The lowering of the US Federal Reserve’s benchmark interest rate by a further 25 basis points, juxtaposed with similar action taken by the Bank of England and European Central Bank’s infusion of liquidity, brings to fore the evolving role of central banks. Textbooks talk of monetary policy in the context of growth and inflation targets. However, the monetary authority has progressively become more responsible for the integrity of the system, which has a bearing on policy formulation. The question is how far it should go to protect the inefficient or failed elements of the system.
The official line taken by the US Fed when it lowered interest rates by 50 basis points earlier was that both GDP growth and inflation are quite satisfactory, but its own proclivity is towards growth. This time, it has said no such thing. But one could guess subprime concerns. The losses to be suffered by the financial system are estimated in a range of $200-400 billion. Estimates of both the OECD as well as The Economist indicate that while growth may be hit, an outright recession is ruled out. In fact, given that commodity prices are rising, inflation is the bigger concern today. Clearly, due to the present liquidity problem, the Fed has been lowering its rate and has held out $24 billion towards liquidity supply. Nothing really wrong in this, but it does provoke a debate on whether or not the central bank should come to the rescue of financial players in times of such crises.
To go back a bit into economic theory, Joseph Schumpeter had espoused “creative destruction”, wherein he emphasised that it is a natural law that as economies move along, crises are but natural and should be allowed to run their course. This will help eliminate inefficient players, and in turn, lead to catharsis that would leave the system better off. Note that the subprime case’s origins can be traced to banks and other mortgage houses lending recklessly to individuals and then securitising the loans. Such institutions that operate on flaky grounds, according to Schumpeter, must not be allowed to survive, and their failure will come to cleanse the system and set an example for others. The Asian crisis, for example, was mainly due to crony capitalism, and had lessons on credit assessment that makes Basle 2 norms all the more relevant. Prudential banking, everyone agrees, is important to economic stability.
Also, by helping save the situation, the Fed (and the Bank of England and European Central Bank) sets a precedent of standing by any financial organisation which bungles, especially so in case there is systemic risk posed to the Economy. In fact, Henry Paulson of the US Treasury has also spoken of repricing subprime mortgage loans, which benefits those who are less likely to comply, thus creating a perverse incentive not to worry about compliance. This results in a moral hazard, which is quite scary because if banks in India, for example, know that the Reserve Bank of India (RBI) will eventually cover them, then they would be that much more reckless in lending.
From the point of view of the protagonists of rescue missions by central banks, there are two compelling reasons for affirmative action. The first is that the financial system today is a very important part of the Economy and has deep implications for the real sector (and overall growth). The Asian economies took over five years to recover, and the other affected countries such as Brazil and Russia took even longer to recover from the slump. Lower US growth is serious business that the Fed cannot ignore.
The other reason is that in the world of globalisation, it is hard to escape the contagion effect. Indian stock Markets were hit when the subprime crisis erupted. It affected not just our banks but also the RBI’s policy stance. Funds were withdrawn from bank stocks across the world, causing market turbulence. Further, various countries’ monetary policies are getting aligned with one another, and given that the “decoupling” of the rest of the world from the US is still not a proven phenomenon, a recession in the US can affect others too. Recall that the Fed took the blame for the Great Depression of the 1930s, which explains why it must be proactive in such situations.
The result is that central banks have taken on a new inadvertent role of protecting inefficient entities—ironically, to protect the Economy. Further, as was the case with Northern Rock, the interests of deposit holders had to be protected. The UK’s regulator, the Financial Services Authority (FSA), was in charge, but the Bank of England had to come to the bank’s rescue to protect deposit holders.
This certainly calls for greater and more stringent financial supervision, either with a separate arm of the central bank or an independent authority which will in turn have to ensure that the rules are obeyed and be responsible for a bailout in times of crisis.
Thursday, December 20, 2007
Friday, December 14, 2007
The green currency : DNA 15th December 2007
Protecting the environment the fiscal way will reap benefits for consumers
The present concern about the environment is significant for three reasons. The first is that we are all progressively getting aware of the seriousness of the problem and accept that we need to do everything possible to control this degradation, as it is going to affect our future — and this may be just 20 to 30 years away. The second is that after the Kyoto Protocol took shape, it became possible to identify these polluters and companies are taking countervailing measures.
The third is that we have also made a neat business of this, wherein carbon credits are actually traded — the preservers of nature earn credits which can be traded with those who pollute the environment, thus making it a zero sum game. The game also mandates that those who do not stop their pollution must pay for it by purchasing these credits. This means that we are able to value these pollutants on a commercial scale.
If all this is true, the government can actively play a part in environment control through a system of taxes and incentives. The carbon credit system enables one to identify the level of pollution caused by an activity. If I am able to reduce the pollution caused by this activity and am able to prove it, then I earn some credits which can be traded with those who emit high pollutants. This means that all organised activity can actually be linked with emission levels, which can then be ‘capped and traded’ or, rather, taxed.
This tax would do two things. The first is that it will ensure that there is revenue for the government which will rise as long as society is willing to pay for it. The other is that any shortfall would automatically mean that pollution is under control as the polluting activity has been checked.
There are essentially two major sources of pollution. The first is the industry where manufacturing causes emission of noxious substances which damages the environment. Prima facie, these activities can be identified and the tax rate can be fixed proportional to the emissions on a progressive scale. Production of fertilisers, plastics, cement, glass, oil and so on can be ranked and taxed accordingly. Power companies could also be forced to move over to more environment friendly fuels that can be used to lower pollution levels. Non-adherence would mean a tax, which may or may not be passed on to the consumer. Considering that the tariff rates for power are partly administered, these companies may choose safer environmental friendly fuels, as carrying the costs would mean losses.
The tax can also cover individuals. At a micro level, individuals are responsible for pollution by activities performed either directly or indirectly. Vehicular pollution is high and would attract a differential tax on the fuel used be it petrol or diesel or CNG. This, by itself, may encourage drivers to shift over to a medium which lets out the least pollution like CNG over petrol and diesel. In fact, subsidies could be given on use of pollution reducing kits.
Another big indirect pollutant is air travel. The aviation industry has been identified as being one of the biggest destroyers of the ozone layer. To discourage such travel or make people more aware of this effect, a flat surcharge on every ticket can be levied by the government which will ensure that all those who contribute to the pollution also pay for it. Government action will actually penalise the polluters while adding to its own revenue.
There will still be a large unorganised set of polluters which will be difficult to track, but models can be built on reducing this by providing incentives instead for doing something that lowers environmental degradation. Simple rules like construction of public amenities and provision of dustbins can be linked with tax benefits for a community in the form of, say, a cheaper water supply.
Today environment control norms are harsher on developed countries, most of which have agreed to adhere to the Kyoto norms. It has been accepted that these countries, in their processes of industrialisation, have added substantially to environmental degradation levels and hence need to atone for it. But developing countries, which are getting increasingly more industrialised, also need to shoulder this burden and need to use a blend of taxation and subsidies to address the problem, and thereby probably earn net revenue.
The present concern about the environment is significant for three reasons. The first is that we are all progressively getting aware of the seriousness of the problem and accept that we need to do everything possible to control this degradation, as it is going to affect our future — and this may be just 20 to 30 years away. The second is that after the Kyoto Protocol took shape, it became possible to identify these polluters and companies are taking countervailing measures.
The third is that we have also made a neat business of this, wherein carbon credits are actually traded — the preservers of nature earn credits which can be traded with those who pollute the environment, thus making it a zero sum game. The game also mandates that those who do not stop their pollution must pay for it by purchasing these credits. This means that we are able to value these pollutants on a commercial scale.
If all this is true, the government can actively play a part in environment control through a system of taxes and incentives. The carbon credit system enables one to identify the level of pollution caused by an activity. If I am able to reduce the pollution caused by this activity and am able to prove it, then I earn some credits which can be traded with those who emit high pollutants. This means that all organised activity can actually be linked with emission levels, which can then be ‘capped and traded’ or, rather, taxed.
This tax would do two things. The first is that it will ensure that there is revenue for the government which will rise as long as society is willing to pay for it. The other is that any shortfall would automatically mean that pollution is under control as the polluting activity has been checked.
There are essentially two major sources of pollution. The first is the industry where manufacturing causes emission of noxious substances which damages the environment. Prima facie, these activities can be identified and the tax rate can be fixed proportional to the emissions on a progressive scale. Production of fertilisers, plastics, cement, glass, oil and so on can be ranked and taxed accordingly. Power companies could also be forced to move over to more environment friendly fuels that can be used to lower pollution levels. Non-adherence would mean a tax, which may or may not be passed on to the consumer. Considering that the tariff rates for power are partly administered, these companies may choose safer environmental friendly fuels, as carrying the costs would mean losses.
The tax can also cover individuals. At a micro level, individuals are responsible for pollution by activities performed either directly or indirectly. Vehicular pollution is high and would attract a differential tax on the fuel used be it petrol or diesel or CNG. This, by itself, may encourage drivers to shift over to a medium which lets out the least pollution like CNG over petrol and diesel. In fact, subsidies could be given on use of pollution reducing kits.
Another big indirect pollutant is air travel. The aviation industry has been identified as being one of the biggest destroyers of the ozone layer. To discourage such travel or make people more aware of this effect, a flat surcharge on every ticket can be levied by the government which will ensure that all those who contribute to the pollution also pay for it. Government action will actually penalise the polluters while adding to its own revenue.
There will still be a large unorganised set of polluters which will be difficult to track, but models can be built on reducing this by providing incentives instead for doing something that lowers environmental degradation. Simple rules like construction of public amenities and provision of dustbins can be linked with tax benefits for a community in the form of, say, a cheaper water supply.
Today environment control norms are harsher on developed countries, most of which have agreed to adhere to the Kyoto norms. It has been accepted that these countries, in their processes of industrialisation, have added substantially to environmental degradation levels and hence need to atone for it. But developing countries, which are getting increasingly more industrialised, also need to shoulder this burden and need to use a blend of taxation and subsidies to address the problem, and thereby probably earn net revenue.
Tuesday, November 27, 2007
Another Brick in the Wall: Financial Express: 26th November 2007
The RBI’s draft report on currency futures is significant and pragmatic for six reasons. The first is that we will have a forex futures market where there are large numbers of players who will determine the price of the dollar in future. This is a big change from what we see today in the OTC market where the banks have the upper hand in price setting.
The second is that these contracts will be for a whole year, and hence market players can choose their tenures for trading. This is unlike the commodity market, where there are generally fewer contracts that are running simultaneously. The third is that the contracts are to be settled in cash, which is again different from commodity Markets where compulsory delivery is the rule. In the currency futures market, this would have been chaotic if dollars had to be delivered because there would be a parallel market for the supply of physical dollars. The RBI has taken this decision ostensibly on the grounds of there being no capital account convertibility.
The fourth is that the RBI has taken on the role of the regulator and also advised the creation of new exchanges. This is pragmatic because it eschews the issues related to having multiple regulators overseeing different activities of the same exchange. Fifth, the settlement price would be announced by the RBI through its spot reference rate on the expiry date, which will do away with the settlement problems faced by the commodity market where no unique and singular price exists and the onus is on the exchange to provide this price. This would lead to an automatic convergence of futures with spot rates on this day. And lastly, the RBI does see a valid role for speculators to play, which comes as a breath of fresh air, considering that the commodity market has had to defend the existence of such players within its fold. Such a market will surely address the grievances of exporters, software firms, euro market borrowers or anyone else getting into a dollar transaction, since they will be able to use currency futures to safeguard themselves from forex fluctuations. Investors in these instruments can make money while adding both liquidity and vital information (through their actions) to the system.
However, some questions need to be posed here, given the structure of the proposed market. Futures prices are determined by the interaction of the demand for and supply of dollars at a future date. This is similar to the futures price of, say, pepper four months hence. The theoretical price is the point at which demand would balance supply. While future demand may be unknown, the participant needs to guess the supply. Can one guess the FII/FDI inflows or the trade balance or the remittances that are coming in? Unlikely, as this is a complicated game where even econometric models have failed. The other issue is that the likely movement of the futures dollar rate would depend on educated guesses taken on RBI action. The exchange rate, though market determined, is not entirely influenced by the forces of demand and supply because the RBI has to keep in mind the monetary implications. This means one has to track credit expansion as well as inflation numbers.
Two issues come up here. The first—one has to keep guessing when the RBI would intervene, which means reading the mind of the Governor as well as Finance Minister. Any statement made by either of them would give rise to more “reading between the lines” conjectures. Volatility would be particularly high during the four credit policy/review periods. The second is an even more fascinating implication—the RBI, which is the regulator, will actually be deciding which way the exchange rate will move. This highlights an anomaly. In the stock or commodity market, the regulator does not intervene so significantly in any way, except through the normal routes of margin and position limits. But, here, the regulator’s own action would necessarily be moving the market, which, though not wrong, is certainly different. Haven’t we heard all about the sterilisation of capital inflows, or RBI interventions to prevent an appreciation of the rupee? If this is how currency rates are set, how much space do market forces have to operate?
What’s more, the existence of the OTC or forward market would be questioned by the futures market, because all the players in the forward market would also be potential candidates for the futures one, with the added attraction of speculators also playing their role to the utmost. If the two exist, then the price has to converge, or else there would be arbitrage opportunities for those on these exchanges.
For all that, the currency futures market is an exciting opportunity. It was the glaring missing link in India’s financial market. It certainly needs to be developed to provide depth to the sector, and the RBI needs to be commended for this initiative. Also, last but not the least, there will be more jobs for analysts and economists alike.
The second is that these contracts will be for a whole year, and hence market players can choose their tenures for trading. This is unlike the commodity market, where there are generally fewer contracts that are running simultaneously. The third is that the contracts are to be settled in cash, which is again different from commodity Markets where compulsory delivery is the rule. In the currency futures market, this would have been chaotic if dollars had to be delivered because there would be a parallel market for the supply of physical dollars. The RBI has taken this decision ostensibly on the grounds of there being no capital account convertibility.
The fourth is that the RBI has taken on the role of the regulator and also advised the creation of new exchanges. This is pragmatic because it eschews the issues related to having multiple regulators overseeing different activities of the same exchange. Fifth, the settlement price would be announced by the RBI through its spot reference rate on the expiry date, which will do away with the settlement problems faced by the commodity market where no unique and singular price exists and the onus is on the exchange to provide this price. This would lead to an automatic convergence of futures with spot rates on this day. And lastly, the RBI does see a valid role for speculators to play, which comes as a breath of fresh air, considering that the commodity market has had to defend the existence of such players within its fold. Such a market will surely address the grievances of exporters, software firms, euro market borrowers or anyone else getting into a dollar transaction, since they will be able to use currency futures to safeguard themselves from forex fluctuations. Investors in these instruments can make money while adding both liquidity and vital information (through their actions) to the system.
However, some questions need to be posed here, given the structure of the proposed market. Futures prices are determined by the interaction of the demand for and supply of dollars at a future date. This is similar to the futures price of, say, pepper four months hence. The theoretical price is the point at which demand would balance supply. While future demand may be unknown, the participant needs to guess the supply. Can one guess the FII/FDI inflows or the trade balance or the remittances that are coming in? Unlikely, as this is a complicated game where even econometric models have failed. The other issue is that the likely movement of the futures dollar rate would depend on educated guesses taken on RBI action. The exchange rate, though market determined, is not entirely influenced by the forces of demand and supply because the RBI has to keep in mind the monetary implications. This means one has to track credit expansion as well as inflation numbers.
Two issues come up here. The first—one has to keep guessing when the RBI would intervene, which means reading the mind of the Governor as well as Finance Minister. Any statement made by either of them would give rise to more “reading between the lines” conjectures. Volatility would be particularly high during the four credit policy/review periods. The second is an even more fascinating implication—the RBI, which is the regulator, will actually be deciding which way the exchange rate will move. This highlights an anomaly. In the stock or commodity market, the regulator does not intervene so significantly in any way, except through the normal routes of margin and position limits. But, here, the regulator’s own action would necessarily be moving the market, which, though not wrong, is certainly different. Haven’t we heard all about the sterilisation of capital inflows, or RBI interventions to prevent an appreciation of the rupee? If this is how currency rates are set, how much space do market forces have to operate?
What’s more, the existence of the OTC or forward market would be questioned by the futures market, because all the players in the forward market would also be potential candidates for the futures one, with the added attraction of speculators also playing their role to the utmost. If the two exist, then the price has to converge, or else there would be arbitrage opportunities for those on these exchanges.
For all that, the currency futures market is an exciting opportunity. It was the glaring missing link in India’s financial market. It certainly needs to be developed to provide depth to the sector, and the RBI needs to be commended for this initiative. Also, last but not the least, there will be more jobs for analysts and economists alike.
Tuesday, November 20, 2007
US still retains its hold : Business Line 20th November 2007
While the US has seen the emergence of several countervailing forces in the economic field, though not so much by design, it is still dominant in the political arena.
