Saved by chance, not design: Financial Express: 17th September 2009

Just as September 11 was a wake-up call for the battle against terrorism, September 15 has become symbolic of vaulting greed, something which may be likened to Macbeth’s vaulting ambition, which “overleaps itself, and falls on the other”. The newspapers are flooded with a retrospective on Lehman and its aftermath, all of which have been traced to the inherent ills in capitalism. Tellingly, even months after the rescue packages were announced, some bankers still have had the temerity to hike their bonuses and stock options, which is the ultimate arrogance of capitalist behaviour. Over here in India, RBI has marked the one year anniversary of Lehman with self-eulogies. The question to be posed is whether at all RBI actually expected the eventuality of the crisis. The answer is that no, no one did anywhere in the world. Otherwise 2008 would have been anticipated after 2007 when Bear Stearns and Northern Rock stumbled. The truth is that while we all knew that something was amiss, no one knew where the cracks lay. Now, when finance from banks is routed to any activity which is price-sensitive, and there is an upsurge in prices, commonsense would say that when prices fall there would be a problem. Therefore, overvalued markets always run this danger. But when is a market overvalued and when will the downturn happen? The answer is that no one can be certain. As Schumpeter had stated a long time ago, capitalism involves a continuous process of creative destruction and we get cleansed and learn as we got through these crises. Should RBI be applauded? To begin with we need to differentiate between the financial crisis and the liquidity crisis which resulted from the former. There was no financial crisis in India, as no institution had failed. Banks did not fail because none took the risks that were taken by their US counterparts. Besides, our system never dealt with sophisticated financial instruments and financial engineering remained confined to text books. In fact, it was quite ironical in the mid-1990s when the first capital market scam emerged, we didn’t know what the banker’s receipt was! Banking has, by and large, been conservative in its operations. Of course, this is a viable model which has been executed very well by RBI. The result has been the emergence of a strong system where risk is low but growth is normal. Innovation has been minimal. In fact, none of us really knew about securitisation and CDOs; and any such knowledge was restricted to textbooks or seminars conducted by professors from US universities. Therefore, to say that we did not encourage such operations is not convincing because we were not sure how they worked and preferred to keep away from the unknown.
Curiously, even today, the working of, say, the commodity futures market is an enigma and the differentiation between volumes traded and open interest created is not understood. Foreign exchange futures and IRFs have come in only in late 2008 and 2009! A banking system where over 30% of assets are locked in government securities and lending to another 40% is directed by the central banks cannot really face a crisis. The biggest potential default lies in the area of agriculture when monsoon fails but we always have governments coming up with bail-out programmes and hence failure is not possible. Further, banks have limited exposure to capital markets or other ‘sensitive’ sectors such as commodities and real estate. In India, we have never had bank failures, and when systems were challenged in mid and late 1990s with stock market related issues, it was more in the nature of fraud. The financial crisis in the West was not about fraud but clearly a case of financial engineering multiplying the possibilities of lending which was to be backed by spiralling prices. And when the prices crashed and defaults resulted, all those who were part of this onward lending spiral suffered losses. It did not have traces of crony capitalism of the East Asian variety. Indian banking has never really been on this line and has been confined to plain vanilla lending. In fact, the only aggressive and dynamic forays have been made by ICICI Bank and it is hence not surprising that our banks do not really feature in the global top league. RBI has done a great job in managing liquidity. However, there is little cheer in a parent feeling one-up on another because his/her children did not get hurt as they never went and played the game. The worry now is that financial reforms could take a back seat under these circumstances with caution being superseded by over caution.

