Once you take into account the forex needs for four months of imports, NRI deposits, short term debt and FII flows, India's forex reserves of $300 billion don't look so large.
The forex story for the country in the last couple of years has been a dream with the onus shifting to the monetary authority to balance increasing liquidity with rupee appreciation. The gathering of dollars essentially from the investment route has prefaced all such stories. While this cannot be contested, there is something else happening in the background which could be a concern that needs to be tracked carefully even though there are presently no signs of any problems. The issue in question is India's external debt.
The Economic Survey has highlighted the sudden surge in external debt which rose from $ 84 billion in 1991 to $ 101 in 2001, registering an average annual increase of $ 1.7 bn. The number was higher at around $ 15 bn per annum in the next six and half years with external debt rising to $ 190 bn by September 2007. This really means that while foreign investment has been flowing in large numbers, the debt component has also been rising. Forex reserves have been rising at around $ 33 bn a year in this period, with acceleration in the last 18 months.
The table shows that the turning point has actually been 2006-07 when external debt ballooned significantly. In 2006-07, external debt rose by roughly $ 31 bn while the FDI and FII inflows were $ 23 bn and $ 7 bn respectively. This trend persists in the first half of 2007-08, where foreign investment was around $ 21-22 bn while debt rose by $ 21 bn. This really means that there was an almost 1:1 incremental debt-equity ratio being registered during these two periods. In fact, while debt has increased by over $ 50 bn in the last eighteen months, our overall forex reserves have risen by $ 85 bn.
The rise in external debt the last 18 months ending September 2007 has been really enormous at over $ 50 bn. The increase has come from three sources, two of which need attention. The first is the rise in the commercial borrowings which have almost doubled in the last 18 months. There are two reasons for this. The first is that Indian companies have been scouting the global markets for funds which are available at a lower cost. It may be noted here that interest rates in India have been rising in the last couple for years while the Fed and ECB have been driving down the rates gradually in the last year or so. This makes it easier for the better rated companies to access the Euro markets for funds. With the interest rate (PLR) differential being between 400-500 bps and adding another 100-150 bps as risk premium and 50 bps for exchange risk (this is low as one expects the rupee to strengthen further) there would still be a net differential of 100-150 bps in interest rates. The other factor is the growing evide nce of carry trade where funds are being borrowed at lower interest rates and on-lent at higher rate with again the exchange rate risk being assumed to be minimal. While this amount cannot be quantified, this could be another reason for higher commercial borrowings. Bank borrowings constitute around 60-70 per cent of these commercial borrowings while the rest are securitized borrowings.
The other serious concern is the rise in short term debt. The increase by $ 10-11 bn in the last 8 months is quite high. It may be recollected that high short-term debt was one of the reasons why the Asian crisis originated and spread quite catastrophically across that part of the continent. This is the kind of funds which could take flight in times of a crisis. We had prided ourselves in maintaining short term debt at a low level of around 4 per centof total debt. Today at 16per cent, it is a worry.
The third factor driving debt has been the NRIs, where interest rate differentials could be the factor driving them along with the India Shining story. This has been somewhat fickle in the past where reduction in interest rate differentials could cause inflows to slowdown.
If these two components, i.e. NRI deposits and short term debt are considered to be vulnerable flows, as they are reversible, then the total quantity would be around $ 75 bn. Add to this another $ 75 bn of FII inflows which today could be valued at between 2-3 times given that these are the absolute investment inflows made cumulatively since 1992 whose value would have risen with the stock markets. In fact, if the FIIs were to withdraw, the amount would be a multiple of this $75 bn. Add to this, four months of prudential imports cover, of around $80 bn. Without taking into account the capital appreciation of our FII inflows, the total vulnerable capital flows would be around $ 230bn. Now, when this number is juxtaposed with the total forex reserves of nearly $ 300 which we have today, the comfort level drops.