Is the US stronger or weaker today than it was, say, a decade and a half ago, when the Cold War had ended and the communist bloc was disbanded? This is interesting because when the Soviet Union broke up, it was felt that there would be no political countervailing power in the world and the US would tend to have its way.
It was also the largest economy in the world which symbolised economic progress and remained the anchor for the world at large. As a corollary, it was felt that their economic hegemony would also widen. But things have started changing in this century.
The US economy, while still being the largest one with considerable influence, is no longer the driving force in the world economy. The growth of the European Union, which works more like a single nation, competes favourably with the US economy and has the potential to be a growth driver.
The East Asian nations created another such informal group which drove the world economy and even though they did stutter in 1997-98, have recovered to hold their positions. China has emerged as another leader today and provides vital growth stimuli to the rest of the world; while India, Brazil and Russia are, along with China, some of the fastest growing nations. A large part of this growth foundation is coming domestically from these economies, thus insulating them partly from the US growth process. Strong influence over other nations
The US economy, though the forerunner still, is not known for prudent management. The fiscal deficit has been reined in, but the high current account deficit of nearly 7 per cent is almost double the prudential limit of 4 per cent set informally by economists.
The reason is that the country is spending beyond its means and manages to do so as the dollar is the anchor currency today and other surplus nations are willing to invest their surpluses in Fed bonds, thus supporting the deficit.
This brings to the fore the point that the dollar could be losing its glitter and the creation of the euro, which was expected to be a viable substitute for other nations, may just about be emerging as a more-sought-after currency.
Today, some feel that export indenting should be in euros. The fall of the dollar is another reason why the OPEC has been raising the price of crude oil.
Another area where the US exerted considerable influence over other nations was the indirect manner in which it extended its own policies. This was through the twin multilateral lending agencies — the International Monetary Fund (IMF) and the World Bank.
These agencies tended to enforce free-market economics on the assisted nations which was more in line with what the US wanted, though it could be expanded to encompass the western developed nations.
Now both the World Bank and the IMF have become relatively less important and potent with growth in the developing nations, in general, and proliferation of capital flows. Fewer countries have run into balance of payments problems and astute regulators are able to pre-empt such crises or take prompt corrective action.
The global capital flows have made countries less reliant on World Bank assistance, which could be directed more to the poorest of nations. The WTO impasse too has most fingers pointing at the US which has been named as being instrumental in trying to push forth unequal treaties. Maybe a decade ago, the US could have gotten the developing nations to agree to its terms, but the latter have now formed an informal alliance to resist such endeavours.
Also, it has been observed that the virtual monopoly power which was held by American companies, which had shifted partly to Japan and Germany in the 1970s and 1980s, has actually migrated to East Asia and China, which dominate the markets right from electronics and automobiles to minor consumer goods and toys. Clearly, the production centres are getting more diversified than they were earlier which has also contributed significantly to the rising import bill of the US.
The Federal Reserve, which is considered to be the most important monetary authority in the world, plays a dominant role, though individual central banks have ceased to pursue the path laid down by the Fed. Countries have tended to look more at their domestic conditions for formulating their policies and the Fed rate acts as best as a benchmark.
The Fed’s action to lower rates, despite the sub-prime crisis, has not made the Bank of England or the ECB follow suit.The political arena
While the US has seen the emergence of several countervailing forces in the economic field, though not so much by design, it is still dominant in the political arena. All the developed countries such as the UK, Germany and Japan either overtly or covertly have supported the US war on terror.
The developing nations are coming closer to the US in the latter’s crusade in this direction though, more often than not, the US has been placating them with economic incentives.
Russia and China are significant military powers, though they have discretely let the US take the lead in any such intervention. Therefore, invariably the US has taken the stick for its policies with Mr George Bush becoming probably the most disliked President both internally and externally.
The decline of the power of the US in the economic sphere has definitely been very gradual and the investment banks expect Brazil, Russia, India and China to be the future leaders. But the US has still retained its charm for being a true democracy which offers a plethora of opportunities and both Indian students and professionals would still cast their votes for a better life in this country. Therein lies the irony.
Is the US stronger or weaker today than it was, say, a decade and a half ago, when the Cold War had ended and the communist bloc was disbanded? This is interesting because when the Soviet Union broke up, it was felt that there would be no political countervailing power in the world and the US would tend to have its way.
It was also the largest economy in the world which symbolised economic progress and remained the anchor for the world at large. As a corollary, it was felt that their economic hegemony would also widen. But things have started changing in this century.
The US economy, while still being the largest one with considerable influence, is no longer the driving force in the world economy. The growth of the European Union, which works more like a single nation, competes favourably with the US economy and has the potential to be a growth driver.
The East Asian nations created another such informal group which drove the world economy and even though they did stutter in 1997-98, have recovered to hold their positions. China has emerged as another leader today and provides vital growth stimuli to the rest of the world; while India, Brazil and Russia are, along with China, some of the fastest growing nations. A large part of this growth foundation is coming domestically from these economies, thus insulating them partly from the US growth process. Strong influence over other nations
The US economy, though the forerunner still, is not known for prudent management. The fiscal deficit has been reined in, but the high current account deficit of nearly 7 per cent is almost double the prudential limit of 4 per cent set informally by economists.
The reason is that the country is spending beyond its means and manages to do so as the dollar is the anchor currency today and other surplus nations are willing to invest their surpluses in Fed bonds, thus supporting the deficit.
This brings to the fore the point that the dollar could be losing its glitter and the creation of the euro, which was expected to be a viable substitute for other nations, may just about be emerging as a more-sought-after currency.
Today, some feel that export indenting should be in euros. The fall of the dollar is another reason why the OPEC has been raising the price of crude oil.
Another area where the US exerted considerable influence over other nations was the indirect manner in which it extended its own policies. This was through the twin multilateral lending agencies — the International Monetary Fund (IMF) and the World Bank.
These agencies tended to enforce free-market economics on the assisted nations which was more in line with what the US wanted, though it could be expanded to encompass the western developed nations.
Now both the World Bank and the IMF have become relatively less important and potent with growth in the developing nations, in general, and proliferation of capital flows. Fewer countries have run into balance of payments problems and astute regulators are able to pre-empt such crises or take prompt corrective action.
The global capital flows have made countries less reliant on World Bank assistance, which could be directed more to the poorest of nations. The WTO impasse too has most fingers pointing at the US which has been named as being instrumental in trying to push forth unequal treaties. Maybe a decade ago, the US could have gotten the developing nations to agree to its terms, but the latter have now formed an informal alliance to resist such endeavours.
Also, it has been observed that the virtual monopoly power which was held by American companies, which had shifted partly to Japan and Germany in the 1970s and 1980s, has actually migrated to East Asia and China, which dominate the markets right from electronics and automobiles to minor consumer goods and toys. Clearly, the production centres are getting more diversified than they were earlier which has also contributed significantly to the rising import bill of the US.
The Federal Reserve, which is considered to be the most important monetary authority in the world, plays a dominant role, though individual central banks have ceased to pursue the path laid down by the Fed. Countries have tended to look more at their domestic conditions for formulating their policies and the Fed rate acts as best as a benchmark.
The Fed’s action to lower rates, despite the sub-prime crisis, has not made the Bank of England or the ECB follow suit.The political arena
While the US has seen the emergence of several countervailing forces in the economic field, though not so much by design, it is still dominant in the political arena. All the developed countries such as the UK, Germany and Japan either overtly or covertly have supported the US war on terror.
The developing nations are coming closer to the US in the latter’s crusade in this direction though, more often than not, the US has been placating them with economic incentives.
Russia and China are significant military powers, though they have discretely let the US take the lead in any such intervention. Therefore, invariably the US has taken the stick for its policies with Mr George Bush becoming probably the most disliked President both internally and externally.
The decline of the power of the US in the economic sphere has definitely been very gradual and the investment banks expect Brazil, Russia, India and China to be the future leaders. But the US has still retained its charm for being a true democracy which offers a plethora of opportunities and both Indian students and professionals would still cast their votes for a better life in this country. Therein lies the irony.
Sunday, November 18, 2007
The future of futures markets: Business Standard: 18th November 2007
Thanks to the ban on four commodities, trading volumes are down to a trickle.
A pertinent question to ask today is whether or not the commodity futures business is viable under the present circumstances? This issue is quite compelling, given that trading volumes are stagnant at not more than an average of Rs 15,000 crore a day, which is a far cry from the equity segment, where volumes are around Rs 100,000 crore a day. Historically and globally, commodities trade a multiple of that of equities (commodities include financial derivatives too on global exchanges); therefore this question.
Futures trading was revived with much fanfare, and the expected happened. The long repressed market exploded with significant trading taking place in most commodities. This is a necessary prerequisite for robust price discovery and it did not matter who traded as long as the rules were obeyed and orderly, which the system ensured. But, then suddenly, somewhere along the way, it was felt that futures trading was responsible for inflation, and while the experts have been quoted as saying that this is ‘utter nonsense’, the ban on futures trading in four commodities pushed the market on to the back foot. Needless to say, there are signs that trading may have shifted to the informal market.
In fact, one of the main motivations for reviving these markets was to provide a hedge for farmers, and today, agri-trading volumes have diminished to less than 20 per cent of total traded volumes. This happened just at the time when liquidity was building up and prices were mirroring quite accurately the supply-demand conditions. Instead, it is the non-agri commodities which dominate the trading terminals, even though this is also stagnant at a higher level. However, it must be remembered that price discovery here is strictly not determined in the domestic market as they are images of international contracts and developments. The domestic price of gold or copper or crude is an image of that on, say, the NYMEX or LME. Does this mean that the core business faces the threat of stagnation, if not gradual disappearance?
This is important because, while the market has become risk averse and appears to be satiated with the current level of volumes, there is need to develop the markets. It must be remembered that presently we have only one instrument called futures with only retail participation, as institutions such as mutual funds and FIIs are out of this ambit. While there are some large-scale hedge positions in certain commodities, it is the trading community which had basically provided liquidity. Quite clearly, there is need to use this opportunity to widen the canvas to grow the market.
An issue which has been raised amid all the controversy is whether farmers are participating in the market. The answer is an honest ‘no’, because there are several hindrances in terms of accessibility and minimum lot size as farmers may not be in a position to bring an economic size lot to the exchange for delivery. Farmers can trade if there are convenient lot sizes and they cannot be offered unless there is enough liquidity — the classic chicken and egg problem. While the exchanges can offer 1 tonne contracts and 10 tonne contracts, from a buyer’s perspective, the 1 tonne contract is not economical as it would entail higher costs. So, the willing seller may not find a buyer. Therefore, liquidity would be missing and the price discovery process would be retarded.
There is need for two entities to step in quickly. The first is the consolidator who can represent the farmers on the exchanges who consolidates the produce of, say, 10 farmers and puts in the contract. The other is to have market makers who would actually offer buy and sell quotes so that liquidity is generated and the two processes buttress one another. The regulatory processes need to be addressed with urgency to put the market back on track.
The other major concern here is that we do not see too many corporates participating in the markets. These entities have the ability to provide large doses of liquidity to the contracts as they deal in large numbers and also are interested in the physical aspects of the goods. Presently, most of them work on forward contracts where the product prices and terms of sale are decided beforehand. They need to be brought onto these platforms through a round of awareness so that they are able to hedge and trade. On the regulatory front, the hedge limits to be offered could be reconsidered because they need to be looked as not just hedgers, but also some kind of market-makers with an interest in physicals.
The present punctuation in the growth of the commodity trading business should be used to rediscover the strengths of this market. Hopefully, the expert committee set up to analyse the relationship between inflation and futures trading will exculpate the market, and restore confidence in futures trading of commodities. It also must be mentioned that all agri-commodities have faced similar problems on other exchanges like CBOT and CME in the past and with time being the great healer, as Shakespeare had said, equilibrium will be established along the way.
What are needed are suitable amendments in regulatory structures in four areas. Firstly, FCRA needs to be amended to bring in options and recognise intangibles as commodities. Secondly, the concept of consolidator needs to be implemented so as to bring in the farmers. Thirdly, market-makers need to be brought in to revive the markets. Lastly, institutional players like mutual funds and FIIs must be allowed to participate with well defined frontiers to add liquidity. Awareness amongst end users such as corporates must run alongside to add weight to these efforts. Or else, interest would dwindle further given that the capital market is spiralling upwards quite relentlessly.
A pertinent question to ask today is whether or not the commodity futures business is viable under the present circumstances? This issue is quite compelling, given that trading volumes are stagnant at not more than an average of Rs 15,000 crore a day, which is a far cry from the equity segment, where volumes are around Rs 100,000 crore a day. Historically and globally, commodities trade a multiple of that of equities (commodities include financial derivatives too on global exchanges); therefore this question.
Futures trading was revived with much fanfare, and the expected happened. The long repressed market exploded with significant trading taking place in most commodities. This is a necessary prerequisite for robust price discovery and it did not matter who traded as long as the rules were obeyed and orderly, which the system ensured. But, then suddenly, somewhere along the way, it was felt that futures trading was responsible for inflation, and while the experts have been quoted as saying that this is ‘utter nonsense’, the ban on futures trading in four commodities pushed the market on to the back foot. Needless to say, there are signs that trading may have shifted to the informal market.
In fact, one of the main motivations for reviving these markets was to provide a hedge for farmers, and today, agri-trading volumes have diminished to less than 20 per cent of total traded volumes. This happened just at the time when liquidity was building up and prices were mirroring quite accurately the supply-demand conditions. Instead, it is the non-agri commodities which dominate the trading terminals, even though this is also stagnant at a higher level. However, it must be remembered that price discovery here is strictly not determined in the domestic market as they are images of international contracts and developments. The domestic price of gold or copper or crude is an image of that on, say, the NYMEX or LME. Does this mean that the core business faces the threat of stagnation, if not gradual disappearance?
This is important because, while the market has become risk averse and appears to be satiated with the current level of volumes, there is need to develop the markets. It must be remembered that presently we have only one instrument called futures with only retail participation, as institutions such as mutual funds and FIIs are out of this ambit. While there are some large-scale hedge positions in certain commodities, it is the trading community which had basically provided liquidity. Quite clearly, there is need to use this opportunity to widen the canvas to grow the market.
An issue which has been raised amid all the controversy is whether farmers are participating in the market. The answer is an honest ‘no’, because there are several hindrances in terms of accessibility and minimum lot size as farmers may not be in a position to bring an economic size lot to the exchange for delivery. Farmers can trade if there are convenient lot sizes and they cannot be offered unless there is enough liquidity — the classic chicken and egg problem. While the exchanges can offer 1 tonne contracts and 10 tonne contracts, from a buyer’s perspective, the 1 tonne contract is not economical as it would entail higher costs. So, the willing seller may not find a buyer. Therefore, liquidity would be missing and the price discovery process would be retarded.
There is need for two entities to step in quickly. The first is the consolidator who can represent the farmers on the exchanges who consolidates the produce of, say, 10 farmers and puts in the contract. The other is to have market makers who would actually offer buy and sell quotes so that liquidity is generated and the two processes buttress one another. The regulatory processes need to be addressed with urgency to put the market back on track.
The other major concern here is that we do not see too many corporates participating in the markets. These entities have the ability to provide large doses of liquidity to the contracts as they deal in large numbers and also are interested in the physical aspects of the goods. Presently, most of them work on forward contracts where the product prices and terms of sale are decided beforehand. They need to be brought onto these platforms through a round of awareness so that they are able to hedge and trade. On the regulatory front, the hedge limits to be offered could be reconsidered because they need to be looked as not just hedgers, but also some kind of market-makers with an interest in physicals.
The present punctuation in the growth of the commodity trading business should be used to rediscover the strengths of this market. Hopefully, the expert committee set up to analyse the relationship between inflation and futures trading will exculpate the market, and restore confidence in futures trading of commodities. It also must be mentioned that all agri-commodities have faced similar problems on other exchanges like CBOT and CME in the past and with time being the great healer, as Shakespeare had said, equilibrium will be established along the way.
What are needed are suitable amendments in regulatory structures in four areas. Firstly, FCRA needs to be amended to bring in options and recognise intangibles as commodities. Secondly, the concept of consolidator needs to be implemented so as to bring in the farmers. Thirdly, market-makers need to be brought in to revive the markets. Lastly, institutional players like mutual funds and FIIs must be allowed to participate with well defined frontiers to add liquidity. Awareness amongst end users such as corporates must run alongside to add weight to these efforts. Or else, interest would dwindle further given that the capital market is spiralling upwards quite relentlessly.
Friday, November 2, 2007
Banks bear the brunt: November 1st 2007, Financial Express
The increase in CRR by the RBI should be examined a little more closely. The RBI’s action in itself is quite straightforward. It wants to control the growth in money supply, and the CRR is a powerful tool as it directly affects the quantity of funds that can be lent. This is the central bank’s way of mopping up excess liquidity from the system and there can really be no quarrel here.