Hedging against inflation across markets: Economic Times 9th September 2009

TODAY, a major concern for everyone is inflation and while the WPI remains in the negative, the CPI is a positive double-digit number. Inflation hedging becomes important considering that one cannot trade any inflation index in the futures market. The alternative is to look for proxies, which are positively correlated with inflation that can be used for hedging purposes.To begin with WPI and CPI are correlated at 0.96, which means that high levels of CPI are associated with high values of WPI. Hence, only the WPI has been considered for preservation of clarity. Some interesting results emerge when these coefficients are calculated on an average monthly basis for the period 2004 to 2009 (up to July) i.e. 67 months.Gold is the best inflation hedge which can be used to guard against inflation followed by the euro. This really means that taking a long position in gold or euro when we expect inflation to increase would make sense as we can sell the same and take cover for inflation. Silver is the third best option. The fact that the euro serves the purpose better indicates that RBI should get set to introduce forex futures in euro as well, especially as the dollar contracts have been quite successful on the NSE. This way the lacunae in the commodity market can be bridged by the forex derivative market.As for the Gsec market, it is not highly correlated with the WPI numbers . It has been held that the WPI number matters for the bond market which is sensitive to the information. The low correlation between the benchmark 10-year bond yield and WPI indicates that on an average long-term basis this relation is not really strong.Surprisingly, the stock market is also not linked strongly with inflation with a correlation of just over 50%. The stock market is guided by other factors and inflation is just one of them. The same holds for crude which, with a weight of 14% in the WPI, could provide a partial hedge with a 51% correlation. The surprise package is guarseed which has a significant though low correlation with inflation, even though it is not a part of the WPI.The rupee-dollar move differently with other markets. Depreciation in the rupee has an inverse relation with both the stock market and crude oil price. While the stock market can be expected to decline with the rupee weakening, typically one would have expected falling crude prices to strengthen the dollar, which has not happened, meaning thereby that the crude oil bill is not significant in affecting the dollar rate and is influenced by a combination of capital receipts as well as RBI action.Commodities like gold, silver and guar have a median positive correlation with Nifty, which means that there are limited opportunities for arbitrage across these segments. The Gsec market, however, becomes negatively related with bullion, indicating substitution and hence offering scope for independent decisions that can be taken by banks and insurance companies in the commodity space.Therefore, there are several windows open for trading and hedging across markets which will improve overall efficiency. And more importantly , inflation cover can be achieved through various options.

An inadequate capital measure: MInt: 9th September 2009

Looking at bank capital adequacy and non-performing assets independently camouflages the true picture With the proliferation of financial reforms under the umbrella of the Basel II Accord on banking supervision, the focus of banking has shifted quite dramatically from size and growth to prudential practices.With accounting prudence being followed, banks are more cognizant of both their quality of assets and possession of capital. The number of non-performing assets (NPAs) is important as they speak a lot about the credibility of the system. The build-up of such assets has invariably resulted in financial crashes and, therefore, there has been considerable discussion on reining in NPAs. Capital adequacy is the other measure of soundness of banks as they need this base to build their balance sheets. Hence, for future expansion banks do require to build their capital base, proportionate to their assets.Usually, both these concepts—NPAs and capital adequacy—are looked at independently, as they indicate separate issues. However, the two can actually be linked which, in turn, provides a different dimension to the health of banks. We normally talk of NPAs as a percentage of total advances while capital adequacy is in terms of the base, or denominator, available to support the risk-weighted assets. This can be misleading because a bank can explode its denominator and still show a low NPA ratio in the conventional sense. Further, a bank showing a high capital adequacy ratio (CAR) may have built up toxic assets, which CAR does not reflect.The two can actually be put together. NPAs per se reflect the contaminated part of the portfolio, which can be juxtaposed against the available capital that belongs to the bank. The idea here is that capital is what the banks actually own—gross NPAs should be adjusted to arrive at the available free capital. Therefore, to begin with, the ratio of gross NPAs to capital (where capital is defined loosely as the sum of equity and reserves) is critical. This gives the extent to which the bank’s own capital is being blocked by its impaired assets. A similar measure was developed by Gerard Cassidy at Canada-based RBC Capital Markets and termed the Texas ratio: Here, NPAs were pitted against the capital as also loan loss reserves, or reserves meant to cover losses on theportfolio. A Texas ratio touching 1 indicates that the bank is in deep crisis.The ratio of gross NPAs to capital has been used here in the broader sense to show how much of capital would be erased by NPAs—this can be termed the “knock-out ratio”. This narrow definition of capital takes into account largely what the Basel Accords define as tier I capital—the core capital of a bank, which is equity and disclosed reserves. This would exclude tier II capital, which takes into account subordinated debt, loan loss reserves and perpetual preference shares. With this ratio so defined, the accompanying table examines the vulnerability of some of the leading Indian for fiscal 2009. The table also extrapolates, in crude terms, what CAR would look like in case NPAs were deducted from the capital of the bank—this is the adjusted CAR. Gross NPAs have been subtracted from capital and the corresponding CAR ratio has been calculated in the absence of information on actual capital and risk-weighted assets of banks.The table shows some hard-hitting facts. First, for the Indian banking sector as a whole as represented by 39 banks (27 public sector and 12 private, including six new private banks), the average “knock-out ratio” (NPAs to capital) was quite high at 20.4%. Second, 14 banks had ratios above this average; another eight were within a range of 2 percentage points below this average. Five of the six new private banks were below the average—indicating that their wherewithal to grow prudently washigher. Third, under the concept of adjusted CAR, six banks now slide below the 9% mark that Basel II stipulates—these banks were in the clear with the conventional CAR—and 11 have adjusted CAR in the single-digit range between 9% and 10%. This means that while only one bank had a single-digit CAR, there are now 17 with adjusted CAR less than 10%. Fourth, the median decline from conventional to adjusted CAR was 2.42—the average decline was 2.6—with the highest being 6.86 for Development Credit Bank and the lowest being 0.87 and 0.9 for Yes Bank and Indian Bank, respectively.Quite clearly, the capital situation of our banks looks less glamorous with these adjustments. In the future, it may be useful for the Reserve Bank of India to work on the concept, and have banks calculate their unimpaired capital adequacy ratio. A variation of this could be presented: adjusting for net NPAs after provisions for the bad debt have been made.

