The recent controversy on government intervention relating to airfares raises a broader question for us: how free are the markets in a deregulated set-up? The issue comes up since while deregulation has meant less direct intervention, there is a strong feeling that oligopolistic power is being exercised by market participants, especially when it is a sellers’ market. This has led to a reversal of stance by the government through selective intervention, either directly or through innuendo.
Let’s see the situation today. We have government intervention when airlines have jacked up their fares. Microfinance institutions have been under the scanner for charging higher interest rates while some time back, mutual funds came under pressure to terminate their commissions paid to the brokers. Banks are being told regularly to keep rates low for industry while high commodity prices have been frowned upon through invocation of the Essential Commodities Act and the ban on futures trading, even when supplies have played truant. Insurance companies have been subjected to a series of regulations on their Ulip schemes. Are we being averse to market play or is there something amiss in our markets?
Ever since we embarked on liberalisation in 1991-92, we have opened up sectors but been reluctant to let the market decide the prices. Further, the measures have been half-hearted as we are not willing to go back fully to the price control days. The airline issue is quite straightforward. The airlines are making losses and decided to increase their fares to improve profitability. The rationale is that if people are willing to pay, so be it. Normally, around 60-80% of the travel is on business account, and hence does not really make a difference.
If people don’t want to pay, they need not travel; and lower sales will automatically bring down airfares as the utilisation rate comes down and hence fares would be mean-reverting. Air travel, it must be remembered, cannot be treated as an essential service like, say, the railways; as in the past, when rates were high, few travelled and no one complained about high rates. Besides, today, with airports being renovated and user charges being heaped on the customers, no one has complained about tripling of charges on all services from parking to catering in these airports. Also, an anomaly is that if one looks at the total price paid on a ticket, the fare is less than the other fees and charges; and interestingly, the latter is not being questioned as it flows to other government entities.
At the broader level should players have the right to set their prices? A market works on the principle of there being a large number of buyers and sellers. Here no one influences the other’s decisions, and the solution is optimal. The problem is that in real life such markets are rare, as they tend to move towards an oligopolistic structure, given that infrastructure cannot afford to have many players. Therefore, we have a set of, say, 10 (airlines)-50 (banks) players that sell products to consumers. These services cannot unequivocally be called ‘essential’. Some services that require high overheads tend to be loss-making, and are on the lookout to increase their charges. When it is a government service, it is understood that losses are part of social expenditure. But when it is private, then the issue gets tricky.
Now, there are several user charges that have been raised as far as individuals are concerned, which can be said to be the result of near monopoly power. These include electricity and water charges, petro-products, MSPs (for farm products), milk, etc, where the prices keep increasing but are accepted as being non-exploiting. The question is, why should airlines be singled out?
In a free society, ideally, markets should be allowed to determine prices. When the market is supreme, cartels will not work when it comes to non-essential products and services as the customers have a choice not to use it. This becomes critical when it is an essential service, where regulation is called for. For essential services, there has to be a price ceiling, but then private operators would be less enthusiastic in case they are not remunerative.
However, a lacuna is the opacity of the pricing systems in all such services. Websites are rarely transparent and complicate matters. This has to be addressed and service providers should be asked to present the same in a rudimentary fashion. Today, the transparency in financial markets is through the fine-print, which is difficult both to read and understand.
At another level, in the case of the airlines, if the government is really keen on ensuring sanity in prices, it should have its own carrier offer the lowest rates to bring down prices of other airlines. That would really set an example for others.
Sunday, December 12, 2010
Great stuff, if it’s true: Editorial: Financial Express 1st Dcember 2010
GDP growth numbers, at 8.9%, have once again taken the analysts by surprise, even as the consensus was closer to the 8.5% mark, though the ministry of finance had earlier let it out that they were sanguine with the 8.8% growth number. Amid all the otherwise distressing news on the other fronts, the GDP growth number comes as a breath of fresh air. With the two so-called lean quarters showing growth of 8.9%, one cannot rule out growth closer to 9% by the end of the year, as the busy season comprises Q3 and Q4, which should be generally more active. We also have healthy stock markets, steady industrial growth, surplus capital inflows, a strong rupee, rising exports, orderly fiscal deficit, declining inflation rate, etc. Things can’t get any better; and it looks like it is time to open the bubbly. But maybe we should pause for a little bit longer for the party to begin. There are actually three points that are sort of perplexing.
The first is that some of the GDP numbers do not gel well. The IIP numbers for mining, manufacturing and electricity are lower than those in the GDP estimates, though, admittedly, the way of reckoning the same is different. Further, the construction sector seems to be booming at a time when the cement industry was in a dormant phase, which is not an aberration as the seasonal monsoon factor comes into play. These numbers are hard to reconcile. Given the track record of revisions, will there be some here? The second area is the statistical biases that will come into play from now on. Agriculture will do well in Q3 and Q4 because the performance was low last year and the ministry of agriculture is gung ho about performance and is already counting space in the warehouses for storing the procured cereals. In fact, while we may like to be happy over the resurgence in agriculture, going by the first advance estimates, the production numbers for cereals and some oilseeds like soybean are still lower than that in FY09. Hence, we may only be regaining lost ground. Industrial growth, on the other hand, has to come on top of very high growth rates witnessed from October 2009 onwards and will, hence, counter a downward bias notwithstanding healthy production numbers. The third issue is more serious. The revisions in Q1 estimates are hard to digest. Gross capital formation has increased from 31.2% to 35% and sector growth rates vary significantly across the spectrum. While the usage of the new WPI for deflating numbers is an okay enough explanation, 3.8% increase in capital formation still remains a mystery across revisions in numbers.
The first is that some of the GDP numbers do not gel well. The IIP numbers for mining, manufacturing and electricity are lower than those in the GDP estimates, though, admittedly, the way of reckoning the same is different. Further, the construction sector seems to be booming at a time when the cement industry was in a dormant phase, which is not an aberration as the seasonal monsoon factor comes into play. These numbers are hard to reconcile. Given the track record of revisions, will there be some here? The second area is the statistical biases that will come into play from now on. Agriculture will do well in Q3 and Q4 because the performance was low last year and the ministry of agriculture is gung ho about performance and is already counting space in the warehouses for storing the procured cereals. In fact, while we may like to be happy over the resurgence in agriculture, going by the first advance estimates, the production numbers for cereals and some oilseeds like soybean are still lower than that in FY09. Hence, we may only be regaining lost ground. Industrial growth, on the other hand, has to come on top of very high growth rates witnessed from October 2009 onwards and will, hence, counter a downward bias notwithstanding healthy production numbers. The third issue is more serious. The revisions in Q1 estimates are hard to digest. Gross capital formation has increased from 31.2% to 35% and sector growth rates vary significantly across the spectrum. While the usage of the new WPI for deflating numbers is an okay enough explanation, 3.8% increase in capital formation still remains a mystery across revisions in numbers.
Why are stock exchanges different, Dr Jalan? 25th November 2010 Financial Express
The Jalan Committee Report is well-timed as it comes when there is a lot happening in this space and there is need for clarity on the structures of MIIs (market infrastructure institutions). This is important as the structure that is decided for the stock exchanges would also set benchmarks for commodity exchanges too. Also, there has been an addition to the number of players in both the stock and commodity markets. The introduction of forex derivatives exchanges will logically lead the way to their trading in stocks, while the commodity space, though apparently saturated, has seen progressive interest in setting up new exchanges. There is apprehension that there could be a game being played wherein promoters may leverage their valuation and make a profitable exit.
In brief, the report talks of three things: profits being earned, ownership patterns involving an anchor investor and listing options for them. Logically, if they are not to be super-normal profit making, then it follows that there should be a regulated ownership structure to retain interest and as a corollary, public listing is out of place. Is this the best combination?
To begin with, is there a consensus on whether stock exchanges are MIIs that address social infrastructure? All financial intermediaries perform the function of transferring and allocating funds and stock exchanges are no different. They are not established by the government but by private firms and hence strictly cannot be compared with say a road, which serves the public at large. In fact, stock exchanges are more private as all participants are there to trade and make money, unlike a typical social infrastructure project. This is the starting point because the entire edifice is built on the underlying concept. Banks and insurance companies also do social good and facilitate transfer of funds and provide services to customers. But they are not guided by non-capitalist objectives. Why should stock exchanges be different?
This is important because the Committee is talking of MIIs not making supernormal profits. All financial institutions make lumpy investments and hence resemble infrastructure. But they operate for profit and we are past the nationalisation phase when such a thought could be justified. If this is so, can we really decide on whether they should earn x or y profits? Further, the nature of the business is such that once the costs are incurred, essentially technology, then there is really little incremental capital to be ploughed in and profits can be exponential, depending on the transactions. While the transaction cost can be regulated to prevent the buildup of monopoly power, the resulting profits cannot really be decided by any extraneous principle in a market economy. In fact, the report talks of surpluses going into an IPF or SGF. But, then we do not have such rules being imposed on banks and insurance companies. So why should it be so for exchanges where provisions are anyway made for these funds.
The need for an anchor investor is important and valid, given the investment being made and the number of players operating; it needs to offer strength and stability. This can be done if there is identification of an anchor investor. Banking is mature and hence the same may not hold. But for insurance, the public needs to be convinced about the credentials of people running the show to put in their funds. Therefore, having an anchor investor makes sense, especially if it is not an institution. The term of 10 years is again debatable and a longer term may be prescribed. But again, drawing an analogy from banks, insisting on an institution to be an anchor investor is hard as this would drive away private entrepreneurs. Therefore, while the lock-in period is justified, the nature of the promoter should be flexible to include any long term investor. Lastly, the listing or rather non-listing of exchanges is an interesting thought. Globally exchanges like the LSE or NASDAQ or NYSE are listed on themselves. The Committee has spoken of how a fall in their value can create turmoil at the exchange, which is fair enough. However, once we accept the concept of anchor investor—which ensures that fly-by-night operators seeking valuation are out of the ambit, then listing should be permitted as a diversified pattern helps the industry to grow. We have not seen any negative repercussions for banks on account of listing and, therefore, can translate the same logic to an exchange.
In a free market economy, enterprise should be allowed to flourish within the regulatory framework. Once the enterprise is non-government, one cannot lay down standards for profitability. The listing of any company should be permitted provided the rules are obeyed. The fact that we have anchor investors will ensure that enterprises are here to stay, which will provide comfort. The same should hold even for stock exchanges.
In brief, the report talks of three things: profits being earned, ownership patterns involving an anchor investor and listing options for them. Logically, if they are not to be super-normal profit making, then it follows that there should be a regulated ownership structure to retain interest and as a corollary, public listing is out of place. Is this the best combination?
To begin with, is there a consensus on whether stock exchanges are MIIs that address social infrastructure? All financial intermediaries perform the function of transferring and allocating funds and stock exchanges are no different. They are not established by the government but by private firms and hence strictly cannot be compared with say a road, which serves the public at large. In fact, stock exchanges are more private as all participants are there to trade and make money, unlike a typical social infrastructure project. This is the starting point because the entire edifice is built on the underlying concept. Banks and insurance companies also do social good and facilitate transfer of funds and provide services to customers. But they are not guided by non-capitalist objectives. Why should stock exchanges be different?
This is important because the Committee is talking of MIIs not making supernormal profits. All financial institutions make lumpy investments and hence resemble infrastructure. But they operate for profit and we are past the nationalisation phase when such a thought could be justified. If this is so, can we really decide on whether they should earn x or y profits? Further, the nature of the business is such that once the costs are incurred, essentially technology, then there is really little incremental capital to be ploughed in and profits can be exponential, depending on the transactions. While the transaction cost can be regulated to prevent the buildup of monopoly power, the resulting profits cannot really be decided by any extraneous principle in a market economy. In fact, the report talks of surpluses going into an IPF or SGF. But, then we do not have such rules being imposed on banks and insurance companies. So why should it be so for exchanges where provisions are anyway made for these funds.
The need for an anchor investor is important and valid, given the investment being made and the number of players operating; it needs to offer strength and stability. This can be done if there is identification of an anchor investor. Banking is mature and hence the same may not hold. But for insurance, the public needs to be convinced about the credentials of people running the show to put in their funds. Therefore, having an anchor investor makes sense, especially if it is not an institution. The term of 10 years is again debatable and a longer term may be prescribed. But again, drawing an analogy from banks, insisting on an institution to be an anchor investor is hard as this would drive away private entrepreneurs. Therefore, while the lock-in period is justified, the nature of the promoter should be flexible to include any long term investor. Lastly, the listing or rather non-listing of exchanges is an interesting thought. Globally exchanges like the LSE or NASDAQ or NYSE are listed on themselves. The Committee has spoken of how a fall in their value can create turmoil at the exchange, which is fair enough. However, once we accept the concept of anchor investor—which ensures that fly-by-night operators seeking valuation are out of the ambit, then listing should be permitted as a diversified pattern helps the industry to grow. We have not seen any negative repercussions for banks on account of listing and, therefore, can translate the same logic to an exchange.
In a free market economy, enterprise should be allowed to flourish within the regulatory framework. Once the enterprise is non-government, one cannot lay down standards for profitability. The listing of any company should be permitted provided the rules are obeyed. The fact that we have anchor investors will ensure that enterprises are here to stay, which will provide comfort. The same should hold even for stock exchanges.
Why MFIs deserve priority: Financial Express 23rd November 2010
When Muhammad Yunus won the Nobel Prize for his work in the microfinance sector, we all applauded. When SKS went public and succeeded, it was interpreted as the market vindication of the business model. But suddenly today it has become a dirty word. Are we over-reacting emotionally to a sound business proposition?
The media has been full of views of ‘assault’ on the ‘MFI model’ to such an extent that even the owners are talking of lowering rates and sounding apologetic of their businesses. The view here is that we need to treat the MFIs, as we do any other business, in a dispassionate manner.
One, we need to realise that in a market setup, every commercial enterprise runs for profit and not on philanthropic terms and there is nothing wrong with this. The government can afford schemes like NREGA, which spend without creating assets that placate the poor but not the fiscal numbers. But the MFIs should not be criticised for working for a profit. While their funds go to the poor, there is some good that happens, but considering that there are costs while carrying out this business, one cannot question a return.