However, the affected parties are the banks that have to bear the cost of the action. The present hike, which is on the entire quantity of deposits, would mean an outflow of around Rs 15,000 crore from the banking system, which means two things for banks. The first is that they would not be able to lend these funds to industry (using this term for the entire set of borrowers), and will also not earn any interest on them. Hence, it is a case of double jeopardy for them, as they lose straight away an earning capacity of, say, 12% on this sum which on an annualised basis is Rs 1,800 crore. Also, the fact that it will have less resources to lend will lead to some kind of rationing of credit under ceteris paribus conditions.
This means that banks could face a cash crunch, given that the surplus funds they were sitting on were estimated at around Rs 20,000 crore—money that was being invested in daily repos. It is this surplus that would now be absorbed at one stroke. In such an event, what happens to the demand for credit—which seems to be growing? Growth in credit during the financial year has been rising quite steadily from 0.5% up to mid-August to 2.8% in mid-Sept to 4.7% in mid-October. The numbers are certainly moderate compared with last year, which has given the illusion that growth is relatively slack. But even so, that is not the end of the story.
The fact is that we are now in the so-called busy season, when growth tends to accelerate. Also, the RBI has acknowledged that GDP growth is going to be steady, and this should indicate that demand for credit will rise over the next few months. We need to ask ourselves what, then, would happen to overall industrial growth—because if banks do not have funds, they will have to increase rates, which will have a negative impact on industrial growth. Admittedly, this is a worst-case scenario being painted here, but nonetheless cannot be ruled out.
There are always countervailing forces, such as rising deposits as well as capital inflows, that can continue to provide liquidity, which is what the RBI had in view when it increased the CRR. But, then weren’t capital inflows the main problem to begin with? If capital flows continue to surge, a stronger possibility with the US Federal Reserve’s rate cut, then liquidity should not be a problem, and on hindsight we may say that the RBI showed good foresight here. But, the same problem would be encountered yet again, which will call for another such move. Remember, we had actually spoken of moving the CRR back to the 2-3% levels but have now gone back to the 2001 level.
So, it is generally agreed that the main motivation here has been capital inflows and possible implications of the Economy overheating. Inflation has been benign, even though the RBI has warned of latent inflation, given the movement in commodity prices, and hence has stuck to its 5% target. All central banks are forward-looking and it is but natural that the RBI has been watching these trends for purposes of extrapolation over the coming months. This means that we need to enquire whether or not there are better ways of tackling these inflows, given that nothing seems to be staunching them. The curbs on ECBs, liberalisation of outflows or the recent panic caused on the PNs front have all failed to deter their velocity.
The RBI has been running out of government paper and the hiking of the MSS limits has not really helped either in conducting open market operations. The most direct way to influence the overall supply of money was to directly impound the resources with banks. But, this move shifts the onus onto banks, which are now worse off, instead of using open market operations—by which at least their sucked-out funds earned around 7-8% per annum. This move therefore appears to injure the profits of banks, which are already under some pressure to meet the new prudential norms set by the RBI and Basel II standards.
There are thus two distinct outcomes of the CRR hike. The first is that the banks will bear the brunt of this move, and will feel constrained. We have not sorted out the problem of copious capital inflows, and have merely shifted part of it from the external sector to the banking sector. Also, we are ironically implicitly assuming that capital inflows would continue to surge to ensure that there is no possibility of a liquidity crunch instead.
This raises an ideological issue of whether or not a major adjustment for an external problem has to be borne internally—especially so since there are alternatives.
However, the affected parties are the banks that have to bear the cost of the action. The present hike, which is on the entire quantity of deposits, would mean an outflow of around Rs 15,000 crore from the banking system, which means two things for banks. The first is that they would not be able to lend these funds to industry (using this term for the entire set of borrowers), and will also not earn any interest on them. Hence, it is a case of double jeopardy for them, as they lose straight away an earning capacity of, say, 12% on this sum which on an annualised basis is Rs 1,800 crore. Also, the fact that it will have less resources to lend will lead to some kind of rationing of credit under ceteris paribus conditions.
This means that banks could face a cash crunch, given that the surplus funds they were sitting on were estimated at around Rs 20,000 crore—money that was being invested in daily repos. It is this surplus that would now be absorbed at one stroke. In such an event, what happens to the demand for credit—which seems to be growing? Growth in credit during the financial year has been rising quite steadily from 0.5% up to mid-August to 2.8% in mid-Sept to 4.7% in mid-October. The numbers are certainly moderate compared with last year, which has given the illusion that growth is relatively slack. But even so, that is not the end of the story.
The fact is that we are now in the so-called busy season, when growth tends to accelerate. Also, the RBI has acknowledged that GDP growth is going to be steady, and this should indicate that demand for credit will rise over the next few months. We need to ask ourselves what, then, would happen to overall industrial growth—because if banks do not have funds, they will have to increase rates, which will have a negative impact on industrial growth. Admittedly, this is a worst-case scenario being painted here, but nonetheless cannot be ruled out.
There are always countervailing forces, such as rising deposits as well as capital inflows, that can continue to provide liquidity, which is what the RBI had in view when it increased the CRR. But, then weren’t capital inflows the main problem to begin with? If capital flows continue to surge, a stronger possibility with the US Federal Reserve’s rate cut, then liquidity should not be a problem, and on hindsight we may say that the RBI showed good foresight here. But, the same problem would be encountered yet again, which will call for another such move. Remember, we had actually spoken of moving the CRR back to the 2-3% levels but have now gone back to the 2001 level.
So, it is generally agreed that the main motivation here has been capital inflows and possible implications of the Economy overheating. Inflation has been benign, even though the RBI has warned of latent inflation, given the movement in commodity prices, and hence has stuck to its 5% target. All central banks are forward-looking and it is but natural that the RBI has been watching these trends for purposes of extrapolation over the coming months. This means that we need to enquire whether or not there are better ways of tackling these inflows, given that nothing seems to be staunching them. The curbs on ECBs, liberalisation of outflows or the recent panic caused on the PNs front have all failed to deter their velocity.
The RBI has been running out of government paper and the hiking of the MSS limits has not really helped either in conducting open market operations. The most direct way to influence the overall supply of money was to directly impound the resources with banks. But, this move shifts the onus onto banks, which are now worse off, instead of using open market operations—by which at least their sucked-out funds earned around 7-8% per annum. This move therefore appears to injure the profits of banks, which are already under some pressure to meet the new prudential norms set by the RBI and Basel II standards.
There are thus two distinct outcomes of the CRR hike. The first is that the banks will bear the brunt of this move, and will feel constrained. We have not sorted out the problem of copious capital inflows, and have merely shifted part of it from the external sector to the banking sector. Also, we are ironically implicitly assuming that capital inflows would continue to surge to ensure that there is no possibility of a liquidity crunch instead.
This raises an ideological issue of whether or not a major adjustment for an external problem has to be borne internally—especially so since there are alternatives.
Monday, October 29, 2007
Money for nothing? DNA, 30th Ocotber 2007
The Sixth Pay Commission will raise government salaries. What about cutting the flab?
The Prime Minister was critical of the pay packages of corporate honchos some time ago and a debate on the subject was ignited. Now there is news that the Sixth Pay Commission has something to say about pay structures in the government sector, with the thrust being unidirectional. Quite naturally there is umbrage, given the mindset about the functioning of the public sector.
The main objective of a Pay Commission, broadly defined, is to revise the pay structure of government employees with every decade; and the justification, among other factors, is to establish some kind of parity with the private sector. The impact of the past Pay Commissions has been manifold — they have reduced the incentive for the better candidates interested in joining the bureaucracy, made lower level government staff far better paid than their private sector counterparts, with no accountability, and put the central and state government finances in jeopardy.
The Fifth Pay Commission, which was implemented in 1997, recommended an increase in the total benefits for central government employees, which automatically translates into higher packages for state-level employees. When salaries go up across the board, the first victim is the fiscal deficit, as expenditure goes up with no corresponding increase in revenue.
In the private sector, pay hikes are related to profit and performance, but when it comes to the government — since there are no profits and the performance system is cloudy — there is no way to quantify the net gain.
To reduce this burden, the Fifth Commission had sought to reduce the total size of the bureaucracy by 30 per cent over a ten-year period and to abolish all unfilled positions, numbering about 350,000, in 1996.Downsizing, computerisation and transfers were spoken of. However, as expected, while the pay increases were instantaneous, the job cuts did not materialise. The Commission recommended contractual assignments; this was implemented only for retired personnel, while regular employees continued to retain their tenures.
The Fifth Pay Commission involved an additional outlay of Rs53,000 crore to the government and was termed by the World Bank as the ‘largest single economic shock’ for India.
In fact, in 2000, 13 states did not have the money to disburse the salaries of their employees!
The Sixth Pay Commission will cover around 4.5 million central government employees involving an expected additional outlay of Rs20,000 crore for the government.
But should there be an enforceable obligations charter for such recommendations? The central government per se does not make profits and so it remains a debit item.
But enhancing efficiency can reduce the overall cost structure that should be linked to these pay hikes.
In the private sector there is a pay-performance payoff, which needs to be put in place in government functioning, too.
The issue that arises is how obligations can be met, along with pay increases in government jobs.
Instead of getting into the micro numbers for various components of the salary, the Commission should have been more innovative in devising the obligation scales.
Ideally, the higher salary hike allocation for every department should have been linked with the number of staff to be laid off or redeployed.
In addition, the performance-linked pay should have been defined at each and every level for various departments.
Also, a definite plan for dealing with non-officials is essential, since the ratio of officers to clerks/peons/hamals could go up to 1:5.
It is agreed today that at the higher level, officials are paid less for the work they do, while at the lower level, where the flab lies, it is the other way around.
Instead of making these amendments, there are fears that the Sixth Commission will very likely do what the Fifth Commission did, later pleading helplessness at being able to implement only part of the package.
To conclude, it is worth recalling John Maynard Keynes, who at the time of the Great Depression had espoused higher government expenditure even on worthless jobs like digging up holes to fill them up to raise demand in the country by offering money to spend.
Pay Commissions’ largesse has often turned out to mimic such policies, where people are paid more for moving files or tea cups. Ironically, a larger government administration also gets reflected in the GDP of the country under the service sector and provides valuable purchasing power to people.
How does this sound as the ultimate clinching argument?
The Prime Minister was critical of the pay packages of corporate honchos some time ago and a debate on the subject was ignited. Now there is news that the Sixth Pay Commission has something to say about pay structures in the government sector, with the thrust being unidirectional. Quite naturally there is umbrage, given the mindset about the functioning of the public sector.
The main objective of a Pay Commission, broadly defined, is to revise the pay structure of government employees with every decade; and the justification, among other factors, is to establish some kind of parity with the private sector. The impact of the past Pay Commissions has been manifold — they have reduced the incentive for the better candidates interested in joining the bureaucracy, made lower level government staff far better paid than their private sector counterparts, with no accountability, and put the central and state government finances in jeopardy.
The Fifth Pay Commission, which was implemented in 1997, recommended an increase in the total benefits for central government employees, which automatically translates into higher packages for state-level employees. When salaries go up across the board, the first victim is the fiscal deficit, as expenditure goes up with no corresponding increase in revenue.
In the private sector, pay hikes are related to profit and performance, but when it comes to the government — since there are no profits and the performance system is cloudy — there is no way to quantify the net gain.
To reduce this burden, the Fifth Commission had sought to reduce the total size of the bureaucracy by 30 per cent over a ten-year period and to abolish all unfilled positions, numbering about 350,000, in 1996.Downsizing, computerisation and transfers were spoken of. However, as expected, while the pay increases were instantaneous, the job cuts did not materialise. The Commission recommended contractual assignments; this was implemented only for retired personnel, while regular employees continued to retain their tenures.
The Fifth Pay Commission involved an additional outlay of Rs53,000 crore to the government and was termed by the World Bank as the ‘largest single economic shock’ for India.
In fact, in 2000, 13 states did not have the money to disburse the salaries of their employees!
The Sixth Pay Commission will cover around 4.5 million central government employees involving an expected additional outlay of Rs20,000 crore for the government.
But should there be an enforceable obligations charter for such recommendations? The central government per se does not make profits and so it remains a debit item.
But enhancing efficiency can reduce the overall cost structure that should be linked to these pay hikes.
In the private sector there is a pay-performance payoff, which needs to be put in place in government functioning, too.
The issue that arises is how obligations can be met, along with pay increases in government jobs.
Instead of getting into the micro numbers for various components of the salary, the Commission should have been more innovative in devising the obligation scales.
Ideally, the higher salary hike allocation for every department should have been linked with the number of staff to be laid off or redeployed.
In addition, the performance-linked pay should have been defined at each and every level for various departments.
Also, a definite plan for dealing with non-officials is essential, since the ratio of officers to clerks/peons/hamals could go up to 1:5.
It is agreed today that at the higher level, officials are paid less for the work they do, while at the lower level, where the flab lies, it is the other way around.
Instead of making these amendments, there are fears that the Sixth Commission will very likely do what the Fifth Commission did, later pleading helplessness at being able to implement only part of the package.
To conclude, it is worth recalling John Maynard Keynes, who at the time of the Great Depression had espoused higher government expenditure even on worthless jobs like digging up holes to fill them up to raise demand in the country by offering money to spend.
Pay Commissions’ largesse has often turned out to mimic such policies, where people are paid more for moving files or tea cups. Ironically, a larger government administration also gets reflected in the GDP of the country under the service sector and provides valuable purchasing power to people.
How does this sound as the ultimate clinching argument?
Sunday, October 21, 2007
Objective View of Capital Controls: Financial Express: 22nd October 2007
Indians as a rule are crazy about cricket, but this is overshadowed by our obsession with the stock market. Understandably so, as several interest groups—the salaried class, politicians, investment banks, mutual funds, banks, brokers, bureaucrats, the media (some TV channels survive on stock markets)—have investments in this market and would like to see the Sensex move upward without a correction.
This helps everybody, as money being invested keeps multiplying while changing hands. It is but natural that investors have taken umbrage to the move by the Securities & Exchange Board of India (Sebi) to control funds coming into the country through participatory notes (PNs). Even the finance minister had to placate markets the following day (though there was no need to do so) and clarify that the government was not against the concept of PNs, who have a very important role to play.
The decision to come down on PNs is probably controversial, but it will help the government control two nagging problems that have been quite elusive. The first relates to controlling the quality of funds coming in, while the second is exercising control over capital inflows, which have created innumerable problems for the Reserve Bank of India (RBI). By accomplishing these two objectives, the government would have also managed to control the proverbial bubble, which we all know is going to burst, though we never know when. PNs are basically investments used by foreigners not registered in India. They operate through foreign institutional investors (FIIs), who are registered with Sebi. FIIs buy Indian shares and issue PNs, which are purchased by entities whose names remain unknown. It is also suspected that Indians themselves could be making such investments to eschew identity as well as find a tax shelter. Also, a lot of laundered money could come in and RBI has always been critical about such money.
But investors don’t like such announcements, even though it seems quite logical to have some discipline in these operations. While the legitimacy of these funds has not come up this time, the government fears that these funds are looking for short-term gains (and could destabilise the markets when they withdraw) and hence provide some kind of irrational boost to share prices.
In fact, the Sensex has risen by over 35% in the last two months, ostensibly due to a large flow of FII funds, with PNs contributing significantly. If this were true, then any responsible regulator would take pre-emptive action lest it be caught napping when things go awry. This should be remembered by critics, who always feel markets should be allowed to work freely—they are never perfect to be allowed this luxury.
What exactly did Sebi do? Firstly, it issued a discussion paper seeking to ban any issue of PNs of FIIs against underlying derivatives, ie, futures and options, while restricting the issue of PNs in the cash segment. This has quite naturally hit the market hard as it has been interpreted as being regressive. The notional value of PNs is around 52% of the FIIs’ account assets. Excluding underlying derivatives, the share was 35%.
Is this a good move? Probably not for the market or FIIs, as they are directly affected by these measures. The stock market fell by over 330 points by the end of the first day, echoing this sentiment after recovering from a fall of over 1,700 points (that means a major erosion of market capitalisation!). But if one looks at this dispassionately, one will realise that there was inherently nothing amiss in the thought process. Funds of a short-term nature tend to be destabilising and given that the ascent witnessed in this market in the last month was due to these funds, it is natural to be concerned.
The other issue, which the finance minister claims to be the more important one, is even more interesting and relates to trying to stem the flow of capital. This comes on top of the curbs placed by RBI not a long time ago on the external commercial borrowing channel of finance. However, the major source of these forex flows into the country in the last year was on account of foreign direct investment rather than portfolio investment.
To the extent that PN investment would come down by these announcements, there would definitely be some clamp down on such inflows. This move, hence, brings to the forefront an interesting theme being tested by the government relating to capital controls. One is not too sure if capital controls are a solution, or even part of the solution, but given that liberalising capital outflows has not helped, the imposition of controls could be worth a try.
