital. Existing VCFs set up by business houses and banking groups will not be affected. Internationally, there is no special classification, primarily because in most countries VCFs are not regulated entities. It would be interesting to see how the regulations are tweaked in India to ensure that only professionals can come together to sponsor a fund. In this case, it would be important how a professional is defined.
FINANCIAL SECTOR… 3
4. INCLUSIVE CEOs Innovative responses to problems
Short selling by FIs back on Street Market regulator Securities Exchange Board of India (SEBI) said short selling by institutional investors, banned after the Ketan Parekh scam six year ago, will be operational from April 21 ’08. SEBI had banned short selling in the aftermath of the Ketan Parekh scam in 2001 as it feared a speculative sell off could exert massive bear pressure on the stock market. Retail investors, however, are already allowed to short sell securities. Analysts believe that short selling would create more liquidity in the market. Simultaneously, a full-fledged securities and borrowing scheme, the essential condition for short selling, would also start from April 21. Sebi asked stock exchanges and depositories to make necessary amendments to the relevant byelaws, rules and regulations for the implementation of this decision. Initially, securities traded in the futures and options segment will be eligible for short selling, and SEBI may review the list of stocks that are eligible for short-selling transactions from time to time. The system of ‘necked short selling’ as is available in the US markets has not been allowed, and all investors must honour their obligations of the delivering the securities at the time of settlement.
5. RISK MANAGEMENT CONSULTANTS Educate – Engineer and Enforce
Currency derivatives Finance minister in the Union Budget 2008-09 proposes to take measure for launching exchange-traded currency and interest rate futures and developing a transparent credit derivatives market with appropriate safeguards. The proposed measures will help Indian to cover risks through electronic platform on BSE and NSE. In many other markets, corporates are able to hedge their currency exposures by buying into exchangetraded derivative products such as currency options and futures. Such a regime provides transparency and improves liquidity, besides offering lower costs and better price discovery. India now has an OTC currency futures market dominated by a clutch of banks. It lacks efficiency, price transparency and access that an exchange-traded currency product offers. Financial market reforms should not be delayed due to the blame game around financial derivatives. Instead all corporates buying financial derivatives should be asked to share their risk management policy. Uncertainty is bad for any market. Uncertainty in the derivatives market would only mean an increased cost of hedging for every legitimate market participant. FM in the Union Budget 2008-09 proposes to encourage the development of a market-based system for classifying financial instruments based on their complexity and implicit risks. The aim is to guide investors, especially retail, and ensure that the right products are sold to the right people. Credit rating agency Crisil, will role out this initiative soon.
FINANCIAL SECTOR… 4
6. FINANCE PROFESSIONALS Developing alternative delivery models
Third-party sub-account If foreign portfolio managers continue to pull out of Indian stocks, the government and regulators will have to think of ways to make it easier for foreign investors to access the Indian markets. For the government, the tricky task is to open up these avenues without giving an impression that it has backtracked on earlier measures. A third-party sub-account could well be one such effort. In a global market haunted by credit crunch, third-party sub-accounts to revive flows may seem like a tall order. The capital market regulator quietly lifted an almost two-year-old embargo to allow foreign investors greater access to the local stock market. While the new route is less flexible than investments through PNs, it may partly offset the impact the PN clampdown has had on the stock market. Kotak – the diversified financial services group – was given the permission for multiple third-party subaccounts. A third-party sub-account is an avenue that allows 20 or more foreign investors to pool in money for trading in Indian stocks. It cans piggy back on an FII, which here is Kotak that has an FII registration. The beauty of a third-part sub-account is that the foreign investors can hire their own fund manager whose trading calls are independent of the FII manager. (In other words: a day when FII is selling R-Power, the third party sub-account actually buying the stock).
7. CREDIT COUNSELORS Resolve convertibility and recompensation issue
Nifty futures on SGX Nifty futures started trading on the SGX since September 2000, following an agreement between NSE and SGX. However, volumes have remained negligible with less than 100 units changing hands on a daily basis till a few months back. Trading volumes of Nifty futures on the Singapore Exchange (SGX) has shot up in the last couple on months, and if market watchers are to be believed, this number could increase further in the coming days. The scenario has changed dramatically since December 2007. Volumes have now shot up to 50,000 units on a daily average, showing that this product is suddenly becoming attractive in the international markets. Some call this the export of Indian financial markets to overseas locations and consider this as a loss for the Indian markets as brokers lose on volumes and exchanges lose on fees. In a way, the rise in volumes on the SGX coincide with the Sebi ban on FIIs from issuing PNs linked to equity derivatives in October ’07. Since the Nifty futures on the NSE cannot be used as underlying to create derivatives products in the overseas markets investors are moving to the SGX Nifty market. In general traders feel that as of now the 6% volume is not worrisome as the Indian markets are price makers and not price takers since 94% of the volumes still happen in the Indian market. But there are others who feel that the price on the Singapore exchange is being closely tracked by many traders.
FINANCIAL SECTOR… 5
8. TECH SAVVY PROFESSIONALS Take first step to ensure efficient and reliable system
Leveling field in IPO Market regulator Sebi will review the IPO procedure with a view to reduce the gap between the opening of an issue and its listing on the bourses. The measures are aimed at creating a level playing field between retail investors and institutional investors. It would be Sebi’s endeavour to reduce the time period to three days and will ask institutional investors to make upfront payments for subscribing to public issue as in the case of retail investors. This would also help curb excess over subscription by institutional investors. Sebi new chairman CB Bhave said the primary market issuance process will be reviewed to reduce the gap between the opening of an issue and listing of its shares. There is a feeling that things are not the same for retail and institutional investors in the IPO process. Institutional investors tend to argue that they put in a lot of money that can’t be locked in for such a long time. Secondly, some people have raised the issue of funds that remain with the banks. That issue will also be automatically addressed once we reduce the gap. He emphasised settlement period in secondary market has been cut from 42 days to T+2 (two days after the trading). “There is a feeling that similar reforms should happen in the primary market. He added: “Once the gap is reduced, the gray market will disappear.”
9. ONE-STOP-SHOPS Dedicated to offer related services under a roof
Reliance Commodities DMCC The Anil Ambani- promoted Reliance Commodities, through its UAE-registered subsidiary – Reliance Commodities DMCC – has kicked off commodity and currency trading facilities to Indian investors outside India. The brokerage, which recently received its trading membership from Dubai Gold and Commodities Exchange (DGCX), plans to offer trading and hedging options in gold, silver, fuel oil, steel and currencies. The idea is to provide a cost-efficient commodity trading facility for Indians and other nationals residing in the Gulf region. DGCX is a Dubai Multi Commodities Centre initiative in partnership with Mumbai-based Financial Technologies and Multi Commodity Exchange of India. The exchange logs 220 trading members (or brokers) of which around 150 are active traders. DGCX CEO Malcolm Wall Morris said: “Several Indian financial services players have approached us for trading membership. A reason for this could be the fact that our average trading volumes have gone up 65% over the past one year. The strength of this exchange is in gold and currency trading. But we will be out with more products soon. DGCX boasts of a fully automated electronic trading platform accessible from anywhere in the world. The bourse deals in UDS denominated contracts and trades 15 hours a day from 8.30 am.
FINANCIAL SECTOR… 6
10. GLOBAL OUTLOOK Rating processes Rating agencies’ business model Rating agencies have come under fire for their role in the US subprime crisis, with critics saying they were too slow to downgrade highly rated securities linked to poor quality mortgages. Regulators and politicians are looking closely at the rating agencies’ business model, and also the efforts they made to ensure the accuracy and reliability of ratings. Standard & Poor’s unveiled an overhaul of its ratings process as it responds to widespread criticism of the quality and accuracy of credit ratings. It announced 27 steps that were aimed at boosting confidence in credit ratings. S&P said: By further enhancing independence, strengthening the ratings process, and increasing transparency, the actions we are taking will serve the public interest. In terms of analysis, the agency said it would highlight additional factors not covered by traditional default ratings, such as liquidity, volatility, correlation and recovery. Its analysis would include the use of ‘what if’ scenarios that would take account of extreme events. The agency added it would also create a user manual and investor guidelines for credit ratings.
11. CONTINUING LEARNING CENTRES Take informed decisions
Compulsory delisting of securities Compulsory delisting can be done by SE as per the norms laid down, which includes non-compliance of the terms of the Listing Agreements (LA) by a company. Prior to delisting, show-cause notices are to be sent to the company. Post delisting, the shareholders are entitled to get fair value of their securities but the mode and manner laid down for enforcement of the same, is hazy. In the first half of 2004, BSE delisted a whopping 992 companies (out of total 5,500 listed companies) for non-compliance of the terms of the LA. Admittedly, BSE did not take any penal action under section 23(2) of SCR Act against them. The shareholders of these companies – which may number over 10 lakh – are generally unaware of the delisting as they were neither informed at any stage, what to talk about the exit option and price offered. The pathetic monitoring of listed companies, non-enforcement of financial penalties (now up to 25 crore) in the SCR Act and mechanical delisting by BSE has rewarded corporate misgovernance at the cost of small investors. As non-compliance was a willful act, white-collar crime in some instances cannot be ruled out. In UK, for late filing of reports to the regulator by companies, financial penalties are imposed. The penalty – for delay up to 28 days – ranges from 10 times to 60 times of the annual listing fees for each breach and higher for delay beyond 28 days. In addition, disciplinary action is taken against the management. Further, the disciplinary committee of the London Stock Exchange is empowered to impose any or all of the sanction, viz., censure, unlimited fine, order that issuer make restitution to pay any person and cancellation to have its securities listed on the exchange.
FINANCIAL SECTOR… 7
12. ISSUES OF THE PRESENT Freedom to get & fail in the system of free enterprise Stock indices The Indian market’s affair with a formal index began in 1986, when the BSE formulated its own gauge and called it the 30-share sensitive index. This index, puckishly nicknamed sensex, soon captured the imagination of a market. Since the launch, the sensex has been on a tumultuous journey. This yardstick has become the lightening rod for capturing the entire range of emotions that stock markets are able to generate. But like all objects of adoration, the stock market index too needs constant care and high maintenance to stay ahead of time. But, recent events seem to indicate that it may probably be time to reassess the current index and make some course corrections. The urgency seems to have got accentuated by the fact that the sensex does not seem to be correctly reflected the market mood, or capturing the core sentiments prevalent in the market. On many occasions, while the sensex has shown an upward movement, a closer look at the disaggregated figures reveals that the number of shares that have declined in the market is far grater than those that registered a gain during the day. Conversely, it has also happened that the advances outnumber the declines on the days when the sensex has lost some ground. One would have expected the Nifty to exhibit greater stability since it has a higher number of stocks. Unfortunately, this odd market behaviour can be witnessed in the movement of the Nifty as well. Leap across continents and compare the behaviour of Dow Jones Industrial Average, which also has 30 shares. There’s a straight, one-to-one correspondence between the index and the fate of all the stocks being traded on the exchanges on most days. This is not the case in India. So, what’s with the Indian stock indices? One thing is clear: the individual stocks in the index are being manipulated, either to mislead investors deliberately or to offset punts in the sensex or Nifty futures. In reality, it is mostly the latter. The futures and options market today is in multiples of the cash market, resulting in the tail wagging the dog. This leads us to a larger point: the market is so shallow that only a few investors can manipulate a couple of stocks and impact the index outcome. Even though both the exchanges say that it is difficult to manipulate index stocks, there is some prima facie evidence to suggest that the securities market regulator needs to take a look at this before it spirals out of hand.
FINANCIAL SECTOR… 8
Sensex follows the pre-budget trend
In 2007, for example, the Sensex fell 789 points between February 1 and February 27. It fell another 540 points on February 28 after the budget was presented. That is, the market moved in the same way as prebudget days. And it could not reach its February 1 figure even after a month – at 13,072 on March 30, 2007, the Sensex was 1,195 points lower compared to 14,267 on February 1.
In contrast, the Sensex had gone up by 88 points on the budget day in 2006 – up from 10,282 on February 27 to 10,370 on Friday 28. This, however, was again the continuation of the pre-budget trend. The market was rising throughout the budget month – up 423 points between February 1 and February 27. The rising trend had continued after the budget too and the Sensex gained 910 points in one month after the budget.