Wednesday, April 30, 2008
Monday, April 28, 2008
Not Good Enough Steps: Financial Express 29th April 2008
‘Hundred Small Steps’ may sound good and practical, but the Rahugram Rajan Committee report on financial reforms does not offer anything new. If anything, there appears to be a proclivity towards liberalisation for the sake of liberalisation. This is only to be expected, as Joseph Stiglitz might put it, considering that the committee was headed by an ex-IMF official. At first sight, the report appears balanced, offering both sides of the issue, but invariably settles for the obvious, with the caveats that there should be strong institutions and governance. But the problem with any financial crisis is institutional failure and unreliable governance. This is where radical approaches falter. The requisite institutions are never built before allowing the game to begin. One question remains unanswered: who regulates hedge funds or securitisation, for that matter?
Financial liberalisation tends to lead to recklessness, which is serious, since it involves other people’s money. Still, the committee appears to prefer the IMF solution of opening up regardless of whether or not it is appropriate. In fact, if the Indian system has stood the test of time, it is because of conservative financial policies. The so-called “dynamic participants” have been often caught in a trap, but this has never been highlighted.
The composition of the Committee deserves comment. It has 11 members, excluding a convener, of which seven are from the private sector, two are academics, one from the IMF and one from the public sector. A committee without participation from the RBI, IBA or Sebi appears to be distorted, to begin with. The virtual absence of the public sector makes it one-sided, and the exclusion of financial service users pushes it further into a corner. It seems to be a view of “market participants” rather than “regulators” or “users of the market”. It is not surprising that the conclusion reached is unbridled liberalisation, with a few cautionary qualifications thrown in.
There are seven issues that have been discussed which provoke comment. The report favours inflation targeting, which is monetarist in spirit, as monetarism holds that excessive money supply is what causes inflation. But, given that monetary policy affects growth, RBI’s current stance of growth with stability appears a better option. In fact, ideally, we should have two numbers that must be targeted: one for growth and the other, inflation.
The committee also favours the use of the repo or reverse repo rate to control inflation. However, in the Indian context, these rates appear to be merely indicative and seldom do banks follow these rates when it comes to deciding their own benchmark rates. It is better to pitch for the CRR, which has the direct impact of affecting potential inflationary liquidity.
Opening up the debt market to foreign investors is a known and good idea, but the RBI approach of caution is preferable. Foreign funds have already poured in $80 billion into the country’s equity market, and at the present value of a multiple of 3:4, actually hold significant potential as a threat in times of distress. Further, allowing provident funds to invest overseas would not make sense, as Indian Markets anyway provide higher yields in comparison with western Markets, which are more secure than the emerging ones.
The report also talks of letting in more private banks. This option has been experimented with, and we have already seen a number of private banks folding up. There is a contradiction here, as we are talking of consolidation on one hand (on grounds of economies of scale) and creating new small banks, on the other. In fact, the creation of universal banks has already created a new problem of long-term funding, which ironically will need the creation of new institutions which will resemble the ones that became universal banks, to begin with!
Further, the issue of priority sector loan certificates (PSLC) is absurd, to say the least. If there is commitment to the priority sector, one has to follow it. Once we accept such lending, banks should be penalised upon failure, instead of allowing inter-bank trade. Given that priority sector loans have a higher probability of turning into NPAs, erring banks could simply fall short of their targets and get away by paying off other banks. The RIDF scheme is a better option.
The report speaks of how banks have been forced to invest in government paper. This is an exaggerated claim. Today, despite an SLR of 25%, banks are stuffed with over 30% government bonds. They offer reasonably good returns and capital appreciation, and are less risky, with a lighter capital burden. Banks are not being “forced” to support the fiscal deficit.
Lastly, the suggestion of a single trading regulator is debatable. Market complexities demand specialisation, and no single regulator could have such wide expertise.