Coincidentally and ironically, just one day after this explanation was given, the International Monetary Fund placed on its website its latest World Economic Outlook, which says global experience reveals that capital controls do not really work. If this is the case, then placing curbs on both the ECB and PN routes may not really serve the purpose, though RBI can always say that it cannot be blamed for not trying.
This helps everybody, as money being invested keeps multiplying while changing hands. It is but natural that investors have taken umbrage to the move by the Securities & Exchange Board of India (Sebi) to control funds coming into the country through participatory notes (PNs). Even the finance minister had to placate markets the following day (though there was no need to do so) and clarify that the government was not against the concept of PNs, who have a very important role to play.
The decision to come down on PNs is probably controversial, but it will help the government control two nagging problems that have been quite elusive. The first relates to controlling the quality of funds coming in, while the second is exercising control over capital inflows, which have created innumerable problems for the Reserve Bank of India (RBI). By accomplishing these two objectives, the government would have also managed to control the proverbial bubble, which we all know is going to burst, though we never know when. PNs are basically investments used by foreigners not registered in India. They operate through foreign institutional investors (FIIs), who are registered with Sebi. FIIs buy Indian shares and issue PNs, which are purchased by entities whose names remain unknown. It is also suspected that Indians themselves could be making such investments to eschew identity as well as find a tax shelter. Also, a lot of laundered money could come in and RBI has always been critical about such money.
But investors don’t like such announcements, even though it seems quite logical to have some discipline in these operations. While the legitimacy of these funds has not come up this time, the government fears that these funds are looking for short-term gains (and could destabilise the markets when they withdraw) and hence provide some kind of irrational boost to share prices.
In fact, the Sensex has risen by over 35% in the last two months, ostensibly due to a large flow of FII funds, with PNs contributing significantly. If this were true, then any responsible regulator would take pre-emptive action lest it be caught napping when things go awry. This should be remembered by critics, who always feel markets should be allowed to work freely—they are never perfect to be allowed this luxury.
What exactly did Sebi do? Firstly, it issued a discussion paper seeking to ban any issue of PNs of FIIs against underlying derivatives, ie, futures and options, while restricting the issue of PNs in the cash segment. This has quite naturally hit the market hard as it has been interpreted as being regressive. The notional value of PNs is around 52% of the FIIs’ account assets. Excluding underlying derivatives, the share was 35%.
Is this a good move? Probably not for the market or FIIs, as they are directly affected by these measures. The stock market fell by over 330 points by the end of the first day, echoing this sentiment after recovering from a fall of over 1,700 points (that means a major erosion of market capitalisation!). But if one looks at this dispassionately, one will realise that there was inherently nothing amiss in the thought process. Funds of a short-term nature tend to be destabilising and given that the ascent witnessed in this market in the last month was due to these funds, it is natural to be concerned.
The other issue, which the finance minister claims to be the more important one, is even more interesting and relates to trying to stem the flow of capital. This comes on top of the curbs placed by RBI not a long time ago on the external commercial borrowing channel of finance. However, the major source of these forex flows into the country in the last year was on account of foreign direct investment rather than portfolio investment.
To the extent that PN investment would come down by these announcements, there would definitely be some clamp down on such inflows. This move, hence, brings to the forefront an interesting theme being tested by the government relating to capital controls. One is not too sure if capital controls are a solution, or even part of the solution, but given that liberalising capital outflows has not helped, the imposition of controls could be worth a try.
Coincidentally and ironically, just one day after this explanation was given, the International Monetary Fund placed on its website its latest World Economic Outlook, which says global experience reveals that capital controls do not really work. If this is the case, then placing curbs on both the ECB and PN routes may not really serve the purpose, though RBI can always say that it cannot be blamed for not trying.
Wednesday, October 17, 2007
The New Moral Hazard, DNA, September 2007
The phrase moral hazard is back in vogue today. Moral hazard in the financial sector is a situation where a deviant institution continues to take risky decisions knowing fully well that it will be helped out by the system in case of failure. Hence, banks can give into indiscretion in case they know that the cost of failure will finally be sorted out by the central bank. Now, the actions of monetary authorities across the world to tackle the sub-prime crisis have actually created this moral hazard. Let us see how this has happened.
The sub-prime crisis was a case where mortgage banks lent to home buyers with limited credit credentials at low rates and then sold them forward for securitization against which securities were issued to investors. As interest rates went up, the threat of default increased. Hedge funds were asked to put forth more money and when they tried to sell the mortgage backed securities their value had fallen. As no one knew where the risk lay and banks were reluctant to lend to one another and the funds dealing with these securities went bus. The Fed and the ECB started providing funds in the market to ensure that liquidity ws available which sent the signal that the monetary authority was willing to intervene to eschew a crisis.
The critics felt that this kind of intervention creates a moral hazard as institutions will use this as a precedent to be more reckless in future knowing that they will not be punished and a solution will be forthcoming from the Fed or ECB. To top it all the discount rate at which the Fed lends money directly to banks was also lowered which prompted all the big ones like Citi, Wachovia, JP Morgan Chase and Bank of America to borrow. And recently the Fed rate has been hiked on grounds of preventing the possibility of a recession in future and is not directly related to bailing out any institution.
Come over to UK now, and the Bank of England has done a similar act of protecting the Northern Rock Bank which though a mortgage bank had a different sort of problem. Its assets were secure but its funding channel got choked as it depended on the capital market and the commercial paper market for funds. This created a stir which got reflected in its stock value and was followed by deposit holders queuing up for their money. The BOE then entered to rescue the bank by not only providing insurance for the deposits but also providing funds against the security of the mortgages which were held.
Two questions arise here. Should these institutions be bailed out and the second is whether the central banks are justified in helping them out? The answer is equivocal here. If financial entities go overboard then it is not unlike a manufacturing concern which makes huge losses has no recourse. Hence for a bad business decision the consequences must be the same.
However, there are two points here. The first is that banks deal with public money and hence cannot be allowed to fail. Secondly, the fear of a contagion arises once one bank is allowed to fail. Therefore, the answer to the question posed earlier about whether the central bank should help out, the answer is yes. The central bank cannot stand by and let the crisis spread. If that is so, is there any way out? Here the Indian case needs to be put in the right perspective.
The Indian banking system is well governed with rules being placed on the lending pattern of banks. Lending to risky ventures like capital markets, commodities and real estate are ‘sensitive sectors’ and is not widely encouraged and is monitored closely. As over three quarters of the banking system is in the public sector, it helps to enforce this discipline.
We have however, had our own share of banking crisis, which have never really escalated to any kind of a contagion. Global Trust Bank had failed following the Ketan Parekh scam but the RBI found a way out through a merger with a public sector bank, Oriental Bank of Commerce. IFCI has been bailed out through financial infusion and subsequent equity sale. The lesser known Benaras State Bank was amalgamated with Bank of Baroda which in turn protected the deposit holders. But, yes, in case of the Ketan Parikh related Madhavpura Bank, the RBI did resort to provide finance to cooperative banks for short tenures to ensure that banking activities were not affected. But earlier following the Harshad Mehta scam in the mid-nineties, both Bank of Karad and Metropolitan Banks were liquidated.
Therefore, the RBI has also changed it approach to bank failures from a strict liquidation regimen just as we embarked on reforms to a more practical merger policy to one of accommodation depending on the circumstances.
An issue which comes to the forefront now is whether the sub-prime crisis could be repeated in India. We do not have such lending but given the large increase in the share of mortgages in the bank portfolio, there is a similarity. Also the fact that this portfolio has been built at a time when interest rates were low and are being re-priced today with higher interest rate regimes does highlight a payment problem for borrowers. Protracted repayment schedules and higher interest costs could affect the ability of borrowers to repay, which was the same with the sub-prime episode. But, the difference that can be seen today is that property prices are still high, which will prevent the value of the collateral from declining which was the case in USA.
The answer hence is quite clear. To begin with whenever public money is involved, the governance needs to be strong. Once in place, a failure should be protected to restore confidence of the public as well as safeguard their interests. But, this should hold only when public funds in deposits are involved, and not investors putting their money in hedge funds where the risks are known beforehand. There is hence need to distinguish between the two.
The sub-prime crisis was a case where mortgage banks lent to home buyers with limited credit credentials at low rates and then sold them forward for securitization against which securities were issued to investors. As interest rates went up, the threat of default increased. Hedge funds were asked to put forth more money and when they tried to sell the mortgage backed securities their value had fallen. As no one knew where the risk lay and banks were reluctant to lend to one another and the funds dealing with these securities went bus. The Fed and the ECB started providing funds in the market to ensure that liquidity ws available which sent the signal that the monetary authority was willing to intervene to eschew a crisis.
The critics felt that this kind of intervention creates a moral hazard as institutions will use this as a precedent to be more reckless in future knowing that they will not be punished and a solution will be forthcoming from the Fed or ECB. To top it all the discount rate at which the Fed lends money directly to banks was also lowered which prompted all the big ones like Citi, Wachovia, JP Morgan Chase and Bank of America to borrow. And recently the Fed rate has been hiked on grounds of preventing the possibility of a recession in future and is not directly related to bailing out any institution.
Come over to UK now, and the Bank of England has done a similar act of protecting the Northern Rock Bank which though a mortgage bank had a different sort of problem. Its assets were secure but its funding channel got choked as it depended on the capital market and the commercial paper market for funds. This created a stir which got reflected in its stock value and was followed by deposit holders queuing up for their money. The BOE then entered to rescue the bank by not only providing insurance for the deposits but also providing funds against the security of the mortgages which were held.
Two questions arise here. Should these institutions be bailed out and the second is whether the central banks are justified in helping them out? The answer is equivocal here. If financial entities go overboard then it is not unlike a manufacturing concern which makes huge losses has no recourse. Hence for a bad business decision the consequences must be the same.
However, there are two points here. The first is that banks deal with public money and hence cannot be allowed to fail. Secondly, the fear of a contagion arises once one bank is allowed to fail. Therefore, the answer to the question posed earlier about whether the central bank should help out, the answer is yes. The central bank cannot stand by and let the crisis spread. If that is so, is there any way out? Here the Indian case needs to be put in the right perspective.
The Indian banking system is well governed with rules being placed on the lending pattern of banks. Lending to risky ventures like capital markets, commodities and real estate are ‘sensitive sectors’ and is not widely encouraged and is monitored closely. As over three quarters of the banking system is in the public sector, it helps to enforce this discipline.
We have however, had our own share of banking crisis, which have never really escalated to any kind of a contagion. Global Trust Bank had failed following the Ketan Parekh scam but the RBI found a way out through a merger with a public sector bank, Oriental Bank of Commerce. IFCI has been bailed out through financial infusion and subsequent equity sale. The lesser known Benaras State Bank was amalgamated with Bank of Baroda which in turn protected the deposit holders. But, yes, in case of the Ketan Parikh related Madhavpura Bank, the RBI did resort to provide finance to cooperative banks for short tenures to ensure that banking activities were not affected. But earlier following the Harshad Mehta scam in the mid-nineties, both Bank of Karad and Metropolitan Banks were liquidated.
Therefore, the RBI has also changed it approach to bank failures from a strict liquidation regimen just as we embarked on reforms to a more practical merger policy to one of accommodation depending on the circumstances.
An issue which comes to the forefront now is whether the sub-prime crisis could be repeated in India. We do not have such lending but given the large increase in the share of mortgages in the bank portfolio, there is a similarity. Also the fact that this portfolio has been built at a time when interest rates were low and are being re-priced today with higher interest rate regimes does highlight a payment problem for borrowers. Protracted repayment schedules and higher interest costs could affect the ability of borrowers to repay, which was the same with the sub-prime episode. But, the difference that can be seen today is that property prices are still high, which will prevent the value of the collateral from declining which was the case in USA.
The answer hence is quite clear. To begin with whenever public money is involved, the governance needs to be strong. Once in place, a failure should be protected to restore confidence of the public as well as safeguard their interests. But, this should hold only when public funds in deposits are involved, and not investors putting their money in hedge funds where the risks are known beforehand. There is hence need to distinguish between the two.
Monetisation is key, not exports data: Economic Times 17th October 2007
A major concern today is the appreciating rupee as it has created a dual problem of affecting exports and creating monetization issues for the RBI. The situation is not very different from what the Euro zone is facing where the Euro is strengthening against the dollar, albeit more freely, and the fear of loss of competitiveness lingers. It is the same feeling in India too with the exporters getting worried that their competitiveness will be eroded in case the rupee continues appreciating.
But, surprisingly so far, the rupee appreciation has not quite led to a fall in exports and the present growth rate is steady at a high level of close to 20%. But, the exporters are saying that this growth would not be sustainable in the face of an appreciating rupee as they are compromising on profit. There is again talk on the various options of hedging for the exporters. The RBI on the other hand is trying hard to control this appreciation but is having a problem with excess monetization and the issuance of new MSS bonds.
In this context it would be interesting to do a bit of statistical analysis of the experiences of the flow of foreign exchange on the exchange rate and money supply and that of the exchange rate on exports growth. This way it may be seen whether the exporters or RBI have a bigger problem on hand. The last four years or 48 months are considered starting from October 2003 to September 2007, which is further bifurcated into two periods of 34 and 14 months. The first period is up to June 2006 while the second period is from July 2006 onwards when the rupee started appreciating continuously against the dollar. The matrix of results is provided in the Table below.
To avoid the use of statistical jargon, the results have been provided in simple language. The overall strength of the relationship between the variables called ‘coefficient of determination’ is denoted by high, medium and low. The direction of impact as well as the significance of the impact of the primary variable is also captured as is the impact of the ‘other variables’ which are not specified. Hence, if exports are affected by say world demand, then it comes under ‘other variables’.
Quite clearly the two periods show contrasting pictures. Firstly, the period up to June 2006 shows that the exchange rate movements are not really driven by forex inflows. This can be rationalized on grounds of RBI intervention which has ensured that the market oriented rate was not reached. Further, while the direction sounds okay, i.e. more forex inflows cause an appreciation (appreciation goes with a negative sign as we are paying fewer rupees for a dollar), it is not statistically significant. Secondly for money supply there is a strong explanation and the impact too is significant. The third observation is that there are contrary images seen when exports are juxtaposed with exchange rate movements. Exchange rates don’t explain exports much as there are evidently other factors which drive them such as demand factors, price movements, status of units (whether SEZ or not), ability to take a hit on profits etc.
The post June 2006 period is the one where the appreciation took place in a continuous manner. Statistically, a small sample is not ideal, but notwithstanding this limitation, we get a different set of results. All the three relationships hold: forex inflows affect exchange rates and money supply; and exports are explained partly by the exchange rate movements. The impact appears to be in the right direction for all the three relationships, including the one for appreciation and rising exports.
Some interesting points that emerge from the data are that the RBI has bigger problems on hand with rising forex inflows than the exporters. Exports so far have not really been affected by the rupee appreciation even when lags of up to 4 months are considered. In fact, the relationship is still not strong and the explanatory power is not significant. However, the direction is still negative meaning thereby that a lower value of the rupee (appreciation) is associated with rising exports. As a corollary, the conclusion would be that the RBI should concentrate more on tackling the monetization part of the dollars rather than stem the appreciation.
But, surprisingly so far, the rupee appreciation has not quite led to a fall in exports and the present growth rate is steady at a high level of close to 20%. But, the exporters are saying that this growth would not be sustainable in the face of an appreciating rupee as they are compromising on profit. There is again talk on the various options of hedging for the exporters. The RBI on the other hand is trying hard to control this appreciation but is having a problem with excess monetization and the issuance of new MSS bonds.
In this context it would be interesting to do a bit of statistical analysis of the experiences of the flow of foreign exchange on the exchange rate and money supply and that of the exchange rate on exports growth. This way it may be seen whether the exporters or RBI have a bigger problem on hand. The last four years or 48 months are considered starting from October 2003 to September 2007, which is further bifurcated into two periods of 34 and 14 months. The first period is up to June 2006 while the second period is from July 2006 onwards when the rupee started appreciating continuously against the dollar. The matrix of results is provided in the Table below.
To avoid the use of statistical jargon, the results have been provided in simple language. The overall strength of the relationship between the variables called ‘coefficient of determination’ is denoted by high, medium and low. The direction of impact as well as the significance of the impact of the primary variable is also captured as is the impact of the ‘other variables’ which are not specified. Hence, if exports are affected by say world demand, then it comes under ‘other variables’.
Quite clearly the two periods show contrasting pictures. Firstly, the period up to June 2006 shows that the exchange rate movements are not really driven by forex inflows. This can be rationalized on grounds of RBI intervention which has ensured that the market oriented rate was not reached. Further, while the direction sounds okay, i.e. more forex inflows cause an appreciation (appreciation goes with a negative sign as we are paying fewer rupees for a dollar), it is not statistically significant. Secondly for money supply there is a strong explanation and the impact too is significant. The third observation is that there are contrary images seen when exports are juxtaposed with exchange rate movements. Exchange rates don’t explain exports much as there are evidently other factors which drive them such as demand factors, price movements, status of units (whether SEZ or not), ability to take a hit on profits etc.