Similarly, in 2005 too although, the market movement was listless and the Sensex had hovered around 6,600 point, it had gained marginally by 17 points between February 1 and February 27. On the budget day, however, the Sensex had gone up by 144 points.
The market had behaved differently on the budget day only once in the last five years. It was P Chidambaram’s first budget in 2004. The market had moved up steadily in June 2004 – gained 120 points between June 1 and July 7 – but on the budget day (July 8, 2004) it lost 112 points. The trend got reversed the very next day and had crossed the 5,000-mark in the next ten trading sessions.
What happened in the past may not happen in the future too. After all, the market analysts believe that the stock market movement does not follow a set pattern. May be, but the statistical evidence shows: “That Indian bourse has followed the pre-budget trend in the immediate post-budget trading too”. The Sensex has fallen in February ‘08 so far – down from 18,242.58 on the February 1. Investors have already lost heavily in the January ’08 crash of approximately 2000 points. They are keeping their fingers crossed and are hoping the budget will reverse the trend. But will it? No one knows, for sure. And past experience too, does not give much hope. The fact, Chidambaram four budgets have not had any definite influence on the market. The Sensex generally followed its pre-budget trend in post-budget trading too.
This time again, the Sensex fell 418 points between February 1 and February 28. It fell another 246 points on February 29, 2008 in the aftermath of Budget populism which included a hike in short-term capital gains tax from 10% to 15%, and closed at 17,578.72. That is, the market moved in the same way as prebudget days.
1. A free market economy
Capital market, as a composite of primary and secondary markets, acts as the platform for channelising scarce economic resources to optimum utilities, fuelling the economic growth. The past few years have witnessed innumerable improvements by market forces and regulators, leading to healthy and efficient markets. Undoubtedly, India now boasts of one of the most efficient and transparent primary markets which has, in turn, helped in improving the depth and breadth of secondary markets. However, the sustained rally in the last few years resulted in complacency across the market. This period has seen secondary market investors developing a habit of buying in small corrections (irrespective of valuations), traders adding positions during every correction (ignoring stop-loss mechanism) and merchant bankers pricing IPOs at valuations on par with that of leading secondary market firms. Over and above that, huge leveraged positions had been built up in the primary and secondary markets, both in official and gray market, as a direct consequence of greed and increase in the risk appetite of investors in the recent past. In a nut shell, complacency resulted in excesses being built into the system in terms of positions and prices. All of us have forgotten the warning from investment guru Warren Buffet: “You only find out who is swimming naked when the tide goes out”. The correction was fast and steep, following a correction in the global markets. The leveraged positions were unwounded with volumes in the secondary market. Also, other effects were a lukewarm response in primary markets, reduction in IPO price band and extension of IPO dates. Primary market as a derivative of secondary market has of late picked up cues for valuations based on relative peer comparison. The basic rule remains – caveat emptor – let buyer beware. It’s a free market economy with a transparent platform available for one and all. And any free-will product comes with a disclaimer to be interpreted and understood by the user at his end. In the manner a cigarette pack states the statutory warning – “Cigarette smoking is injurious to health”, an IPO prospectus mentions the risk factors in the red herring prospectus (RHP) clearly stating – “An investment in our equity shares involves a high degree of risk. You should carefully consider all the information in this RHP, including the risks and uncertainties described below, before making an investment in our equity shares.” Now, the onus lies on the investor to read and value the propositions and match the same with one’s own risk return profile. Since the repeal of CCI Act (Capital Control Issue) of IPO pricing, red herring prospectus provides justification of premium being charged. However, the pricing has been tuned to the market sentiment, which may not reflect fair valuation.
PRIMARY MARKET… 10
Let’s not forget that in a free market economy, there is no benefit for ignorance. Retail investors should not invest based only on the prevailing grey market premiums. In the recent market momentum, retail investors having ignored the importance of valuations and investment horizons. Markets, which are supposed to create wealth over a period of time when turned into a trading platform, fuelled by greed, become a risky proposition.
2. Markets spare none Erosion of wealth worth nearly half of the total investments of Rs 16,516 crore is never a pretty picture. But when the losing side happens to comprise the big daddies of investment, private equity (PE) players, it just goes to show that the markets spare none. With the fall in the market the underlying value of the investment is going down every day. And in number instances, almost full value has been wiped off. Clearly, the perception that PE money tends to be smart money seems to be just that, a perception. The decline is a secular one in that virtually all investments across the board have taken a hit. However, the worst-affected seem to be high-growth sectors like real estate, information technology, banking and financial services, and healthcare, which have all seen a sharp battering. The picture is not a complete one though, given that it is impossible to know the extent of losses that PE firms have taken on account of their investments in unlisted companies. Having said that, one could well argue that these would be significant given the rich valuations that many of these companies got then, which they are unlikely to receive from the market should they list today. Though it is too early to comment on the investment rationale and valuations at which these deals are struck, given that PE money is for a long duration. But the PE story also proves that the market spares none. Even the brightest of brains of equity markets have taken a beating.
3. Room for further evolution The role of the Indian IPO market is to enable companies to acquire growth capital directly or to provide early stage investors with an exit. In this respect the Indian IPO market has withstood many tests by fire over the last decade and has continued to grow and evolve. There is nothing dramatically wrong with the Indian IPO market today – but as with any system there is room for further evolution. The recent withdrawal of a few IPOs may give an impression that the IPO process is broken – but IPOs getting withdrawn is part and parcel of any market wherein the buyers and sellers cannot agree to a price. The withdrawals are not so much a failure but a mismatch between the price at which buyers are willing to buy and sellers are willing to sell. This may be part and parcel of any market-driven process but our focus should be to make such breakdowns few and far between. This is a good time to sit back and reflect on how to make the process stronger:
PRIMARY MARKET… 11
Process of pricing Pricing is an art but can use a lot of knowledge and science as an input. One of the main jobs of an investment banker is to help a company arrive at its ‘fair’ valuation. Companies – naturally – will be more positive on the value of their stock (to any promoter a company is like a child – invaluable) but bankers have to play the role of trusted advisors who can delicately make the companies understand the realities of the market place and hence bring about a fair price. We in India have gone from CCI formula based pricing to ‘what the market can bear’ based pricing. May be the answer is in between – the pricing should based on what the market should bear! Pricing range We have a 20% pricing range which does not account for the volatility of the market. In India there is a 34 week gap between finalising the pricing range and opening the issue. As nowadays stock can move 2530% in any volatile 3-4 week period, 20% pricing range is not sufficient for these volatile times. May be a mid point with 20% around its (40%) range will give more flexibility to the final pricing as then there is more probability of a clearing price getting established for an issue.
Process time and costs The IPO is a lengthy and cumbersome process. From the date of pricing range (ROC filing) there exists a 3-4 week gap before the issue opens. The issue is then open for five days, the refund disbursed in 15-20 days and the stock listed about a week later – an 8-9 week gap. This is too long. We should aim for pricing range to listing in just over a week. Sebi has been looking at using the secondary market infrastructure for bidding, settlement and payment for IPOs. These could make the IPO process shorter. While we have managed to bring down costs such as distribution and commission in the secondary market, the same has not been done for the primary market. Many retail investors enter the stock markets via the IPOs. Hence it is important that we make this process cost efficient. Margin and refund process Further, the margin and refund process should be streamlined. A 10% margin for QIB seems too low and a refund process of 15 days is too long. Sebi can look at realigning the margining system and see if the refund process can be cut down to one week. All in all, India has a robust IPO market with around 100 issues and 40,000-50,000 crore raised every year. That is reason enough for us to introspect from time to time on how to improve the system and make it increasingly shock-proof.
PRIMARY MARKET… 12
The beginning Market regulator Sebi will review the IPO procedure with a view to reduce the gap between the opening of an issue and its listing on the bourses. The measures are aimed at creating a level playing field between retail investors and institutional investors. It would be Sebi’s endeavour to reduce the time period to three days and will ask institutional investors to make upfront payments for subscribing to public issue as in the case of retail investors. This would also help curb excess over subscription by institutional investors. Sebi new chairman CB Bhave said the primary market issuance process will be reviewed to reduce the gap between the opening of an issue and listing of its shares. There is a feeling that things are not the same for retail and institutional investors in the IPO process. Institutional investors tend to argue that they put in a lot of money that can’t be locked in for such a long time. Secondly, some people have raised the issue of funds that remain with the banks. That issue will also be automatically addressed once we reduce the gap. He emphasised settlement period in secondary market has been cut from 42 days to T+2 (two days after the trading). “There is a feeling that similar reforms should happen in the primary market. He added: “Once the gap is reduced, the gray market will disappear.”
Quoting the legendary investor Warren Buffett is a preferred pastime for businessmen around the world. In India, the in-vogue Buffett mantra is: “Price is what you pay, value is what you get”. For capital markets to cricketers, from real estate to human resources, every asset category in the country seems to be trading several times above fair value. The craze for asset ownership of every kind has hit the conventional wisdom of valuations for a huge six. There is no doubt we are going through a phase of hypervaluation. The country is a land of illusions now. In emerging markets excesses exit but what we are witnessing is a hyper perception about everything. Clearly, there’s an air of invincibility among Indians about their own economy and the domestic market’s absorptive capacity. It is a bubble of optimism. People have started living in it for a year of now, relegating past and future to the back seat. A Merrill Lynch, report published in January ’08, contends that the Indian market is currently trading at a price-earnings (P/E) multiple of about 19 times the estimated earnings of 2009 fiscal. When compared with other markets in the region, it does appear steep – in Korea it is 12 and in China it is 15. What we should not forget is that only three years back our markets were undervalued. Everybody was concerned. And today when we are in a high growth area, the overvaluation buzz has started going around. But that’s how the economics works. It is a business cycle. The euphoria of investing in an emerging market has been the significant factor for the current over valuation. The same momentum isn’t sustainable especially with fears of a global meltdown. 1. Market correction The savage in equity market correction in January & February ‘08 from the recent peak caught most market participants off guard largely because investors were lulled into a sense of impish confidence with their easy success in investment in recent times. Though stretched valuations led many observers to question the sustainability of the continuing bull-run, the sheer weight of foreign inflows kept pushing the market to ever new highs.
Unwinding of P-notes At the centre of the sudden and steep correction was a robust swing in foreign portfolio inflows that averaged some $ 1.5 billion per month during 2007 tumbled to an unprecedented outflow of $ 3.3 billion in January ‘08. This pronounced swing in foreign portfolio flows was influenced to a significant extent by unwinding of P-Notes.
SECONDARY MARKET… 14
With the curbs on building new positions in P-Notes, the holders were clutching on to their profitable positions in the hope of riding on the ongoing bull market till the global equity meltdown motivated them to unwind their position, fearing further profit erosion.
Non-US banks in trouble On the domestic front, the economic forces at work continue to be favourable since the days what appeared to be an unending bull market. Domestic demand continues to be strong, interest rates have peaked and are possibly on the way down, the banking system is in good shape and corporate profit growth continues to be robust while the government’s tax revenues are recording unprecedented buoyancy. There are currently no signs of any inflationary outbreak. The change in the market mood is primarily on the back weak international markets and after-shocks of the credit market crisis leading to general risk aversion affecting portfolio flows into emerging markets. With the wave of losses in the banking system engulfing even the non-US banks, there does not appear to be any quick-fix solution to the burgeoning credit crisis that could take quite some time to resolve.
Shut down of broker terminals One aspect of the market mechanism that has repeatedly magnified intra-day corrections is the collection of margins during episodes of extreme volatility. A state-of-the-art stock trading system in India sits somewhat uncomfortably with a creaking payment system where same-day funds are difficult to come by from brokers’ clients. This has frequently resulted in the shut down of broker terminals and forced selling of stocks held by the exchanges as security. Unfortunately, this has led to a situation where even buying orders in a falling market are unable to be executed because of the inefficiencies of the payment system making clear balances for margin money unavailable in good time.