The report, to be fair, is comprehensive. There are some anomalies which need to be reviewed. Its approach to the free market Economy is quite textbookish, its chief failing. Free Markets work well when conditions are perfect. But, since they are not, RBI’s approach of gradualism is worth adhering to.
Financial liberalisation tends to lead to recklessness, which is serious, since it involves other people’s money. Still, the committee appears to prefer the IMF solution of opening up regardless of whether or not it is appropriate. In fact, if the Indian system has stood the test of time, it is because of conservative financial policies. The so-called “dynamic participants” have been often caught in a trap, but this has never been highlighted.
The composition of the Committee deserves comment. It has 11 members, excluding a convener, of which seven are from the private sector, two are academics, one from the IMF and one from the public sector. A committee without participation from the RBI, IBA or Sebi appears to be distorted, to begin with. The virtual absence of the public sector makes it one-sided, and the exclusion of financial service users pushes it further into a corner. It seems to be a view of “market participants” rather than “regulators” or “users of the market”. It is not surprising that the conclusion reached is unbridled liberalisation, with a few cautionary qualifications thrown in.
There are seven issues that have been discussed which provoke comment. The report favours inflation targeting, which is monetarist in spirit, as monetarism holds that excessive money supply is what causes inflation. But, given that monetary policy affects growth, RBI’s current stance of growth with stability appears a better option. In fact, ideally, we should have two numbers that must be targeted: one for growth and the other, inflation.
The committee also favours the use of the repo or reverse repo rate to control inflation. However, in the Indian context, these rates appear to be merely indicative and seldom do banks follow these rates when it comes to deciding their own benchmark rates. It is better to pitch for the CRR, which has the direct impact of affecting potential inflationary liquidity.
Opening up the debt market to foreign investors is a known and good idea, but the RBI approach of caution is preferable. Foreign funds have already poured in $80 billion into the country’s equity market, and at the present value of a multiple of 3:4, actually hold significant potential as a threat in times of distress. Further, allowing provident funds to invest overseas would not make sense, as Indian Markets anyway provide higher yields in comparison with western Markets, which are more secure than the emerging ones.
The report also talks of letting in more private banks. This option has been experimented with, and we have already seen a number of private banks folding up. There is a contradiction here, as we are talking of consolidation on one hand (on grounds of economies of scale) and creating new small banks, on the other. In fact, the creation of universal banks has already created a new problem of long-term funding, which ironically will need the creation of new institutions which will resemble the ones that became universal banks, to begin with!
Further, the issue of priority sector loan certificates (PSLC) is absurd, to say the least. If there is commitment to the priority sector, one has to follow it. Once we accept such lending, banks should be penalised upon failure, instead of allowing inter-bank trade. Given that priority sector loans have a higher probability of turning into NPAs, erring banks could simply fall short of their targets and get away by paying off other banks. The RIDF scheme is a better option.
The report speaks of how banks have been forced to invest in government paper. This is an exaggerated claim. Today, despite an SLR of 25%, banks are stuffed with over 30% government bonds. They offer reasonably good returns and capital appreciation, and are less risky, with a lighter capital burden. Banks are not being “forced” to support the fiscal deficit.
Lastly, the suggestion of a single trading regulator is debatable. Market complexities demand specialisation, and no single regulator could have such wide expertise.
The report, to be fair, is comprehensive. There are some anomalies which need to be reviewed. Its approach to the free market Economy is quite textbookish, its chief failing. Free Markets work well when conditions are perfect. But, since they are not, RBI’s approach of gradualism is worth adhering to.