Two, the return is considered to be very high, which in a way is true, but there could be a justification for the same. Today, they borrow at between 12-15% from banks, incur incidentals of 6-7%, and make provisions for NPA, CAR and insurance, which comes to another 3-4%. Intuitively, the cost could cross 20%. Now, the question is what should be the return for such an enterprise that will make a lending rate acceptable? Do we apply such standards for other industries that also provide goods and services to the poor? The answer is No. One may recollect that when the mobile telephony business commenced, costs were multiple times what we are paying today. The force of competition brought this down, and the same will hold for MFIs, if the system is allowed to grow.
Three, is the 30% interest rate high? One cannot give a clear answer here. Today commercial banks charge similar amounts on credit cards and while RBI has sounded them on being transparent, the charges are still usurious. If one is talking of transparency, it is another issue wherein the MFIs may be told to explain the product to the borrower, which incidentally is never done when selling credit cards by banks.
Four, using counter-intuitive logic, the fact that people are willing to pay, let’s say 30%, as interest for a loan of Rs 10,000 means that they are doing it willingly as there is no alternative. The moneylender charges higher rates and hence the MFI makes sense for them.
Five, can the loans being offered by MFIs be provided by banks? The answer is that it is not happening in any significant measure. Therefore, the fact that MFIs are entering a rather virgin terrain is quite commendable as others have consciously had limited exposure here. Curiously, the BC model being spoken of partly reflects what the MFIs may be doing on the lending side.
Six, the latest data provided by RBI shows that overall NPAs of banks are almost equally divided between the priority and non-priority sectors. Given that outstanding non-priority sector loans are around twice that of priority sector loans, the probability of a loan going bad in the priority sector is almost 70% more than that in non-priority sector. The MFI segment would carry higher risk and is less attractive for banks. Also, there is interest rate subvention to the extent of 2% on farm loans, which enables loans at 7%. No such facility is available for MFI loans.
Seven, the use of force for recoveries has come under criticism. There are three issues here. The first is that there are legal processes that can be invoked if something wrong is being done. Second, we have similar tales on commercial banks regarding consumer and auto loans, where coercive measures are used, which, however, do not provoke a similar response. Lastly, in India, as a rule, we are sympathetic to defaulters and hence apply a double standard when someone does not repay loans. Defaulters across all segments have the upper hand with their lenders, which is not sustainable if we want a strong financial system.
Admittedly, there is certainly a case for bringing in more regulation and transparency to the operation of MFIs. But given that there are no alternatives available for this section, we need to develop this area and move beyond the politicisation of the issue. We need not eulogise the MFI business as being fit for the Nobel Prize, but, to borrow words from the legendary rock band Pink Floyd, this is just another ‘brick in the wall’. As a corollary, Teacher, leave the kids (MFIs) alone.
The media has been full of views of ‘assault’ on the ‘MFI model’ to such an extent that even the owners are talking of lowering rates and sounding apologetic of their businesses. The view here is that we need to treat the MFIs, as we do any other business, in a dispassionate manner.
One, we need to realise that in a market setup, every commercial enterprise runs for profit and not on philanthropic terms and there is nothing wrong with this. The government can afford schemes like NREGA, which spend without creating assets that placate the poor but not the fiscal numbers. But the MFIs should not be criticised for working for a profit. While their funds go to the poor, there is some good that happens, but considering that there are costs while carrying out this business, one cannot question a return.
Two, the return is considered to be very high, which in a way is true, but there could be a justification for the same. Today, they borrow at between 12-15% from banks, incur incidentals of 6-7%, and make provisions for NPA, CAR and insurance, which comes to another 3-4%. Intuitively, the cost could cross 20%. Now, the question is what should be the return for such an enterprise that will make a lending rate acceptable? Do we apply such standards for other industries that also provide goods and services to the poor? The answer is No. One may recollect that when the mobile telephony business commenced, costs were multiple times what we are paying today. The force of competition brought this down, and the same will hold for MFIs, if the system is allowed to grow.
Three, is the 30% interest rate high? One cannot give a clear answer here. Today commercial banks charge similar amounts on credit cards and while RBI has sounded them on being transparent, the charges are still usurious. If one is talking of transparency, it is another issue wherein the MFIs may be told to explain the product to the borrower, which incidentally is never done when selling credit cards by banks.
Four, using counter-intuitive logic, the fact that people are willing to pay, let’s say 30%, as interest for a loan of Rs 10,000 means that they are doing it willingly as there is no alternative. The moneylender charges higher rates and hence the MFI makes sense for them.
Five, can the loans being offered by MFIs be provided by banks? The answer is that it is not happening in any significant measure. Therefore, the fact that MFIs are entering a rather virgin terrain is quite commendable as others have consciously had limited exposure here. Curiously, the BC model being spoken of partly reflects what the MFIs may be doing on the lending side.
Six, the latest data provided by RBI shows that overall NPAs of banks are almost equally divided between the priority and non-priority sectors. Given that outstanding non-priority sector loans are around twice that of priority sector loans, the probability of a loan going bad in the priority sector is almost 70% more than that in non-priority sector. The MFI segment would carry higher risk and is less attractive for banks. Also, there is interest rate subvention to the extent of 2% on farm loans, which enables loans at 7%. No such facility is available for MFI loans.
Seven, the use of force for recoveries has come under criticism. There are three issues here. The first is that there are legal processes that can be invoked if something wrong is being done. Second, we have similar tales on commercial banks regarding consumer and auto loans, where coercive measures are used, which, however, do not provoke a similar response. Lastly, in India, as a rule, we are sympathetic to defaulters and hence apply a double standard when someone does not repay loans. Defaulters across all segments have the upper hand with their lenders, which is not sustainable if we want a strong financial system.
Admittedly, there is certainly a case for bringing in more regulation and transparency to the operation of MFIs. But given that there are no alternatives available for this section, we need to develop this area and move beyond the politicisation of the issue. We need not eulogise the MFI business as being fit for the Nobel Prize, but, to borrow words from the legendary rock band Pink Floyd, this is just another ‘brick in the wall’. As a corollary, Teacher, leave the kids (MFIs) alone.
What drives stock indices? A reality check: Economic Times 17th November 2010
The India shining story is often linked with the reflection seen in these numbers. At the same time, sceptics hold that the market is sentiment-driven and hence, at times, even good news on the economy front can be overwhelmed by random events. The market buzz on hiking of interest rates could lead to a decline in the market when economic conditions are otherwise sanguine. What really is the true picture?
The right way to go about this exercise is a regression analysis looking at changes in the Sensex and juxtaposing them with economic variables which prima facie have a bearing. The variables that can affect the market mood are growth in credit, industrial growth, capital issues, inflation, FII investments, exchange rate movements, changes in forex reserves and mutual funds investments.
The period chosen is from April 2006 to September 2010 and data has been reckoned on a monthly basis. This takes care of the day to day aberrations in the stock market movements. It has been noticed that even on a daily basis news affects the Sensex only momentarily which is generally mean reverting by the end of the day.
The multivariate regression model gives some interesting results. The first is that growth in credit, industrial production, exchange rate and changes in forex reserves do not really affect the Sensex. In fact, industrial production growth has a negative effect on the Sensex (though it is not significant, meaning the relation is spurious). The sign is also negative for the exchange rate suggesting that a falling rupee pushes down the market mood. Usually one would associate credit growth to mirror industrial buoyancy, but when it comes to the market, it doesn’t really matter.
How about the significant variables? The other four variables are significant. Higher inflation actually pushes back the Sensex and goes with a negative sign, which makes sense. But it questions the thought that the stock market buffers one from inflation. Primary issues have a negative relation with the Sensex, which is not what one would expect as the two are expected to move in consonance as IPOs become more visible when the market is on the rise. The other two important variables are net FII and mutual fund investments, which have coefficients of 0.003 and 0.00097. A net inflow of $1 million of FII funds leads to 0.003% increase in the Sensex or $1 billion implies 3% increase in the same. The impact of mutual funds is more muted with the coefficient being 0.00097. While these numbers by themselves are not sacrosanct, the major takeaway is that these four variables explain 48% of the variation in the Sensex, also called the coefficient of determination. What does this mean?
This implies that roughly half of the variation in the stock indices is driven by economic factors, while the rest is guided by sentiments that cannot really be explained. Therefore, when we talk of market sentiment which is positive or negative, it is really a collection of different trading thoughts that are not amenable to statistical calculation.
The implication is significant as it also means that we should not get swayed by this index in terms of being reflective of something dramatic in the economy. Maybe, this is why the stock market gyrations are often associated with the human emotion of exuberance — albeit irrational, when things move downwards.
The other important metric that can be examined within the world of econometrics is causation. While FIIs and mutual funds appear to be drivers of the market in statistical terms, is it possible to say that they cause the Sensex to move? The Granger Causality tests carried out do not show a relation either ways — FIIs or mutual funds causing the Sensex to move or the Sensex causing these flows to expand or contract. What all this means is that the stock market movements will remain an enigma for the statistically minded investor where economic fundamentals explain part of the story, while the rest will remain the proverbial mystery.
The right way to go about this exercise is a regression analysis looking at changes in the Sensex and juxtaposing them with economic variables which prima facie have a bearing. The variables that can affect the market mood are growth in credit, industrial growth, capital issues, inflation, FII investments, exchange rate movements, changes in forex reserves and mutual funds investments.
The period chosen is from April 2006 to September 2010 and data has been reckoned on a monthly basis. This takes care of the day to day aberrations in the stock market movements. It has been noticed that even on a daily basis news affects the Sensex only momentarily which is generally mean reverting by the end of the day.
The multivariate regression model gives some interesting results. The first is that growth in credit, industrial production, exchange rate and changes in forex reserves do not really affect the Sensex. In fact, industrial production growth has a negative effect on the Sensex (though it is not significant, meaning the relation is spurious). The sign is also negative for the exchange rate suggesting that a falling rupee pushes down the market mood. Usually one would associate credit growth to mirror industrial buoyancy, but when it comes to the market, it doesn’t really matter.
How about the significant variables? The other four variables are significant. Higher inflation actually pushes back the Sensex and goes with a negative sign, which makes sense. But it questions the thought that the stock market buffers one from inflation. Primary issues have a negative relation with the Sensex, which is not what one would expect as the two are expected to move in consonance as IPOs become more visible when the market is on the rise. The other two important variables are net FII and mutual fund investments, which have coefficients of 0.003 and 0.00097. A net inflow of $1 million of FII funds leads to 0.003% increase in the Sensex or $1 billion implies 3% increase in the same. The impact of mutual funds is more muted with the coefficient being 0.00097. While these numbers by themselves are not sacrosanct, the major takeaway is that these four variables explain 48% of the variation in the Sensex, also called the coefficient of determination. What does this mean?
This implies that roughly half of the variation in the stock indices is driven by economic factors, while the rest is guided by sentiments that cannot really be explained. Therefore, when we talk of market sentiment which is positive or negative, it is really a collection of different trading thoughts that are not amenable to statistical calculation.
The implication is significant as it also means that we should not get swayed by this index in terms of being reflective of something dramatic in the economy. Maybe, this is why the stock market gyrations are often associated with the human emotion of exuberance — albeit irrational, when things move downwards.
The other important metric that can be examined within the world of econometrics is causation. While FIIs and mutual funds appear to be drivers of the market in statistical terms, is it possible to say that they cause the Sensex to move? The Granger Causality tests carried out do not show a relation either ways — FIIs or mutual funds causing the Sensex to move or the Sensex causing these flows to expand or contract. What all this means is that the stock market movements will remain an enigma for the statistically minded investor where economic fundamentals explain part of the story, while the rest will remain the proverbial mystery.
Spit and polish: Financial Express Editorial 13th November 2010
Did we really expect the G20 meet to provide solutions to the present
problems of currency wars that are dominating our mindspace? The
answer is probably no, because issues that have not been sorted out
over months cannot be resolved in two days. But, if we have to take a
positive view of things, then we can say that this meet got the
concerned parties together to at least agree that there is a problem
that has to be sorted out. As there are two diametrically opposite
stances taken by the US and the emerging markets (also sensationalised
to a Barack Obama vs Hu Jintao conflict), the solution, if at all, was
going to be a compromise. The communiqué is naturally filled with
bromides and motherhood statements that, at best, cogently state the
obvious. The joint statement blows hot and cold on the actual action
points. There is agreement not to have competitive devaluations, and
Obama has reiterated that exchange rates should reflect reality. By
harping on sustainable growth, the US has in a way defended the QE2
and other actions that may follow to resuscitate the US economy. But a
kind of blinking green light has been provided for (developing)
countries to consider capital controls when there are currency issues.
Five areas have been brought into focus for policy debate under the
indicative guidelines that were issued: monetary issues, exchange
rates, trade and development, fiscal and financial reforms. But we
still have no idea as to how these objectives are to be met as there
has been no numbers attached to any goal. That would have meant
commitment and in such gatherings, no country would like to shoulder
this responsibility.
Were there any good takeaways from this meet? Obama averred that
nothing that is done in such meets would be dramatic, while the UK PM
David Cameron maintained that pressures over currencies and trade
imbalances can never be solved overnight. French President Nicolas
Sarkozy, who takes over G20 leadership next year, felt that the summit
had allayed the tension that existed before its start, which was an
achievement. Also, China nodded at the indicative guidelines and
maintained that the polices that it was pursuing were anyway always
consistent with these guidelines! More specifically, while there were
fractious discussions for these two days, the good thing was that
these had not broken up into acrimony. Remember WTO? The focus will
now shift to 2011, which will be important for two deadlocked
issues—WTO and, now, G20.
problems of currency wars that are dominating our mindspace? The
answer is probably no, because issues that have not been sorted out
over months cannot be resolved in two days. But, if we have to take a
positive view of things, then we can say that this meet got the
concerned parties together to at least agree that there is a problem
that has to be sorted out. As there are two diametrically opposite
stances taken by the US and the emerging markets (also sensationalised
to a Barack Obama vs Hu Jintao conflict), the solution, if at all, was
going to be a compromise. The communiqué is naturally filled with
bromides and motherhood statements that, at best, cogently state the
obvious. The joint statement blows hot and cold on the actual action
points. There is agreement not to have competitive devaluations, and
Obama has reiterated that exchange rates should reflect reality. By
harping on sustainable growth, the US has in a way defended the QE2
and other actions that may follow to resuscitate the US economy. But a
kind of blinking green light has been provided for (developing)
countries to consider capital controls when there are currency issues.