2. Collateral Damage History repeats itself. The stock exchanges and the regulator have learnt their lessons from the stock market crash of 2001, and acted on them. This is evident from the fact that there have been no payment crises at the bourses when stock prices fell sharply in May 2004, May 2006 and now in January 2008. But the same cannot be said for many retail brokerages, which have not yet learnt from their past mistakes, or conveniently forget them during boom times. Benchmark indices have recovered after every crash. However, trading terminals at many retail broking houses – especially the outstation franchisee centres – still remain shutting, for lack of funds to meet margin commitments to the exchanges.
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Besides, misuse of margin funds given to the brokers has emerged as the most widespread complaint among investors. Retail investors have a genuine reason to feel cheated, where balance in their margin accounts used up by the broking firm to meet margin commitments to the exchanges in a bid to keep the trading terminals active and at the same time to protect his positions. And this has not happened just in the case of funds maintained with the broker. Many investors routinely left shares with their brokers. Many brokers are learnt to have pledged their clients’ shares with the exchanges in a bid to meet their (brokers’) margin commitments to the exchange. This is in violation of NSE norms, which state that a broker cannot pledge share of his client with the exchanges, without the client’s consent. When the clients approached the brokers for their shares, they were told that it was the exchange, which was at fault for having liquidated the shares.
3. Recoupling Decoupling, the theory that the rest of the world doesn’t have to catch a cold if the US sneezes, which could easily go down as one of the shortest-lived buzzwords in economic theory. Economists, wealth managers, analysts and media commentators, are busy writing off the ‘myth’ of decoupling. They are looking for explanations to give their clients after the carnage in the Asian markets. Recoupling argues that growth economies or not, the rest of the world is still umbilically attached to the state of the US economy, maybe a lot more for Europe and somewhat less for Asia. Goldman Sachs, which with its BRIC reports becomes some kind of messiah for emerging markets, has now put out an investor note titled ‘Signs of recoupling in Europe’. “Our view is that the US will now fall into recession and this increases the risks to growth in the rest of the world.” It goes something like this: US’ problems last year were mostly domestic, based on housing, but as signs of recession deepen, Europe, at least will not be able to escape the ill-effects and will take a hit on domestic growth. The alternative ‘growth’ engines of China and India, despite the large domestic consumption, will not be able to fill the gap left by the US. Stephen Roach, chairman of Morgan Stanley Asia argues: that you can’t have both globalisation and decoupling in the same world space, and pointed out that the US consumed over $ 9.5 trillion in 2007 – six times of the combined consumption totals for china ($ 1 trillion) and India ($ 650 million).
4. Stay put Wondering whether to stay put in your stocks that may have been hit in the market crash or to liquidate and shift investments in other asset classes. Here are 10 reasons why it still makes sense to remain invested. While some of us might be thinking of cutting losses and putting money in safe havens, there are more than one reason still favouring the equity markets. Let’s check them out:
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Long-term plan The basic principle that often gets buried in a bull market situation is that one should make investments with a long term perspective. Any serious investor should remain invested in stocks, no matter what the current market situation is, for a couple of years. The intervening years may be volatile but the light at the end of the tunnel is what we all should look forward to.
Value-picking Perfect time for value picking, isn’t it? Stocks you always wanted to own but deferred, thinking they are a little overpriced. Experts believe that this is the opportunity to buy stocks, now available at better valuations. It’s like picking your favourite stuff from a superstore at, say one buy, two get free. So, hurry while the offer lasts.
Bottom fishing There are talks that the markets may have bottomed out. This means one can make fresh investments during this downturn. Did anyone ask what if the markets correct further? Probably, it will be an even better buying opportunity!
Chance to diversify We all are aware of the need to diversify our investment, not just in different asset classes but also within classes. So if you had failed to do so, this is the time to add stocks of sectors missing in your portfolio. It might be that you had picked up stocks from sectors expected to give good returns in past but now have run out of favour. So, take your pick from the buzzing sectors of today.
Growth story The growth story of Indian economy is largely in place. There were signs of some softening recently but again such policy matters are gauged with a long-term perspective. There are no reasons why the outlook of Indian economy in the foreseeable period should change. Huge investments lined up in Indian companies are going to drive the economy further. Also, India’s contribution to the world GDP is on the rise and the current market situation is just a reflection of the global markets.
Invest step by step Can’t recall who said this: “Time spent trying to time the market is better used analysing stocks good for holding in the long term”. No one can time the market; it’s like saying ‘when the next earthquake will hit Delhi’ with surety. Here, the rupee-cost averaging strategy becomes even more important. By doing so, the ups and downs of the market get smoothened out by investing a fixed amount of money on a regular basis over a longer period irrespective of the market situation.
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Ride on volatility Markets by their very nature move up and down. The real nature of the market doesn’t get reflected without this. In fact, volatility gives the chance to fund managers and small investors to revisit the market and pick stocks.
Time to get started If you haven’t made investments in equities but always wanted to, now is the time to get started. From 21k level, not too long back, the Sensex is now trading in the 15,000-16,000 range. So, what are you waiting for? It’s all yours.
Lower taxes How can we miss on taxes? Actual returns on any investment are known only after factoring in how much tax we pay on the gains. As far as equities are concerned, one is liable to pay short-term capital gain tax if investing in equities for less than a year. This means one can save on these taxes by playing long.
Index return Sensex alone has given a historical record of 18% in the past 20 years or so. This means that if we simply invest in index stocks every year, the investment will generate better returns than from other avenues like FDs, PPF, Post-Office Saving Schemes, etc. That’s all for now, till then buy & buy!
5. Stick to quality portfolio The stock market has been witnessing considerable volatility and there are concerns about its future direction. The nervousness regarding the unfolding events, post subprime crisis, continues to impinge on the minds of overseas investors. Foreign portfolio investors have been reducing their exposure to equities in the region. India has seen a net negative outflow. Given the current shallow nature of markets, this has led to a steeper correction than would normally be warranted by such an outflow. The market has also seen withdrawal of several IPOs, which indicates lack on interest in the retail segment. Investors’ confidence, which was bordering on euphoria earlier, has now been tempered to a large extent. This, combined with India Inc’s sluggish third-quarter results, has put a question mark on the sustainability of companies’ earning growth. During Q3 FY08, earnings growth for the Sensex group of companies stood at around 16% year-on-year (y-o-y). This compares with 25% for Q2 and 30% for Q1. At 23.6%, the average growth for the three quarters is still healthy and well in line with the full-year estimate of 20%. But the manner in which growth has been attained indicates a slowdown. So, what has changed in the market? The answer is: investor sentiment.
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The market is driven by perception, rather than reality, in the short term. As of now, news emanating from the US and other parts of the developed world is not encouraging. This reinforces the perception that going will be tough in future. However, in the long run, these may just be blips on the growth chart. Though investors do have concerns which make them think twice before venturing into the market, one must not forget that returns are gained only by understanding risk. So, what appears to be a bleak situation (under normal circumstances) is the cause of abnormal gains if the bet is called right. In the strictest sense of the theory of efficient markets, no one would make above normal gains otherwise. So, these fluctuations, driven by a mixture of facts and sentiments, are the quagmire that investors have to face on a regular basis. The relentless rise in the market over the past three years had desensitised investors to a large extent. Hence, the above phenomenon seems difficult to understand as of now. Most investors are also in denial at times, which generally (if the market continues to fall) gives rise to despondency and eventual capitulation. Nobody claimed that the equity market is meant for everybody, or that it is a safe place to be in, or that it is a place to make easy and free money. Patient investors who stick to quality equity portfolios through thick and thin make the most money. Studies dedicated to buy and hold strategies have proved this time and again. The market is self-correcting in nature. In the long run, it’s capable of pricing assets efficiently. But in the near term, it’s harder, if not impossible, to predict. Opportunities abound at the current market level. However, these opportunities may not lead to immediate gains; a much longer outlook is required for gains to accrue to investors. What is undeniable is India’s appetite for infrastructure development and increasing consumerism in the country. If the domestic market is aided by a benign interest rate regime and supportive regulatory framework, it may become the best market in the future.
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Is market bottomed out? International credit markets are in a crisis and the stock markets have been shaky. Nobody is in a position to react to the big macro issue such as where the dollar is going, what is the likely GDP growth of US and China, and so on. Equity markets are down by more than 25% from their top. Certain unanticipated events have resulted in this fall, contrary to the expectation at the beginning of the year. The subprime crisis in the US has resulted in the drying of liquidity chasing momentum around the world. The Indian market is not an exception. As far as valuations are concerned although the Indian markets are now trading at 14-15 x FY09E, and a large part of the froth generated is now out of the system, the sustainability of any upward move in the market clearly depends on global factors. Experts feel that the markets are trading closer to fair fundamental value but a minor down-move is not ruled out in the short term. Clearly, retail investors should look at the systematic investment plan as the right investment option. Equity as an asset class will definitely bounce back and offer significantly better returns. So, this is an excellent time for an investor to build a quality portfolio. Retail investor should not try and time the market; they should be in the market for a time. When attempting to arrive at an answer, one must assess what factors have driven the correction, and evaluate what aspects may, going forward, benefit or hinder the market. From a technical perspective the picture is somewhat different. A significant amount of capital invested in the Indian market was driven not by fundamental drivers, but rather to take advantage of strategies such as cash/futures arbitrage. These strategies have come under pressure as the upward momentum has waned and the rupee has weakened against currencies such as the yen. The reduction of profitability of such strategies has led to an unwinding of trades by the participants and a wholesale reduction of leverage in the system. If one examine the current open interest in the derivative market the levels are fairly similar to those of May 2006 when the market also corrected by approximately 14%. There is one difference though. The market did take a couple of months to recover after the May 2006 drawdown, but it was against a backdrop of a strengthening rupee which undoubtedly played a role in attracting technically-driven monies back into the market. Today, the case for a strong rupee is much more tenuous, with the currency in fact poised for further weakening depending on the actions of the RBI. As such, the impact of this technically-driven capital on valuations is likely to be far more muted, at least in the near term. Where does it leave one with respect to calling a bottom in the market? In essence, a lot of the negative sentiment has been priced in and the overvaluation corrected. This does not mean that we will not witness further declines, especially if global sentiment continues to deteriorate and risk aversion becomes more acute. However, the risk-reward tradeoff is increasingly looking skewed in the investor’s favour. The impact of positive news on the market should outweigh that of further negative news given where the market is currently trading. The market could very well end up trading in a range for several months, but further decline of the magnitude we have witnessed are unlikely. What is clear is that for the foreseeable future any price appreciation will likely be driven by earnings growth as opposed to P/E expansion.
INDIA India requires a shared vision “Where there is no vision, the people parish”, says the Bible in the Old Testament. Moreover, as Dutch scholar Fred Polak explains, nations with a profound vision of their future succeed even when they do not have the right resources or an obvious strategic advantage. In his book, The Image of the Future, he traces the histories of Greece, Rome, Spain, France, England, and the US and shows that a positive image of their own future preceded these nations’ successes. Their visions guided the actions of people, leading on to the nations’ achievements. What is the vision of India shared by its people? Effective leaders know that just as a strategy is useless unless it is implemented, a ‘vision statement’, no matter how well phrased, is of no consequence if it does not motivate action by people. Therefore, the quality of the process by which a vision is shared and adopted by people is as important for the success of the nation. Hence the critical question for India’s leaders is how can a shared vision be developed for such a large and diverse country? Whereas until independence, the people of India, though diverse, were united in a common quest for freedom, and whereas subsequently, for many years, the political party that had rallied the people towards independence continued to dominate the political scene. But, the country is now becoming increasingly decentralised. Power is being devolved, by design, even to India’s villages. Regional political parties are gaining strength. Coalitions are necessary to establish governments at the Centre, and even in many states. Caste-based parties are growing. Other differences are also becoming accentuated in the public discourse, such as those based on access to economic opportunity – India versus Bharat, and rural versus urban. Amidst this democratic cacophony, various formations, some political, other economic, are competing for their vision. As it is always easier to sell a negative vision – one that is based on fear of an enemy against which a leader can rally people – in the country like India, with many internal differences, it is tempting for leaders to rally support for themselves by exaggerating internal threats. Raj Thackeray’s recent action in Maharashtra is not the first and will not be the last of such divisive movements. Such divisive strategies may get local leaders votes to win their elections. But they also make it imperative for national leaders to find a larger vision to unify the entire country. “Into that heaven of freedom, O Father, let my country awake,” was Rabindranath Tagore’s prayer for India. Tagore was not talking about freedom from colonial masters. The ‘heaven of freedom’ for him was a country ‘not broken into fragments by narrow domestic walls’. And one of which everyone’s ‘head is held high’. His vision was of a country in which, from its eastern to its western, and northern to southern extremities, very diverse people can feel they are part of one country with one destiny. And he was envisioning a country in which every last Indian, as Gandhi said after him, could lead his or her life in dignity. We are far from realising those visions. India is moving into a national election year. Political configurations will attempt to win elections, many with parochial, politically convenient slogans – often more likely to divide than to unite. Meanwhile the economy has begun to grow rapidly at last and the country is pregnant with possibilities for a better future for its people. This is the time to develop a unifying national vision behind which the people can rally to produce a country that all Indians will be happy to live in and be proud of too. It is high time for some national formation of people to catalyse and enable the emergence of a national vision. If they hesitate, they should ask, “If not now, then when? If not us, then who?”
