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.

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.

More transparency needed in NPAs: Economic Times 19th July 2007

Transparency in accounts is pertinent for banks since they deal with public money. The stakeholders involve a large number of individuals starting from the owners and staff to the borrowers and deposit holders. The quickest indicator of the health of a bank is the ratio of non-performing assets to total assets. Assuming that prudential accounting practices are pursued, this number indicates the strength of a bank. If this ratio increases, then one can smell trouble. In the US, where the accounting norms are strict and transparency mandatory, there are some good chapters that should be incorporated in our systems. The first is that these health indicators should be announced more frequently with less scope given for window dressing. The second is that a simple number for the ratio is not really adequate and we must strive to have a drill down of this number. To see how this can be tackled, we can borrow what the Fed does. The first table (Heavy Burden) drills down the delinquent assets of various categories of banks and bank assets. Five major findings emerge from this table. Firstly, delinquency rates are higher for the larger banks compared to the smaller ones; which is the result when larger banks are more aggressive in building their asset portfolio. The second highlight is that consumer loans have higher delinquency rates with credit cards being the most vulnerable section. This is significant given that the focus of banking is on the retail end, where the consumer loan segment is being targeted aggressively by banks. The rates charged here are normally higher than the median rates charged on other loan categories. Thirdly, real estate loans, especially residential, have higher rates than the commercial real estate loans, meaning thereby that individuals tend to be the larger defaulters. This finding gels well with the earlier observation that the consumer loan segment is more vulnerable than other categories of loans. Fourthly, industry in particular is better at servicing their loans; and also agriculture loans have lower rates of default. Lastly, the larger banks are more vulnerable, when it comes to consumer or real estate loans, implying that they would tend to be more aggressive when dealing with individuals where the default rates are higher. For the other banks, the challenge is more at controlling the growth in industrial defaults since there would be a tendency for the lower-rated companies to access them since the larger ones would be more stringent with their lending norms. Now this is important for us since there has been a tendency for consumer loans to increase in our context. The table alongside shows the broad composition of bank loans in the US and India, and some of the categories of loans are equally important in India. The two sets of data may not be strictly comparable as the definition of segments is dissimilar in some places. However, the important point here is that the non-mortgage consumer segment, which is of an equal dimension in the two countries, has the same share in total credit for both sets of banks. Real estate, in our context, is the mortgage portfolio while it also includes commercial real estate in the US. The fact that the real estate (or mortgage in our case) segments are dominant in the US, and are beginning to dominate in our case is indicative of the problems that could beset our system in the years to come. The RBI has taken note of the same, but there is a need for close monitoring of the data and trigger points should be drawn so that prompt corrective action may be taken as these proportions rise. Also, as in the case of the US, this information needs to be revealed on a quarterly basis under standardised definitions so that there is equal access to this information. The absolute numbers of NPAs as well as ratios need to be mentioned to eschew any kind of camouflage which is resorted to by some banks by inflating the loan book when the NPA levels increase. This will strengthen the prudential processes that have been instituted and pursued assiduously by RBI for the last decade and a half.