Five areas have been brought into focus for policy debate under the
indicative guidelines that were issued: monetary issues, exchange
rates, trade and development, fiscal and financial reforms. But we
still have no idea as to how these objectives are to be met as there
has been no numbers attached to any goal. That would have meant
commitment and in such gatherings, no country would like to shoulder
this responsibility.
Were there any good takeaways from this meet? Obama averred that
nothing that is done in such meets would be dramatic, while the UK PM
David Cameron maintained that pressures over currencies and trade
imbalances can never be solved overnight. French President Nicolas
Sarkozy, who takes over G20 leadership next year, felt that the summit
had allayed the tension that existed before its start, which was an
achievement. Also, China nodded at the indicative guidelines and
maintained that the polices that it was pursuing were anyway always
consistent with these guidelines! More specifically, while there were
fractious discussions for these two days, the good thing was that
these had not broken up into acrimony. Remember WTO? The focus will
now shift to 2011, which will be important for two deadlocked
issues—WTO and, now, G20.
Fool’s gold standard: Financial Express 11th November 2010
There is a distinct feeling of déjà vu with Robert Zoellick broaching the idea of returning to the gold standard. The concern emanating from the current global monetary disorder is quite palpable, especially after the US has gone in for quantitative easing, round two (QE2). Curiously, the financial crisis has led to a new generation of policy stances beginning with Basel-III, QE2 and now possibly GS-2, which makes the shadows longer than the subjects. What are we talking of?
Today almost everyone is questioning the basis of having the dollar as the reserve currency as it has violated the tenets of an ideal ‘anchor’ that should support the global monetary system. The US has been quite brash, burdening the other nations with the onus of adjustment, which has prompted possible policy responses that, in turn, are being frowned upon by the West.
Robert Zoellick, in an op-ed article in FT, has made a reference to bringing in more currencies for better monetary cooperation and, as a corollary, suggested that along with the dollar, euro, renminbi, pound and yen, we could bring in gold. Gold could be used to assess market expectations for inflation, deflation and future currency values.
It may be recollected that after WW2, currencies were linked to the dollar, which had its value fixed to gold at $35/ounce. This did not work as the US walked out of this in 1971, which led to BW-II (Bretton Woods). Now, Zoellick has suggested that we could consider going back to such an anchor as gold is today viewed as good as currency. In fact, it is held as a substitute for the dollar and there is an inverse relation between the two—when the dollar drops, the price of gold goes up, as investors move from the dollar to gold. Will this work?
The value of the dollar has slid by 13%, helping US exports but troubling its partners. QE2 only exacerbates the situation as other nations have to adjust to tackling these inflows. Quite clearly, one country’s problems cannot be allowed to become major hindrances for the rest of the world. In fact, today currencies are vulnerable to the whims of governments, which are being driven by inward-looking policies, so much so that monetary policy has become politicised. It is for this reason that there is this talk of currencies being linked once again to gold.
The problem with this approach is that one cannot link the entire monetary system of the world to a metal that has a limited and fixed supply. Countries would lose control over domestic policy in times of crisis. If expanding money supply was strictly linked to the quantity of gold held by governments, Keynesian reflation would be ruled out, thus leading to a chaotic situation. Also, making gold the reserve currency would lead to large-scale hoarding of the metal, which, in turn, would lead to considerable volatility in the monetary conditions across the world. In fact, there is divided opinion over the speculative nature of gold wherein trading in paper gold through the derivative market influences the current price, which is driven by investors (read speculators). The reserve currency cannot have its price driven by this class.
India, for one, would be in a peculiar situation where it is the largest consumer of gold (20% share), which also gets hoarded automatically in the form of jewellery. Linking such hoarded gold to policy would be a mammoth task. Therefore, making gold the reserve currency may not really be tenable for central banks across the world.
Can gold really anchor expectations of inflation or deflation or currency movements? The answer is a shoulder shrug as linking currencies with gold will actually restrict policy flexibility. The biggest problem for a reformed gold standard would be the mismatch between the value of official gold holdings and the size of the monetary system. In 2008, the values of the two were $1,300 billion and $61,000 billion, respectively. Such a peg can be destabilising for any currency if others failed to sustain domestic monetary and financial stability, leading to dramatic flows of gold between currencies that are better managed, thus changing their relative values.
However, the fundamental issue remains that we need to have a system in which countries should not be able to manipulate their currency or money supply to the detriment of other nations. The SDR is a solution but can gold be a part of this basket? The fact that there is perfect correlation with the dollar, would actually make the mathematics convoluted and hence the idea may be brushed aside as being a theoretical novelty, which does not have practical applicability in a world that has become more complex than it was in 1945. We have moved on.
Today almost everyone is questioning the basis of having the dollar as the reserve currency as it has violated the tenets of an ideal ‘anchor’ that should support the global monetary system. The US has been quite brash, burdening the other nations with the onus of adjustment, which has prompted possible policy responses that, in turn, are being frowned upon by the West.
Robert Zoellick, in an op-ed article in FT, has made a reference to bringing in more currencies for better monetary cooperation and, as a corollary, suggested that along with the dollar, euro, renminbi, pound and yen, we could bring in gold. Gold could be used to assess market expectations for inflation, deflation and future currency values.
It may be recollected that after WW2, currencies were linked to the dollar, which had its value fixed to gold at $35/ounce. This did not work as the US walked out of this in 1971, which led to BW-II (Bretton Woods). Now, Zoellick has suggested that we could consider going back to such an anchor as gold is today viewed as good as currency. In fact, it is held as a substitute for the dollar and there is an inverse relation between the two—when the dollar drops, the price of gold goes up, as investors move from the dollar to gold. Will this work?
The value of the dollar has slid by 13%, helping US exports but troubling its partners. QE2 only exacerbates the situation as other nations have to adjust to tackling these inflows. Quite clearly, one country’s problems cannot be allowed to become major hindrances for the rest of the world. In fact, today currencies are vulnerable to the whims of governments, which are being driven by inward-looking policies, so much so that monetary policy has become politicised. It is for this reason that there is this talk of currencies being linked once again to gold.
The problem with this approach is that one cannot link the entire monetary system of the world to a metal that has a limited and fixed supply. Countries would lose control over domestic policy in times of crisis. If expanding money supply was strictly linked to the quantity of gold held by governments, Keynesian reflation would be ruled out, thus leading to a chaotic situation. Also, making gold the reserve currency would lead to large-scale hoarding of the metal, which, in turn, would lead to considerable volatility in the monetary conditions across the world. In fact, there is divided opinion over the speculative nature of gold wherein trading in paper gold through the derivative market influences the current price, which is driven by investors (read speculators). The reserve currency cannot have its price driven by this class.
India, for one, would be in a peculiar situation where it is the largest consumer of gold (20% share), which also gets hoarded automatically in the form of jewellery. Linking such hoarded gold to policy would be a mammoth task. Therefore, making gold the reserve currency may not really be tenable for central banks across the world.
Can gold really anchor expectations of inflation or deflation or currency movements? The answer is a shoulder shrug as linking currencies with gold will actually restrict policy flexibility. The biggest problem for a reformed gold standard would be the mismatch between the value of official gold holdings and the size of the monetary system. In 2008, the values of the two were $1,300 billion and $61,000 billion, respectively. Such a peg can be destabilising for any currency if others failed to sustain domestic monetary and financial stability, leading to dramatic flows of gold between currencies that are better managed, thus changing their relative values.
However, the fundamental issue remains that we need to have a system in which countries should not be able to manipulate their currency or money supply to the detriment of other nations. The SDR is a solution but can gold be a part of this basket? The fact that there is perfect correlation with the dollar, would actually make the mathematics convoluted and hence the idea may be brushed aside as being a theoretical novelty, which does not have practical applicability in a world that has become more complex than it was in 1945. We have moved on.
Dealing with Surpluses: Business Standard: 30th october 2010
The combined surplus cost of forex, money and commodity markets can be interpreted as the cost of stability and security
The era of socialistic economics typified a country with perennial shortages where success was measured by having enough to go by. Things have changed after reforms were introduced, which evolved in an era of globalisation when India has turned around to become a dominant force in the global economic space. Shortages have given way to surpluses quite often. The question that has arisen is whether or not we have learnt to live with surpluses and, as a corollary, the cost attached to those surpluses.
Three markets that come to mind when we talk of surpluses pertain to forex, money and foodgrain (commodities). In the past, we had shortages and the solution was straightforward: have exchange controls, print more money and import foodgrain. With surpluses, we can sit back and watch them grow, but the cost could be significant.
The forex market has seen our reserves grow substantially over the years and was around $255 billion by March 2010. The trade deficit is no longer a critical factor since software receipts, foreign institutional investors (FII) and foreign direct investment (FDI) inflows have more than made up for this deficit. While there has been debate over what should be done with these forex reserves, the Reserve Bank of India (RBI) has, as a prudent measure, parked them essentially in safe havens of Federal bonds, other central banks, the Bank of International Settlements and so on. This ensures that the money is safe.
The RBI Annual Report for FY10 states that the return on these reserves in the form of investments fell about 200 basis points in FY10 due to the global recession and the decision across the developed world to retain interest rates at a low level. Now, assuming that the prudential limit for forex reserves is four months of our imports, which in turn could be around $350 billion this year provided they grow by over 20 per cent, it works out to around $115 billion, which implies a surplus of $140 billion in our reserves. If a further provision of 50 per cent is made for short-term debt, which is around $50 billion, we would still have a surplus of $115 billion. The imputed cost of 2 per cent would mean a loss of around Rs 10,580 crore (based on an exchange rate of Rs 46/$). This is the cost of security on the external front.
If a commercial rate were applied to these surpluses, the cost would be even higher, though there would be a risk attached. Forex reserves also run the risk of losing value, which will happen every time the rupee appreciates considering that most of our reserves are in dollar assets. Hence, the RBI has to protect the rupee from appreciating in the interests of exporters as well as forex reserves.
Money market intervention is necessary for all central banks to control interest rates. Ideally, there should be intervention only when there is a high level of volatility in the call market. There were times when the rates would come close to zero or cross 100 per cent when there were acute shortages. The RBI would then try and draw out liquidity or supply it through the rediscounting window to stabilise rates. However, over time the RBI has fixed the upper and lower bands of the repo and reverse repo rates. While there are two views on this issue, the RBI does bear a cost when there are surpluses in the system. For example, in FY10, there were surpluses of an average of Rs 1,00,000 crore a day that went into the reverse repo auctions. Providing this window to banks cost the system Rs 3,250 crore, which may be interpreted as being the cost of monetary stability. At the other end, a continuous shortage of liquidity in the form of borrowing from the RBI through the repo means a subsidy to banks since the repo rate at, say, 5.75 per cent protects them from higher market rates.
The third market relates to commodities, where the government comes into the picture in the process of procuring foodgrain and then stocking it or distributing it. Since the procurement scheme is an open-ended one, the Food Corporation of India perforce has to take in what is offered. This being the case, it has stocked 58 million tonne as on July 2010 against a buffer norm of 32 million tonne, stored, which means there is a surplus of 12 million tonne of rice and 14 million tonne of wheat.
Rice is procured at Rs 10,000 per tonne and wheat at Rs 11,000 per tonne. The combined cost of these surplus foodgrain is Rs 27,400 crore. The government borrows from the banks (food credit) at, say, 10 per cent per annum, which means a cost of Rs 2,740 crore. To this one must add the other costs of procurement: Rs 2,890 a tonne for rice and Rs 2,120 for wheat, which indicates a cost of Rs 6,500 crore. The stocking of excess grains works out to a little over Rs 9,200 crore.
If all these three costs are summed, it would work out to between Rs 23,000 crore and Rs 25,000 crore a year, which is significant in a framework that is committed to the market mechanism. This can be interpreted as the cost of security or stability that is being borne by different arms of the government. There is ideologically nothing wrong or right about this expenditure, though it may be useful to revisit these policies and costs.
The era of socialistic economics typified a country with perennial shortages where success was measured by having enough to go by. Things have changed after reforms were introduced, which evolved in an era of globalisation when India has turned around to become a dominant force in the global economic space. Shortages have given way to surpluses quite often. The question that has arisen is whether or not we have learnt to live with surpluses and, as a corollary, the cost attached to those surpluses.
Three markets that come to mind when we talk of surpluses pertain to forex, money and foodgrain (commodities). In the past, we had shortages and the solution was straightforward: have exchange controls, print more money and import foodgrain. With surpluses, we can sit back and watch them grow, but the cost could be significant.
The forex market has seen our reserves grow substantially over the years and was around $255 billion by March 2010. The trade deficit is no longer a critical factor since software receipts, foreign institutional investors (FII) and foreign direct investment (FDI) inflows have more than made up for this deficit. While there has been debate over what should be done with these forex reserves, the Reserve Bank of India (RBI) has, as a prudent measure, parked them essentially in safe havens of Federal bonds, other central banks, the Bank of International Settlements and so on. This ensures that the money is safe.
The RBI Annual Report for FY10 states that the return on these reserves in the form of investments fell about 200 basis points in FY10 due to the global recession and the decision across the developed world to retain interest rates at a low level. Now, assuming that the prudential limit for forex reserves is four months of our imports, which in turn could be around $350 billion this year provided they grow by over 20 per cent, it works out to around $115 billion, which implies a surplus of $140 billion in our reserves. If a further provision of 50 per cent is made for short-term debt, which is around $50 billion, we would still have a surplus of $115 billion. The imputed cost of 2 per cent would mean a loss of around Rs 10,580 crore (based on an exchange rate of Rs 46/$). This is the cost of security on the external front.
If a commercial rate were applied to these surpluses, the cost would be even higher, though there would be a risk attached. Forex reserves also run the risk of losing value, which will happen every time the rupee appreciates considering that most of our reserves are in dollar assets. Hence, the RBI has to protect the rupee from appreciating in the interests of exporters as well as forex reserves.
Money market intervention is necessary for all central banks to control interest rates. Ideally, there should be intervention only when there is a high level of volatility in the call market. There were times when the rates would come close to zero or cross 100 per cent when there were acute shortages. The RBI would then try and draw out liquidity or supply it through the rediscounting window to stabilise rates. However, over time the RBI has fixed the upper and lower bands of the repo and reverse repo rates. While there are two views on this issue, the RBI does bear a cost when there are surpluses in the system. For example, in FY10, there were surpluses of an average of Rs 1,00,000 crore a day that went into the reverse repo auctions. Providing this window to banks cost the system Rs 3,250 crore, which may be interpreted as being the cost of monetary stability. At the other end, a continuous shortage of liquidity in the form of borrowing from the RBI through the repo means a subsidy to banks since the repo rate at, say, 5.75 per cent protects them from higher market rates.