It all collapses There are distinct phases in investment madness in emerging markets. Phase one is growth: You get a lot of foreign investment – The locals deregulate everything because the World Bank tells it will attract foreign investment. Government-owned businesses are sold cheaply to the favoured sons and their foreign cronies. Government controls are relaxed as foreigners tell the locals that it will create jobs and wealth. In phase two, living standards improve for the fortunate: For the bulk of the people, nothing changes, of course – A middle class develops chasing McDonald’s and Wal-Mart consumer heaven. Property prices and shares go crazy. More and more money comes in. Local banks lend recklessly. Foreign banks lend recklessly to local banks. The foreign banks think the local banks won’t fail because of government support. Investors dive in. They talk about “growth” and “portfolio diversification”. People are exited; Prices spiral up as the tidal wave of money pours in. In phase three, costs rise to levels that make the economy uncompetitive: They are not cheap any more. Alas, the capitalist caravan must move on. Everything is over priced. Politicians talk bravely about the “need to move up the value chain”. They launch ambitious initiatives – the world’s tallest building, the world’s longest building, a new port in a country. Locals bristle at any criticism. Prices don’t make any rational sense. You only buy because you think you can sell it tomorrow to someone else at a higher price. You are caught in an endless spiral of higher and higher prices. Fears and greed rule financial markets. You are afraid that you might miss out. Your greed is endless. Foreigners develop a peculiar hubris. They are bulletproof. Fundamentals of value are irrelevant in the world. The Sensex shot up to over 21,000 in its upward journey thanks to the hubris created by sophisticated investment banks, the new alchemists. It worked in South East Asia. There government opened up faster than they should have, certainly well before they had the institutional wherewithal to deal with volatile capital flows with disastrous consequences. It would have worked here too (ask those know in financial circles and they will tell you how some of our new private sector banks were wholesale enthusiasts of exotic financial instruments). And the fact is that the whole thing collapsed like a house of cards. A description of what we’re witnessing today? We had enough evidence of hype, the beeline of overseas corporates, investment bankers, global leaders, all desperate to get a toehold in India, the fully-booked hotels, flights, zooming real estate and stock prices and the rush of portfolio capital. However two things saved us: Our substantially higher forex reserves and our democracy. Higher reserves cushioned the stock in the face of volatile flows and democracy ensured that policy makers could not be pushed beyond a point.
INDIAN ECONOMY Decoupled or shackled together?
Decoupling is very much in vogue. The debate is essentially whether India and other emerging economies would suffer synchronised recession along with the US. Suppose these economies are coupled together like the coaches of a train, with the US acting as the locomotive pulling the rest along. If the US slows down, so would all the rest. If, on the other hand, the economies are decoupled, a US slowdown or recession would be less of a worry. For many observers, the way the sensex tumbles when bad news comes out of the US has clinched the argument against decoupling. Such a conclusion would, however, be facile. To begin with, one must appreciate the short-term divergence between financial markets and the real economy. When the US Fed cuts interest rates, to stimulate a faltering economy, the markets actually go up. Shouldn’t the Fed’s confirmation of a slowdown on the horizon move the stock market in the opposite direction? In actual fact, the immediate response of the market is driven by the short-term rise in liquidity arising from the Fed’s rate cuts. Movements in financial markets, let us be clear, have no one-to-one correspondence with developments in the real economy. The latest issue of The Economist examines the decoupling debate in some detail. It finds that developing countries are far less dependent today then they were in the past on the US as an export destination. Exports to the US account for only 8% of China’s GDP, 4% of India’s, 3% of Brazil’s and 1% of Russia’s. And these economies together contributed 40% of the global GDP growth last year. The US contribution to global growth was just 16%. The point to note is that growth and prosperity in the emerging economies also drive trade amongst them. China is India’s fastest growing trade partner. Emerging markets collectively sent more than half their exports to other emerging markets. In fact, China by itself absorbed more than 15% of all emerging market exports, a little more than what the US did. If China were to go into recession, that would be a real problem. While the Chinese authorities are indeed trying to slow down their economy from last year’s 11.2%, that slower rate would still be a fabulous one. If the global economy were indeed to be hurt by the US slowdown or recession, the least reprieve we would have got is lower commodity prices. But oil continues to soar. Steel makers are happily hiking prices, as are virtually all other commodity producers. Rising prosperity also increases the demand for high value foods. When crores of Indians and Chinese start consuming milk, eggs and meat on a regular basis, the additional demand this creates for animal feed can be imagined. Well, in retrospect, no one anticipated the sustained demand for goods of all kinds that high growth in India and China would unleash; Hence the shortage. It will take some time for capacity to be created to meet the demand.
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The process of capacity creation will drive up real investment; which is what has been happening in India; the investment rate (investment as a proportion of total value of goods and services produced) in India has shot up from under 23% in 2001-02 to upwards of 37% in 2007-08. Investment is taking place in infrastructure – new townships, roads, power plants, and power & telecom towers – and not just in industrial capacity, of which export-oriented units is a subset. Whether these investments would be sustained or not depends more on domestic policy than on the global economy. If growth has slowed down in India, that is the result of deliberate policy action by the central bank to ward off inflation. The Budget 2008-09 offers the stimulus, through tax cuts and a hefty fiscal deficit, to insulate growth from any global slowdown. In other words, India’s real economy can and is decoupled from a slowing US. But the financial markets are not. Perception of risk – general, rather than country-specific – make fund managers to pull their resources out of emerging markets and transfer them to the US and the EU. However, global investment community would determine that India could, indeed, offer a safe haven for investment even as growth in the west slumps.
9% growth achievable despite US Prime Minister Manmohan Singh expressed confidence that the country will be able to achieve 9% growth rate. However, interest rate policy would focus on holding the price line. Growth cannot be at the expense of inflation which hurts the poor and strains the polity. However, he also admitted that the country cannot be completely insulated from chilly global winds that may blow in its direction. I do not see a reason why we cannot sustain 9% growth even in the face of a global slowdown. The domestic economy has the potential to sustain such growth. The challenge before us is to ensure we tap into the potential and make it work for us. Speaking at Ficci’s golden jubilee auditorium, Dr Singh echoed his theme that industrialists served as trustees of society. “Patriotism is not the monopoly of the political class,” he said, underlining the shift in ideology: banias are no longer untrustworthy exploiters, but partners in progress.” I sincerely believe the government and business can achieve a lot by working together to create income and employment, wealth and welfare, prosperity and progress. Our captains of industry have played a vital role on nation building. I salute you and wish you all success. The prime minister also explained why battling inflation was the top priority of his government. “An important policy stance we have adopted to ensure that growth is more inclusive has been to keep inflation under check. Some of you are not happy about our emphasis on inflation control. I see things differently. Inflation is an iniquitous tax. It hurts the poor more than a rich. He also highlighted the government’s achievements in the infrastructure sector. “I read a lot being said about the poor state of our infrastructure. In fact, facts tell a slightly different story”. He cited airport modernisation, ‘revolutionary transformation’ in railways and revival of private participation in power generation as key instances of turn around in infrastructure sector.
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In all, prime minister’s speech appeared as an attempt at showcasing the UPA government as the rightful custodian of impressive and inclusive economic growth. PM gave his government credit for higher growth and putting in place ‘the basic architecture necessary for ensuring that this growth is broad based’. PM also cited slower growth rate for the period between 1997 and 2002 to portray how previous governments failed to fuel the economic growth. The governments of the day were unable to inspire. They were preoccupied with divisive agendas and their economic agenda was not focused.
India story here to stay Don’t lose heart over a one-month slip in industrial production figures. A sustained boom in investments and headroom for additional public spending, thanks to a low fiscal deficit, will sustain India’s growth story notwithstanding the threat of inflation and turbulence in financial markets around the world. At the same time, the government expects industry to do its bit to hold the price line by increasing capacity rather than simply taking advantage of demand-supply mismatches. Dispelling doubts about the sustainability of the country’s economic performance, finance minister P Chidambaram has said India’s growth story is here to stay. Stepping up public and private investment, protecting price lines, ensuring smooth delivery of goods & services and completing projects without time and cost overruns is part of his prescription for ensuring high growth rates, beyond 8%, over 5-10 years. The principle driver of India’s economic growth is investment. We should be ambitious. I am very optimistic that if we can hold the price line, gets investments, improve production and implementation, 510 years of high growth in the country is achievable. The Union Budget 2008-09 had addressed people’s aspiration to consume more by leaving “more money in their pockets.” The economy should strive to produce more both in the agriculture and manufacturing sectors. The country should reduce dependence on import of agri products by producing more wheat, rice, pulses and edible oil. On the manufacturing side, the FM cautioned the industry against giving in to the temptation of taking advantage of medium-term demand-supply mismatch. The industry should resist the self-defeating strategy of exploiting medium-term demand-supply mismatch. Instead, they should enhance production to meet demand. The manufacturing, which had a weightage of 52% in the inflation basket, played a significant role in keeping inflation rates high. “The manufacturing sector also has the responsibility of holding the price line.” A significant challenge the economy faced was of improving delivery. All the capital that was invested would come to naught if the delivery system was not improved. “There exist notorious inefficiencies in delivery or primary education and healthcare”. In a bid to get around the delivery problem, the FM said the government had decided to set up a non-profit organisation outside the government to impart skills to the youth. Also, Delivering projects without cost and time overruns was an important problem which the economy has to overcome. “Most public sector projects and programmes run beyond the initial estimates of cost and time. If we are able to keep projects within estimates, we will not only get 8-9% growth, we should be way beyond.”
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Mild US slowdown may help India Is economic slowdown in the US bad news for India? No-brainer, you may say, but there is a twist in the tale in the current context. If the slowdown in the US is marginal, it might prove beneficial in the Indian economy. By moderating capital flows – remember that the country’s forex reserves stand at an all-time high of $ 300 billion – and forcing India Inc to improve its competitiveness, a small dose of the bitter pill could turn out to be just what the doctor ordered. This theory comes from none other than C Rangarajan chairman of Prime Minister’s Economic Advisory Council (EAC). Considering the upheavals caused by the rupee’s strong appreciation in 2007, moderation in capital inflows would easy the RBI to find it simpler to manage the situation and exporters would not be crying for more succors to meet international competition. Add to this more business to the IT sector as American companies may have to outsource more to tighten their belts. A note of caution, however, is that the US slowdown should not be prolonged or serious enough to trigger capital outflows from India.
We’ll bounce back: Bush US President George Bush acknowledged that the US economy is experiencing a tough time on housing and financial markets, but it will regain its strength in the long run because the economic foundation remains solid. The US economy is resilient and will return to stronger growth. The ingenuity and resolve of the American people is what help us deal with these issues. He said a root cause of the economic slowdown has been the downturn in the housing market. We fully understand that the mounting concern over housing is shaking the broader market that spread uncertainty through the global financial markets. The economy has experienced many challenges during his administration, but every time, this economy has bounced back better and stronger than before. In the long run, I am confident that the economy will continue to grow because the foundation is solid, citing a low jobless rate of 4.8%, rising wages, strong productivity, all-time high exports, and deficit “well below historical average”. He touted “decisive” action taken to jumpstart the economy, including 168 billion dollar stimulus plan, which includes tax rebates ranging from $ 300 to more than $ 1,200 for 130 million households. The families will receive the money in the second week of May. The stimulus package is expected to spur consumer spending, which will start to have an effect on the economy in the second and third quarters of the year. He cautioned against over-correction in managing the economy. “When you overcorrect, you end up in a ditch.” It’s important to be steady. US president George Bush praised the steps taken by the Federal Reserve to bolster the economy, commending Fed Chairman Ben Bernanke for “doing a good job under tough circumstances.”