The post June 2006 period is the one where the appreciation took place in a continuous manner. Statistically, a small sample is not ideal, but notwithstanding this limitation, we get a different set of results. All the three relationships hold: forex inflows affect exchange rates and money supply; and exports are explained partly by the exchange rate movements. The impact appears to be in the right direction for all the three relationships, including the one for appreciation and rising exports.
Some interesting points that emerge from the data are that the RBI has bigger problems on hand with rising forex inflows than the exporters. Exports so far have not really been affected by the rupee appreciation even when lags of up to 4 months are considered. In fact, the relationship is still not strong and the explanatory power is not significant. However, the direction is still negative meaning thereby that a lower value of the rupee (appreciation) is associated with rising exports. As a corollary, the conclusion would be that the RBI should concentrate more on tackling the monetization part of the dollars rather than stem the appreciation.
Friday, September 21, 2007
Resolving the Wheat Crisis: Business Standard, 22nd September 2007
Using futures to fix procurement prices is a good idea as this will link them to global prices and appears the only way to get farmers to sell their stocks to the government.
There are four interesting facts about the wheat scenario in India. The RBI Annual Report indicates that wheat production this year has been 74.9 million tonnes which is 5.5 million tonnes higher than that last year. The second is that the government is importing wheat at close to $390 per tonne. The third is that the procurement this year by the FCI has been 11 million tonnes which is higher than the 9.2 million tonnes last year but still lower than the targeted amount of 15 million tonnes. The last is that the minimum support price offered to the farmers was Rs 850 per quintal, after an additional bonus of Rs 100 was offered to them over the Rs 750 announced earlier, when it looked likely that the procurement target would not be met.
These facts are interesting for more than one reason as they individually raise a series of issues which need to be pieced together cogently. The first question is whether or not production is really higher than what it was last year. This is important because the import of wheat needs to be justified on grounds of lower production.
If the production number is correct, then the government is importing wheat because it is not able to procure the same from the farmers. In fact, with a marketed surplus of 63 per cent, there is actually 47 million tonnes which has come to the market (or partly held at home) of which only 11.1 million has gone to the government. Why should this be so?
The farmers are not selling because either they want a better price and are progressively aware of the market prices thanks to futures trading (before the ban) or due to the entry of private players. This, in turn, means that the price of Rs 850 offered is very low. A farmer may feel that he deserves a better price considering that the government is paying $390 per tonne which works out to over Rs 1,500 per quintal as global prices are on the rise due to supply issues, which is 75 per cent higher than what was offered to the Indian farmer.
This issue could have been ignored as being an unusual aberration but for the fact that the government has had a problem on the procurement end for the second successive year — the first was a deficit production year, while the second has been a year for surplus. Evidently, a strategy needs to be devised to ensure that there is no repetition of the same in the next year.
The basic issue goes back to the government procurement of wheat. Procurement has a bearing on the output perception, the future minimum support price (MSP), the current price as well as import decisions. Ideally the government may have to review the MSP system as the MSP is supposed to be a price support system and not necessarily a procurement aid. By attempting to target both the objectives with one instrument, a contradiction has arisen. In fact, economic theory always says that rarely can one achieve two objectives with one instrument.
This is so, as we have noticed that the farmers have become progressively more aware of the market conditions and are in a position to demand the same from the government. Therefore, even in years of good production such as 2007, while production has been steady, the procurement programme has run into an impasse.
It is said that some of the private players were offering prices of over Rs 2,000 a quintal for some grades of wheat. If this were so, then evidently there is a market price which is quite different from the MSP and we need to either change the MSP calculation or keep it as a benchmark and use the market to get signals for procurement.
The futures market was providing valuable signals of the wheat price, which can provide an alternative for determining procurement prices. The futures price can be used to fix the MSP so that the FCI is able to purchase the requisite amount at a fair market price. Hence, we will have the traditional MSP which serves as the base price, while the futures price will be the actually Implemented Procurement Price (IPP).
The IPP could be variable with the market price or also fixed in advance based on the futures price so as to be market-aligned. An analogy could be borrowed from the money market here. This would be similar to the bank rate and the repo rate, where the bank rate is the benchmark, and the fixed repo rate mimics the same based on market conditions through the RBI policy. This way the farmers are assured of a fair price which is the market price. If the market price falls to low levels, then the benchmark MSP could be used for the same purpose. This would eschew the need to import wheat when there are surpluses in the country.
The major problem here is that the MSP is serving as a base price-cum-procurement price which is progressively becoming anachronistic in a market-driven system. Private players are pushing aggressively for wheat given the retail boom, which is only going to explode further. Futures markets had provided price information to a considerable section of the farmer population so that they could ask for a higher price in the market. The government, hence, has become just another player that will have to procure at market rates.
Again, to draw a comparison with the G-sec market, the T-bills which were issued to finance the budget got away with a 4.6 per cent rate prior to liberalisation. Once this segment opened up, the government had to pay a higher rate. So, shouldn’t the same thing happen in the case of wheat?
There are four interesting facts about the wheat scenario in India. The RBI Annual Report indicates that wheat production this year has been 74.9 million tonnes which is 5.5 million tonnes higher than that last year. The second is that the government is importing wheat at close to $390 per tonne. The third is that the procurement this year by the FCI has been 11 million tonnes which is higher than the 9.2 million tonnes last year but still lower than the targeted amount of 15 million tonnes. The last is that the minimum support price offered to the farmers was Rs 850 per quintal, after an additional bonus of Rs 100 was offered to them over the Rs 750 announced earlier, when it looked likely that the procurement target would not be met.
These facts are interesting for more than one reason as they individually raise a series of issues which need to be pieced together cogently. The first question is whether or not production is really higher than what it was last year. This is important because the import of wheat needs to be justified on grounds of lower production.
If the production number is correct, then the government is importing wheat because it is not able to procure the same from the farmers. In fact, with a marketed surplus of 63 per cent, there is actually 47 million tonnes which has come to the market (or partly held at home) of which only 11.1 million has gone to the government. Why should this be so?
The farmers are not selling because either they want a better price and are progressively aware of the market prices thanks to futures trading (before the ban) or due to the entry of private players. This, in turn, means that the price of Rs 850 offered is very low. A farmer may feel that he deserves a better price considering that the government is paying $390 per tonne which works out to over Rs 1,500 per quintal as global prices are on the rise due to supply issues, which is 75 per cent higher than what was offered to the Indian farmer.
This issue could have been ignored as being an unusual aberration but for the fact that the government has had a problem on the procurement end for the second successive year — the first was a deficit production year, while the second has been a year for surplus. Evidently, a strategy needs to be devised to ensure that there is no repetition of the same in the next year.
The basic issue goes back to the government procurement of wheat. Procurement has a bearing on the output perception, the future minimum support price (MSP), the current price as well as import decisions. Ideally the government may have to review the MSP system as the MSP is supposed to be a price support system and not necessarily a procurement aid. By attempting to target both the objectives with one instrument, a contradiction has arisen. In fact, economic theory always says that rarely can one achieve two objectives with one instrument.
This is so, as we have noticed that the farmers have become progressively more aware of the market conditions and are in a position to demand the same from the government. Therefore, even in years of good production such as 2007, while production has been steady, the procurement programme has run into an impasse.
It is said that some of the private players were offering prices of over Rs 2,000 a quintal for some grades of wheat. If this were so, then evidently there is a market price which is quite different from the MSP and we need to either change the MSP calculation or keep it as a benchmark and use the market to get signals for procurement.
The futures market was providing valuable signals of the wheat price, which can provide an alternative for determining procurement prices. The futures price can be used to fix the MSP so that the FCI is able to purchase the requisite amount at a fair market price. Hence, we will have the traditional MSP which serves as the base price, while the futures price will be the actually Implemented Procurement Price (IPP).
The IPP could be variable with the market price or also fixed in advance based on the futures price so as to be market-aligned. An analogy could be borrowed from the money market here. This would be similar to the bank rate and the repo rate, where the bank rate is the benchmark, and the fixed repo rate mimics the same based on market conditions through the RBI policy. This way the farmers are assured of a fair price which is the market price. If the market price falls to low levels, then the benchmark MSP could be used for the same purpose. This would eschew the need to import wheat when there are surpluses in the country.
The major problem here is that the MSP is serving as a base price-cum-procurement price which is progressively becoming anachronistic in a market-driven system. Private players are pushing aggressively for wheat given the retail boom, which is only going to explode further. Futures markets had provided price information to a considerable section of the farmer population so that they could ask for a higher price in the market. The government, hence, has become just another player that will have to procure at market rates.
Again, to draw a comparison with the G-sec market, the T-bills which were issued to finance the budget got away with a 4.6 per cent rate prior to liberalisation. Once this segment opened up, the government had to pay a higher rate. So, shouldn’t the same thing happen in the case of wheat?
Tuesday, September 18, 2007
Country, ball by ball, Indian Express, 18th September 2007
Cricket, whether is the Test, One-day or Twenty-20 variety, is always the flavour of the season in India. And if the spectators have their quirks, so do those who inhabit the commentary box. The discerning viewer can perceive on his/her TV screen whether the ball hit the bat or the pad. But the non-discerning patriot only wants to know if we have hit a six or whether the opponent is out.
If you had followed cricket in the eighties and early nineties, you will recollect that Sunil Gavaskar, Ravi Shastri and Mohindar Amarnath were three great Indian cricketers who were responsible for almost all our losses in one-day matches as they could never really distinguish between the limited overs and the five-day versions of the game. Now that each one of them has metamorphosed into important TV commentators, it is refreshing to hear them talk very profoundly on how one-day games must be approached and when the accelerator needs to be pressed.
When master blaster Sachin Tendulkar comes out to bat, Gavaskar or Harsha Bhogle will invariably tell you that there is a “tense hush” as the great man comes in. Unfortunately, Tendulkar then proceeds to get out early in his innings. But as far as Messrs Gavaskar, Bhogle are concerned, this is never for any fault of his. They will invariably lament that the ball did not touch the bat or, even if it did hit the pads, it would have missed the stumps by at least eight inches. They can never understand how any umpire can give such a decision. And Gavaskar will add, “Frankly, that was a bad decision.”
It is always “unfortunate” that Tendulkar gets out at 0, 1, 4 and 99 due to incorrect umpiring decisions. This can only mean that there is some bias against our master blaster. But what is amazing is that the whole world seems to be against him.
Umpires everywhere, whether they happen to be English, Australian or Indian, are clearly biased when it comes to Tendulkar. And this is also why we always lose matches. Truly, Indian commentators smell of patriotism and never miss an opportunity to brandish it on TV.
If you had followed cricket in the eighties and early nineties, you will recollect that Sunil Gavaskar, Ravi Shastri and Mohindar Amarnath were three great Indian cricketers who were responsible for almost all our losses in one-day matches as they could never really distinguish between the limited overs and the five-day versions of the game. Now that each one of them has metamorphosed into important TV commentators, it is refreshing to hear them talk very profoundly on how one-day games must be approached and when the accelerator needs to be pressed.
When master blaster Sachin Tendulkar comes out to bat, Gavaskar or Harsha Bhogle will invariably tell you that there is a “tense hush” as the great man comes in. Unfortunately, Tendulkar then proceeds to get out early in his innings. But as far as Messrs Gavaskar, Bhogle are concerned, this is never for any fault of his. They will invariably lament that the ball did not touch the bat or, even if it did hit the pads, it would have missed the stumps by at least eight inches. They can never understand how any umpire can give such a decision. And Gavaskar will add, “Frankly, that was a bad decision.”
It is always “unfortunate” that Tendulkar gets out at 0, 1, 4 and 99 due to incorrect umpiring decisions. This can only mean that there is some bias against our master blaster. But what is amazing is that the whole world seems to be against him.
Umpires everywhere, whether they happen to be English, Australian or Indian, are clearly biased when it comes to Tendulkar. And this is also why we always lose matches. Truly, Indian commentators smell of patriotism and never miss an opportunity to brandish it on TV.
Monday, September 10, 2007
Riding the troika: RBI's Travails: Financial Express 10th September, 2007
The RBI must be the most harried institution in the country today. The irony is that this state of mind comes at a time when the FM is reiterating strong growth in the country which has been supported by the Economic Advisory Council of the PMO and the RBI itself. It does appear that the theoretical issue raised in textbooks on attaining internal and external equilibrium has resurfaced again creating a rather complex situation for the monetary authority.
There are presently three objectives before the RBI. The first is to maintain foreign exchange rate equilibrium — meaning a stable ‘currency rate movement’ regime. The second is to bring about growth with easy interest rates, and the third is price stability.
On the face of it there does not appear to be a problem with the rupee strengthening amid large forex inflows, stable inflation at around 4.4%, and demand for credit not picking up as yet. But, the monetary authority has to be forward looking and must assess potential inflation as inflationary expectations are more important than actual inflation; and these expectations are fed by the policy moves of the RBI.
Let us try and grasp as to what is happening presently. The rupee is appreciating due to large capital inflows. The trade deficit has widened but booming current receipts led by IT and software inflows as well as FDI, FII and ECB inflows have made the forex reserves swell. Last year, the foreign currency assets have risen on a point to point basis by $ 47 bn and the rupee strengthened by 2.3% with all the RBI interventions. But this year, so far foreign currency assets have risen by $ 26 bn and the rupee has strengthened by around 7%. Therefore, there is a concern here. One view is that the RBI cannot let the rupee appreciate too much, which though a theoretical solution would militate against exports and the IT sector. At the same time we cannot stop FDI or FII inflows as they are critical for the economy.
There has been some feeble attempt to curb the inflow of ECBs recently, ostensibly to check the possible carry-trade transactions being carried out given the interest rate differentials in India and the rest of the world.
Borrowings have been pegged to a band of up to Libor plus 250 bps limit, but the difference with Indian PLRs is still around 500 bps, which makes such trade attractive even after taking into account the other accompanying risks.
The result has been that the RBI is buying dollars in the market, which is creating monetary problems. When the RBI buys forex, then it has to provide domestic currency, which increases money supply. Rising money supply is inflationary as it has the potential to create excess demand forces. When money supply increases the RBI has to sterilize it with either market stabilization bonds (MSS) or curb the ability of banks to lend by increasing the CRR, which it has just done in the last policy, or increase interest rates. While this could have a soothing effect on inflation, it can create problems on growth. As of today this is not an issue, but with rising rates, investment would get affected. The reverse movement of interest rates in the late nineties will be in the RBI’s rear view mirror when monetary tightening led to a recession.
This situation is quite a contrast to what the Euro zone is facing today. The ECB has let the euro appreciate against the dollar, and has managed to maintain stable interest rates, though reserving the prerogative to raise interest rates to curb inflation if the rate starts to move up. Hence, it has been looking more inward than outward.
The case of China is quite different. China absorbs more dollars than India; so how does it manage the show. The central bank buys up dollars in the market and also virtually pegs the interest rate. This way there are no major issues when it comes to growth or inflation.
What are the solutions for the RBI? Logically, the rupee should be allowed to float and strengthen as markets are free and exporters cannot ask for protection and have to learn to be competitive. Besides, the RBI cannot and should not play favourites to any one group.
But, if this is not feasible, then attempts must be made to open up the capital account. While some measures have been taken earlier this year, this sounds a bold decision which could have severe repercussions if something goes amiss. Imagine a situation where we can invest freely in foreign capital markets or open a fixed deposit in a New York based bank instead of a domestic bank in Mumbai. This too appears to be far fetched presently. Besides, the liberalization of limits for investment is not really being used up and further action may not be useful. Putting curbs on ECBs cannot really be effective though it has had a good announcement effect.
Also we cannot stop other foreign flows from coming in.
The RBIs ride on the troika of exchange rate, interest rate and inflation is uneven. A decision needs to be taken or else the markets will be left conjecturing the next move, which could be unsettling. Therefore, a clear stance and targets need to be explained clearly to remove uncertainty.
There are presently three objectives before the RBI. The first is to maintain foreign exchange rate equilibrium — meaning a stable ‘currency rate movement’ regime. The second is to bring about growth with easy interest rates, and the third is price stability.
On the face of it there does not appear to be a problem with the rupee strengthening amid large forex inflows, stable inflation at around 4.4%, and demand for credit not picking up as yet. But, the monetary authority has to be forward looking and must assess potential inflation as inflationary expectations are more important than actual inflation; and these expectations are fed by the policy moves of the RBI.
Let us try and grasp as to what is happening presently. The rupee is appreciating due to large capital inflows. The trade deficit has widened but booming current receipts led by IT and software inflows as well as FDI, FII and ECB inflows have made the forex reserves swell. Last year, the foreign currency assets have risen on a point to point basis by $ 47 bn and the rupee strengthened by 2.3% with all the RBI interventions. But this year, so far foreign currency assets have risen by $ 26 bn and the rupee has strengthened by around 7%. Therefore, there is a concern here. One view is that the RBI cannot let the rupee appreciate too much, which though a theoretical solution would militate against exports and the IT sector. At the same time we cannot stop FDI or FII inflows as they are critical for the economy.