The third market relates to commodities, where the government comes into the picture in the process of procuring foodgrain and then stocking it or distributing it. Since the procurement scheme is an open-ended one, the Food Corporation of India perforce has to take in what is offered. This being the case, it has stocked 58 million tonne as on July 2010 against a buffer norm of 32 million tonne, stored, which means there is a surplus of 12 million tonne of rice and 14 million tonne of wheat.
Rice is procured at Rs 10,000 per tonne and wheat at Rs 11,000 per tonne. The combined cost of these surplus foodgrain is Rs 27,400 crore. The government borrows from the banks (food credit) at, say, 10 per cent per annum, which means a cost of Rs 2,740 crore. To this one must add the other costs of procurement: Rs 2,890 a tonne for rice and Rs 2,120 for wheat, which indicates a cost of Rs 6,500 crore. The stocking of excess grains works out to a little over Rs 9,200 crore.
If all these three costs are summed, it would work out to between Rs 23,000 crore and Rs 25,000 crore a year, which is significant in a framework that is committed to the market mechanism. This can be interpreted as the cost of security or stability that is being borne by different arms of the government. There is ideologically nothing wrong or right about this expenditure, though it may be useful to revisit these policies and costs.
Thursday, October 28, 2010
The Crisis and Morning After: Book Review in Business World: 5th December 2009
The narrative of 'Too Big To Fail' is of the Robert Ludlum variety, where there is no Jason Bourne, but frantic CEOs and CFOs jet setting to make deals to save organisations, or rather themselves
Alan Greenspan had taken pride in his mathematical prowess, but admitted that the business of collateralised debt obligations (CDOs) had quite stumped him. It is not surprising that the subprime crisis became a financial crisis. And investment banks, hedge funds, banks, regulators and the media took the centre stage as rescue operations were conducted with mixed success to save institutions and the credibility of the system. Too Big to Fail does not go too much into how the crisis took place, but succinctly summarises its genesis. It deals with the manoeuvres involved in sorting out the mess, and is in a different genre.
Andrew Ross Sorkin’s book reads like a novel, and the reader can sense déjà vu. The narrative is of the Robert Ludlum variety, where there is no Jason Bourne, but frantic CEOs and CFOs jet setting to make deals to save organisations, or rather themselves. A layman could pass this off as finance pulp fiction, but as Sorkin says in the beginning, it is based on 500 hours of interviews with over 200 people involved in the crisis, including Wall Street CEOs, government officials, investors, lawyers and accountants.
By the third page, Sorkin tells us what the next 500-odd pages are going to be, as Jamie Dimon of JP Morgan, who is the pivot in this saga says, “We need to prepare right now for Lehman Brothers filing… and for Merrill Lynch filing… and for AIG filing… and for Morgan Stanley filing… and potentially for Goldman Sachs filing.” This sums up the crisis, though the central theme is Lehman, with the others thrown in to make the picture complete. Dick Fuld, Lehman’s CEO, is the protagonist who tries to save the institution. Lehman tries everything possible to survive, as its glamorous CFO, Erin Callan, juggles $6-billion exposure to CDOs with a provision of $200 million convincingly.
Hank Paulson, then US treasury secretary, is in the midst, and given his links with the investment banking fraternity, is their ally. They all work hard to bail out Lehman, which otherwise seemed too big to fail. They also seriously consider converting it to a bank so that it would have access to the discount window. Negotiations go on to sell it to Bank of America, while KDB (Korea Development Bank), with a modicum of intrigue, becomes a potential partner.
Meanwhile, John Thain of Merrill Lynch wants to sell 9.9 per cent stake to Bank of America, which insists on 100 per cent. The 16th floor of AIG is the next venue for the drama that unfolds with a bailout being discussed; with the Federal Reserve finally taking 79.9 per cent stake and providing a line of credit of $85 billion after convincing President George W. Bush.
Morgan Stanley is linked with financial services firm Wachovia. Once rumors of its exposure to AIG surface, shorting results. The drama heightens when Deutsche Bank sends feelers that it is a solid counterparty. This gradually leads the way to Mitsubishi paying up $9 billion for its stake, after Dimon refused assistance on grounds of it jeopardising J.P. Morgan’s future. Goldman Sachs quietly converts itself to a bank. So does Morgan Stanley.
Sorkin adeptly steers across organisations, going into details of the problems and behind- the-scene activities. Timothy Geithener of the Fed is a strong character who tries to orchestrate mergers for Goldman Sachs and Morgan Stanley. Ben Bernanke has to act against the shadow of the Depression, when it was felt that the Fed did not do much. Then there is ubiquitous short seller David Einhorn, a hedge fund manager who shorted Lehman’s shares and publicly questioned its accounting. Interestingly, the crisis converted business hostility into camaraderie, as 11 institutions get together to create an extra $100 billion for them, as the inevitability of Lehman sinks in.
In all, the story is illuminating as it highlights the strong links between the financial sector, the Fed and the US treasury department. We invariably find that those working with the government or regulators had once been frontrunners heading these big financial institutions. Is this why they are better able to appreciate the crisis, or is there an incestuous relationship between these two? The reader has to decide on this. They all got relief through the government’s troubled asset relief programme eventually. We also get to see the murkier side of how firms present results with clever masquerades that disguise the facts until the crisis unfolds.
Andrew Ross SorkinFor film buffs, Gordon Gekko provided the intrigue in the movie Wall Street in 1987, which was also famous for Black Monday. We now see the potential of this real drama translate to celluloid in Hollywood once again in the upcoming Wall Street II.
Author Details:
Andrew Ross Sorkin is The New York Times’s chief mergers-and-acquisitions reporter and a columnist. He is also the editor of DealBook, an online daily financial report he started in 2001. A bachelor in science from Cornell University, he has broken news of major M&As such as Chase’s acquisition of J.P. Morgan and HP’s acquisition of Compaq.
Alan Greenspan had taken pride in his mathematical prowess, but admitted that the business of collateralised debt obligations (CDOs) had quite stumped him. It is not surprising that the subprime crisis became a financial crisis. And investment banks, hedge funds, banks, regulators and the media took the centre stage as rescue operations were conducted with mixed success to save institutions and the credibility of the system. Too Big to Fail does not go too much into how the crisis took place, but succinctly summarises its genesis. It deals with the manoeuvres involved in sorting out the mess, and is in a different genre.
Andrew Ross Sorkin’s book reads like a novel, and the reader can sense déjà vu. The narrative is of the Robert Ludlum variety, where there is no Jason Bourne, but frantic CEOs and CFOs jet setting to make deals to save organisations, or rather themselves. A layman could pass this off as finance pulp fiction, but as Sorkin says in the beginning, it is based on 500 hours of interviews with over 200 people involved in the crisis, including Wall Street CEOs, government officials, investors, lawyers and accountants.
By the third page, Sorkin tells us what the next 500-odd pages are going to be, as Jamie Dimon of JP Morgan, who is the pivot in this saga says, “We need to prepare right now for Lehman Brothers filing… and for Merrill Lynch filing… and for AIG filing… and for Morgan Stanley filing… and potentially for Goldman Sachs filing.” This sums up the crisis, though the central theme is Lehman, with the others thrown in to make the picture complete. Dick Fuld, Lehman’s CEO, is the protagonist who tries to save the institution. Lehman tries everything possible to survive, as its glamorous CFO, Erin Callan, juggles $6-billion exposure to CDOs with a provision of $200 million convincingly.
Hank Paulson, then US treasury secretary, is in the midst, and given his links with the investment banking fraternity, is their ally. They all work hard to bail out Lehman, which otherwise seemed too big to fail. They also seriously consider converting it to a bank so that it would have access to the discount window. Negotiations go on to sell it to Bank of America, while KDB (Korea Development Bank), with a modicum of intrigue, becomes a potential partner.
Meanwhile, John Thain of Merrill Lynch wants to sell 9.9 per cent stake to Bank of America, which insists on 100 per cent. The 16th floor of AIG is the next venue for the drama that unfolds with a bailout being discussed; with the Federal Reserve finally taking 79.9 per cent stake and providing a line of credit of $85 billion after convincing President George W. Bush.
Morgan Stanley is linked with financial services firm Wachovia. Once rumors of its exposure to AIG surface, shorting results. The drama heightens when Deutsche Bank sends feelers that it is a solid counterparty. This gradually leads the way to Mitsubishi paying up $9 billion for its stake, after Dimon refused assistance on grounds of it jeopardising J.P. Morgan’s future. Goldman Sachs quietly converts itself to a bank. So does Morgan Stanley.
Sorkin adeptly steers across organisations, going into details of the problems and behind- the-scene activities. Timothy Geithener of the Fed is a strong character who tries to orchestrate mergers for Goldman Sachs and Morgan Stanley. Ben Bernanke has to act against the shadow of the Depression, when it was felt that the Fed did not do much. Then there is ubiquitous short seller David Einhorn, a hedge fund manager who shorted Lehman’s shares and publicly questioned its accounting. Interestingly, the crisis converted business hostility into camaraderie, as 11 institutions get together to create an extra $100 billion for them, as the inevitability of Lehman sinks in.
In all, the story is illuminating as it highlights the strong links between the financial sector, the Fed and the US treasury department. We invariably find that those working with the government or regulators had once been frontrunners heading these big financial institutions. Is this why they are better able to appreciate the crisis, or is there an incestuous relationship between these two? The reader has to decide on this. They all got relief through the government’s troubled asset relief programme eventually. We also get to see the murkier side of how firms present results with clever masquerades that disguise the facts until the crisis unfolds.
Andrew Ross SorkinFor film buffs, Gordon Gekko provided the intrigue in the movie Wall Street in 1987, which was also famous for Black Monday. We now see the potential of this real drama translate to celluloid in Hollywood once again in the upcoming Wall Street II.
Author Details:
Andrew Ross Sorkin is The New York Times’s chief mergers-and-acquisitions reporter and a columnist. He is also the editor of DealBook, an online daily financial report he started in 2001. A bachelor in science from Cornell University, he has broken news of major M&As such as Chase’s acquisition of J.P. Morgan and HP’s acquisition of Compaq.
Story Of A Street Smart Exchange: Business World Book Review: 6th February 2010
The focus of 'For Crying Out Loud' is on the transition of CME from an open outcry to an electronic platform during 1996-2006
By Leo Melamed
With open positions of $1.1 billion valued at $1.1 trillion, CME, known as a house that pork bellies built, did not have a single default during the financial crisis. Amazing? Yes. Leo Melamed in his semi-autobiographical book For Crying out Loud extols his belief in economist Milton Friedman’s ‘tyranny of the status quo’ that kept CME constantly innovating and improving. The degree of adaptability shown in terms of product response, alliances and fundamental business platform is quite remarkable for an organisation that is over a century old.
While the focus of the book is on the transition of CME from an open outcry to an electronic platform during 1996-2006, Melamed links the success to its inherent dynamism in responding to circumstances. He highlights the importance of John Maynard Keynes who said “when the facts change, I change”. This philosophy has been instrumental in bringing about change in the otherwise traditional institution.
CME was an exchange known for farm products and pork bellies. But today, it is a powerhouse in the financial future and options (F&O) segment. It has faced the challenges posed by its main competitor CBOT with alacrity. CME’s innovative live cattle contract was matched by CBOT’s carcass beef, which was improved by the ‘dressed beef’ contract of CME.
In the 1980s, CME replied to the launch of Nasdaq Index on CBOT with the S&P Index; and the victory of CBOT to launch Dow Jones was matched with 24-hour electronic trading in a mini S&P contract. Ironically, CBOT merged with CME in July 2007.
The author attributes the success of CME to a combination of four factors: leadership, technology, personnel and luck. While the first three are understandable, luck was manifest in US President Richard Nixon’s decision to move the dollar off gold, which, in turn, made the dollar market extremely volatile and boosted F&O trading in currencies. Stable currency environment, which was the rule under the Bretton Woods agreements, did not otherwise provide a sound basis for currency trade.
CME’s journey to become an electronic exchange through Globex was an adventure. With the shareholders against a disruption of the status quo, electronic trading started with post-traditional trading hours before gaining final acceptance. Here, the author shows human frailty as exhibited by the mind’s reluctance to change from the status quo in spite of the accompanying benefits.
Competition from LIffe in London, American Futures Exchange and Cantor Financial Futures Exchange (where US Treasuries and euro-dollar contracts were traded) provided the impetus. CME had hired Mckinsey for a roadmap, which, asked the exchange to go in for complete e-trading and demutualisation. A revived Globex, experimented with the chemicals F&O contracts on its electronic B2B platform.
The next level of innovation was in going public in 2002, and the ultimate push to convert to e-trading came when Eurex got the permission from CFTC to operate in the financial F&O segment in the US. Melamed attributes the wake-up call to three cross-currents: globalisation, capitalism and micro-dynamism. He also terms the financial crisis a grey swan as it was driven by the over-the-counter (OTC) derivatives markets, which could have been different if routed through exchanges.
The author, however, is noncommittal on whether the days of the trading pit are over. Going ahead, he sees the emergence of 2-3 mega futures exchanges and the integration of the securities and futures markets. That is the big picture waiting to emerge.
The story of CME is pertinent for India from the point of view of commodity exchanges. The revival of futures trading in commodities helped create electronic exchanges, making India a leader in e-trading. The lead was taken by the National Stock Exchange in the 1990s; it had the advantage of not having the baggage of history. Hence, it became one of its kinds in the world, where people could trade from home. While many were sceptical whether the trading community would accept this form of business, its inevitability was vindicated when the Bombay Stock Exchange too went electronic. In a way, India can take some pride in being ahead of times.
Leo MelamedAuthor Details:
Leo Melamed is an attorney and an active futures trader. He is currently chairman emeritus of CME Group, the world’s largest futures and options exchange, and CEO of consulting firm Melamed and Associates. Melamed has been an adviser to the US Commodity Futures Trading Commission. His books include Leo Melamed on the Markets, The Tenth Planet and Escape to the Futures.