Friday, April 25, 2008
A world agricultural bank? Economic Times: 26th April 2008
What does a country which has a foreign currency problem emanating from a fundamental balance of payments disequilibrium do? It goes to the IMF for assistance. What are the options for a country when it needs money for a development project? It goes to the World Bank, IDA or ADB for aid. What can a country which has a physical food problem do? It cannot look beyond probably imports which have their own limitations of being uncertain, besides carrying the ubiquitous threat of higher inflation being transmitted. Presently there is no way out for a country which has a shortage of food and cannot supplement the same with imports. The problem is more acute when the product is rare, like pulses which are grown by a few countries. This situation should sow the seeds of the idea of establishing a world agricultural bank (WAB) which can respond appropriately in times of crisis. The food situation today is serious. It is not that countries do not have money to buy food, but the way things are progressing, it may not be far off when there will be shortages throughout the world as production is just not keeping pace with demand. Presently, there may be no reason to panic as the higher prices are a reflection of stable or lower production and depleting stocks (which are still reasonable at the global level). Once this comfort disappears, there will be a problem for all countries. The ever increasing population, especially in the developing and underdeveloped world, is one part of the problem. The other threat comes from a more recent phenomenon — the emphasis on bio-fuels. The IMF has estimated that nearly 50% of the increase in food prices today can be attributed to the demand emanating from bio-fuels. Bio-fuels just sometime back appeared to be the panacea for the fuel problem (but hasn’t quite delivered as yet), and several countries (particularly Brazil and the United States) have diverted land to the production of crops like corn or soyabean. Two things have resulted. Shifting cultivation has led to a fall in production of other crops on account of this diversion, with wheat being the main casualty. Secondly, prices have started moving up perniciously for virtually all agricultural commodities across the globe, and this has both social and political implications. After assiduously encouraging the farmers to grow more of these crops, governments cannot do a U-turn now. Going back today universally to a regime of controls where such conversion of crops into fuel is possible, though not practical. Therefore, there is a need for an alternative, which is the WAB.
The WAB should be established by member countries which will have to contribute both equity capital as well as grains/oilseeds to the Bank. The Bank could choose the products that it would like to stock and can include those which normally are subject to production volatility. This would form a corpus which can be used to assist member countries in times of distress. The Bank on its part would be in the business of procuring products from the market at all times to build a buffer and would also be tapping all countries for surpluses. The prices at which procurement would take place could be the prevailing market price. The members can be allowed to buy a certain times their contribution or quotas (as was the case with the IMF at one time) as may be decided by the Bank at a predetermined price, which may be announced at the beginning of the year. This way, the prices would be lower for the member country than the prevailing market prices in times of a crisis. The Bank on its part would be rolling over stocks to ensure that there is minimal loss of the product on account of storage. The Bank could also carry out its own farming activity by either procuring land or leasing the same in different countries and growing the deficit crops such as corn, wheat, oilseeds, etc, so as to augment its own supplies. The business model would be quite straight forward. It would be a profit making institution which earns income from four sources. The first would be through the interest on base capital. The second would be on the difference between the purchase price and the sale price. The sale price would normally be higher than the purchase price, but at the same time lower than the current prevailing price so that the member country would be better off buying from the Bank than importing the same. The third would be interest on loans given to member countries for purchase of agri-products. The last would be a combination of hedging and trading activity. The Bank would need to hedge its own price risk and would have a trading desk whereby the hedge transactions are carried out. In fact, by its sheer size and possible clout, it could help to rein in price increases on the exchanges in times of global shortfalls. The creation of such an institution is a compelling need today on account of the proliferation of the twin issues of globalisation and food shortages. Rapid globalisation has transmitted these shocks across countries due to the strong trade links which has enveloped the regions. And both of them are here to stay. Therefore, rather than living with the vicissitudes of nature with a lot of stress, a solution can be had by this institution which will help in alleviating the situation. This, in turn, will help check global inflation, which appears to be driven essentially by three factors: food, fuel and minerals. By addressing the first issue, a lot can be achieved as it provides governments a lot of political comfort. Presently, individual countries are doing their best to build buffers which will help in the short term. The World Agricultural Bank will provide the balm for more countries in a sustained manner over the medium and long terms, which is what one should be looking at. The problem after all is global and is not localised