There has been some feeble attempt to curb the inflow of ECBs recently, ostensibly to check the possible carry-trade transactions being carried out given the interest rate differentials in India and the rest of the world.
Borrowings have been pegged to a band of up to Libor plus 250 bps limit, but the difference with Indian PLRs is still around 500 bps, which makes such trade attractive even after taking into account the other accompanying risks.
The result has been that the RBI is buying dollars in the market, which is creating monetary problems. When the RBI buys forex, then it has to provide domestic currency, which increases money supply. Rising money supply is inflationary as it has the potential to create excess demand forces. When money supply increases the RBI has to sterilize it with either market stabilization bonds (MSS) or curb the ability of banks to lend by increasing the CRR, which it has just done in the last policy, or increase interest rates. While this could have a soothing effect on inflation, it can create problems on growth. As of today this is not an issue, but with rising rates, investment would get affected. The reverse movement of interest rates in the late nineties will be in the RBI’s rear view mirror when monetary tightening led to a recession.
This situation is quite a contrast to what the Euro zone is facing today. The ECB has let the euro appreciate against the dollar, and has managed to maintain stable interest rates, though reserving the prerogative to raise interest rates to curb inflation if the rate starts to move up. Hence, it has been looking more inward than outward.
The case of China is quite different. China absorbs more dollars than India; so how does it manage the show. The central bank buys up dollars in the market and also virtually pegs the interest rate. This way there are no major issues when it comes to growth or inflation.
What are the solutions for the RBI? Logically, the rupee should be allowed to float and strengthen as markets are free and exporters cannot ask for protection and have to learn to be competitive. Besides, the RBI cannot and should not play favourites to any one group.
But, if this is not feasible, then attempts must be made to open up the capital account. While some measures have been taken earlier this year, this sounds a bold decision which could have severe repercussions if something goes amiss. Imagine a situation where we can invest freely in foreign capital markets or open a fixed deposit in a New York based bank instead of a domestic bank in Mumbai. This too appears to be far fetched presently. Besides, the liberalization of limits for investment is not really being used up and further action may not be useful. Putting curbs on ECBs cannot really be effective though it has had a good announcement effect.
Also we cannot stop other foreign flows from coming in.
The RBIs ride on the troika of exchange rate, interest rate and inflation is uneven. A decision needs to be taken or else the markets will be left conjecturing the next move, which could be unsettling. Therefore, a clear stance and targets need to be explained clearly to remove uncertainty.
Saturday, September 8, 2007
Let Friedman-Keynes deliver: Economic Times, 8th September 2007
Keynes did not believe that laissez faire economics could deliver adequately, while Friedman did. Keynes had a good role chalked out for the government while Friedman found it meddlesome and ineffective. Keynes preferred fiscal over monetary policy especially when there was a liquidity trap while Friedman relied on monetary policy. Friedman spoke of a long run rate of unemployment in which monetary policy could do nothing, while Keynes believed that in the long run we are all dead. Which of these two economists should one follow? Most central bankers today seem to believe that you can control the economy through cogent interest rates management. The focus is on inflation control and it is believed that interest rates can be used to either expand or contract credit growth and hence money supply. And barring oil prices, inflation at the global level is viewed as a monetary phenomenon a la Friedman. This conclusion has been independently arrived at by them based on their own domestic circumstances. Does this mean the end of Keynesian economics? This is interesting because the economics of Keynes has been the driving factor for several decades now where governments have used budgetary deficits to drive their economies. But, today deficits are not encouraged and even the Indian government is committed to fiscal responsibility. It fits in well with the modern tenets of globalisation wherein countries are covertly committed to free markets and less government interference in economic activity. Growth is spurred by lowering interest rates, which even Friedman would have admitted was effective in the short run though never in the long run. Now, Keynes had his theories right at times of economic distress when pump priming worked. It now appears that when economies are on a downswing, there will be a preference for the Keynesian prescription as it is the only way out from a low equilibrium trap. A clear case is Japan where a recession, on more than one occasion has made monetary policy impotent, due to the existence of a ‘liquidity trap’ where increase in money supply is ineffective as excess cash is only hoarded and not spent. The solution is to go back to Keynes and run deficits to induce demand-led growth measures, which worked reasonably well. In India too before we were on the 8% growth path, we did pursue discretionary monetary policies to induce growth through accommodative measures such as low interest rates and banking preemptions. The story becomes different when economies are on the upswing. At this stage, growth does not matter or rather becomes a concern because of prospective overheating. Governments are quick to advise their monetary authorities to apply the brakes because high inflation is possible, and could be politically destabilising. Interest rates are then increased until such time that a slowdown is engineered. The idea is to make credit expensive which lessens the impact of excess demand forces. So it is a case of monetarism taking over from demand-led strategies. Some curious conclusions can be drawn from these patterns observed both inter-temporally and inter-spatially. The first is that it is essential to identify the part of the business cycle that we are traversing for deciding on the economic doctrine as the remedies address specific conditions. The second suggests that developing countries should typically persevere with Keynesian economics where growth is low and deserves a big push. The developed countries could fall back on monetarism on the upward cycle but revert to Keynes in case of a downswing. But, when any country embarks on high growth through demand-led strategies, inflation would tend to be high and a 5-10% range should not be alarming. This is really a tradeoff which we should be prepared for because we were uncomfortable with a 6% inflation rate last year even as growth had crossed the 9% mark. The third ideological issue raised is whether or not deficits are good. Presently, fiscal deficits are not encouraged which makes implementing demand-driven policies that much more difficult. This is critical for developing countries as they would be at a disadvantage in the global financial markets when high fiscal deficits invariably lead to lower sovereign credit ratings. There is evidently need to move away from this mindset and make judicious use of fiscal deficits when warranted. The clues provided here are that it is not possible to be a monetarist or Keynesian all the time. The circumstances need to be examined before adopting an approach. Economic theory says that if there are two objectives, i.e., economic growth and price stability, then it is essential to use two instruments, in which case interest rates and fiscal policy are both pertinent. Fiscal policy is important in countries like India where distribution is critical as also for private sector incentives in the form of tax related concessions. Monetary policy combats inflation directly and can also drive growth. Therefore, we need both Keynes and Friedman today.
What drives commodity prices: Financial Express 8th September 2008
Commodity cycles are known to appear every 25-30 years. Looking around, and at the way commodity prices have been moving in the last year, the question that arises is how long this cycle will last. Normally, as long as there are excess supplies in the market, prices tend to get tempered down. But, given the global economy’s growth, oversupply indications could very well be only temporary occurrences in the midst of a longer phase of excess demand conditions in a cycle of increased amplitude.
Prima facie, it appears that with the world economy growing at nearly 5% per annum, and new nations joining the high-growth bandwagon, the boom has to continue for long. This is the view held by experts based on fundamentals as they exist today and the factors in operation over the next decade that would drive trends forth.
Commodities can be classified into precious metals, non-precious metals, energy and agricultural products. It is widely believed that all these segments would be guided primarily by the growth process as well as critical changes taking place in the political arena and the adaptations being made by society to them.
Gold, the leader in the precious metals segment, has its price determined by two factors. There is a demand side factor, where demand is rising at a steady rate with the supply being more or less limited (with fewer new explorations). Though there is the possibility of central banks releasing gold reserves into the system, this is unlikely in the foreseeable future in significant quantities. The other factor influencing the price of gold would be the US dollar rate. There is a high correlation between the price of gold and that of the dollar—estimated at around 0.95—and this has been breached only twice in the last decade and a half. The stronger the dollar, the lower is the demand for gold, seen as a store-of-value substitute. But the dollar is weakening against the euro. This is so because of the large current account deficit of the US, estimated at around $850 billion now and nearing 7% of its GDP. A correction involving a sharp dollar fall appears distant, and the euro zone economies would resist such an event that would weaken their export competitiveness. Yet, one can expect the dollar to weaken, which would impact gold.
Prices of other metals such as steel, copper, aluminum, zinc and lead are contingent on usage demand on account of commercial activity and the pace of industrialisation. Emerging markets such as Russia, India and China, as well as Brazil, Chile and Argentina, have embarked on a growth path that has industrialisation as the driving force. This, alongwith urbanisation, which are the centrepieces of this growth doctrine, also have infrastructure as a priority on the development agenda. This would support metal prices over the next decade or so. There is also an investment backlog across most commodity subsectors after over 20 years of low and range-bound commodity prices. High prices are needed to attract more investment in these commodities.
Energy prices will be driven by ever-increasing demand and the response of producers. Demand per se would take the same incline as the economy. This means robust demand over the decade, with only a few aberrations coming in the form of occasional growth slowdowns. Note that central banks today are quite reluctant to allow recessions and are willing to step in with lower interest rates.
The bulk of energy supplies would have to come from Opec and other nations, and this makes for some uncertainty. The crisis in West Asia is unlikely to be resolved quickly, which raises the risk of supply shocks. The curious thing here is that supply at the moment is not really a problem, as reserves exist. But the willingness of suppliers to invest in output capacity is hard to determine.
Meanwhile, the use of alternative fuels and other energy sources is slowly catching on, and its proliferation would mean moderation in the demand for oil, which may put pressure on Opec to hold prices. Therefore, while in the short-run prices would tend to remain firm, once the switchover trend towards alternatives crosses a threshold, it would have a moderating effect on conditions in the international energy market.
Agriculture remains vulnerable to the vagaries of nature, and it was observed globally that a shortfall in prices of wheat and corn in 2006 has increased prices across all countries, thus making it a global concern. Add to this the fact that there would be considerable diversion of production of corn and sugarcane for the production of ethanol, a replacement fluid for crude oil, and one senses upward pressure on prices here too. Production will have to increase substantially to eschew this pressure, a possibility which cannot be ruled out. The optimism would be expected to continue until such time as these changes materialise.
Given these tendencies in the market, it appears that the bull run is here to stay in commodities, and while there could be deviations in the short run, it is more or less an unequivocal case in the longer run—at least for a decade.
Prima facie, it appears that with the world economy growing at nearly 5% per annum, and new nations joining the high-growth bandwagon, the boom has to continue for long. This is the view held by experts based on fundamentals as they exist today and the factors in operation over the next decade that would drive trends forth.
Commodities can be classified into precious metals, non-precious metals, energy and agricultural products. It is widely believed that all these segments would be guided primarily by the growth process as well as critical changes taking place in the political arena and the adaptations being made by society to them.
Gold, the leader in the precious metals segment, has its price determined by two factors. There is a demand side factor, where demand is rising at a steady rate with the supply being more or less limited (with fewer new explorations). Though there is the possibility of central banks releasing gold reserves into the system, this is unlikely in the foreseeable future in significant quantities. The other factor influencing the price of gold would be the US dollar rate. There is a high correlation between the price of gold and that of the dollar—estimated at around 0.95—and this has been breached only twice in the last decade and a half. The stronger the dollar, the lower is the demand for gold, seen as a store-of-value substitute. But the dollar is weakening against the euro. This is so because of the large current account deficit of the US, estimated at around $850 billion now and nearing 7% of its GDP. A correction involving a sharp dollar fall appears distant, and the euro zone economies would resist such an event that would weaken their export competitiveness. Yet, one can expect the dollar to weaken, which would impact gold.
Prices of other metals such as steel, copper, aluminum, zinc and lead are contingent on usage demand on account of commercial activity and the pace of industrialisation. Emerging markets such as Russia, India and China, as well as Brazil, Chile and Argentina, have embarked on a growth path that has industrialisation as the driving force. This, alongwith urbanisation, which are the centrepieces of this growth doctrine, also have infrastructure as a priority on the development agenda. This would support metal prices over the next decade or so. There is also an investment backlog across most commodity subsectors after over 20 years of low and range-bound commodity prices. High prices are needed to attract more investment in these commodities.
Energy prices will be driven by ever-increasing demand and the response of producers. Demand per se would take the same incline as the economy. This means robust demand over the decade, with only a few aberrations coming in the form of occasional growth slowdowns. Note that central banks today are quite reluctant to allow recessions and are willing to step in with lower interest rates.
The bulk of energy supplies would have to come from Opec and other nations, and this makes for some uncertainty. The crisis in West Asia is unlikely to be resolved quickly, which raises the risk of supply shocks. The curious thing here is that supply at the moment is not really a problem, as reserves exist. But the willingness of suppliers to invest in output capacity is hard to determine.
Meanwhile, the use of alternative fuels and other energy sources is slowly catching on, and its proliferation would mean moderation in the demand for oil, which may put pressure on Opec to hold prices. Therefore, while in the short-run prices would tend to remain firm, once the switchover trend towards alternatives crosses a threshold, it would have a moderating effect on conditions in the international energy market.
Agriculture remains vulnerable to the vagaries of nature, and it was observed globally that a shortfall in prices of wheat and corn in 2006 has increased prices across all countries, thus making it a global concern. Add to this the fact that there would be considerable diversion of production of corn and sugarcane for the production of ethanol, a replacement fluid for crude oil, and one senses upward pressure on prices here too. Production will have to increase substantially to eschew this pressure, a possibility which cannot be ruled out. The optimism would be expected to continue until such time as these changes materialise.
Given these tendencies in the market, it appears that the bull run is here to stay in commodities, and while there could be deviations in the short run, it is more or less an unequivocal case in the longer run—at least for a decade.
Wednesday, August 29, 2007
Curbing bank loans to fight inflation : Economic Times: 30th August 2007
RBI’S monetary actions are primarily focused on countering the rapid growth of foreign exchange reserves and all measures tantamount to controlling growth in commercial credit, which in turn has raised other issues on future growth. This approach is quite different from the earlier one where the RBI had to accommodate the flow of funds to the government, which at times could mean curbing the growth in commercial credit. Either way, monetary policy appears to be targeting growth in commercial credit to control inflation. It has been observed that at times when growth in credit is buoyant and the RBI is keen to lower the lending power of banks, it becomes essential to use direct controls on credit growth. This is also suggested by an analysis of the components of incremental money supply in the last seven years. The changing structure of the components of incremental money supply suggests five major trends. The first is that the share of the government has come down quite rapidly between FY02 and FY05. This has happened in two stages with RBI initially placing less of government paper with itself. In fact, it has reduced the intake of private placements along the way before eliminating them. After offloading these bonds to commercial banks through open market operations, the next step has been for banks to off-load these securities and lower their investment deposit ratio. This has been more prominent in the last two years, where banks were able to increase their lending to the commercial sector with credit growing by an average of 33% amidst monetary tightening by the RBI. The second trend is that forex assets have actively taken over from the government in terms of dominance in the last three years. The average growth of net forex assets of banks has been around 24%, comparable with the growth in bank credit. Thirdly, bank credit has grown rapidly in the last three years by an average of 31% which has pushed up the credit-deposit ratio to 74% from 53% at the beginning of the century. Banks have shuffled their investment portfolios to secure funds even as RBI has increased the CRR. This has been prompted by the high industrial growth rate during this period where companies have borrowed notwithstanding higher interest rates.
Fourthly, credit policy is now trying to counter the large inflows of forex assets which are responsible for the higher growth in money supply. The preference has been on using direct measures such as the CRR to interest rates. Monetary tightening had started from 2004-05 and the CRR has been raised from 4.75% to 6.5%. This has been more effective than the reverse repo rate, which also has been raised from 4.5% to 6%. But, in general it has been observed that the RBI has used the reverse repo or repo rate to signal its desired direction of movement in interest rates, while it has used the CRR to have a direct impact on money supply growth through pre-emption of resources. Higher interest rates do not really work to curb growth in credit at a time when the industrial sector is booming. More direct action is needed to sterilise inflows from the forex channel. Lastly, the component of non-monetary liabilities of the banking system is quite worrisome as it is a large amount which distorts the picture. By definition this reflects amounts that do not add to money supply and are in the nature of RBI deposits with international agencies such as the IMF, contribution to national funds and superannuation funds, paid up capital, reserves, and provisions of commercial banks and so on. However, as this number is also a balancing figure drawn by calculating the money supply through the deposits route and subtracting these sources of funding on the credit side, there is need to reconcile these numbers. This is more so because the share of this component is very high at times. Quite clearly, the message is that we need to have a policy of tackling external capital inflows directly as monetary policy has become fairly inhibitive in the last quarter or so... the room for manoeuvre has also narrowed down.
Tuesday, August 21, 2007
Are You left holding the baby? Hindustan Times, 22nd August 2007
When I was a student in college, there was a lecturer who devised a scheme wherein a list was prepared with her name to begin with. It was sold to 20 people, who paid Rs 100 for the same. Rs 100 in 1983 meant a lot of money. Each of them sold the list to another 20 and so on. The rule was that whoever bought the list had to send Rs 100 each to all those on the list and then strike out the first name and include their own as the last. In the next round, they would be receiving money from a multiple of 20 persons and so on. This was a fool proof scheme as only like-minded people would join and the rules would be obeyed. The problem would arise when someone at the end could not find another 20 to sell to. Those people would be the losers and the scheme would crumble.