By Leo Melamed
With open positions of $1.1 billion valued at $1.1 trillion, CME, known as a house that pork bellies built, did not have a single default during the financial crisis. Amazing? Yes. Leo Melamed in his semi-autobiographical book For Crying out Loud extols his belief in economist Milton Friedman’s ‘tyranny of the status quo’ that kept CME constantly innovating and improving. The degree of adaptability shown in terms of product response, alliances and fundamental business platform is quite remarkable for an organisation that is over a century old.
While the focus of the book is on the transition of CME from an open outcry to an electronic platform during 1996-2006, Melamed links the success to its inherent dynamism in responding to circumstances. He highlights the importance of John Maynard Keynes who said “when the facts change, I change”. This philosophy has been instrumental in bringing about change in the otherwise traditional institution.
CME was an exchange known for farm products and pork bellies. But today, it is a powerhouse in the financial future and options (F&O) segment. It has faced the challenges posed by its main competitor CBOT with alacrity. CME’s innovative live cattle contract was matched by CBOT’s carcass beef, which was improved by the ‘dressed beef’ contract of CME.
In the 1980s, CME replied to the launch of Nasdaq Index on CBOT with the S&P Index; and the victory of CBOT to launch Dow Jones was matched with 24-hour electronic trading in a mini S&P contract. Ironically, CBOT merged with CME in July 2007.
The author attributes the success of CME to a combination of four factors: leadership, technology, personnel and luck. While the first three are understandable, luck was manifest in US President Richard Nixon’s decision to move the dollar off gold, which, in turn, made the dollar market extremely volatile and boosted F&O trading in currencies. Stable currency environment, which was the rule under the Bretton Woods agreements, did not otherwise provide a sound basis for currency trade.
CME’s journey to become an electronic exchange through Globex was an adventure. With the shareholders against a disruption of the status quo, electronic trading started with post-traditional trading hours before gaining final acceptance. Here, the author shows human frailty as exhibited by the mind’s reluctance to change from the status quo in spite of the accompanying benefits.
Competition from LIffe in London, American Futures Exchange and Cantor Financial Futures Exchange (where US Treasuries and euro-dollar contracts were traded) provided the impetus. CME had hired Mckinsey for a roadmap, which, asked the exchange to go in for complete e-trading and demutualisation. A revived Globex, experimented with the chemicals F&O contracts on its electronic B2B platform.
The next level of innovation was in going public in 2002, and the ultimate push to convert to e-trading came when Eurex got the permission from CFTC to operate in the financial F&O segment in the US. Melamed attributes the wake-up call to three cross-currents: globalisation, capitalism and micro-dynamism. He also terms the financial crisis a grey swan as it was driven by the over-the-counter (OTC) derivatives markets, which could have been different if routed through exchanges.
The author, however, is noncommittal on whether the days of the trading pit are over. Going ahead, he sees the emergence of 2-3 mega futures exchanges and the integration of the securities and futures markets. That is the big picture waiting to emerge.
The story of CME is pertinent for India from the point of view of commodity exchanges. The revival of futures trading in commodities helped create electronic exchanges, making India a leader in e-trading. The lead was taken by the National Stock Exchange in the 1990s; it had the advantage of not having the baggage of history. Hence, it became one of its kinds in the world, where people could trade from home. While many were sceptical whether the trading community would accept this form of business, its inevitability was vindicated when the Bombay Stock Exchange too went electronic. In a way, India can take some pride in being ahead of times.
Leo MelamedAuthor Details:
Leo Melamed is an attorney and an active futures trader. He is currently chairman emeritus of CME Group, the world’s largest futures and options exchange, and CEO of consulting firm Melamed and Associates. Melamed has been an adviser to the US Commodity Futures Trading Commission. His books include Leo Melamed on the Markets, The Tenth Planet and Escape to the Futures.
The Money Manager’s Trapez: Book Review in Business World: 19th June 2010
Vinh Q. Tran focuses on how to preserve capital value while lowering risk factors to earn money when the markets are “upside down”
Market Upside Down: How to invest profitably in a shrinking economy
By Vinh Q. Tran
Predicting the future is hazardous. besieged as it is with mistaken signs and distorted rear view mirrors, made foggier with the passage of time and emotion. These words of Vinh Q. Tran summarise the substance of his book as he guides investors into doing the right thing with their money even in the wrong times.
In Market Upside Down, Tran’s attention is directed primarily to those who may be saving for post-retirement and would like to preserve their capital value and earn something above it. More importantly, they would like to lower their risk as much as possible. The focus is, hence, on how to earn money when the markets are “upside down”.
Tran manoeuvres your thought process through the beta curves (market risk exposure) and alphas (excess returns over the market adjusted for beta) to warn us against some common fallacies that we make while investing. A rising market is a no-brainer because you would gain at some time.
But Tran believes that this will not always hold if the downward cycles last longer — which is uncertain — and one gets caught at this time when searching for liquidity. Tran gives his version of the financial crisis, and feels the resuscitation packages have not taught us our lessons, and institutions may be engendering a new one.
This, combined with the fact the hegemony of the US dollar is eroded, means things could change drastically anytime. This view may change today in light of the Greek and Euro crisis where the dollar has once again become important, albeit by default.
Tran’s suggestion is that those who rely on stockmarkets after retirement should not enter the market as ‘strategists’ thinking the ‘bull run’ has begun. In the past cycle after the tech rally, the Dow had returned to the start after a sharp fall of 44 per cent. So, the concept of mean reverting can catch the investor in this trap.
Tran’s analysis of US markets shakes the shibboleths that have been held sacred. The first of them is that one cannot take the position that one can never lose in the long run, as the period is not defined. This is a major blow for your investment advisor who makes such a loose statement.
The second is the theory that stockmarkets are an inflation hedge. It works only in half the number of observed cycles, which shatters the image that has been held all along.
The third myth is that cost averaging yields optimal results. This debunks our own concept of systematic investment plans. This is quite a revelation that can leave the small investor wondering what to do as we are told that SIPs are the way out for an apprehensive investor.
The fourth myth broken is that risk and return go together. This questions the basis of the wisdom spewed in textbooks that correlates the two in terms of a trade-off. And the fifth one is an even greater blow to the theory of finance: VaR (value at risk) does not work as the Dow has recorded losses of 30 per cent or more very often. This comes as a shocker for the normal curve and its theories.
Further, few funds have a beta substantially lower than or greater than one, and few really outperform the market. We need to watch the regular analysts’ reports more closely to look beyond those numbers when they talk of the fund beating the market.
Finally, believing that the market is mean reverting could be an error as the time points can never be known.
In that case, how much should we put in stocks? One option is to think of how much of our wealth are we willing to lose. Now, just double it and put it in stocks. Another idea is to simply subtract our age from 100 and keep that proportion in stocks. These thumb rules are worth pursuing.
Tran suggests that we follow the policy of absolute return strategy where we diversify across equities, bonds, commodities, etc. in relation to our age profile. While this is again common-sense, the book should be viewed more as a reminder of moving towards ‘sanity’ while “we try and discern the contours of a vague outline”.
The book is recommended for all those who are attracted by the benefits of the market — often reiterated by our investment advisors. But reading this twice may make a first timer remain on the periphery of the market.
Author's Details:
Vinh Q. Tran has worked as a money manager for Morgan Stanley, Bank of America and Aetna Life and Casualty for 20 years. He has taught advanced investment as adjunct professor of finance at New York University’s Stern School of Business, and is the author of Evaluating Hedge Fund Performance. Tran holds a Ph.D. and MBA in finance from George Washington University.
Market Upside Down: How to invest profitably in a shrinking economy
By Vinh Q. Tran
Predicting the future is hazardous. besieged as it is with mistaken signs and distorted rear view mirrors, made foggier with the passage of time and emotion. These words of Vinh Q. Tran summarise the substance of his book as he guides investors into doing the right thing with their money even in the wrong times.
In Market Upside Down, Tran’s attention is directed primarily to those who may be saving for post-retirement and would like to preserve their capital value and earn something above it. More importantly, they would like to lower their risk as much as possible. The focus is, hence, on how to earn money when the markets are “upside down”.
Tran manoeuvres your thought process through the beta curves (market risk exposure) and alphas (excess returns over the market adjusted for beta) to warn us against some common fallacies that we make while investing. A rising market is a no-brainer because you would gain at some time.
But Tran believes that this will not always hold if the downward cycles last longer — which is uncertain — and one gets caught at this time when searching for liquidity. Tran gives his version of the financial crisis, and feels the resuscitation packages have not taught us our lessons, and institutions may be engendering a new one.
This, combined with the fact the hegemony of the US dollar is eroded, means things could change drastically anytime. This view may change today in light of the Greek and Euro crisis where the dollar has once again become important, albeit by default.
Tran’s suggestion is that those who rely on stockmarkets after retirement should not enter the market as ‘strategists’ thinking the ‘bull run’ has begun. In the past cycle after the tech rally, the Dow had returned to the start after a sharp fall of 44 per cent. So, the concept of mean reverting can catch the investor in this trap.
Tran’s analysis of US markets shakes the shibboleths that have been held sacred. The first of them is that one cannot take the position that one can never lose in the long run, as the period is not defined. This is a major blow for your investment advisor who makes such a loose statement.
The second is the theory that stockmarkets are an inflation hedge. It works only in half the number of observed cycles, which shatters the image that has been held all along.
The third myth is that cost averaging yields optimal results. This debunks our own concept of systematic investment plans. This is quite a revelation that can leave the small investor wondering what to do as we are told that SIPs are the way out for an apprehensive investor.
The fourth myth broken is that risk and return go together. This questions the basis of the wisdom spewed in textbooks that correlates the two in terms of a trade-off. And the fifth one is an even greater blow to the theory of finance: VaR (value at risk) does not work as the Dow has recorded losses of 30 per cent or more very often. This comes as a shocker for the normal curve and its theories.
Further, few funds have a beta substantially lower than or greater than one, and few really outperform the market. We need to watch the regular analysts’ reports more closely to look beyond those numbers when they talk of the fund beating the market.
Finally, believing that the market is mean reverting could be an error as the time points can never be known.
In that case, how much should we put in stocks? One option is to think of how much of our wealth are we willing to lose. Now, just double it and put it in stocks. Another idea is to simply subtract our age from 100 and keep that proportion in stocks. These thumb rules are worth pursuing.
Tran suggests that we follow the policy of absolute return strategy where we diversify across equities, bonds, commodities, etc. in relation to our age profile. While this is again common-sense, the book should be viewed more as a reminder of moving towards ‘sanity’ while “we try and discern the contours of a vague outline”.
The book is recommended for all those who are attracted by the benefits of the market — often reiterated by our investment advisors. But reading this twice may make a first timer remain on the periphery of the market.
Author's Details:
Vinh Q. Tran has worked as a money manager for Morgan Stanley, Bank of America and Aetna Life and Casualty for 20 years. He has taught advanced investment as adjunct professor of finance at New York University’s Stern School of Business, and is the author of Evaluating Hedge Fund Performance. Tran holds a Ph.D. and MBA in finance from George Washington University.
The Psychology Of Money Making: Book Review in Business World 1st November
'The Invisible Hands' focuses on 10 hedge fund managers, who succeeded to prosper during the height of the financial crisis with adaptive strategies
One class of professionals who flourished after the financial crisis is authors who wrote myriad books on the subject. Invariably, most of the books have been worded with clever hindsight as they eloquently pontificate on what should or should not have been done.
Steven Drobny steers away from such bromides and brings in a breath of fresh air in this book — his second. Drobny starts by highlighting the concern of real money funds, such as pension funds, which went bust during the crisis on account of investment decisions going awry. Instead of dissecting what went wrong, he focuses on 10 hedge fund managers, who succeeded with adaptive strategies.
Two things stand out in this book: first, these wizards go as anonymous investors, and the second is that their thoughts come out through meticulously prepared interviews. Refreshingly, the interviews are quite easy to read as the style is conversational. It is, hence, not without the touch of literary irony that Drobny has titled his book the invisible hands.
An important lesson emerging is that the pain of investment losses is not linear and there is a kink after which one is forced to change behaviour. Therefore, short-term investment performance has consequences for the long-term investor. Drobny concludes that it is easier to be a proprietary trader as you know your risk and losses, and are prepared for it. But, the same does not hold for a fund manager who is working on other people’s money.
Drobny talks a bit on the questions that we keep posing in these crazy markets. Should we hold illiquid instruments with higher returns? Do we deal with instruments where we can exit easily? To hedge illiquidity, do we need to stay liquid? Is holding cash actually cheap when the chips are down? Should it be commodities or equities or bonds or currencies, or something of everything: if so, then how much of each? Does the Sharpe ratio (risk-adjusted return) matter?
Drobny’s book dwells on portfolio construction, investment and risk management. But there are evidently no clear answers and the 10 invisible investors go with a different set of names, which adequately capture their approach to investment. The ‘house’, for instance, kept several hundred positions open at any point of time, while the ‘philosopher’ went behind the numbers and looked at economic fundamentals to create models of potential outcomes in terms of probabilistic expectations.
The ‘bond trader’ made sure that he never had a situation where redemptions created a deluge. The ‘professor’ was an adventurer who scoured the world for trading ideas and translated them into risk-reward outcomes. Cogent risk management involves using the ‘titanic funnel’ to estimate maximum loss. The professor, in fact, thinks Indian markets are hot, because with half the investment ratio of China, India trails in gross domestic product growth by just about a percentage point.
The ‘commodity trader’ goes on hard fundamentals and believes that speculation can work in the short run, but never in the long run. He worked on buying volatility when it was cheap to earn asymmetric payoffs. The ‘commodity investor’ was a long-run bull who managed risk by hedging large tail risks and worked on triangulated conviction — a complex thought where a simple theme is run across a matrix of assets after studying the micro and macro aspects. Risk management is through diversification, direction (long or short) and duration (commodities are long and equity short). The ‘commodity hedger’, a lady this time, uses stringent risk management collars on all large trades which would have actually saved the real money funds substantial looses.
Then there was the ‘equity trader’, who took a risk-based approach when managing real money portfolio, and would aim to get the best beta. Changing the style of operation every six months, typified what Drobny has called the ‘predator’ who ensured that you never find out how he operates, and hence stays ahead in the race. In 2008, he abandoned value considerations, reduced exposures, and settled for cash. Typically, he makes money on the long side and uses the short side to manage risk. Lastly, the adaptable investor is the ‘plasticine macro trader’ who gets various ideas, and then manages risk by being malleable and flexible.