Against the background of the financial crisis, it does make sense to pay more attention to these ratios, especially CAR, as this measure has been used to show the solvency of banks. By not netting out the existence of toxic assets, banks may be overstating their positions, which may camouflage the true picture. Lehman Brothers, one must remember, had a very high CAR when it went down.

Bulls on top, but bears lurk below : Financial Express 9th September 2009

The bath tub inspired not just Archimedes but also Alan Greenspan who coined the phrase ‘irrational exuberance’ centuries later in 1996, before he had to deliver his black-tie dinner speech titled ‘The Challenge of Central Banking in a Democratic Society’ at the American Enterprise Institute in Washington. It is now well known that these words brought down the markets in Tokyo and Hong Kong by 3%, London and Frankfurt by 4% and the US by 2%. We are, therefore, careful with words today. But, these words would really best describe what we are seeing in BKC (Bandra Kurla Complex where NSE is located) and Dalal Street (which houses BSE) these days. The Sensex has soared to cross 16,000—this mark has been reached after 361 trading days; it was last seen at this level on 2nd June 2008. Since April 1, the Sensex had soared by 62% to reach 16016 on the 7th of August (16123 on 8th) while the Nifty has gained 56%. Those who back stock markets as being reflective of true sentiments would say that conditions are looking bright with a monsoon revival, commitment of the world to move out of the recession, foreign funds gushing in and IPOs meeting with stupendous success. Stock market movements are always justified to reflect developments that may be coincidental. That is how the spirit is kept up and that’s how money keeps moving the market in a certain direction. We already have broking firms pointing at the sky because by doing so the sentiment is built up and people invest more, thus keeping the spiral moving. It should be remembered that markets boom when more money pours in. This is not so much fresh money being generated but merely transfer of funds from buyers to sellers in such a cycle. There is no new wealth being generated as such and hence the basic question is whether or not this is sustainable? To answer this question we need to check the factors that may be causing the indices to increase—the fundamentals. The economic fundamentals have not changed, and while growth has been encouraging in Q1, the government has admitted that growth in Q2 and Q3 would not be that good. The monsoon has failed and it is now accepted that farm output will be down and inflation higher. In fact, even as the possible drought scenario had spread from the beginning of... July, the Sensex had bounced by 9.4% till date. Further, the Sensex has climbed by 5% since 21st August when the FM uttered the dreaded D (drought) word. This really means that monsoon news does not matter for the stock market. If this is so, then the news that there has been a revival of the monsoon cannot be a factor driving sentiments. Against this backdrop one could expect fiscal intervention—the fiscal response will entail outlays that can impact the deficit as well as interest rates ultimately. Hence the near-term environment is not too conduciveto enthusiasm. While industry has shown signs of growing, corporate profits in Q1 are more due to cost cutting and weak commodity prices rather than topline growth. And given the present upward trend in commodity prices, such a scenario may not be sustainable. Also growth in credit so far has been tardy and does not warrant euphoria. The other factor which has been quoted as being responsible for these price movements is that foreign investors are taking greater interest. However, this is not really borne by Sebi data which shows that in September so far, there had been an inflow of just $ 19 million in equity up to 8th September. The impact of the G20 resolution to continue with the economic stimulus measures also needs to be viewed with caution. The fact that all countries are keen to move out of the recession was known to all as governments and central banks have provided several relief measures to their financial sectors as well as invoked tax cuts and enhanced expenditures to keep their economies moving. Hence, the present resolution is only a continuation of a resolve and not any specific measure(s) to actually provide a further boost to the world economy. Lastly, the success of IPO is a bit contrived. A bull market run by irrational exuberance instills faith in investors who go out shopping for deals, and IPOs provide an option. The absence of alternatives with interest rates being low has made investors turn to the bourses. All this means that while the present impetus may be attributed to positive sentiments emanating from various announcement effects, the underlying conditions do not appear to be too sanguine in terms of growth or inflation. The fundamentals as of now do not inspire confidence and there is a limit to which sentiment, either rational or irrational,can keep the spirits up. A correction may be expected soon.