The WAB should be established by member countries which will have to contribute both equity capital as well as grains/oilseeds to the Bank. The Bank could choose the products that it would like to stock and can include those which normally are subject to production volatility. This would form a corpus which can be used to assist member countries in times of distress. The Bank on its part would be in the business of procuring products from the market at all times to build a buffer and would also be tapping all countries for surpluses. The prices at which procurement would take place could be the prevailing market price. The members can be allowed to buy a certain times their contribution or quotas (as was the case with the IMF at one time) as may be decided by the Bank at a predetermined price, which may be announced at the beginning of the year. This way, the prices would be lower for the member country than the prevailing market prices in times of a crisis. The Bank on its part would be rolling over stocks to ensure that there is minimal loss of the product on account of storage. The Bank could also carry out its own farming activity by either procuring land or leasing the same in different countries and growing the deficit crops such as corn, wheat, oilseeds, etc, so as to augment its own supplies. The business model would be quite straight forward. It would be a profit making institution which earns income from four sources. The first would be through the interest on base capital. The second would be on the difference between the purchase price and the sale price. The sale price would normally be higher than the purchase price, but at the same time lower than the current prevailing price so that the member country would be better off buying from the Bank than importing the same. The third would be interest on loans given to member countries for purchase of agri-products. The last would be a combination of hedging and trading activity. The Bank would need to hedge its own price risk and would have a trading desk whereby the hedge transactions are carried out. In fact, by its sheer size and possible clout, it could help to rein in price increases on the exchanges in times of global shortfalls. The creation of such an institution is a compelling need today on account of the proliferation of the twin issues of globalisation and food shortages. Rapid globalisation has transmitted these shocks across countries due to the strong trade links which has enveloped the regions. And both of them are here to stay. Therefore, rather than living with the vicissitudes of nature with a lot of stress, a solution can be had by this institution which will help in alleviating the situation. This, in turn, will help check global inflation, which appears to be driven essentially by three factors: food, fuel and minerals. By addressing the first issue, a lot can be achieved as it provides governments a lot of political comfort. Presently, individual countries are doing their best to build buffers which will help in the short term. The World Agricultural Bank will provide the balm for more countries in a sustained manner over the medium and long terms, which is what one should be looking at. The problem after all is global and is not localised
Tuesday, April 15, 2008
Fed: Sending the wrong signals: Business Line: 12th April 2008
The Federal Reserve appears to be chasing a crooked shadow. Let us track its approach to policy since last August. It has turned Keynesian instead of being Monetarist by preferring to fine-tune a rules approach.
There has been too much of fine-tuning, with the assumption being that piece-meal moves help. The discount rate has been lowered eight times since August while the benchmark rate has been lowered six times. Add to these, oodles of financial windows be ing opened up quite liberally.Factors at work
There are evidently three factors at work. The first is growth. There is a feeling that growth is retarded due to lower consumption and house-buying. Therefore, interest rates need to be lowered. Besides, unemployment has also been rising in the last two months — primarily in the financial and real-estate sectors. This bad combination leads to the second factor — politics.
With elections around the corner, the George Bush Government would not like to be seen as one which brought growth down due to stringent monetary policy action. Besides, stagflation could be doing the rounds in the US, where prices could be increasing due to the commodity boom and unemployment rising simultaneously.
This brings back the déjÀ vu of the 1970s which should not be replicated. And, third, there is the financial mess that needs to be cleaned up, and the Fed has decided that it should not remain a mute spectator. Lending is now possible to non-banks and it has also pledged $200 billion of treasuries to be exchanged for mortgage-backed bonds issued by Freddie Mac and Fannie Mae and other private companies.
Lowering interest rates
The stagflation dilemma is real. If growth has slowed down, then interest rates have to come down. However, when the problem is structural, as today, lower interest rates do not help.