Each of them had their favourite investments such as residential estate in the US, inflation linked debt, sub-Sahara, Latin America, currencies, crude oil, soya bean, gold and oil. One of them with a touch of humour went on to say that all he needed was a Bloomberg terminal!
By talking to the winners themselves and getting them to answer queries on asset allocation, Drobny makes the book extremely informative and readable. For those not too familiar with the nuances of finance, there are help boxes that help you meander through the labyrinth of jargon, so that the reader can navigate the pages as successfully as the invisible hands did with their terminals.
Author Details:
Steven Drobny is co-founder of Drobny Global Advisors (DGA), an international macroeconomic research and advisory firm. Drobny has worked with Deutsche Bank’s Hedge Fund Group in London, Singapore and Zurich. He holds a master’s degree from the London School of Economics and Political Science. His first book is Inside The House Of Money: Top Hedge Fund Traders On Profiting In The Global Markets.
One class of professionals who flourished after the financial crisis is authors who wrote myriad books on the subject. Invariably, most of the books have been worded with clever hindsight as they eloquently pontificate on what should or should not have been done.
Steven Drobny steers away from such bromides and brings in a breath of fresh air in this book — his second. Drobny starts by highlighting the concern of real money funds, such as pension funds, which went bust during the crisis on account of investment decisions going awry. Instead of dissecting what went wrong, he focuses on 10 hedge fund managers, who succeeded with adaptive strategies.
Two things stand out in this book: first, these wizards go as anonymous investors, and the second is that their thoughts come out through meticulously prepared interviews. Refreshingly, the interviews are quite easy to read as the style is conversational. It is, hence, not without the touch of literary irony that Drobny has titled his book the invisible hands.
An important lesson emerging is that the pain of investment losses is not linear and there is a kink after which one is forced to change behaviour. Therefore, short-term investment performance has consequences for the long-term investor. Drobny concludes that it is easier to be a proprietary trader as you know your risk and losses, and are prepared for it. But, the same does not hold for a fund manager who is working on other people’s money.
Drobny talks a bit on the questions that we keep posing in these crazy markets. Should we hold illiquid instruments with higher returns? Do we deal with instruments where we can exit easily? To hedge illiquidity, do we need to stay liquid? Is holding cash actually cheap when the chips are down? Should it be commodities or equities or bonds or currencies, or something of everything: if so, then how much of each? Does the Sharpe ratio (risk-adjusted return) matter?
Drobny’s book dwells on portfolio construction, investment and risk management. But there are evidently no clear answers and the 10 invisible investors go with a different set of names, which adequately capture their approach to investment. The ‘house’, for instance, kept several hundred positions open at any point of time, while the ‘philosopher’ went behind the numbers and looked at economic fundamentals to create models of potential outcomes in terms of probabilistic expectations.
The ‘bond trader’ made sure that he never had a situation where redemptions created a deluge. The ‘professor’ was an adventurer who scoured the world for trading ideas and translated them into risk-reward outcomes. Cogent risk management involves using the ‘titanic funnel’ to estimate maximum loss. The professor, in fact, thinks Indian markets are hot, because with half the investment ratio of China, India trails in gross domestic product growth by just about a percentage point.
The ‘commodity trader’ goes on hard fundamentals and believes that speculation can work in the short run, but never in the long run. He worked on buying volatility when it was cheap to earn asymmetric payoffs. The ‘commodity investor’ was a long-run bull who managed risk by hedging large tail risks and worked on triangulated conviction — a complex thought where a simple theme is run across a matrix of assets after studying the micro and macro aspects. Risk management is through diversification, direction (long or short) and duration (commodities are long and equity short). The ‘commodity hedger’, a lady this time, uses stringent risk management collars on all large trades which would have actually saved the real money funds substantial looses.
Then there was the ‘equity trader’, who took a risk-based approach when managing real money portfolio, and would aim to get the best beta. Changing the style of operation every six months, typified what Drobny has called the ‘predator’ who ensured that you never find out how he operates, and hence stays ahead in the race. In 2008, he abandoned value considerations, reduced exposures, and settled for cash. Typically, he makes money on the long side and uses the short side to manage risk. Lastly, the adaptable investor is the ‘plasticine macro trader’ who gets various ideas, and then manages risk by being malleable and flexible.
Each of them had their favourite investments such as residential estate in the US, inflation linked debt, sub-Sahara, Latin America, currencies, crude oil, soya bean, gold and oil. One of them with a touch of humour went on to say that all he needed was a Bloomberg terminal!
By talking to the winners themselves and getting them to answer queries on asset allocation, Drobny makes the book extremely informative and readable. For those not too familiar with the nuances of finance, there are help boxes that help you meander through the labyrinth of jargon, so that the reader can navigate the pages as successfully as the invisible hands did with their terminals.
Author Details:
Steven Drobny is co-founder of Drobny Global Advisors (DGA), an international macroeconomic research and advisory firm. Drobny has worked with Deutsche Bank’s Hedge Fund Group in London, Singapore and Zurich. He holds a master’s degree from the London School of Economics and Political Science. His first book is Inside The House Of Money: Top Hedge Fund Traders On Profiting In The Global Markets.
The Proverbial Contest: Book Review of Super Power in Business World
The Proverbial Contest
Raghav Bahl's Superpower? is a 50-50 game that provides a defensive Indian view of why we are better but does not weave a cogent analysis out of the multiple threads
By
India is good, but can never get as ‘sexy’ as China. It is a land of contradictions. We make good hotels, but will not bother about getting the road to the entrance right. We speak impeccable English, but are xenophobic. And so on. This is the starting point of Raghav Bahl’s journey into the now-clichéd India-China debate. Are we better than China? If China has bridges and roads, we have a young populace and speak English. The book, which makes the more patriotic Indian feel good, is a 50-50 game.
Bahl continues this comparison throughout. There are slices of history, politics and religion thrown in. Religion, though, seems incongruous; neither Hinduism nor Confucianism is akin to the Protestant ethic that, according to sociologist Max Weber, had influenced growth under western capitalism. The relations with the US also have their place somewhere. Reams have been churned out by the likes of Financial Times, The Economist and the IMF on the subject. Does Bahl have anything new to offer?
His analogy of hare and tortoise is novel. But a bit puerile at times, as we lose track of which one is ahead of the other. On infrastructure, China scores. We do better with language, legal system, entrepreneurship, stockmarket, etc. Often, western analysts are condescending about India, and talk of lost chances and the fact that China is bigger and more open. Bahl feels we are actually not that far off and it is a matter of time before we can get there, provided we want to.
The book is full of examples of what China ‘has’ and does ‘not have’. Its non-democratic government gets things done easily, and the success is manifest in economic data. Land acquisition is clear in China, but a hindrance in India where it comes in the way of progress. But China’s growth, which is based on investment and exports, may not be sustainable. People do not consume, but save, and hence India scores over China. We have three engines — liberalisation’s children, women consumers and rural economy. Chinese banks have been forced to lend and their non-performing assets could be higher than stated. Besides, its data is unreliable. It is a classic case of four ‘un’s — unstable, unbalanced, uncoordinated and unsustainable.
For every success story in China, there is also a Google or Danone or Rio Tinto. Also, China’s growth model after the Cultural Revolution has pushed entrepreneurship back, with the state solely controlling production. Foreign brands using China as an outsourcing hub is a mirage.
Though Bahl says India’s strengths have to be harnessed, he does not connect the dots. For example, he talks a lot on India’s young population, against China’s ageing. Concurrently, he shows how our social infrastructure, especially mass education, lags China. So, what is the use of such a large youth class, which will take to streets? Further, he says our robust financial system helped us escape the Lehman crisis. The truth, critics would say, was that we were too scared to innovate and self-eulogies are not tenable. China’s model has worked without the strength of English. Hence, it is not a limitation.
Bahl’s portraits are at times blurred, given that the hare and tortoise have different expressions of feeling at the end of each chapter. It would have been interesting if a roadmap was drawn, especially since the objective appears to have been to leverage these advantages. The action points could have covered those that can be done and should be done, but not immediately attainable given the limits of democracy.
The epilogue has just three pages, where the author blows hot and cold over everything. The disparaged Chinese set-up suddenly ends up having the ‘drive’ that India should not miss. And the much-touted democracy in India may not mean much. To play safe, Bahl comments that it is ‘advantage China’ though the odds are on ‘India’. Can you guess what that means?
So, how could one rate the book, which says things we know already? It provides a defensive Indian view of why we are better than what we thought by looking at an oft-debated issue with an Indian flavour. But it does not weave a cogent analysis out of the multiple threads. Nonetheless, it leaves the reader with the sense of feel good. India Inc. has endorsed the book, as one deciphers from the praises on the cover. And one hopes it has understood the India tilt in Bahl’s book correctly.
Raghav Bahl's Superpower? is a 50-50 game that provides a defensive Indian view of why we are better but does not weave a cogent analysis out of the multiple threads
By
India is good, but can never get as ‘sexy’ as China. It is a land of contradictions. We make good hotels, but will not bother about getting the road to the entrance right. We speak impeccable English, but are xenophobic. And so on. This is the starting point of Raghav Bahl’s journey into the now-clichéd India-China debate. Are we better than China? If China has bridges and roads, we have a young populace and speak English. The book, which makes the more patriotic Indian feel good, is a 50-50 game.
Bahl continues this comparison throughout. There are slices of history, politics and religion thrown in. Religion, though, seems incongruous; neither Hinduism nor Confucianism is akin to the Protestant ethic that, according to sociologist Max Weber, had influenced growth under western capitalism. The relations with the US also have their place somewhere. Reams have been churned out by the likes of Financial Times, The Economist and the IMF on the subject. Does Bahl have anything new to offer?
His analogy of hare and tortoise is novel. But a bit puerile at times, as we lose track of which one is ahead of the other. On infrastructure, China scores. We do better with language, legal system, entrepreneurship, stockmarket, etc. Often, western analysts are condescending about India, and talk of lost chances and the fact that China is bigger and more open. Bahl feels we are actually not that far off and it is a matter of time before we can get there, provided we want to.
The book is full of examples of what China ‘has’ and does ‘not have’. Its non-democratic government gets things done easily, and the success is manifest in economic data. Land acquisition is clear in China, but a hindrance in India where it comes in the way of progress. But China’s growth, which is based on investment and exports, may not be sustainable. People do not consume, but save, and hence India scores over China. We have three engines — liberalisation’s children, women consumers and rural economy. Chinese banks have been forced to lend and their non-performing assets could be higher than stated. Besides, its data is unreliable. It is a classic case of four ‘un’s — unstable, unbalanced, uncoordinated and unsustainable.
For every success story in China, there is also a Google or Danone or Rio Tinto. Also, China’s growth model after the Cultural Revolution has pushed entrepreneurship back, with the state solely controlling production. Foreign brands using China as an outsourcing hub is a mirage.
Though Bahl says India’s strengths have to be harnessed, he does not connect the dots. For example, he talks a lot on India’s young population, against China’s ageing. Concurrently, he shows how our social infrastructure, especially mass education, lags China. So, what is the use of such a large youth class, which will take to streets? Further, he says our robust financial system helped us escape the Lehman crisis. The truth, critics would say, was that we were too scared to innovate and self-eulogies are not tenable. China’s model has worked without the strength of English. Hence, it is not a limitation.
Bahl’s portraits are at times blurred, given that the hare and tortoise have different expressions of feeling at the end of each chapter. It would have been interesting if a roadmap was drawn, especially since the objective appears to have been to leverage these advantages. The action points could have covered those that can be done and should be done, but not immediately attainable given the limits of democracy.
The epilogue has just three pages, where the author blows hot and cold over everything. The disparaged Chinese set-up suddenly ends up having the ‘drive’ that India should not miss. And the much-touted democracy in India may not mean much. To play safe, Bahl comments that it is ‘advantage China’ though the odds are on ‘India’. Can you guess what that means?
So, how could one rate the book, which says things we know already? It provides a defensive Indian view of why we are better than what we thought by looking at an oft-debated issue with an Indian flavour. But it does not weave a cogent analysis out of the multiple threads. Nonetheless, it leaves the reader with the sense of feel good. India Inc. has endorsed the book, as one deciphers from the praises on the cover. And one hopes it has understood the India tilt in Bahl’s book correctly.
Don’t stop those flows: Financial Express: October 28 2010
The torrent of FII flows into the country has once again germinated the debate on imposing a tax on capital inflows. We have countries like Brazil and Thailand that have resorted to taxing them and RBI has been trying to make the right sounds, though admittedly the same has not been spoken of as yet. The pressure is palpable, given that the interest rates in the West will remain benign for most part of 2011, which will mean that capital inflows will come for some more time and hence cannot be looked at as being a temporary aberration. What really is the right way to go about it?
We need to separate the two issues here—capital inflows and their impact on the currency. The former has an impact on the latter but they need to be addressed independently. Let us ask the question as to whether we need capital inflows today. The answer is a big ‘yes’ because we are running a current account deficit that will move towards the 3.5% mark this year. This is so because our trade deficit is widening, which is a good sign, since imports of the non-oil variety are increasing. Also with the US or rather some parts of the US talking tough on outsourcing, software receipts will be impacted, leading to a larger current account deficit.
The best way of tackling these deficits is through higher capital inflows. FDI would come in the normal course as would NRI funds. The ECB market is still regulated by RBI, which means that the FIIs have to provide support in some form. This is the beginning part of the Tobin tax story. These funds have been pouring into the country creating problems on rupee appreciation. There are two reasons put forward for controlling these flows. The first is that this is perceived as hot money that could reverse any time, which is destabilising. The second is that they are creating problems on the currency side, which, in turn, has monetary policy implications. In the last two decades or so, there have been only two instances when there were net outflows from the country in FY99 and FY09. Therefore, to assume that these funds, which cumulate to around $114 bn, would dispel smells of paranoia, especially if we believe in the India growth story.
Are these numbers alarming? Getting in, say, around $20 bn in 6 months is not really a large amount, given our balance of payments situation. While our foreign currency reserves are high at $270 bn, we must realise that our import cover ratio (4 months is around $120 bn) is also rising, as is our external debt, which was $273 bn in June 2010. Therefore, we cannot really get smug about these inflows because we need them.
Now the more serious issue for us is the appreciation of the rupee. More capital inflows lead to appreciation of the currency and while the text book says that we should let the rupee strengthen, the world does not operate that way. China has been recalcitrant with the renminbi and our trade competitors are holding back their currency from strengthening, which means that we have to follow suit or else our exports would slide.