Why sugar leaves a bitter taste: Financial Express: September 3, 2009

Just think of a product valued at Rs 50,000 crore that is consumed by individuals who contributearound Rs 20,000-22,000 crore to its consumption. The product has a combined weight of 5.2% in the WPI and accounts for around 6% of private consumption in both direct and indirect terms. Its price is on the verge of doubling by October as output for the ‘product year’ 2008-09 is expected to decline by more than 50%. The product is sugar, and the story is not new.
Sugar cycles in India are well known, and there is a sugar crisis. every 4-5 years. Production falters, and when not supported by imports, results in higher prices, and panic policy responses. We have already seen the government ban futures trading in sugar (the price continues to increase) and introduce strict stock limits to prevent hoarding (but prices still increase). The logical response is to import sugar, which should have been done earlier when the futures prices indicated that there would be problems on the supply front. But, by delaying the decision, the severity of the issue has been exacerbated.
India is one of the largest consumers of sugar, and the USDA estimates that global sugar output is to fall by 17 million tonnes in 2008-09. Sugar production has been affected by various factors including past decisions to divert land to the production of bio fuels which lowered cane production. This has had an impact even on the current production of sugar in major producing countries. India’s entry into the import market, as a very large consumer, automatically pushes up prices.
The problem in India, of course, starts in the sugarcane fields. Price is controlled through the statutory minimum price programme which assures a fixed price to the farmers. However, farmers are not paid on time as the mills can pay them only after they sell processed sugar. But sugar sales are regulated, even in the free market, through a release system where the government announces monthly releases. While the releases system aims to balance the supplies and ensure that it is available throughout the year, it creates problems for the mills in terms of their ability to pay the farmers on time.
The result is that the farmers often move away from sugarcane cultivation. They also prefer to sell to the molasses and gur manufacturers where payment is less of an issue. Therefore, cane production per se has been whimsical. Further, the monsoon playing truant has affected the production of cane, and given that there has not been substantial improvement in productivity, yields remain stagnant. The yield had touched a high of 71 kg/hectare in FY00 and has remained at a lower level since then. The area under cultivation has fluctuated between 37 lakh hectares and 52 lakh hectares, which lends to uncertainty in the output. The fact that cane is a water-intensive crop implies that any shortfall in rainfall in terms of late arrival or progress causes farmers to switch crops, as has happened this year, which finally impacts the production of sugarcane and sugar.
The solution is evidently to improve productivity, and policies on sugar. Enhanced productivity is possible only in the medium run. While sugar is partly decontrolled, it is the only industry which faces regulation at both the raw material and final product ends. In the case of wheat and rice, the MSP helps the farmer and the government through the FCI which is the main buyer, but in case of cane, the price is fixed and the private mills have to pay this price and have no alternative. While the free market price is theoretically free, as mentioned earlier, its distribution is subject to the releases announced by the government thus making it a controlled product. This does not happen for any other product—there is just too much intervention in the production and distribution cycle.
Looking ahead, the government should take a stance on whether sugar is as critical as rice or wheat for food security. While one view is that the market should take care of the dynamics, the other believes that sugar is too critical to be left to the market as it is a mass consumption item. If this is to be the stance then the government should consider the creation of a buffer stock, just as in rice and wheat. More importantly, at a broader ideological level, we do need to seriously look at the extent to which the government should be intervening in price stabilisation of all products that are consumed by people. We began with rice and wheat and now have made sugar and edible oils targets of government price intervention. Should the same stretch to vegetables and milk which are also essentials, and affect the common man? Surely not. That will createmore problems than solutions ...