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Growth set to ease as industry, farm misfires The Indian economy is sustaining its growth momentum, with the Central Statistical Organisation (CSO) forecasting growth in the current fiscal at 8.7%. This is slower than the 9.6% growth achieved in 2006-07 and 9.4% registered in 2005-06, but on par with the average annual compound growth rate achieved over the four years of high growth commencing in 2003-04. The GDP grew at 9.1% during the first half of this fiscal. It grew at 9.3% in the first quarter and 8.9% in the next. The advance estimates showed a further moderation during the rest of the year. GDP at factor cost at constant (1999-2000) prices in the year 2007-08 is likely to attain a level of Rs 31, 14,452 crore as against Rs 28, 64,310 crore in 2006-07. The total value of the Indian economy at current market price stands at Rs 47 lakh crore ($ 1.175 trillion). Relatively slow expansion in industrial and farm output is responsible for the slowdown in growth, CSO’s farm growth estimate, at 2.6% against 3.8% last year. Manufacturing growth is likely to come down from 12% last fiscal to 9.4%. Mining and quarrying sector is estimated to grow at 3.4% as compared to 5.7% in the previous financial year. Among the booming service sector, trade, hotels, transport and communication activities are likely to expand by 12.1% from 11.8%. However, finance, real estate and business services are estimated to grow at 11.7% as against 13.9%. The forecast also brings out the real slowdown in export. In rupee terms, export growth would be just 8.6%. Experts feel the moderation in manufacturing sector was expected, what is worrying is the slowdown projected in the farm sector despite a good monsoon. The advance estimates revealed that agriculture and allied activities will likely grow at a much slower rate of 2.6% during the fiscal, against 3.8% in the previous year. Agriculture is the only major worry. The policy response ought to be to raise the potential growth rate of the Indian economy. This involves policy reform in lagging sectors like mining where private sector investment has been stymied by red tape. Other measures include investment in infrastructure, lifting FDI caps and reduction in bureaucracy and paperwork. The per capita income at current prices this fiscal is estimated to be Rs 33,131 as compared to Rs 29,642 last year, showing a rise of 11.8%. The CSO figures also reveal that economy wide price rise would be limited to 4.5% for the year as a whole. What is truly remarkable about the national income figures out by the CSO is the investment rate, which has climbed to a historic high of 38.5% of GDP. This augurs well for future growth prospects of the economy. And savings are projected to grow to 37% of GDP, another historic high.
INDIAN INC Its on prowl in US
The global credit crunch and recession in the US do not seem to have impacted the momentum of Indian companies acquiring US-based companies. The first two months of 2008 saw 10 US-bound acquisitions, the majority of which were the IT sector, lending credence to the fact that adequate liquidity and comfortable valuations have helped Indian companies buck the global trend. Investment banking firms feel that the valuations of many mid-sized US companies are dropping and many Indian firms are on the prowl to clinch a deal. The largest transaction in the first two months was Tata Chemical’s acquisition of General Chemicals for over $ 1 billion. The recession in the US market has opened a lot of opportunities for Indian firms as the valuation of US firms are dropping and M&A activity among the US firms are negligible. Indian companies are aggressively looking for companies in the US. Indian companies are banking on the funds they have raised through various routes such as External Commercial Borrowings (ECBs) and Foreign Convertibles Commercial Borrowings (ECCBs). However, other investment banks seem to differ. Though they concur that valuations in the US has dropped, its not smooth sailing for Indian companies, especially for mid and large sized acquisitions. Cost of credit has gone up and except for higher investment grade companies from the US, global bankers are not comfortable in lending due to the liquidity crisis post subprime. Also, with the capital markets in a tail spin, many companies are not in a position to raise money from the markets. According to US-based investment banking firm Virtus Global Partners’ latest report on acquisition in the US, Indian companies accounted for a total of 83 US-bound acquisitions in calendar year 2007 with a cumulative transaction value of over $ 10 billion. This represents a 73% increase over the 48 transactions in the calendar year 2006. The mega deals of 2007 included Hindalco’s acquisition pf Novelis for $ 6 billion, Rain Calcining’s acquisition of CII Carbon for $ 595 million, Wipro’s acquisition of Infocrossing for $ 568 million and Firstsource’s acquisition of MedAssist for $ 330 million. IT/ITeS leads the pack, capturing an over 51 per cent share of the total US-bound transactions by volume, followed by healthcare (11%), chemicals, textile, and automobiles (5% each), metals & mining, jewellery, travel, and media (4%). Other industries accounted for less than 2% each in terms of volume. Deal sizes of less than $ 25 million accounted for 76% of 2007 US-bound acquisitions volume, followed by transactions in the $ 25 to $ 50 million range (8%). This reflects the increasing pressure to gain scale amongst smaller companies. Most transactions involved acquisition of 100% stock for cash consideration. These transactions generally had an earn-out structure, where a portion of the deal value is paid on future milestones. Increasing competitive pressures, emerging global opportunities and the decline in overseas trade and investment barriers are encouraging Indian companies to seek acquisitions in the US. Factors supporting this trend are strong balance sheets, easy access of capital, business confidence and a relatively stable economic and political regime.
INDIA INC… 28
Quarterly results There are a number of factors that influence the movement of stocks on the bourses. We all know that global cues, market sentiments, political and social environment influence stock prices. A sound investment is generally made after understanding the business, the environment (including social and political) in which it operates and the consequent risks that can impact the attainment of the entity’s corporate objectives. But the most critical factor that influences market sentiment is the quarterly result. Here’s a layman’s guide to interpreting these results that reveals much more that just the performance of the company in question. A company’s quarterly financial statements typically contain the profit and loss account for the last quarter, the corresponding results in the previous year, the year-to-date financial performance on the profit and loss account, segment information in a prescribed format, investor grievances and comments on the actions taken by the management to address the auditors’ qualifications in the immediately previous audited financial statements. According to analysts, all these information about the company’s most recent financial performance acts as an important trend indicator on the company’s earnings achievement. However, there could be problems too for those looking to buy and sell stocks on fundamentals alone. While an analysis of the fundamentals can generally indicate whether a company’s business holds promise and is on the right track, it is the timing of purchase of the stock, that perhaps the more important factor in the markets today. That’s why you sometimes come across companies with perfectly good businesses languishing because of their failure to attract the ephemeral “market fancy”. Analysts believe that there are no definite answers that can help investor to ascertain whether the company’s business will deliver such return or whether the said company’s operations are likely to remain technically sound in the future. However, there are some financial ratios that help us get closer to the answers. The level and historical trends of these ratios can be used to draw inferences about a company’s financial condition, its operations and attractiveness as an investment. These ratios include return on capital employed (a measure of the efficiency with which a company uses its fund), return on equity (a measure of returns generated on shareholder funds), inventory turnover ratio, debtor turnover ratio, current ratio, price-to-earnings (the most commonly used and perhaps abused valuation tool!), price-to-book value (illustrates how adequately or inadequately the share price of a company reflects the shareholders’ share of assets in the business). The fundamentals speak more about the story of a company. The analysis of a company’s fundamentals involves getting deep into its financials, rather than day-to-day movement in its share price. It is done in order to calculate the intrinsic value of a company’s stock. So if a stock is trading above intrinsic value or fair value, then the stock is overvalued, and if a stock is trading below the intrinsic value, then the stock is undervalued. Analysts caution that you should not make profound assumptions on the future of a company’s performance on the basis of its quarterly results. For instance, looking at profit margins for a company is meaningless by itself; financial ratios facilitate comparison, across companies in a sector and for a company over a period of time. Thus, you should compare these factors with the company’s competitors before drawing any inferences on the company’s profitability. While financial ratios contribute towards making the right investment decision, analysts say that even they have limitations. Reason: Most financial ratios rely on historical financial data which may not capture subjective issues like management quality, business potential, investor’s friendliness and stock liquidity, which are all key components of an investment decision. These financial tools, analysts reckon, should only be used by investors to pick up the right stocks.
MUTUAL FUND Tracking and ranking fund managers
MERCER, an investment consulting firm, provides services to more than 2,750 clients with assets of over $ 3.5 trillion in 35 countries. The firm is better known for tracking and ranking fund managers across the globe as per the requirement of their clients. MERCER plans to launch similar services in India where they plan to rate fund managers for their international clients. Rashmi Mehrotra, business leader for investment consulting and head-retail for Asia Pacific region said: There is a significant difference in performance between top quartile and bottom quartile schemes, which compounds over time. Mutual fund schemes are being ranked regularly by many people based on their past performances. Though past performance can be relevant, it does not give much understanding of the future of the fund or its performance. Thus we would like to look at this more qualitatively than quantitatively. If we understand the competitive advantage of asset management firms better, we would better understand the likely relative performance of schemes. Ranking various strategies offered by asset management firms include understanding everything about this particular fund manager by using the Mercer matrix that we use globally. Mercer maintains an investment manager database for more than 2,800 managers and 17,000 investment strategies. Mercer matrix: We focus on four key factors like idea generation, portfolio construction, implementation and business management. We believe that well managed investment firm are more likely to maintain and enhance the competitiveness of their investment strategies over time than poorly managed firms. We understand that Indian market is different and the people who operate here will also be different. But all these things should not really change the fundamentals of the Mercer model. We do this exercise in so many markets. And we believe that we will get the same welcome in India as doing this research for large institutional clients. This is big business for fund management companies so I am sure that AMC in India will co-operate with us. The India growth story is intact. There are long-term investors who are interested in the Indian market and they want concrete research which is not available now. We are here to provide that qualitative research for these clients on the Indian market. We cater to clients more than 30 markets which say a lot about our capabilities. In addition to the market returns, it’s possible that Indian managers have the ability to give a higher alpha. A lot of our clients are interested in finding these alpha sources, wherever they may be located. We want to find these managers in India.
MUTUAL FUND… 30
Time to exit index funds Index funds are mutual fund schemes that purport to invest in a basket of stocks similar to that of its benchmark index and in the same proportion. This proportion is same both for stocks as well as sector allocations. The performances of such funds are, therefore, closely linked to the performance of the underlying benchmark index. In India, we have index funds that track either the S&P CNX Nifty or the BSE sensex. Both are largecap indices and therefore, by defaults, the index funds tracking them are ‘largecap’ funds. Index funds differ from regular diversified equity funds in the sense that index funds are passively managed whereas diversified equity funds are actively managed. While the ‘active vs passive managed funds’ is open to debate, the fact is that passive management reduces the cost of operating funds and thus enhance the returns such funds generate. Investors looking to invest in quality stocks across the leading sectors can take a medium to long-term view and patiently ride through the market gyration can consider investing in index funds. There’s a widespread belief among proponents of Index funds that the index-funds handily beat actively managed funds over the long-term. However, when challenged to provide some hard numbers to back up this belief, one never gets anything except a vague reference to some hazily-recalled American study that someone once heard of. Often it will be said that actively managed funds may do better than indices for a short while, but in the long run, the indices will trump you. Fortunately, the study of long-term investment performance is not one of those areas where one has to go by anecdotes or opinions. It is a field uniquely suited to hard numbers, the harder the better. And here are some of the hardest you’ll find about this matter. At this point of time, there are 60 actively managed diversified equity mutual funds in India that have existed for five years or more. If you were to add the sensex and the Nifty to these 60 and rank the resulting list for five year investment performance, you’ll find that the sensex is ranked 50 out of 62 and the Nifty 58 out of 62. it is true that you take a shorter period, say, one year, you’ll find the sensex and Nifty doing better with the sensex ranked at 101 out of 169 and Nifty 87 out of 163 but that’s better only compared to their longer-term performance. No, matter how detailed a look one takes at the numbers, the truth is that there are odd periods when the indices do better but most of time, most active funds beat them handily. However, one is by no means wedded to the idea of active management. In fact, one happens to think that fund management standards in India are declining and eventually, the indices will start doing better than the average (but not the better) funds. But when that day comes, there won’t be any need for debate and opinions, hard numbers will prove it beyond doubt.