Now, if we accept that we need the dollars, which is not hot money, but do not want the appreciation, the best way out is for the RBI to mop them up. Currently, with deposits growing slower than credit, there is a liquidity crunch, which is being made good by these dollars. Assuming that this equation balances, then RBI should buy the dollars to ensure that the currency is stable.
The economic argument here is that money supply increases will be inflationary and a chaotic paradox for RBI, which is hiking rates to control demand-pull-monetary forces. But we have a countervailing move that can be invoked, in the form of issuance of MSS bonds. Our budget included Rs 50,000 crore of such bonds for the year and hence should be used to counter these flows. The cost will be the interest component that the government will have to bear, which at an average rate of 8% would work out to Rs 4,000 crore a year.
The takeaways are that if we believe in the 10% growth story, we should allow unhindered capital inflows. These funds would support liquidity in the system when it is scarce. RBI intervention subsequently is advisable to hold the currency through the MSS sterilisation process. The cost is not really high considering that we get the best of the capital flows as well as a stronger rupee in an imperfect inward-looking economic world.
We need to separate the two issues here—capital inflows and their impact on the currency. The former has an impact on the latter but they need to be addressed independently. Let us ask the question as to whether we need capital inflows today. The answer is a big ‘yes’ because we are running a current account deficit that will move towards the 3.5% mark this year. This is so because our trade deficit is widening, which is a good sign, since imports of the non-oil variety are increasing. Also with the US or rather some parts of the US talking tough on outsourcing, software receipts will be impacted, leading to a larger current account deficit.
The best way of tackling these deficits is through higher capital inflows. FDI would come in the normal course as would NRI funds. The ECB market is still regulated by RBI, which means that the FIIs have to provide support in some form. This is the beginning part of the Tobin tax story. These funds have been pouring into the country creating problems on rupee appreciation. There are two reasons put forward for controlling these flows. The first is that this is perceived as hot money that could reverse any time, which is destabilising. The second is that they are creating problems on the currency side, which, in turn, has monetary policy implications. In the last two decades or so, there have been only two instances when there were net outflows from the country in FY99 and FY09. Therefore, to assume that these funds, which cumulate to around $114 bn, would dispel smells of paranoia, especially if we believe in the India growth story.
Are these numbers alarming? Getting in, say, around $20 bn in 6 months is not really a large amount, given our balance of payments situation. While our foreign currency reserves are high at $270 bn, we must realise that our import cover ratio (4 months is around $120 bn) is also rising, as is our external debt, which was $273 bn in June 2010. Therefore, we cannot really get smug about these inflows because we need them.
Now the more serious issue for us is the appreciation of the rupee. More capital inflows lead to appreciation of the currency and while the text book says that we should let the rupee strengthen, the world does not operate that way. China has been recalcitrant with the renminbi and our trade competitors are holding back their currency from strengthening, which means that we have to follow suit or else our exports would slide.
Now, if we accept that we need the dollars, which is not hot money, but do not want the appreciation, the best way out is for the RBI to mop them up. Currently, with deposits growing slower than credit, there is a liquidity crunch, which is being made good by these dollars. Assuming that this equation balances, then RBI should buy the dollars to ensure that the currency is stable.
The economic argument here is that money supply increases will be inflationary and a chaotic paradox for RBI, which is hiking rates to control demand-pull-monetary forces. But we have a countervailing move that can be invoked, in the form of issuance of MSS bonds. Our budget included Rs 50,000 crore of such bonds for the year and hence should be used to counter these flows. The cost will be the interest component that the government will have to bear, which at an average rate of 8% would work out to Rs 4,000 crore a year.
The takeaways are that if we believe in the 10% growth story, we should allow unhindered capital inflows. These funds would support liquidity in the system when it is scarce. RBI intervention subsequently is advisable to hold the currency through the MSS sterilisation process. The cost is not really high considering that we get the best of the capital flows as well as a stronger rupee in an imperfect inward-looking economic world.
Investors guide to equitable information : Economic Times: 28th October 2010
grade is not only a recommendation to buy but only an evaluation of the fundamentals of a company going in for an initial public offering.
When the idea of equity grading was first proposed in the late 1990s,it was dismissed by critics as being a good theoretical,though fantastical,concept.
The purpose of rating equities was to provide the potential investor with a view if a company was fundamentally sound.
More than a decade down the line,IPO grading has caught on and sounds a capital idea in a market that is characterised by information asymmetry that becomes even more acute given the imperfections in the market.What exactly are we talking of
The capital market is booming today,and since a rising stock index is a prerequisite for buoyancy in the primary market,this is the right time for companies to raise money.
Prior to reforms,shares had to be priced according to a preset formula of the Controller of Capital Issues.
With reforms,this institution was abolished and free pricing became the norm as innovations such as book-building with price discovery invoked within a band becoming popular.
While this is good in a market economy where companies could get the premium that the fundamentals demanded,many fly-by-night operators raised money to later disappear or get into sick mode,leaving the investors holding junk paper.
The situation is not dissimilar to the information system in the second-hand car market lemons where the issuer knows how good the company is but the investor does not have much to go on.
This is the idea behind the concept of IPO grading that the creditrating agencies have offered to investors.
The grading is based on a thorough study of fundamentals of the company,its financials,prospects,promoters,industry profile,etc.
The grades,between 1 and 5,tell the investor about the fundamentals of the company seen at this level.
This is of particular importance for companies going for an initial public offering (IPO) where the public has limited knowledge of the unit.
The information is drawn from documents filed with the regulator.
But a layman cannot really make much of this bundle of literature.
Hence,a credit rating agency bridges this information gap with a grading.
However,a grade is not a recommendation to buy but only an evaluation of the fundamentals of a company going in for an IPO.
The problem today is that it has been interpreted as being a recommendation to purchase a security and,hence,the evaluation of the grading has been juxtaposed with the market price.
This is a typical manifestation of investor frailty where one ends up interpreting any view as an advice.
This would not be the right way to go about it as markets move up and down based on a mlange of factors that often may not have a bearing on the performance of the company.
Therefore,it has been taken to be analogous to the concept of equity research done by investment banks and brokers who give a trading call: buy or sell.
The debate today is that if the IPO grading system is not going to be tested against the market,then does it serve any purpose.
It is pertinent to note that once we move away from the scheme of intermediation and enter the market,the transition is into the world of unknown where the investor only gets to see what the issuers want you to see.
In case of a bank,one puts money as a deposit.
The bank has the skills to bridge the information gap and has the risk-taking ability to actually lend onwards to the borrower.
The cost of intermediation is high at times,but that is the price that the ultimate saver pays for security.
Once in the market,the risk and returns are borne by the investor.
This is where the credit-rating agency comes into the frame.
The rating given for debt or the grading to an IPO is an evaluation of either the servicing ability of the issuer or the fundamental strength of the company.
This view,which is not an advise,is given independently by a specialist body and,hence,provides an additional input to be taken by the investor before putting in money.
It is not a certification of the price being right or not.
Now,is this product a useful one This can be examined from both the ends.
Based on counter-intuitive reasoning,that companies are going for grading and not complaining given that it is mandatory,meaning they see value in the exercise.
From the investors point of view,she gets the analysis in one number and can use this to judge if the pricing is right as the grading is done before the price is fixed.
Also,the test of the grading is not in the market price but the overall performance of the company;as prices vary depending on extraneous conditions.
And the market is the final judge of the agency that has its reputation at stake.
Therefore,any evaluation of the IPO grading process should work on the premise that it is the grading of the fundamentals that is done even before the price is fixed by the issuer.
Else,one could come to an erroneous conclusion if it is taken to be an investment advisory service.
To quote Ayn Rand,Contradictions do not exist.
Whenever you think you are facing a contradiction,check your premises.
You will find that one of them is wrong. This should be the spirit behind viewing such a product.
When the idea of equity grading was first proposed in the late 1990s,it was dismissed by critics as being a good theoretical,though fantastical,concept.
The purpose of rating equities was to provide the potential investor with a view if a company was fundamentally sound.
More than a decade down the line,IPO grading has caught on and sounds a capital idea in a market that is characterised by information asymmetry that becomes even more acute given the imperfections in the market.What exactly are we talking of
The capital market is booming today,and since a rising stock index is a prerequisite for buoyancy in the primary market,this is the right time for companies to raise money.
Prior to reforms,shares had to be priced according to a preset formula of the Controller of Capital Issues.
With reforms,this institution was abolished and free pricing became the norm as innovations such as book-building with price discovery invoked within a band becoming popular.
While this is good in a market economy where companies could get the premium that the fundamentals demanded,many fly-by-night operators raised money to later disappear or get into sick mode,leaving the investors holding junk paper.
The situation is not dissimilar to the information system in the second-hand car market lemons where the issuer knows how good the company is but the investor does not have much to go on.
This is the idea behind the concept of IPO grading that the creditrating agencies have offered to investors.
The grading is based on a thorough study of fundamentals of the company,its financials,prospects,promoters,industry profile,etc.
The grades,between 1 and 5,tell the investor about the fundamentals of the company seen at this level.
This is of particular importance for companies going for an initial public offering (IPO) where the public has limited knowledge of the unit.
The information is drawn from documents filed with the regulator.
But a layman cannot really make much of this bundle of literature.
Hence,a credit rating agency bridges this information gap with a grading.
However,a grade is not a recommendation to buy but only an evaluation of the fundamentals of a company going in for an IPO.
The problem today is that it has been interpreted as being a recommendation to purchase a security and,hence,the evaluation of the grading has been juxtaposed with the market price.
This is a typical manifestation of investor frailty where one ends up interpreting any view as an advice.
This would not be the right way to go about it as markets move up and down based on a mlange of factors that often may not have a bearing on the performance of the company.
Therefore,it has been taken to be analogous to the concept of equity research done by investment banks and brokers who give a trading call: buy or sell.
The debate today is that if the IPO grading system is not going to be tested against the market,then does it serve any purpose.
It is pertinent to note that once we move away from the scheme of intermediation and enter the market,the transition is into the world of unknown where the investor only gets to see what the issuers want you to see.
In case of a bank,one puts money as a deposit.
The bank has the skills to bridge the information gap and has the risk-taking ability to actually lend onwards to the borrower.
The cost of intermediation is high at times,but that is the price that the ultimate saver pays for security.
Once in the market,the risk and returns are borne by the investor.
This is where the credit-rating agency comes into the frame.
The rating given for debt or the grading to an IPO is an evaluation of either the servicing ability of the issuer or the fundamental strength of the company.
This view,which is not an advise,is given independently by a specialist body and,hence,provides an additional input to be taken by the investor before putting in money.
It is not a certification of the price being right or not.
Now,is this product a useful one This can be examined from both the ends.
Based on counter-intuitive reasoning,that companies are going for grading and not complaining given that it is mandatory,meaning they see value in the exercise.
From the investors point of view,she gets the analysis in one number and can use this to judge if the pricing is right as the grading is done before the price is fixed.
Also,the test of the grading is not in the market price but the overall performance of the company;as prices vary depending on extraneous conditions.
And the market is the final judge of the agency that has its reputation at stake.
Therefore,any evaluation of the IPO grading process should work on the premise that it is the grading of the fundamentals that is done even before the price is fixed by the issuer.
Else,one could come to an erroneous conclusion if it is taken to be an investment advisory service.
To quote Ayn Rand,Contradictions do not exist.
Whenever you think you are facing a contradiction,check your premises.
You will find that one of them is wrong. This should be the spirit behind viewing such a product.
The enduring metal: 23rd October 2010 Indian Express
Gold has always been an enigma for investors all over the world. India is, of course, the world’s largest consumer of the metal — Indians have traditionally invested in gold more as a necessity driven by social compulsions. But now it has also become an attractive
investment option, since it’s viewed as a natural hedge against inflation. At a more academic level, it’s also a substitute for the dollar.
The price of gold has been increasing sharply in the last couple of months to cross $1,300 an ounce and analysts have not ruled out its touching the $1,500 mark in near future. The question is whether this trajectory will continue upwards or whether it will stabilise and then drift downwards after a while.
The price of any product is driven by demand relative to supply, and gold is no exception to this rule. At the moment, demand is moving faster than supply and that’s pushing up prices. Look at the demand side. Conventional demand has increased as more people are moving towards gold as an asset class. The weakening dollar is the economic justification and the rising price of gold on its own is creating further demand for this class of users. Second, the gold exchange traded funds have been busy buying gold and accounted for around a third of the physical demand for gold in Q2 of 2010. On the back of these purchases of gold, financial products are then offered in the market for investors. The third category of entities which demand gold are the consumers who buy jewellery, where demand has been rising, albeit moderately. Therefore, it’s the investor class, more than the consumer class, which has really driven demand.
How about supply? The World Gold Council has stated that supplies are more or less fixed in terms of what is mined annually — which is valued at around $200 billion. Q2 had witnessed a supply valued at around $40
billion. Central banks have also been active in the gold market. In the past, gold was held as a non-remunerative asset and central banks preferred to invest their surpluses in bonds rather than gold. It may be recollected that, not long ago, the fear that such sales may depress prices had led central banks of Europe to impose restrictions among themselves on the sale of gold. However, after the financial crisis there have been doubts cast on the US economy and the strength of the dollar. Hence, it’s not surprising that central banks have gone back to acquiring gold instead of selling it — a change in role from a supplier to an active buyer in the market.
In this scenario, where are gold prices headed? Gold has a direct relation with the dollar. As long as the dollar weakens, investors will move to gold, and the correlation here is as high as between 80-90 per cent. The dollar is weakening against the euro in the range of around 1.35-1.40 and this scenario will probably persist given that the US economy is shaky while the euro region is
relatively better off. However, a strong euro may not work in favour of the eurozone, and there would be resistance to the extent to which the dollar can fall. Therefore, this particular factor may not persist for too long.
Besides, the US is trying to lower its deficits, which could also help to strengthen the dollar.
This leaves the other factors at play — central banks and funds. Central banks are still in shopping mode and funds would leverage the conditions to keep their incomes ticking. Gold is traditionally a good investment option and gives returns between 15-18 per cent and can be positioned somewhere between government bonds and the stock market. This interest will always remain and hence the price may not really recede and would tend to stabilise even after global adjustments occur. As long as there is scepticism about the world monetary order, interest in gold will remain strong.