This is a kind of a Ponzi scheme which is fine as long as the direction is maintained. A break would mean a fall for lots of people with the early entries making the money and those holding the stock of lists being the losers. The stock market is similar to a regulated and organized Ponzi scheme where everything is good as long as all are buying and making money without any effort. But, when some big guys sells, then those left holding the stock suffer losses and there is a crash. Should one grieve for these losses? The answer is really no.
The stock market has been falling since the sub-prime specter has afflicted global markets. What happened was quite plain and simple. In the USA, when interest rates were low, people bought property and banks financed them at low interest rates (sub prime lending rates). The idea was that as real estate prices were rising, low rates were good enough and even if there were defaults, that would not matter since the property could be sold and the amount recovered. Now, the world of finance is a crazy one. Fancy models guide you as to how the future will be. To top it all there are new instruments such as securitization which made banks reorganize such assets and issue securities to others, including hedge funds. The risks are passed on or rather scattered among more risk-takers. These funds bought them for a song and knew that they were backed by rising real estate assets.
Now as we come to 2006, interest rates move up and the price of property comes down. This means that those holding on the estate backed securities realize that their collateral value has diminished. The borrowers are unable to repay their mortgages when rates rise, and the banks have sold these securities to hedge funds, which after a point of time cannot be identified. The result is mounting losses for these funds. Nobody wanted to lend to anyone and the commercial paper and call rates rose, which finally got the Fed and ECB to intervene.
The result was a collapse of global stock markets. After all if the financial sector is in jeopardy, the share market must reflect them and therefore share prices started tumbling. Funds are answerable to investors and need to sell assets elsewhere to pay the returns that are expected. So they start selling in overseas markets such as India which caused the Sensex and NIFTY to take a beating.
When the Bear Sterns crisis erupted and the Nifty and Sensex slid, it was called a correction waiting to happen. But, now it looks more serious even though there is nothing incorrect about our fundamentals. Our banking system is strong and has not been lending recklessly to real estate. It is an externality, which Thomas Friedman would be proud of, that has caused these travails.
There are irrational cycles in markets which are waiting to collapse - stock markets as well as sub-prime lending market. There is a perception to begin with which starts from positive things about the future leading to rising prices. It happened in the real estate sector and stock markets world over with credit pouring in. Fortunately our banking regulation ensures that prudence supersedes animal spirits. Then there is over-trading wherein everyone seems to be in the market. In case of the USA, people were borrowing money to buy property to sell it to others to make a quick buck. This euphoria is often cautioned as being a bubble, but is disparaged by the market moghuls – after all India is shining. And then there is the inevitable fall, and the experts are already predicting doomsday.
Now, stock market movements are always governed by ‘herding’ where everyone follows everyone in which ever direction the herd moves. There is little rationale or logic. The economy has always been strong in the last 3 years and has displayed no exceptional trait. But, this state of existentialism was used to justify the booming market, when funds poured in. But, such exuberance is not always rational as the words of Mr Alan Greenspan have been resonating for a few years now.
It is anecdotal that the legendary tennis star Arthur Ashe when detected with AIDS had a fan pleading with the Almighty as to why did he choose Sir Arthur Ashe for this punishment. Ashe’s reply was quite soul touching. There were thousands of people who played tennis, of which hundreds played in the Grand Slam tournaments. Of them some 60 odd played the Wimbledon while 4 made it to the semi finals and 2 to the finals. And ultimately only 1 won the tournament. When he won the Wimbledon in 1975, he never looked up to ask the Heavens as to why be he the chosen one. So it was the same with the AIDS attack.
Take this analogy to Dalal Street. When the Sensex zoomed, we never stopped to ask “but why”. Now that it is falling, just sit back and ruminate over your losses without; but don’t complain.
This is a kind of a Ponzi scheme which is fine as long as the direction is maintained. A break would mean a fall for lots of people with the early entries making the money and those holding the stock of lists being the losers. The stock market is similar to a regulated and organized Ponzi scheme where everything is good as long as all are buying and making money without any effort. But, when some big guys sells, then those left holding the stock suffer losses and there is a crash. Should one grieve for these losses? The answer is really no.
The stock market has been falling since the sub-prime specter has afflicted global markets. What happened was quite plain and simple. In the USA, when interest rates were low, people bought property and banks financed them at low interest rates (sub prime lending rates). The idea was that as real estate prices were rising, low rates were good enough and even if there were defaults, that would not matter since the property could be sold and the amount recovered. Now, the world of finance is a crazy one. Fancy models guide you as to how the future will be. To top it all there are new instruments such as securitization which made banks reorganize such assets and issue securities to others, including hedge funds. The risks are passed on or rather scattered among more risk-takers. These funds bought them for a song and knew that they were backed by rising real estate assets.
Now as we come to 2006, interest rates move up and the price of property comes down. This means that those holding on the estate backed securities realize that their collateral value has diminished. The borrowers are unable to repay their mortgages when rates rise, and the banks have sold these securities to hedge funds, which after a point of time cannot be identified. The result is mounting losses for these funds. Nobody wanted to lend to anyone and the commercial paper and call rates rose, which finally got the Fed and ECB to intervene.
The result was a collapse of global stock markets. After all if the financial sector is in jeopardy, the share market must reflect them and therefore share prices started tumbling. Funds are answerable to investors and need to sell assets elsewhere to pay the returns that are expected. So they start selling in overseas markets such as India which caused the Sensex and NIFTY to take a beating.
When the Bear Sterns crisis erupted and the Nifty and Sensex slid, it was called a correction waiting to happen. But, now it looks more serious even though there is nothing incorrect about our fundamentals. Our banking system is strong and has not been lending recklessly to real estate. It is an externality, which Thomas Friedman would be proud of, that has caused these travails.
There are irrational cycles in markets which are waiting to collapse - stock markets as well as sub-prime lending market. There is a perception to begin with which starts from positive things about the future leading to rising prices. It happened in the real estate sector and stock markets world over with credit pouring in. Fortunately our banking regulation ensures that prudence supersedes animal spirits. Then there is over-trading wherein everyone seems to be in the market. In case of the USA, people were borrowing money to buy property to sell it to others to make a quick buck. This euphoria is often cautioned as being a bubble, but is disparaged by the market moghuls – after all India is shining. And then there is the inevitable fall, and the experts are already predicting doomsday.
Now, stock market movements are always governed by ‘herding’ where everyone follows everyone in which ever direction the herd moves. There is little rationale or logic. The economy has always been strong in the last 3 years and has displayed no exceptional trait. But, this state of existentialism was used to justify the booming market, when funds poured in. But, such exuberance is not always rational as the words of Mr Alan Greenspan have been resonating for a few years now.
It is anecdotal that the legendary tennis star Arthur Ashe when detected with AIDS had a fan pleading with the Almighty as to why did he choose Sir Arthur Ashe for this punishment. Ashe’s reply was quite soul touching. There were thousands of people who played tennis, of which hundreds played in the Grand Slam tournaments. Of them some 60 odd played the Wimbledon while 4 made it to the semi finals and 2 to the finals. And ultimately only 1 won the tournament. When he won the Wimbledon in 1975, he never looked up to ask the Heavens as to why be he the chosen one. So it was the same with the AIDS attack.
Take this analogy to Dalal Street. When the Sensex zoomed, we never stopped to ask “but why”. Now that it is falling, just sit back and ruminate over your losses without; but don’t complain.
Thursday, August 9, 2007
Sixty years and young and counting: Hindustan Times, 9th August 2007
Six decades back our leaders had made a tryst with destiny and had vowed to redeem their pledges. The Preamble of our Constitution had outlined the broad contours, which were to be fulfilled in the post-independence years. As we complete now 60 years of independence, it is appropriate to review these pledges and objectively evaluate whether or not we have redeemed ourselves properly.
The Preamble talks of 10 goals, each of which can be evaluated on a score of 1 and summed across to aggregate 10. We remain a ‘sovereign’ country and despite global turmoil and alliances our policies are dictated by Indians. This is saying a lot because developing countries have tended to slip into the former Soviet Bloc prior to 1990 or become a USA crony in return for favours. We have truly remained non-aligned and there is one point to be scored here.
We were to be a ‘socialist’ country, but have made limited progress here. While efforts have been on in the beginning to reduce inequalities through the public sector and mixed economy dictum, there has been a tendency for capitalist principles to predominate in the last decade and a half. There is nothing wrong in pursuing such policies except that there has been a tendency for the gulf between the rich and poor to widen. There have been policies espoused in the Plans to relieve poverty, but the implementation has been tardy. So it is half mark here.
India was to be built as a ‘secular’ nation. Unfortunately, secularism has been the most abused term used very often to divide society by our leaders. While secularism is a doctrine which gives equality to all religions in all respects, our polity has tended to use this term to garner votes, split society and create ill-will between people of different religions. This could be through either affirmative action or through plain bad-speaking of other religious doctrines. Either way, the nation remains polarized today on religious grounds as politicians. Conditions have been exacerbated by bringing in the caste factor, when religion is a non-issue. We have definitely failed here and there are no marks to be had.
The nation can take pride in being ‘democratic’ despite all the ups and downs that have been faced in the economic and social spheres. There has been just one minor aberration during the mid-seventies when democracy was subverted, but that did not last long. And given that we are one of the most populous nations, it is commendable that we remain a democracy with fair elections and no sign of a deviation from the processes. It is a different issue that we may not be voting in the right kind of people or vote for the wrong people time and again. But, holding free and fair elections in the country for 60 years deserves applause and one point further for this achievement.
The Preamble promised a ‘Republic’ where the leader is an elected person and not a monarch or part of a dynasty. We have again lived up to this spirit and can claim another point here. Often we mistake the Nehru family rule to be dynastic. This is misplaced because if a nation of 1 billion chooses on its own will a person in the same family, the fault lies with the people and not the system. Similarly, if parties end up propping up one surname for leader, it may reflect the paucity of ideas, but we cannot blame the system.
The Preamble also promised ‘justice’: social, economic and political. Out here the performance has been mixed. The judicial system appears to be very slow to dispense justice just as the recent rulings on the bomb blasts of 1993 demonstrate. The processes are so intricate that the common man can spend a life time making rounds of the courts searching for justice. Even today the underprivileged classes do not get social justice. But as the judicial system functions well and is known to be impartial, another half mark may be added.
The Preamble further assured us ‘liberty’ of thought, expression, belief, faith and worship. On this score, we would compare well with any western developed country. There are none or few controls imposed by the system. However, in the recent past we are seeing certain fundamental views which are being expressed not just in words but in destructive action by some intolerant political and religious groups. The reference is intolerance towards certain kinds of literature (Shivaji), art (MF Hussain), celebration of festivals (Valentine’s Day), conversions (Staines) dress codes and so on. These are some dangerous signs which need to be dealt with strictly by the judicial system before these Talibanistic tendencies spread and get ingrained in our social fabric. Three-quarter marks here.
The Preamble also guarantees ‘equality’ of status and opportunity. While we have had conscious affirmative action by the government to meet this objective, there have been problems in implementation of the reservations policy. Also the real under-privileged are not really receiving this benefit. But, to the extent that our laws have taken this objective seriously and made such provisions, we could give another three-quarter marks here.
Lastly, the Preamble talks of building ‘fraternity’ and the success has been quite remarkable despite all the problems that we have faced. People do stand up as one when it comes to the country with the nationalistic fervour prevailing. While this gives us one more point, the credit goes more to the people of the country rather than the system.
We have hence scored 6.5 points on a score of 10, which is quite good given the vastness of our country and the contradictions that lie in our society in terms of religion, caste, politics, social differences, education and conservatism. We need to consciously work on these factors to improve this score and should not let any extraneous elements get in the way.
The Preamble talks of 10 goals, each of which can be evaluated on a score of 1 and summed across to aggregate 10. We remain a ‘sovereign’ country and despite global turmoil and alliances our policies are dictated by Indians. This is saying a lot because developing countries have tended to slip into the former Soviet Bloc prior to 1990 or become a USA crony in return for favours. We have truly remained non-aligned and there is one point to be scored here.
We were to be a ‘socialist’ country, but have made limited progress here. While efforts have been on in the beginning to reduce inequalities through the public sector and mixed economy dictum, there has been a tendency for capitalist principles to predominate in the last decade and a half. There is nothing wrong in pursuing such policies except that there has been a tendency for the gulf between the rich and poor to widen. There have been policies espoused in the Plans to relieve poverty, but the implementation has been tardy. So it is half mark here.
India was to be built as a ‘secular’ nation. Unfortunately, secularism has been the most abused term used very often to divide society by our leaders. While secularism is a doctrine which gives equality to all religions in all respects, our polity has tended to use this term to garner votes, split society and create ill-will between people of different religions. This could be through either affirmative action or through plain bad-speaking of other religious doctrines. Either way, the nation remains polarized today on religious grounds as politicians. Conditions have been exacerbated by bringing in the caste factor, when religion is a non-issue. We have definitely failed here and there are no marks to be had.
The nation can take pride in being ‘democratic’ despite all the ups and downs that have been faced in the economic and social spheres. There has been just one minor aberration during the mid-seventies when democracy was subverted, but that did not last long. And given that we are one of the most populous nations, it is commendable that we remain a democracy with fair elections and no sign of a deviation from the processes. It is a different issue that we may not be voting in the right kind of people or vote for the wrong people time and again. But, holding free and fair elections in the country for 60 years deserves applause and one point further for this achievement.
The Preamble promised a ‘Republic’ where the leader is an elected person and not a monarch or part of a dynasty. We have again lived up to this spirit and can claim another point here. Often we mistake the Nehru family rule to be dynastic. This is misplaced because if a nation of 1 billion chooses on its own will a person in the same family, the fault lies with the people and not the system. Similarly, if parties end up propping up one surname for leader, it may reflect the paucity of ideas, but we cannot blame the system.
The Preamble also promised ‘justice’: social, economic and political. Out here the performance has been mixed. The judicial system appears to be very slow to dispense justice just as the recent rulings on the bomb blasts of 1993 demonstrate. The processes are so intricate that the common man can spend a life time making rounds of the courts searching for justice. Even today the underprivileged classes do not get social justice. But as the judicial system functions well and is known to be impartial, another half mark may be added.
The Preamble further assured us ‘liberty’ of thought, expression, belief, faith and worship. On this score, we would compare well with any western developed country. There are none or few controls imposed by the system. However, in the recent past we are seeing certain fundamental views which are being expressed not just in words but in destructive action by some intolerant political and religious groups. The reference is intolerance towards certain kinds of literature (Shivaji), art (MF Hussain), celebration of festivals (Valentine’s Day), conversions (Staines) dress codes and so on. These are some dangerous signs which need to be dealt with strictly by the judicial system before these Talibanistic tendencies spread and get ingrained in our social fabric. Three-quarter marks here.
The Preamble also guarantees ‘equality’ of status and opportunity. While we have had conscious affirmative action by the government to meet this objective, there have been problems in implementation of the reservations policy. Also the real under-privileged are not really receiving this benefit. But, to the extent that our laws have taken this objective seriously and made such provisions, we could give another three-quarter marks here.
Lastly, the Preamble talks of building ‘fraternity’ and the success has been quite remarkable despite all the problems that we have faced. People do stand up as one when it comes to the country with the nationalistic fervour prevailing. While this gives us one more point, the credit goes more to the people of the country rather than the system.
We have hence scored 6.5 points on a score of 10, which is quite good given the vastness of our country and the contradictions that lie in our society in terms of religion, caste, politics, social differences, education and conservatism. We need to consciously work on these factors to improve this score and should not let any extraneous elements get in the way.
Calling the call centre: Indian Express, 8th August 2007
They wish you a nice day... right after destroying every prospect of it
Hi-Tech banks claim that transactions carried out at a branch cost Rs 50. At an ATM, they come down to Rs 15, if they are through a call centre, they cost Rs 10, and it’s just Rs 2-4 if they are done on the internet. That is why customers are ‘encouraged’ to opt for cheaper modes.
Now call centres may sound like a good idea, but watch how they change your life — and mood. If the bank has a jingle, you are welcomed with a song. You are then provided with nine single-digit numbers corresponding to nine different banking options. If you forget what they stand for, you will have to wait for them to be replayed. You yearn for a human being on the other side, but that option is not easy to access. You start with choosing a language. Then you are asked to key in your 16-digit credit/debit card number. You do not have it on you so you either disconnect and try again or yell to someone to get you your card. You may be asked to key in your date of birth too, but before you get around to it, you are thanked for using the facility — the call is dropped.
You ring up again, go through the same process and this time manage to get through to the call centre staff. While the call is being transferred, you are politely told that your call is important and that someone will serve you “as soon as possible”. The jingle is supposed to keep you tuned in but makes you want to tear your hair out. Finally Rita, Vishal or Vinamra comes on the line and asks you to identify yourself. They will ask you for your address — and you better reel it off as it was typed in your particulars or else your call won’t be entertained. Your mother’s name will then be asked. What is the credit limit? What is the expiry date? When, and if, you finally break the barrier, you pose your question.