Elephant is an animal that rings in money irrespective of whether it is alive or dead. When alive, the mammal is forced to work its tusk out; and when dead there are always buyer for tusk, nail, hair and skin. For brokers on the D-street, market is like an elephant. It rings in money when up and alive; and all the more profitable when it is down. Post the market drubbing over the last four weeks and the eventful loss of investor capital thereafter, brokerages are dishing out portfolio management services (PMS) schemes for frenzied investors who are running for cover. Past three weeks have seen a slew of PSM schemes being launched in Indian Market. A majority of these are ‘pool PMSs’ which enables smaller investors to participate in these otherwise exotic ‘affluent-centric’ schemes. Brokerages argue that this is a good option for investors who do not have the knowledge backup or time to invest in market judiciously. Pool PMS, the most common and popular segment, is a structured product for a specific group of clients (investors) with similar investment preferences. Unlike general PMSs, pool PMS is not directed to an exclusive client. Customers do not even need a demat account to invest in Pool PMSs; they only have to sign a general PMS agreement, entrusting the brokerage to manage their investments. Anil Ambani’s Reliance Money has launched PMS with minimum investment of Rs 5 lakh, as specified by Sebi. The scheme that targeted executives and professionals in metros and smaller towns would be available with an infinite upper investment limit. “The firm will not charge any fees if the returns are less than 8%. However if the return is between 8-20%, it would charge a nominal 10% as fees. Funds managers have the liberty to include as many investors as they want to pool-in a sizeable investment. As far as investors are concerned, they are literally hand-held through their investments till the maturity date. Apollo Sindhoori Capital Investments is planning to start a PMS scheme that would target pension earners. The brokerage plans to generate secured returns through arbitrage operations between cash and futures markets. The brokerage expects to generate a minimum 12% annualised return to its investors. Kotak Securities has launched a PMS product – GEMS or Globally Emerging Manufacturing & services portfolio – to capitalise on the returns offered by growing multinational companies, emerging businesses, manufacturing and services sector in India. Through GEMS, the portfolio manager may invest in private placements or pre follow-on public offering placement of listed securities. Almondz Global Securities has launched a discretionary PMS scheme called Compounding Growth Portfolio (CGP) in association with UK-based Commander Asset Management. CGP is a structured product that works on a computerized algorithm and aims at providing enhanced returns from a diversified portfolio of 50 large-cap stocks. The US-based AIG Investments is planning to launch a PMS scheme which will invest in the real estate sector. Credit Suisse and Tata Securities are planning out roll-out portfolio schemes for their rich clients.
COMMODITIES Need to widen the doors There is blood on the commodity floor as a lethal mix of red-hot cash markets and unexpected margin calls in futures pushes traders over the edge. With defaults and losses rife, India’s farm commodity markets are going tough wringer. Even exporters of sugar and cotton are feeling the heat as mills renege on contracts signed when world prices were lower. The continuous rise in the local cash markets and overseas futures is compelling Indian contracts to hit the upper circuit virtually daily. On Monday, soya beans and oil, rapeseed, chillies, potato and turmeric all hit the upper price circuit on NCDEX. Once a contract hits the limit, exchange rules prohibit trading until the next day. It also triggers enhanced margin calls, which is forcing many players out of the market. Short sellers have to shell out much more margin money. For the small players among them, finding several lakhs extra is impossible at short notice. Hedgers are equally affected. Those holding short positions to hedge their cash positions are getting hammered by escalating margin calls. They are also making a loss in the physical market because no one is willing to supply at the old lower price. Ironically, the problem of margin calls has been made worse by regulator FMC’s decision to reduce daily price movement limits from February 18. From 6%, the limit is now 4%. When the market has more players and more depth, we need to widen the doors, not shut it and open a window. Overseas, exchanges are rapidly increasing price limits because current market swings are too large to be contained by them. Prices of internationally aligned futures rise in tandem. If CBoT and NyBoT rise, MCX and NCDEX have to rise in line. But by reducing limits, the same price increase is now chopped into smaller pieces. That lasts over several trading sessions. That automatically increases upper circuit hits and special margins. Worse, since circuits shut down trading for the day, players are not able to exit. That creates a stampede for the following day, further worsening the situation.
Market mayhem When prices show extreme movements, exchanges have no choice but to collect special margins. For those caught unawares, the sky fell. How do you find a few lakhs in spare (and tax-paid) cash at a day’s notice? That became a huge issue for many. Things were not so bad. Most people paid up their mark-tomarket. But having done that, they didn’t have the courage to punt aggressively once again. While volumes have not dropped overall, traders have been forced to exit some counters to pay up for others. Many legitimate hedgers were forced to liquidate positions. The market’s troubles didn’t end there. Futures markets were moving up because of technical factors. So their movements were not reflected in the demand-supply-driven physical markets. Because of this discount, business in the spot markets dried up. Given the risk, most merchants have totally withdrawn from spot market, making it very difficult, if not impossible, for producers to get decent bids for their supplies. Since the basis is widening, forward contracts in the spot markets are thin on the ground. Defaults are rampant.
Internationally, a lot of large trading companies are booking huge losses for the same medley of reasons. Quite a few are no longer considered well enough for doing business on credit. Since MNCs have a global footprint, they face the challenge of meeting delivery commitments in one country, while dealing with farmer defaults in another, and exchange losses in a third.
So what’s next? A market watcher says that if left unchecked, the big funds on US exchanges are eventually going to swallow up physical market players. He believes that funds are trying to force out physical market hedgers and commercial traders by making them pay bigger and bigger margin calls and mark-to-market. Eventually, only the large funds with fathomless pockets would play with commodity derivatives, driving out the rest. That sounds like a conspiracy theory. The sheer scale of investment lends weight to this theory. Take just ETFs. According to Morgan Stanley, a global ETF asset at the end of 2007 was at $ 796.60 billion, a 41% increase from the previous year. Growth in commodities ETFs increased 87%, to $ 6.32 billion. This inflow isn’t too surprising. Every investment-banker knows commodities are the easiest way to recession-proof a portfolio. Businesses can go bankrupt. Commodities can’t. Commodities have a low-tonegative correlation to nearly every other asset in the typical portfolio. That makes them worth picking up, and ETFs, hedge funds and index funds are quick to learn. Experts feel that their entry has completely distorted the very purpose and objective of commodity derivatives. There’s something odd going on when we set up a derivative platform for transparent and reliable price discovery, but then find no willing buyer in the physical market at those prices. Many producers have ‘discovered’ a price they like and wish to sell, but when they go to their usual cash market, no window is open because of the risk and uncertainty. The problem is now so complex that there are no easy answers either with the US regulator CFTC, or at a pinch, with our own FMC.
Commodities’ delisting issue crops up again Rising inflation along with high commodity prices may push the government to take up the issue of essential commodities being delisted from futures trading once again. The government due to inflationary concerns had already delisted urad and tur, followed by wheat and rice early last year from commodities futures exchanges. The prices of most of the commodities have not only risen in the global markets, but have also seen unprecedented highs in the domestic markets. The government on Monday, 17th March ’08, banned the export of edible oils even through Indian exports were modest. According to traders, the government may introduce due measures to restrict futures trading in edible oil complex, like increasing margins, and decreasing the position limit.
Creeping liberalisation of the country’s agricultural trade With almost no political fuss, the country has managed to push its doors wide open to produce from foreign farms. There has been a creeping liberalisation of the country’s agricultural trade spiraling food prices force the government to chip away at import barriers. Custom duties on most major food items in short supply are now at zero or an all-time low. This is no small achievement because tariffs have been lowered for all trading partners, including the lower-cost producer of each agricultural product. India has now zero duty on major staples such as wheat, wheat flour, pulses, and jute. For Indian consumers suffering from food price inflation, the move has come a moment too soon. However, for farmers, the deal may be mixed. While they gain from cheaper food in shops, their produce may lose to direct price competition. The effective duty on edible oils is less than 20% for crude palm and soya oil, though they compete directly with the country’s oilseed production. Moreover, under South Asia Free Trade Agreement (Safta), duty has been reduced from 16-40% to zero on meat, fish, milk, dairy products and dry fruit from Bangladesh, Nepal, Bhutan and Maldives. Duty on the goods imported from Pakistan and Sri Lanka has been reduced to 12% from 20%. However, head-on competition with foreign farmers may upset the Indian agriculture economy in more ways than one. A new simulation study by Carnegie Endowment, Indira Gandhi Institute of Development Research, Mumbai, and Institute of Development Studies finds that complete trade liberalisation under WTO or bilateral FTAs can affect families in rural areas and increase rural unemployment. The studies suggested: • Because such a high proportion of the country’s labour force is still engaged in agriculture, and the sector is still the main reservoir of poverty in the country, the risks posed by agriculture trade liberalisation are high and must be carefully managed.” Unskilled labour loses from reduction of agricultural tariffs and domestic subsidies while it gains from reduction of manufactured tariffs. Skilled labour and owners of capital both benefit from all liberalisation measures except a reduction of agricultural subsidies. Land owners lose from all agricultural liberalisation measures and gain from liberalisation of manufacturer’s trade. Owners of natural resources lose overall. They gain from agricultural liberalisation, but the gains are more than offset by losses from manufacturing liberalisation.” Interestingly, the same effect of lower farm Custom duties can be seen in other countries as well. China gains from elimination of manufacturing tariffs but loses from elimination of agricultural and food tariffs and subsidies.
Animal diet feasting on global trade
Global trade in corn, sorghum, barley and oats has outstripped wheat and is four times larger than rice trade. The majority of the grains go into feeding cattle, chicken and pigs. With grains, meat and energy inextricably roped together, animal agriculture is deciding the new geography of world commodity trade. Five factors are deciding shift in feed grain trade around the world: (1) One, a country’s feed grain import is increasingly linked to the meat it prefers. Of the 300 million tonnes meat consumed in 2007 globally, 40% is pork, followed by poultry at 30% and beef at 25%.
Beef cows are fed fattening diets to make their meat tender and marbled. Corn is most useful because it adds fat and serves to increase their weight and, hence, the profitability. Dairy cows are purposely kept lean to get more milk.
Pigs and poultry are fed mainly compound feed made from corn and soyameal. Since global pork and poultry meat consumption is growing, it has made corn grab 70% share of global feed grain trade.
Saudi Arabia is the world’s top barley importer to feed its camels, goats and sheep.
(2) Two, countries that have shifted to eating more poultry and beef from goat and sheep, such as those in North Africa and West Asia, are buying more corn. Around half the production and consumption of meat in the EU-25 is pork. The production of pig and poultry meat is growing and the production of beef is in decline. (3) Three, all veggie feeds are becoming important. The use of animal by-products in formula feeds is decreasing in response to public concern about transmissible diseases such as BSE, salmonellosis, and avian influenza. This has further raised demand for coarse grains. (4) Four, countries wanting to produce their own meat, dairy and poultry but not able to grow enough feed grains are also importing more. North Africa and West Asia are poised to buy more feed grain because a richer and larger population wants more home-made animal products. The same push factor will also force South-east Asia to raise corn imports by a third in a few years. (5) Five, strong domestic demand means countries exporting surplus feed grain will start running short fairly soon. China and India, for instance, will export less corn in the future because the domestic market would be quite profitable.