Today, banks do not want to lend because they are not sure of the quality of the asset. And they do not want to lend to other banks because they are not sure of their creditworthiness. So, liquidity is not the issue. People do not want to borrow to buy houses, and banks to not want to lend to the owner or builder because the asset has become tainted. And there’s the rub. By lowering interest rates, one may end up creating a demand-pull spiral which may supersede the cost-push inflation which, according to the Fed, will soon be controlled.
The Fed’s actions are also directed more to bailing out the failed financial firms such as Bear Stearns. The issues raised are several. The first is whether or not it is the duty of the Fed to do so. After all, if funds are not being invested properly, the regulator should not bother. But the Fed has to bear judgment that a financial failure has repercussions across the sector and cannot be treated as an anomaly. This leads to the second question of whether financial crises should be allowed to play their full role.
Going by the Schumpeterian doctrine of creative destruction, such crises are needed to ensure that the bad is separated from the good. This is so because during boom times, it is but natural that there are players who overplay the risk card and suffer injury. In such a case, the Fed or central bank should not bother too much, especially if it is fund and not a bank. Incorrect signals
Third, there is the issue of moral hazard. By not allowing a Bear Stearns to fail, the Fed is sending incorrect signals to the sector, that others too can gamble, and even take in huge bonuses with an implicit assurance that if things fail, they will not be penalised as the Fed is there to take care of their interests.
But protagonists of the Fed’s approach claim that it is precisely because the Fed sat back and did nothing that the Depression of the 1930s happened. Thus, by intervening, the Fed has pre-empted a crisis that could have crossed several continents.
The way things are shaping up now, it looks like the Fed may just be preparing the ground for another boom spell which could have a hard landing. The area may not be known, though the pattern is hard to miss. A rules approach to policy and stern approach towards resuscitation packages is advisable under the circumstances.
There has been too much of fine-tuning, with the assumption being that piece-meal moves help. The discount rate has been lowered eight times since August while the benchmark rate has been lowered six times. Add to these, oodles of financial windows be ing opened up quite liberally.Factors at work
There are evidently three factors at work. The first is growth. There is a feeling that growth is retarded due to lower consumption and house-buying. Therefore, interest rates need to be lowered. Besides, unemployment has also been rising in the last two months — primarily in the financial and real-estate sectors. This bad combination leads to the second factor — politics.
With elections around the corner, the George Bush Government would not like to be seen as one which brought growth down due to stringent monetary policy action. Besides, stagflation could be doing the rounds in the US, where prices could be increasing due to the commodity boom and unemployment rising simultaneously.
This brings back the déjÀ vu of the 1970s which should not be replicated. And, third, there is the financial mess that needs to be cleaned up, and the Fed has decided that it should not remain a mute spectator. Lending is now possible to non-banks and it has also pledged $200 billion of treasuries to be exchanged for mortgage-backed bonds issued by Freddie Mac and Fannie Mae and other private companies.
Lowering interest rates
The stagflation dilemma is real. If growth has slowed down, then interest rates have to come down. However, when the problem is structural, as today, lower interest rates do not help.
Today, banks do not want to lend because they are not sure of the quality of the asset. And they do not want to lend to other banks because they are not sure of their creditworthiness. So, liquidity is not the issue. People do not want to borrow to buy houses, and banks to not want to lend to the owner or builder because the asset has become tainted. And there’s the rub. By lowering interest rates, one may end up creating a demand-pull spiral which may supersede the cost-push inflation which, according to the Fed, will soon be controlled.
The Fed’s actions are also directed more to bailing out the failed financial firms such as Bear Stearns. The issues raised are several. The first is whether or not it is the duty of the Fed to do so. After all, if funds are not being invested properly, the regulator should not bother. But the Fed has to bear judgment that a financial failure has repercussions across the sector and cannot be treated as an anomaly. This leads to the second question of whether financial crises should be allowed to play their full role.