But your agony does not end there. If you are a ‘privileged’ customer you are transferred to a special division where the interrogation begins again. If you are lucky, your query gets answered at this stage. Otherwise, you are told that the system is down and that you will have to call back. Or you are told that you will get a response in four days’ time. Never mind if the call is about a lost credit card or something as urgent; the “four-days” answer is universal. Then comes the icing on the cake: “Sir/madam, is there anything else I can do for you? Have a nice day.”
But how can you have a nice day when your question has still not been answered? It makes you feel almost nostalgic for the days when you stood in the sweaty queue of your neighbourhood bank and waited for the person behind the counter to finish his cup of tea!
Hi-Tech banks claim that transactions carried out at a branch cost Rs 50. At an ATM, they come down to Rs 15, if they are through a call centre, they cost Rs 10, and it’s just Rs 2-4 if they are done on the internet. That is why customers are ‘encouraged’ to opt for cheaper modes.
Now call centres may sound like a good idea, but watch how they change your life — and mood. If the bank has a jingle, you are welcomed with a song. You are then provided with nine single-digit numbers corresponding to nine different banking options. If you forget what they stand for, you will have to wait for them to be replayed. You yearn for a human being on the other side, but that option is not easy to access. You start with choosing a language. Then you are asked to key in your 16-digit credit/debit card number. You do not have it on you so you either disconnect and try again or yell to someone to get you your card. You may be asked to key in your date of birth too, but before you get around to it, you are thanked for using the facility — the call is dropped.
You ring up again, go through the same process and this time manage to get through to the call centre staff. While the call is being transferred, you are politely told that your call is important and that someone will serve you “as soon as possible”. The jingle is supposed to keep you tuned in but makes you want to tear your hair out. Finally Rita, Vishal or Vinamra comes on the line and asks you to identify yourself. They will ask you for your address — and you better reel it off as it was typed in your particulars or else your call won’t be entertained. Your mother’s name will then be asked. What is the credit limit? What is the expiry date? When, and if, you finally break the barrier, you pose your question.
But your agony does not end there. If you are a ‘privileged’ customer you are transferred to a special division where the interrogation begins again. If you are lucky, your query gets answered at this stage. Otherwise, you are told that the system is down and that you will have to call back. Or you are told that you will get a response in four days’ time. Never mind if the call is about a lost credit card or something as urgent; the “four-days” answer is universal. Then comes the icing on the cake: “Sir/madam, is there anything else I can do for you? Have a nice day.”
But how can you have a nice day when your question has still not been answered? It makes you feel almost nostalgic for the days when you stood in the sweaty queue of your neighbourhood bank and waited for the person behind the counter to finish his cup of tea!
Monday, July 30, 2007
Has the ban worked? Business Standard, 29th July 2007
Futures trading was banned in four commodities in the beginning of the year ostensibly because it was felt that they were responsible for higher inflation. Five months have passed since the ban was imposed and it is essential to assess the impact of this ban on prices and the market — more so because there is a Committee that is looking into aspects of futures trading to provide a clearer perspective.
The inflation impact has not really been positive. The moderation in inflation from the 6 per cent mark to the 4.3 per cent mark witnessed today has been more due to a higher base effect as well as the aftermath of the rabi crop, which was good this year. Also this is the time when inflation is typically lower than in the latter part of the year, when demand picks up across the board.
Therefore, we have seen the prices of wheat and urad decline to begin with as the rabi harvest came in the months of March, April and May . However, ironically this was indicated by the futures prices at the time of the ban. But in the case of wheat, the story did not really end because the government has still not managed to procure the 15 million tonne target set for the FCI.
Either the production estimates of wheat, which is supposed to be close to 75 million tonnes, is not right or the farmers have become savvy and are not interested in selling to the government at a price of Rs 850/quintal especially since the landed cost of wheat could be anywhere up to Rs 1,200 per quintal at a minimum price of $263/tonne. The wheat chaff has yet to settle down and imports have been reckoned for the second successive year.
Tur was the other commodity which was banned, and its price continues to increase in the market, as output has fallen short of the target as indicated by the ministry of agriculture. This was also what the futures prices had indicated in January. In case of urad, the futures prices were falling anyway due to the rabi arrival as well as the imports which come towards the end of the first quarter from Myanmar. Quite evidently, the important signals provided by the futures market were incorrectly interpreted which resulted in what was euphemistically termed as a delisting of these commodities.
The consequences on the market have been fairly harsh. Firstly, market participants are apprehensive of trading in agricultural commodities as there is fear that the same kind of restrictions may be imposed on other commodities as well, in which case moving out of the market on satisfactory terms would be difficult. Therefore, participation in trading in agricultural commodities has come down quite significantly by between 10-20 per cent.
Secondly, the volumes of future starting in agricultural commodities have also come down and the commodity market appears to be buoyant only in non-agricultural commodities. The share of agricultural commodities in total traded volumes fell from around 55 per cent in FY06 to 35 per cent in FY07 and has further declined to 29 per cent in the first quarter of FY08.
Thirdly, diminishing volumes as well as participation in the futures markets have also affected the liquidity of contracts on the exchanges. Liquidity is important because an efficient market means there are large volumes, which is the prerequisite for efficient price discovery which, in turn, implies lower impact cost. This process has been set in motion in the last three years and has been quite competently established in an array of commodity groups such as cereals, spices, pulses and oils and oilseeds.
Fourthly, the very purpose of having futures trading has been defeated as it was proposed that futures trading would bring the benefit of fair prices to farmers when this market was resurrected in 2002. However, with diminished interest in futures trading, this bridge would get that much farther. While it is true that farmers are not trading today on the exchanges, there is enough evidence to show that in certain pockets of the country, the community is making use of the prices.
It is true that farmers would take time to actually trade as there are a number of enabling provisions in the regulatory structure that need to be put in place before this can happen. But before this can be embarked upon, we need to have a liquid market for agricultural commodities. The drying up of liquidity would automatically make the market that much less efficient and keep the farmers away from this system. There is a view that vested interest groups, who have seen their oligopolistic power diminished with the advent of futures trading, have been constantly trying to present an incorrect picture which could have influenced the decision to ban the trading of futures in four essential commodities.
The last consequence of a thin agricultural futures market is that a very important tool for taking economic decisions would be lost. Futures prices have, in the last couple of years, indicated well that crop harvests and prudential regulation from the FMC have ensured that price deviations have by and large reflected the fundamentals. This tool can hence be used at a more practical level by the government for fixing the MSPs as they will provide the market view of things.
At a different level, the ban has also affected the global view of the country in an age where markets are being liberalised; India appears to be dragging its feat. However, it is heartening that there are a number of foreign investors who are still interested in taking equity stakes in commodity exchanges with an equal interest being shown in trading.
The delisting logically needs to be removed to restore the equilibrium though it would take time for the market to restore its faith. This would be a pragmatic decision.
The inflation impact has not really been positive. The moderation in inflation from the 6 per cent mark to the 4.3 per cent mark witnessed today has been more due to a higher base effect as well as the aftermath of the rabi crop, which was good this year. Also this is the time when inflation is typically lower than in the latter part of the year, when demand picks up across the board.
Therefore, we have seen the prices of wheat and urad decline to begin with as the rabi harvest came in the months of March, April and May . However, ironically this was indicated by the futures prices at the time of the ban. But in the case of wheat, the story did not really end because the government has still not managed to procure the 15 million tonne target set for the FCI.
Either the production estimates of wheat, which is supposed to be close to 75 million tonnes, is not right or the farmers have become savvy and are not interested in selling to the government at a price of Rs 850/quintal especially since the landed cost of wheat could be anywhere up to Rs 1,200 per quintal at a minimum price of $263/tonne. The wheat chaff has yet to settle down and imports have been reckoned for the second successive year.
Tur was the other commodity which was banned, and its price continues to increase in the market, as output has fallen short of the target as indicated by the ministry of agriculture. This was also what the futures prices had indicated in January. In case of urad, the futures prices were falling anyway due to the rabi arrival as well as the imports which come towards the end of the first quarter from Myanmar. Quite evidently, the important signals provided by the futures market were incorrectly interpreted which resulted in what was euphemistically termed as a delisting of these commodities.
The consequences on the market have been fairly harsh. Firstly, market participants are apprehensive of trading in agricultural commodities as there is fear that the same kind of restrictions may be imposed on other commodities as well, in which case moving out of the market on satisfactory terms would be difficult. Therefore, participation in trading in agricultural commodities has come down quite significantly by between 10-20 per cent.
Secondly, the volumes of future starting in agricultural commodities have also come down and the commodity market appears to be buoyant only in non-agricultural commodities. The share of agricultural commodities in total traded volumes fell from around 55 per cent in FY06 to 35 per cent in FY07 and has further declined to 29 per cent in the first quarter of FY08.
Thirdly, diminishing volumes as well as participation in the futures markets have also affected the liquidity of contracts on the exchanges. Liquidity is important because an efficient market means there are large volumes, which is the prerequisite for efficient price discovery which, in turn, implies lower impact cost. This process has been set in motion in the last three years and has been quite competently established in an array of commodity groups such as cereals, spices, pulses and oils and oilseeds.
Fourthly, the very purpose of having futures trading has been defeated as it was proposed that futures trading would bring the benefit of fair prices to farmers when this market was resurrected in 2002. However, with diminished interest in futures trading, this bridge would get that much farther. While it is true that farmers are not trading today on the exchanges, there is enough evidence to show that in certain pockets of the country, the community is making use of the prices.
It is true that farmers would take time to actually trade as there are a number of enabling provisions in the regulatory structure that need to be put in place before this can happen. But before this can be embarked upon, we need to have a liquid market for agricultural commodities. The drying up of liquidity would automatically make the market that much less efficient and keep the farmers away from this system. There is a view that vested interest groups, who have seen their oligopolistic power diminished with the advent of futures trading, have been constantly trying to present an incorrect picture which could have influenced the decision to ban the trading of futures in four essential commodities.
The last consequence of a thin agricultural futures market is that a very important tool for taking economic decisions would be lost. Futures prices have, in the last couple of years, indicated well that crop harvests and prudential regulation from the FMC have ensured that price deviations have by and large reflected the fundamentals. This tool can hence be used at a more practical level by the government for fixing the MSPs as they will provide the market view of things.
At a different level, the ban has also affected the global view of the country in an age where markets are being liberalised; India appears to be dragging its feat. However, it is heartening that there are a number of foreign investors who are still interested in taking equity stakes in commodity exchanges with an equal interest being shown in trading.
The delisting logically needs to be removed to restore the equilibrium though it would take time for the market to restore its faith. This would be a pragmatic decision.
Friday, July 27, 2007
Carving out value: dna 25TH July 2007
It is not unusual to see a company separating one of its divisions into a new entity and getting a nod in the stock market for its action.
The share price goes up and the shareholders gain, thus vindicating the decision. This keeps happening in USA, Europe and Japan. In the last six years there have been a number of such actions in India which come under the umbrella of the synonyms of demergers, spin-offs, carve-outs, and so on.
There was a time when companies went in for diversification — very often in unrelated fields, either because it was trendy or because it came along with an alliance with a foreign collaborator.
After a while, the management realises that this business is a burden on the P&L account. Demergers then are the logical corollary, and the market applauds it with higher valuation for both the entities.
The basic premise here is that parts of the company get a better valuation than the single entity. The issue now is whether or not this can be a workable strategic proposition: Can we get superior valuations from demergers?
Companies such as Hindustan Lever, L&T, Tata Steel and Tata Motors have moved away from their non-core businesses using this route. Exiting from unviable businesses has been a common corporate strategy to address the challenges of competition.
Two aspects need to be debated: the motivations for such an action and the actual experiences of companies in this regard.
Spin-offs or demergers are definitely used to get better market valuations. That’s so because the market now gets more information on both the companies, thus reducing the information asymmetry, and investors are able to evaluate the companies in a better way.
A company would typically try and spin-off a unit or line of business which no longer adds value to the balance sheet.
Selling unwanted and surplus or unconnected parts in the business is a restructuring strategy to get rid of the sick parts of the company.
The other reason could be to return to its core competence and move away from unrelated fields. At times the better valuation helps it garner resources to finance an acquisition.
Such moves also help to make financial and managerial resources available for developing other, more profitable opportunities.
Take the case of L&T, which is primarily an engineering firm. It had capital locked in cement, which was driving the profit level down. So it made sense to demerge this unit so that the valuation of L&T improved. How did this happen?
The profit ratios improved as the balance sheet of the cement division was separated and the share price rose manifold.
Similarly, EID Parry was able to separate its sugar business from fertilizers, which went to Coromandel fertilizers. Now Reliance Communications is planning to hive off its towers business to unlock value at the bourses.
These success stories could be attributed to proper planning where there is better management focus and greater flexibility in operations.
While the results have been encouraging in terms of better valuation, the motivation was definitely restructuring of business lines. All spin offs have not been successful even when they’ve made theoretical sense.
This holds especially for the IT education business, where companies such as Aptech and NIIT separated software from education.
However, this could be attributed more to the diminishing importance of the education business where it was no longer the prerogative of these institutes to provide the service.
The question now is whether or not the value created through such separations is real. Most spin-offs are invariably of divisions that are not performing: rarely does a company find an unrelated business a burden if the profits are streaming in!
In the last 6 years or so, there have been more successes than failures. As long as the premises are right, the chances of success are greater. However, there are some preconditions.
The resulting business has to be a viable one (NIIT). Secondly, the business (to be spun-off) must be one which is bringing down the value of a company due to the absence of the required skills or management time for the same (L&T). Thirdly, the hived off unit must have a capable management.
Anecdotal evidence suggests that the market is mostly rational and awards a better valuation only if enhanced value is seen. Mere spin-offs do not guarantee better valuations. This critical point must not be missed.
The share price goes up and the shareholders gain, thus vindicating the decision. This keeps happening in USA, Europe and Japan. In the last six years there have been a number of such actions in India which come under the umbrella of the synonyms of demergers, spin-offs, carve-outs, and so on.
There was a time when companies went in for diversification — very often in unrelated fields, either because it was trendy or because it came along with an alliance with a foreign collaborator.
After a while, the management realises that this business is a burden on the P&L account. Demergers then are the logical corollary, and the market applauds it with higher valuation for both the entities.
The basic premise here is that parts of the company get a better valuation than the single entity. The issue now is whether or not this can be a workable strategic proposition: Can we get superior valuations from demergers?
Companies such as Hindustan Lever, L&T, Tata Steel and Tata Motors have moved away from their non-core businesses using this route. Exiting from unviable businesses has been a common corporate strategy to address the challenges of competition.
Two aspects need to be debated: the motivations for such an action and the actual experiences of companies in this regard.
Spin-offs or demergers are definitely used to get better market valuations. That’s so because the market now gets more information on both the companies, thus reducing the information asymmetry, and investors are able to evaluate the companies in a better way.
A company would typically try and spin-off a unit or line of business which no longer adds value to the balance sheet.
Selling unwanted and surplus or unconnected parts in the business is a restructuring strategy to get rid of the sick parts of the company.
The other reason could be to return to its core competence and move away from unrelated fields. At times the better valuation helps it garner resources to finance an acquisition.
Such moves also help to make financial and managerial resources available for developing other, more profitable opportunities.
Take the case of L&T, which is primarily an engineering firm. It had capital locked in cement, which was driving the profit level down. So it made sense to demerge this unit so that the valuation of L&T improved. How did this happen?
The profit ratios improved as the balance sheet of the cement division was separated and the share price rose manifold.
Similarly, EID Parry was able to separate its sugar business from fertilizers, which went to Coromandel fertilizers. Now Reliance Communications is planning to hive off its towers business to unlock value at the bourses.
These success stories could be attributed to proper planning where there is better management focus and greater flexibility in operations.
While the results have been encouraging in terms of better valuation, the motivation was definitely restructuring of business lines. All spin offs have not been successful even when they’ve made theoretical sense.
This holds especially for the IT education business, where companies such as Aptech and NIIT separated software from education.
However, this could be attributed more to the diminishing importance of the education business where it was no longer the prerogative of these institutes to provide the service.
The question now is whether or not the value created through such separations is real. Most spin-offs are invariably of divisions that are not performing: rarely does a company find an unrelated business a burden if the profits are streaming in!
In the last 6 years or so, there have been more successes than failures. As long as the premises are right, the chances of success are greater. However, there are some preconditions.
The resulting business has to be a viable one (NIIT). Secondly, the business (to be spun-off) must be one which is bringing down the value of a company due to the absence of the required skills or management time for the same (L&T). Thirdly, the hived off unit must have a capable management.
Anecdotal evidence suggests that the market is mostly rational and awards a better valuation only if enhanced value is seen. Mere spin-offs do not guarantee better valuations. This critical point must not be missed.
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