BANKING SECTOR India’s biggest banking deal The boards of HDFC Bank and Centurion Bank of Punjab met to give an in-principle approval for the two banks’ merger – the largest in the Indian banking sector. The banks have jointly appointed CA firm Dalal & Shah, and Ernst & Young as independent valuers to determine the share swap ratio. J Sagar Associates has been appointed as the legal advisor for the transaction. The deal which will be the largest in the banking sector in India is likely to be at over Rs 10,000 crore. The combined balance sheet size of the merged entity would be Rs 156,842 crore, making it the sixth largest bank in the country. While the merged entity will have the maximum number of branches among private banks, its asset size will still be far below ICICI Bank’s. HDFC Bank has 754 branches and has RBI’s permission to add another 250 branches, which would bring its network on par with ICICI Bank. The addition of 394 branches of CBoP will help the bank leap frog ahead of ICICI Bank, in terms of branch presence. The merger would also help HDFC Bank to get an additional leeway in its capital market business, where it is one of the strongest players. The boards will again meet to decide on the swap ratio which is likely to be in the region of 1:27 - 1:28 – a CBoP shareholder would get one share of HDFC bank for every 27-28 shares he/she holds. The shareexchange ratio would be worked around Rs 56 a share of CBoP. HDFC will see its shareholding in the bank fall to less than 19% from the current 23-28%. The mortgage player will increase its shareholding in the bank to above 20% by buying from the market or subscribing to a fresh issue of HDBC Bank shares. Merger swap ratio at 1:29: CBoP shareholders will get one HDFC Bank share for every 29 shares they hold, as per the swap ratio approved by the boards of the respective bank. HDFC Bank is likely to issue preference shares to promoter HDFC to enable the mortgage company to retain its shareholding above 20% after the merger. HDFC’s which has currently has 23.28% in the bank will go down to around 19%. Given the ratio, HDFC Bank appears to have valued CBoP at around Rs 9700 crore, which makes this the largest deal in the private sector. A preferential issue would substantially hike HDFC Bank’s net worth. If HDFC wants to retain its current 23.2% stake in the bank, it would have to pump in around 3,900 crore. HDFC chairman said it has constituted a committee of its board to examine the different fund-raising options and take a call on issues like to what extent should HDFC have a stake in HDFC Bank. Reverse merger: Whether HDFC would get into a reverse merger with HDFC Bank, Mr Parekh said, that there are no plans to go in for reverse merger with HDFC Bank at the moment. There is no specific time frame. As a non-banking entity in the housing finance space, HDFC does not have to fulfil the central bank’s requirements towards maintaining the cash reserve ratio and the statutory liquidity ratio. Next stop, overseas: After acquiring Centurion Bank of Punjab, HDFC Bank the second largest private sector bank after ICICI Bank, may look at an overseas buy. The bank would look at an acquisition for increasing its presence in the corporate and retail banking space abroad. HDFC Bank had recently kicked off its international foray after receiving a licence for a branch in Bahrain. HDFC Bank MD Aditya Puri said, “We don’t want to try and go into an overcrowded market that’s going through difficulties. We want to go where we have strengths, and that is the NRI-network – the global NRI network that is looking at investing in global assets. So, we will provide global products once our Bahrain branch opens up, which will be in the next two-three months.
BANKING SECTOR… 37
Sub-prime woes The Germans have a nice word for it: schadenfreude, pleasure or satisfaction at someone else’s misfortune. When the sub-prime crisis hit the Western world and one by one, the big names in global banking reeling under losses went around cap in hand seeking additional capital, the authorities in India watched with barely-concealed schadenfreude at how the mighty had been humbled. In the globalised world it is naïve to expect that Indian banks alone can escape a global phenomenon, good or bad. Indeed as we open up further and our banks, both in India and abroad, take more exposure to overseas risks, we must be prepared for more such losses. The answer is not to go back to the days of directed lending when bank functioned like departmental undertakings of the government but to spruce up both internal risk management systems and regulatory over-sight. We were led to believe that Indian banks have no exposure to the subprime crisis. Of course, part of the reason is that our banks don’t have much freedom when it comes to operational matters. But that is not case with private sector banks. There, animal sprits reign supreme. It is no surprise, therefore, that ICICI Bank, one of the most aggressive private sector banks in India, has been hit by the sub-prime crisis. Often seen as the ‘Citi’ of Indian banks for its tendency to punt, it is, perhaps, inevitable that ICICI Bank should have burnt its fingers in the crisis that hit bigger and more reputed banks, globally. Having said that the worry about ICICI Bank’s losses is not the $ 265 million hit it took on its overseas credit derivative exposures. Given its balance sheet strength, this is a rap the banks can take without much problem. But rather that the disclosure regarding the loss should have come from the minister of state for finance, Pawan Kumar Bansal, in Parliament, not from the bank or the banking sector regulator, the RBI. As one of the most-widely held bank in India, with more than 70% of its shares held by overseas investors known for upholding the best standards of corporate governance, ICICI Bank should have come clean much earlier. The bank’s contention that these losses are only the result of pricing assets according to what they will fetch in the market (mark-to-market). Mark-to-market is a basic principle of accounting in banks. Subprime losses reported by banks the world over are of the same genre so to argue that ICICI Bank’s losses are somehow different does not speak well of a bank of ICICI’s statute. The onus is now with the RBI. Following the announcement regarding ICICI Bank’s losses, there are reports that Bank of Baroda and possibly, the State Bank of India too, many have taken a hit, though much smaller. The central bank has so far not made any statement regarding the extent of exposure (and possible loss) of Indian banks to the sub-prime crisis. Given that many public sector banks have overseas branches, the possibility of their suffering losses cannot be ruled out. Their innate caution and conservatism may have saved them but we need to know for sure. With ICICI Bank’s losses now in the open, the cat is out of the bag. We must not be kept in the dark any longer.
BANKING SECTOR… 38
NPAs are as bad as subprime loans The finance minister’s enunciation of the basic economics of loan recovery is on par with the tactics adopted in the US to resolve the subprime lending crisis. Both are, obviously, economically indefensible. In economic management, the challenge of correction is so demanding that we should deem correction to be an equal part of the process of policymaking. The fragile financial structure globally and domestically could do with a better approach to correction. Before we go any further, we must understand what goes generally as subprime lending. This stands for assistance provided to clients who are not creditworthy and which can turn sticky. But, US banks gave a new dimension by introducing several derivatives to soften the debt burden and make the facility much too tempting to refuse. On the face, Indian banks have only limited exposure to subprime housing and other personal loans and that meant no great difficulty in dealing with the situation at hand. However, things have not been all that smooth and defaults had occurred in housing loans and the RBI was entirely justified in stipulating more stringent checks. There was some neglect on the part of loan managers in their assessment of the credit worthiness of clients. Examined in isolation, this was serious enough since bad loans are bad and calling them non-performing assets, does not render these acceptable. Even, fraudulence was not taken on the agenda in respect of loans provided for housing and personal consumption. Still, accumulation of NPAs bank-wise is by no means tolerable. It is said that the emergence of the phenomenon of subprime lending in the housing and personal finance sector in India was nothing to worry about. Since, there has been no evidence that bank officials sought to send the message across to borrowers that they could go easy on debt servicing and their investments were safe and would remain so without their having to bother too much about the debtor’s conventional obligation – precisely a message that had been indiscriminately given in the US, regardless of the damaging consequences for prudent banking. In fact, bringing down the proportionate level of assets that do not perform has become a major aspect of banking operations. Nobody used the term subprime lending, although NPA has been widely seen as an irregularity. Enhancement of the bank’s capital adequacy and prudential norms as part of the Basel II package, no doubt, was prompted by the dimension of NPAs, but should not be seen essentially as a remedy to this problem. Strengthening the capital base of banks really does nothing to improve utilisation of the loans provided and, thereby, the recovery to the banks themselves in terms of interest earnings and expeditious return of the loans. It is true that the advance department in any bank is under mounting pressure not to create too many procedural or other hassles to interested borrowers, but this does not mean that assistance is, or should be, provided without requisite checks on the potential viability of the request for financial support. Against the backdrop of the US crisis, it would be entirely in order to subject NPAs to the kinds of checks that US subprime lending has been brought under.
TAX PLANNING Tax planning vs Investment planning
Tax planning for most of us seems boring and we rush for it in the month of March. But some advance planning helps you do avoid last-minute confusion. Tax experts observe that barring items, which require timely payments like insurance premium, most individuals make their tax savings investment only in March, the last month of a financial year cycle. That’s why the months of February and March are marked by low consumption and maximum savings. It is during this period that many more tax saving products is introduced in the market, thus widening your choice. For small income earning assessees, investment planning forms a major part of tax planning exercise. The same, however, doesn’t hold true for the assessee whose tax burden is more. According to financial planners, the concept of tax planning has undergone a slow but steady change in India. More so, it is because of the changing dynamics of the workforce. Today, investment planning is in fashion and leading towards financial instruments such as ELSS, Ulips, and infrastructure funds, which promise to multiply your savings. But financial planners caution that if risky financial products, such as Ulips and ELSS can potentially give you very high returns, there is a downside too. You can post a loss in case the market stays depressed for a long period of time. You should always take this into consideration while building your portfolio. Tax planning is a much wider term and includes many components, other than making investments under Section 80C/80D of the Income-Tax Act, 1961. This is because the law has set an upper cap for such investments, and an investor/assessee can only save tax to some extent only. However, it motivates people to invest, which help them to learn the art of investing for longer term. For beginners, tax incentives have traditionally been devised to encourage certain behaviour. Thus they have either been linked to improving social security (for example, employee provident fund, PPF, life and health insurance premia), mobilising investments (ELSS, long term bank deposits, mutual funds) or asset creation (housing loans, etc). The true definition of tax planning goes beyond investments – it improves social security or creates a safety net for the individual. After putting some money into this category, if the individual studies how to spread his balance savings across various investment alternatives, so as to maximise his capital appreciation and derive maximum tax benefits. And if you are unable to decide whether to invest in tax-saving products or to forgo a few thousands in taxes because buying a financial instrument would mean you are left with very less or little cash-in-hand, then the situation warrants the need to consult a professional. Most of the time, the tax saving exercise may result in very little cash in hand. So, first you should assess – do you really need to save for avail tax benefits. And second, what should be the ideal mix, so that you can pay some tax and also have enough liquid cash. This is situation specific and applicable to people earning in the range of Rs two to four lakhs. Experts feel that you should always have some portion of the savings in short-term deposits or any other investments that can be liquidated at short notice to meet emergencies. For those who want to maximise savings, experts advice that they should invest in securities, which have higher returns and low/negligible tax implications on the income arising out of the investment.
MISCELLANOUS UPDATES Right to Education The UPA government decided to introduce the Right to Education Bill in the Parliament. Prime Minister Manmohan Singh expressed the need for Central legislation to be introduced soon. The ministry of human resource development (HRD) is in the process of preparing a Cabinet note, which is due to be taken up for consideration within a short time. A working committee headed by A K Rath, secretary, school education and literacy, ministry of HRD, is finalising the draft of the legislation. In its final form, the RTE will provide the blueprint for making systematic changes in the elementary education sector. The ministry is clear that RTE is not another way to garner more funds for elementary education, but an opportunity to reform and rationalise the system. The promise of systemic reforms will also help to counter the growing lobby for the privatisation of school education. The private school lobby has consistently called for the opening up of the education sector, allowing “for profit” organisations to play a role on the grounds that government schools can’t provide quality education. Legislation geared to providing quality and norms for it would counter this move as well as improve quality of schools across the spectrum. Both issues of increased fiscal outlay and legal responsibility are being addressed. Many of the expenses of operationalising the RTE are being taken care of by the funding for the Sarva Shiksha Abhiyan (SSA) and teacher’s education. A more realistic and lower expenditure bill is being arrived at by dovetailing the expenses of the Right to Education Bill, and the SSA and teachers’ education. The fear of increased volume of public interest litigations (PIL) mandating the Centre to sanction and fund infrastructure far beyond its financial capabilities is being addressed by setting realistic targets for states to roll the implementation of the Bill. For the enabling right to education, it has been a long and arduous journey. More than five years have gone since Parliament passed the 86th Constitutional Amendment giving every child between the age of 6 and 14 years the right to free and compulsory education (Article 21 A). Work on the RTA was started by NDA government soon after Parliament passed the Constitutional Amendment Bill in December 2002. The first delay came when NDA was voted out of power in May 2004. Work on the RTA was then taken up by the Kapil Sibel committee of the Central Advisory Board of Education (CABC). The financial implication for the Sibal draft was worked out by the then National Institute of Education Planning and Administration (NIEPA). As per these estimates, the government would require to spend a minimum of Rs 3,21,196 crore over six years to implement the legislation – the outer limit of spending was set at Rs 4,36,258.5 crore. The Cabinet then set up a high-level group comprising HRD minister Arjun Singh, finance minister P Chidambaram, deputy chairman of the Planning Commission Montek Singh Ahluwalia and PM’s economic advisor C Rangarajan to consider the RTE Bill in the broader context of the National Common Minimum Programme, its legal and constitutional framework and its financial implications. The group met in January 2006. Fearing increased litigation in case states failed to deliver and a high financial commitment, this group suggested opting for a state legislation route. The Centre would restrict itself to a model bill for the states to follow.