Going by the Schumpeterian doctrine of creative destruction, such crises are needed to ensure that the bad is separated from the good. This is so because during boom times, it is but natural that there are players who overplay the risk card and suffer injury. In such a case, the Fed or central bank should not bother too much, especially if it is fund and not a bank. Incorrect signals
Third, there is the issue of moral hazard. By not allowing a Bear Stearns to fail, the Fed is sending incorrect signals to the sector, that others too can gamble, and even take in huge bonuses with an implicit assurance that if things fail, they will not be penalised as the Fed is there to take care of their interests.
But protagonists of the Fed’s approach claim that it is precisely because the Fed sat back and did nothing that the Depression of the 1930s happened. Thus, by intervening, the Fed has pre-empted a crisis that could have crossed several continents.
The way things are shaping up now, it looks like the Fed may just be preparing the ground for another boom spell which could have a hard landing. The area may not be known, though the pattern is hard to miss. A rules approach to policy and stern approach towards resuscitation packages is advisable under the circumstances.
Wednesday, April 2, 2008
Risky Business: DNA, 3rd April 2008
Companies need strong risk practices to shield themselves from sudden crises elsewhere
Situation A. A large Indian engineering firm has a risk mitigation policy in place and decides to hedge its raw materials price risk on the LME (London Metal Exchange). Typically, one does it when prices are on the upswing, as the input costs would shoot up in case prices move up. By buying at a fixed price, one is buffered against an adverse price movement. However, one bargains that prices will not fall and takes positions accordingly. However, prices of some metals crash suddenly due to market conditions, and the company has to book losses of about Rs200 crore.
Situation B. A large private bank with sophisticated risk management tools goes in for some persuasive investments in credit default swaps (CDS). A CDS is basically an instrument where the owner of the asset passes on the risk of a default to a third party in return for a fee. This is a sound strategy. Now, from nowhere, there is a sub-prime asset crisis in the USA, leading to an increase in the spreads on CDS in general. Higher rates mean lower value of the asset. The bank, which has a $2.2 billion exposure to credit derivatives, though not related to the sub-prime crisis, faces a notional loss when the portfolio is valued at current prices, which in financial parlance is called mark-to-market. There is a loss of Rs1000 crore that has to be shown based on sound accounting practices.
What is one to make of these two situations which are different yet similar? The first point to be understood is that the world is getting flat and no one can insulate themselves from what happens in other countries, especially the USA.
The second is that Indian companies are suave and are making use of the most sophisticated asset classes like CDS or maybe even CDOs (collateralised debt obligations). While the world of finance provides these opportunities, banks need to have their risk mitigation processes in place and follow the early warning systems. The signal given last year should have prompted the bank to unwind positions, which was not done.
The third is that even hedging decisions can go wrong, and hence an instrument such as commodity hedge on LME can go awry when conditions change dramatically. The commodity cycle needs to be understood well and companies should enter the market as hedgers and not traders as it could have been in this case.
The fourth is the fact that we are gradually seeing more transparency in the operation of companies in both the financial and commodity-related fields, which cover virtually 80 per cent of industrial and service activity in the organised sector. These losses would otherwise have gotten hidden in the font 6 notes to accounts in the balance sheet, thus escaping public scrutiny.
The question that can be posed is: why have things failed suddenly? The globalisation part of the story is the clue, and the intrinsic risk in the instruments being used is the other part. Derivatives have become complex instruments as the original parties in a deal disappear in the maze, as happened in the sub-prime crisis. Therefore, monitoring the underlying asset becomes difficult.
Do these stories indicate a systemic crisis that is lurking around? Definitely no, as what has been seen today is a risk which is attached to every business. Rigorous stop-loss rules need to be drawn up and followed in order to cap potential losses in these instruments. Derivatives such as CDS evidently need to be monitored better, given that it is felt that there are several large public sector banks which have similar exposures. These losses need to be tackled head-on and structures need to be built to eschew them in future.