MISCELLANEOUS UPDATES… 41
Small savings turns negative For the first time perhaps, net collections of small savings – particularly postal savings deposits and certificates such as Kishan Vikas Patra and National Saving Certificates (NSC) – have become negative over the first nine months ending December ‘07. This change in Indian households’ saving habits spells good news for banks, mutual funds and stock markets and bad news for state governments, which are eligible to borrow 100% of the small savings collected in their respective territories. According to data collated by the Controller General of Accounts, net collections of savings deposits and certificates were negative. What this means is that the fresh collections from small savings this fiscal were not adequate to make good the repayment of investments which matured and then ensure a surplus in the National Small Saving Fund (NSSF) which administers small savings schemes. Thus the net negative collection would mean the government providing cash to meet repayment whereas it comes up. This could be a clear pointer to the shifting change in saving habits. Indian savers seem to be opting to park their money increasingly in either bank deposits, mutual funds and more risky avenues such as equity linked instruments than the safe old small savings instruments. Over the course of this decade, the government had sought to work out a policy design to try and discourage small savings. And it did not adopt any of the recommendations of experts. The turning point may well have been the decision over three years not to revise the interest rates upwards, even as interest rates hardened across the board. Since then, savers have migrated to banks, especially after they started offering attractive rates even on short-term deposits. In the Union Budget 2008-09, finance minister proposes to add the Senior Citizens Saving Scheme 2004 and Post Office Time Deposit to the basket of saving instruments under Section 80C of the Income Tax Act. However, experts argue for more concessions for small saving schemes.
Angel investor for IFCI There is a change in strategy for IFCI. After an unsuccessful attempt at bringing in a strategic investor, it is now looking to roping in an angle investor. IFCI CEO Atul Rai said: “IFCI is a long-term story, investors understand that. Our medium-term objective is to build the institution. Solvency is not an issue anymore. Although there is no proposal right now, we will find a partner who could be an angle investor of sorts and provide IFCI the vision.” The IFCI is in no need of capital now. The capital adequacy is currently at 18%. We therefore do not strictly need a pure financial investor, since we have had recoveries and made good our investments by unlocking value in them. At the end of the third quarter in December 2007, IFCI’s net profit increased 146% to Rs 318.94 crore on the back of strong recovery of bad debts. We are also not pursuing the Rs 1,300 crore budgetary provisions for IFCI for this fiscal (2007-08). IFCI has just launched an ambitious voluntary retirement scheme, though which it aims to cut staff to a third. Creditor’s banks converted their debt into equity at the SEBI formulated price of Rs 107 in December 2007. While it is understood that some of the banks sold their shares almost immediately, some of them have been left holding onto shares whose value has plummeted since. We are sorry for these investors because of the loss in value, but everyone knows that equities can go up or down.
REALTY ASSETS The India Post Urban post offices located in key commercial areas may soon have to share space with swanky malls, multiplexes and high-rise offices as the government has awoken to the money-spinning potential of the postal department’s realty assets. To facilitate its plans to raise resources, the government will transfer real estate, which can be commercially exploited to a new body called the Postal Development Corporation (PDC) – a corporate entity spun off from the Department of Posts (DoP). The rationale behind PDC is to transform the loss-making postal department, which is supported by huge government subsidies, into a self-sustaining entity. The postal department has already identified 1,800 chunks of real estate land spread across its urban centres, including the four metros, for commercial development. The land will be developed on a JV basis as is being done in the case of National Textile Corporation’s (NTC) Mumbai properties. Thus, PDC will be a corporate set-up on the lines of state-owned telcos such as BSNL. The corporation will enter into public-private partnerships to develop the postal department’s real estate assets across the country. From Connaught Place in Delhi to Nariman Point in Mumbai, the Department of Posts owns large chunks of invaluable real estate across the country. After the setting up of PDC, India Post, which is making losses currently, will no longer require support from the government. The LIC of India Life Insurance Corporation (LIC) is looking to jointly develop close to one lakh square feet residential premises in the Borivali suburb in northwest Mumbai, which would be its first residential project in Mumbai after many decades. It is also developing close to 80,000 square feet of commercial space in Vastrapur, Ahmedabad. The corporation was looking at a policyholder housing project after rehabilitating existing tenants in Borivali. The policyholder housing project envisages extending finance to buyers against the security of their LIC policies. Although the corporation had developed many such properties in the ‘70s, development came to standstill due to non-availability of land. The surge in real estate prices has, however, made it viable for the corporation to develop the Borivali plot even after rehabilitating tenants in existing single story structure. Officials said although it owned several lakh square feet of commercial space in South Mumbai, most of these were non-performing assets, as they were inherited by the corporation along with tenants. The inherited property includes those premises that belonged to erstwhile private and foreign life insurance companies which were consolidated into the Life Insurance Corporation at the time of nationalisation of the industry in 1956. The corporation is now looking for ways where it can earn revenue of these NPA properties. It has called for tenders from real estate consultants, who will help LIC in resolving these NPAs. LIC has constituted a strategic business unit for real estate which will consolidate all assets under this category and derive the best value. Officials said that a centralised approach was necessary because most of the matters could not be resolved at the branch level and needed inter-ministerial constitution.
REALTY ASSETS… 43
Surplus VSNL land The Telecom Commission, department of telecom’s (DoT) arm responsible for approving all policies, has cleared the government’s proposal to auction 773 acres of surplus VSNL land. Back-of-the-envelop calculations show the land would be worth over Rs 10,000 crore ($ 2.5 billion). The land is spread across four cities – Delhi, Pune, Kolkata and Chennai. The commission has said, the Tatas, a majority stakeholder in VSNL, are eligible to participate in the auction. The government sold VSNL to the Tatas in 2002, but 773 acres of surplus land was not part of the deal. The government will get 51.12% of the proceeds of the land sale in line with its shareholding. VSNL employees in the form of Esops hold 1.85%, while another 21% is with foreign companies. Other shareholders include FIIs (10.86%), Indian FIs and mutual funds (7.9%), general public (4.92%) and other Indian corporates (3.09%). Bank’s properties Rising property prices have prompted State Bank of India, the country’s largest lender, to reassess its fixed assets, including some of the palatial office buildings that have been assesses at just Rs 1 since the days of the Raj. The first-time move is aimed at balance sheet. Punjab National Bank is also reassessing its properties to shore up its capital base. About half the gains post-revaluation will be added to the bank’s capital. Nearly Rs 1,800 crore will be added to tier II capital in case of SBI, and about Rs 450 crore for PNB. Boards of both the banks have approved the proposal. For SBI, some of its properties such as the central office in Mumbai and the heritage Mumbai main branch – the headquarters of the erstwhile Imperial Bank – are valued at Rs 1. The central office is now revalued at Rs 900 crore while the Mumbai main branch is valued at Rs 150 crore. As per RBI rules, only 45% of the total gains arising out of revaluation can be added to the tier II capital. The properties selected by SBI (offices in metro and urban areas) were valued at about Rs 4,000 crore, while that of PNB were assessed at Rs 1,300 crore. While SBI is looking at revaluing only offices in metros and urban office, PNB has done revaluation of all its properties. SBI balance sheet for financial year 2007-08 may not reflect revaluation of its properties since the process may not be completed by the end of March. SBI’s branches and offices in 30 cities have been revalued and the bank has appointed Ernst & Young to certify the procedure and the valuation report submitted by valuers in various cities. E&Y is yet to submit its report. PNB officials expect the revaluation of properties to reflect in this year’s balance sheet. “PNB has been revaluating its properties every three years and thus it is in tune with the same.” Bank of India was among the first banks this year to carry out this exercise. It was followed by Vijaya Bank and Union Bank of India. Bank of India added about Rs 732 crore to its tier II capital and Vijaya Bank around Rs 200 crore. The south-based bank had revalued 64 properties across the country after a gap of 12 years. Its properties were valued at Rs 442 crore.
The largest land deal Delhi based real estate firm BPTP has bagged the country’s largest land deal worth Rs 5,006 crore. In a fiercely fought bidding war, BPTP beat the country’s largest real estate firm DLF to win the 95-acre plot in Noida’s sector 94. It is a staggered payment, where BPTP will have to pay only 30% of the total amount now. The company will pay the rest in 16 instalments over eight years, along with an interest of 11% compounded annually on the due amount.
INSURANCE Insurance against risk of sundry debtors Many companies insure all their tangible assets, but leave out Receivables/Sundry debtors to the vagaries of trade. While the Indian foreign trade going great guns and domestic trade also assuming great proportions, it is very important to ensure that a company’s receivables are protected through insurance. A company doing very well can see bad times if their receivables are not realised. The answer lies in an insurance termed as credit insurance. It is an insurance protection of account receivables against non payment due to: • • • Insolvency of the buyer, Protracted default and Political risk – currency inconvertibility.
It is a total business solution for short-term trade receivables. Credit sales is important for both domestic and international market but then one gets exposed to the contingencies of trade and end up in bad debts owing to the above factors, which even the best of CFOs cannot predict. Huge losses may be accrued if unexpectedly a long-term buyer fails to make huge payment, or there is significant market volatility affecting a large number of buyers or the political/economic environment in the buyer’s country gets vitiated. Events such as war in the Middle East, South-East Asian currency crisis, WTC disaster, protected recession in Japan and the present subprime crisis in the US can lead to significant credit risk. While protecting your balance sheet, this insurance also ensures to stabilise cash flow in the event of a credit loss. It is an effective tool for the finance executive to hedge against both commercial and political risks beyond his/her control. Other added advantages are:
It secures better financing terms as the quality of accounts receivables gets enhanced with this kind of insurance, one competes more effectively as it offers more flexibility of shifting from the letter of credit mode to open credit, thus increasing one’s saving, Expand sales to existing customers without increasing the risk, leverage on the knowledge of insurance companies about global markets, and expand sales to new markets. Optimise bank financing, protect against potential restatement of earnings and last but not the least, it supplement credit risk management.
Credit insurance basically provides indemnity for bad-debt losses but does not finance your receivables. However, credit insurance can be used to facilitate financing. It does not cover wrongful or dishonest acts like the insured’s failure to fulfil terms and conditions with the buyer or disputed debts, which are not legally enforceable, losses caused by nuclear or radiation effects, etc.
This insurance is normally extended to companies that have sold products on credit terms for good number of years and does not have adverse history and has good credit control procedures. One important factor, which all insurance companies, prefer is that the corporate should insure its entire turnover and not take insurance for selected buyers although some underwriters do give for selected top clients after through verification. Insurance companies normally offer two types of products. One takes of the domestic trade and protects a business house against insolvency of the buyer and protracted default. The other relates to exports and this again takes care of insolvency of the buyer, protracted default and political risks, like war/civil war, export/import/transfer restrictions or currency inconvertibility, cancellation of export contracts or LC discrepancy. The pricing generally depends on the type of industry, country where one trades, past loss record, quality of credit management, terms of payment and of course, the losses which a corporate is ready to keep to themselves (commonly known in insurance parlance as excess/deductibles). The insured needs to adhere to ones credit and collection procedures, maintain a legally enforceable debt, not to reschedule dues from the buyer without informing insurance company, agree to co-operate with insurer to effect recoveries, etc. This insurance was pioneered in India by ECGC for export credit but now companies such as New India, TATA-AIG, Oriental, ICICI Lombard and IFFCO TOKIO are offering the same insurance along with domestic credit. Insurers are varying of domestic credit insurance but they do give after thorough scrutiny of the credit management of the corporate and past loss records. In a jist, you cannot stop your customers going insolvent, but through this insurance, you can ensure that they do not take you along with them.
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