Lastly, what is an investor to make of these episodes? There is a need to recognise that the risks involved with businesses diversifying into new areas would always be there. Conventional policies do not deliver extraordinary results, and when institutions are in the pursuit of shareholder value, such risks are a corollary.
Some simple rules could go this way. Commodity-based business will always be prone to price shocks and unless the companies are strong in their risk practices and swift to anticipate and take cues quickly, there will always be a lingering doubt. The same holds for the financial sector, where financial innovations also have their consequences which should be understood. More importantly, companies need to be more open with their disclosures so that investors are aware of the risks being taken.
Situation A. A large Indian engineering firm has a risk mitigation policy in place and decides to hedge its raw materials price risk on the LME (London Metal Exchange). Typically, one does it when prices are on the upswing, as the input costs would shoot up in case prices move up. By buying at a fixed price, one is buffered against an adverse price movement. However, one bargains that prices will not fall and takes positions accordingly. However, prices of some metals crash suddenly due to market conditions, and the company has to book losses of about Rs200 crore.
Situation B. A large private bank with sophisticated risk management tools goes in for some persuasive investments in credit default swaps (CDS). A CDS is basically an instrument where the owner of the asset passes on the risk of a default to a third party in return for a fee. This is a sound strategy. Now, from nowhere, there is a sub-prime asset crisis in the USA, leading to an increase in the spreads on CDS in general. Higher rates mean lower value of the asset. The bank, which has a $2.2 billion exposure to credit derivatives, though not related to the sub-prime crisis, faces a notional loss when the portfolio is valued at current prices, which in financial parlance is called mark-to-market. There is a loss of Rs1000 crore that has to be shown based on sound accounting practices.
What is one to make of these two situations which are different yet similar? The first point to be understood is that the world is getting flat and no one can insulate themselves from what happens in other countries, especially the USA.
The second is that Indian companies are suave and are making use of the most sophisticated asset classes like CDS or maybe even CDOs (collateralised debt obligations). While the world of finance provides these opportunities, banks need to have their risk mitigation processes in place and follow the early warning systems. The signal given last year should have prompted the bank to unwind positions, which was not done.
The third is that even hedging decisions can go wrong, and hence an instrument such as commodity hedge on LME can go awry when conditions change dramatically. The commodity cycle needs to be understood well and companies should enter the market as hedgers and not traders as it could have been in this case.
The fourth is the fact that we are gradually seeing more transparency in the operation of companies in both the financial and commodity-related fields, which cover virtually 80 per cent of industrial and service activity in the organised sector. These losses would otherwise have gotten hidden in the font 6 notes to accounts in the balance sheet, thus escaping public scrutiny.
The question that can be posed is: why have things failed suddenly? The globalisation part of the story is the clue, and the intrinsic risk in the instruments being used is the other part. Derivatives have become complex instruments as the original parties in a deal disappear in the maze, as happened in the sub-prime crisis. Therefore, monitoring the underlying asset becomes difficult.
Do these stories indicate a systemic crisis that is lurking around? Definitely no, as what has been seen today is a risk which is attached to every business. Rigorous stop-loss rules need to be drawn up and followed in order to cap potential losses in these instruments. Derivatives such as CDS evidently need to be monitored better, given that it is felt that there are several large public sector banks which have similar exposures. These losses need to be tackled head-on and structures need to be built to eschew them in future.
Lastly, what is an investor to make of these episodes? There is a need to recognise that the risks involved with businesses diversifying into new areas would always be there. Conventional policies do not deliver extraordinary results, and when institutions are in the pursuit of shareholder value, such risks are a corollary.
Some simple rules could go this way. Commodity-based business will always be prone to price shocks and unless the companies are strong in their risk practices and swift to anticipate and take cues quickly, there will always be a lingering doubt. The same holds for the financial sector, where financial innovations also have their consequences which should be understood. More importantly, companies need to be more open with their disclosures so that investors are aware of the risks being taken.
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