What does it mean for us in India? India, though the largest consumer of gold, is a price taker. This means we take the price that’s determined on COMEX. The prices would replicate global trends, which in turn are influenced by our demand. With income levels increasing and high inflation prevailing there has been a tendency at the margin for households to look at gold progressively — though there is not much evidence of substantially higher imports of gold by India. There will hence be a tendency for the prices to move up during this festival season.
investment option, since it’s viewed as a natural hedge against inflation. At a more academic level, it’s also a substitute for the dollar.
The price of gold has been increasing sharply in the last couple of months to cross $1,300 an ounce and analysts have not ruled out its touching the $1,500 mark in near future. The question is whether this trajectory will continue upwards or whether it will stabilise and then drift downwards after a while.
The price of any product is driven by demand relative to supply, and gold is no exception to this rule. At the moment, demand is moving faster than supply and that’s pushing up prices. Look at the demand side. Conventional demand has increased as more people are moving towards gold as an asset class. The weakening dollar is the economic justification and the rising price of gold on its own is creating further demand for this class of users. Second, the gold exchange traded funds have been busy buying gold and accounted for around a third of the physical demand for gold in Q2 of 2010. On the back of these purchases of gold, financial products are then offered in the market for investors. The third category of entities which demand gold are the consumers who buy jewellery, where demand has been rising, albeit moderately. Therefore, it’s the investor class, more than the consumer class, which has really driven demand.
How about supply? The World Gold Council has stated that supplies are more or less fixed in terms of what is mined annually — which is valued at around $200 billion. Q2 had witnessed a supply valued at around $40
billion. Central banks have also been active in the gold market. In the past, gold was held as a non-remunerative asset and central banks preferred to invest their surpluses in bonds rather than gold. It may be recollected that, not long ago, the fear that such sales may depress prices had led central banks of Europe to impose restrictions among themselves on the sale of gold. However, after the financial crisis there have been doubts cast on the US economy and the strength of the dollar. Hence, it’s not surprising that central banks have gone back to acquiring gold instead of selling it — a change in role from a supplier to an active buyer in the market.
In this scenario, where are gold prices headed? Gold has a direct relation with the dollar. As long as the dollar weakens, investors will move to gold, and the correlation here is as high as between 80-90 per cent. The dollar is weakening against the euro in the range of around 1.35-1.40 and this scenario will probably persist given that the US economy is shaky while the euro region is
relatively better off. However, a strong euro may not work in favour of the eurozone, and there would be resistance to the extent to which the dollar can fall. Therefore, this particular factor may not persist for too long.
Besides, the US is trying to lower its deficits, which could also help to strengthen the dollar.
This leaves the other factors at play — central banks and funds. Central banks are still in shopping mode and funds would leverage the conditions to keep their incomes ticking. Gold is traditionally a good investment option and gives returns between 15-18 per cent and can be positioned somewhere between government bonds and the stock market. This interest will always remain and hence the price may not really recede and would tend to stabilise even after global adjustments occur. As long as there is scepticism about the world monetary order, interest in gold will remain strong.
What does it mean for us in India? India, though the largest consumer of gold, is a price taker. This means we take the price that’s determined on COMEX. The prices would replicate global trends, which in turn are influenced by our demand. With income levels increasing and high inflation prevailing there has been a tendency at the margin for households to look at gold progressively — though there is not much evidence of substantially higher imports of gold by India. There will hence be a tendency for the prices to move up during this festival season.
A clearer route for foreing banks: 21st October Financial Express
The choice is really between operating as a branch of an entity that is incorporated overseas or functioning as a subsidiary of the same. The former means that they operate in the current manner where there are apparent barriers to expansion. They pay higher corporate tax rates but have it easy when meeting the preemption norms in the form of priority sector lending. The subsidiary route would imply that they would work like any domestic bank, except that the equity holding would be different.
The issue has come up for two reasons. RBI, for its part, would like to be better able to regulate foreign banks in the country considering the role they could play, given their financial strength. But the financial crisis showed that there is a major risk in the current model wherein the branch would be jeopardised in case the overseas parent had severe problems. This could be destabilising at the limit for the domestic banking system. Therefore, from the point of view of risk management, RBI would prefer to have better oversight over their operations.
As far as foreign banks are concerned, they would like to expand their operations in the country but are constrained in terms of the number of branches that they could set up as the rules are clear—not more than 12 branches a year as per the WTO agreements. There are 31 foreign banks operating in the country with 310 branches as of March 2010—with 75% being held by 5 banks. The market is vast and they do have the skill sets to reach out and expand their business in rural India, provided they are allowed to do so. The current regulatory environment may be considered to be inhibiting.
From the point of view of the banks, the subsidiary route would help them expand their business, which would probably apply to these 5 banks. They would get more operational flexibility and can push forth their business plans. Further, they would be able to grow inorganically through M&A activity, which is not available currently. Therefore, there would be certain gains for them in operating as a subsidiary as their market share increases. Also, given the financial strength of the parent company, they would be able to bring in the requisite capital to support their enhanced operations. In fact, given that there would be more new private banks operating in the interiors, the foreign banks would get left out from this business and would, hence, find the subsidiary route a convenience.
However, what is not clear is whether or not there would be the encumbrance of priority sector lending the way it is defined for Indian banks. There will probably be no concession here, which means that they would perforce have to go into the rural interiors and cater to the agriculture, small scale industry sector, weaker sections, etc. Currently, they get away with 32% ratio, which also includes export finance. Also, the tax rules governing capital gains or stamp duty are not quite clear when they convert from a branch to subsidiary, which will have to be examined before taking a decision. The DTC, however, has addressed the issue of corporate taxation, which used to be at a higher level for foreign companies, which will be restored to that for domestic companies.
RBI would also have to provide clarity on the listing requirements for such subsidiaries as there would be stipulations for new private banks. A public offering would be good for the country as domestic shareholders could get a slice of the benefits of the operations of these banks. This would be a major consideration for banks, which would want to convert to a subsidiary. Management issues would probably not be a major issue as the branches too operate with an Indian management and changes would only be at the fringe.
Setting the stage for the expansion of foreign banks is pragmatic but given that they are heterogeneous, all may not prefer the subsidiary route. Ideally, they should have the right to choose the route. They would have, to use the cliché, to decide to be or not to be a subsidiary.
The issue has come up for two reasons. RBI, for its part, would like to be better able to regulate foreign banks in the country considering the role they could play, given their financial strength. But the financial crisis showed that there is a major risk in the current model wherein the branch would be jeopardised in case the overseas parent had severe problems. This could be destabilising at the limit for the domestic banking system. Therefore, from the point of view of risk management, RBI would prefer to have better oversight over their operations.
As far as foreign banks are concerned, they would like to expand their operations in the country but are constrained in terms of the number of branches that they could set up as the rules are clear—not more than 12 branches a year as per the WTO agreements. There are 31 foreign banks operating in the country with 310 branches as of March 2010—with 75% being held by 5 banks. The market is vast and they do have the skill sets to reach out and expand their business in rural India, provided they are allowed to do so. The current regulatory environment may be considered to be inhibiting.
From the point of view of the banks, the subsidiary route would help them expand their business, which would probably apply to these 5 banks. They would get more operational flexibility and can push forth their business plans. Further, they would be able to grow inorganically through M&A activity, which is not available currently. Therefore, there would be certain gains for them in operating as a subsidiary as their market share increases. Also, given the financial strength of the parent company, they would be able to bring in the requisite capital to support their enhanced operations. In fact, given that there would be more new private banks operating in the interiors, the foreign banks would get left out from this business and would, hence, find the subsidiary route a convenience.
However, what is not clear is whether or not there would be the encumbrance of priority sector lending the way it is defined for Indian banks. There will probably be no concession here, which means that they would perforce have to go into the rural interiors and cater to the agriculture, small scale industry sector, weaker sections, etc. Currently, they get away with 32% ratio, which also includes export finance. Also, the tax rules governing capital gains or stamp duty are not quite clear when they convert from a branch to subsidiary, which will have to be examined before taking a decision. The DTC, however, has addressed the issue of corporate taxation, which used to be at a higher level for foreign companies, which will be restored to that for domestic companies.
RBI would also have to provide clarity on the listing requirements for such subsidiaries as there would be stipulations for new private banks. A public offering would be good for the country as domestic shareholders could get a slice of the benefits of the operations of these banks. This would be a major consideration for banks, which would want to convert to a subsidiary. Management issues would probably not be a major issue as the branches too operate with an Indian management and changes would only be at the fringe.
Setting the stage for the expansion of foreign banks is pragmatic but given that they are heterogeneous, all may not prefer the subsidiary route. Ideally, they should have the right to choose the route. They would have, to use the cliché, to decide to be or not to be a subsidiary.
Of paramount importance: Financial Express: October 14, 2010
The news about Paramount Airways and Oriental Insurance Company is interesting as it opens up a debate on a larger question on credit cover in the form of credit insurance. This is even more relevant, given the backdrop of the financial crisis, which has brought credit risk to the forefront. A debate is necessary, even though there have not been many instances of such defaults leading to turmoil in the financial sector.
The case is quite straightforward. We have an airline company that took a guarantee from a set of banks against which it bought fuel from oil companies. These loans were covered by an insurance company for credit default. Now the company is unable to pay, invoking the guarantee, which means that the banks have to pay the oil company. The banks, in turn, claim the loss on the account from the insurance company. As a result, Irda has decided to do away with such credit insurance schemes until a regulatory structure is put in place. The problem is significant because the insurance company did not reinsure these loans. Reinsurance would have helped diversify the risk across more players.
Credit insurance schemes are generally used for foreign trade and not commonly used by banks to cover defaults on their books. Banks covering credit risk is not uncommon in countries like the US where insurance can be procured on loans. AIG had to pay banks when the CDOs failed, and the rest as they say, is history. Credit default swaps can also be used, wherein the third party picks up the risk in exchange for a fee—the swap spread.
In India, RBI has published guidelines for CDS for bonds to make the market more robust. However, bank loans are not covered. Thus, credit insurance does appear to be a fairly good form of financial engineering for diversifying risk and expanding business—for the borrower, lender, guarantor and cover provider. This way banks would be better able to lend or provide a guarantee when loans are on the borderline.
Irda has recently barred insurance companies from selling such policies as it felt that the market is not transparent and has little regulatory oversight. The participants from different segments covering different financial arenas has led to a regulatory overlap. The concern is that insurance companies may not be sufficiently equipped to evaluate such loans when providing a cover. The system can, therefore, be gamed by intermediaries who could get the borrower to actually pay the premium to the insurance company, embedded in the bank guarantee cost for the bank. Hence, the risk from one sector would get transferred to the insurance segment, jeopardising the balance sheets of these companies. There has been reason for separating the banking sector from the insurance sector and while this concept of credit guarantee would work well in good times, it could be destabilising in times of crisis.
From a bank’s point of view, this raises issues of the quality of credit appraisal. Banks that are insured would be tempted to be more liberal in credit appraisals, knowing that the insurance company is there to back it up. In fact, the reason for a bank's intermediation job is that it bridges the information asymmetry between savers and borrowers, and takes on risk based on its superior credit skills, earning a spread on the money. If they were to go back to the insurance company, however, then they are not efficient.
Theoretically, insurance companies should insure any product that carries risk. But, when there are efficient derivative markets that price risk well, insurance companies should not participate—they are not equipped to gauge this risk. Alternatively, insurance companies could hone their skills and have a proper line of business where credit is insured.
A solution here is to take recourse to the CDS market and allow a bank to get cover from it. This implies that RBI should open the CDS market for bank loans as well, possibly in the second stage of expansion.
The case is quite straightforward. We have an airline company that took a guarantee from a set of banks against which it bought fuel from oil companies. These loans were covered by an insurance company for credit default. Now the company is unable to pay, invoking the guarantee, which means that the banks have to pay the oil company. The banks, in turn, claim the loss on the account from the insurance company. As a result, Irda has decided to do away with such credit insurance schemes until a regulatory structure is put in place. The problem is significant because the insurance company did not reinsure these loans. Reinsurance would have helped diversify the risk across more players.
Credit insurance schemes are generally used for foreign trade and not commonly used by banks to cover defaults on their books. Banks covering credit risk is not uncommon in countries like the US where insurance can be procured on loans. AIG had to pay banks when the CDOs failed, and the rest as they say, is history. Credit default swaps can also be used, wherein the third party picks up the risk in exchange for a fee—the swap spread.
In India, RBI has published guidelines for CDS for bonds to make the market more robust. However, bank loans are not covered. Thus, credit insurance does appear to be a fairly good form of financial engineering for diversifying risk and expanding business—for the borrower, lender, guarantor and cover provider. This way banks would be better able to lend or provide a guarantee when loans are on the borderline.
Irda has recently barred insurance companies from selling such policies as it felt that the market is not transparent and has little regulatory oversight. The participants from different segments covering different financial arenas has led to a regulatory overlap. The concern is that insurance companies may not be sufficiently equipped to evaluate such loans when providing a cover. The system can, therefore, be gamed by intermediaries who could get the borrower to actually pay the premium to the insurance company, embedded in the bank guarantee cost for the bank. Hence, the risk from one sector would get transferred to the insurance segment, jeopardising the balance sheets of these companies. There has been reason for separating the banking sector from the insurance sector and while this concept of credit guarantee would work well in good times, it could be destabilising in times of crisis.
From a bank’s point of view, this raises issues of the quality of credit appraisal. Banks that are insured would be tempted to be more liberal in credit appraisals, knowing that the insurance company is there to back it up. In fact, the reason for a bank's intermediation job is that it bridges the information asymmetry between savers and borrowers, and takes on risk based on its superior credit skills, earning a spread on the money. If they were to go back to the insurance company, however, then they are not efficient.
Theoretically, insurance companies should insure any product that carries risk. But, when there are efficient derivative markets that price risk well, insurance companies should not participate—they are not equipped to gauge this risk. Alternatively, insurance companies could hone their skills and have a proper line of business where credit is insured.
A solution here is to take recourse to the CDS market and allow a bank to get cover from it. This implies that RBI should open the CDS market for bank loans as well, possibly in the second stage of expansion.
How much am I worth: DNA October 13, 2010
Irony seldom escapes the characters on the economic stage; and when the issue pertains to one’s own well-being, Adam Smith’s free market self-interest or Ayn Rand’s virtue of selfishness prevails.
And why not, since we all want to partake a portion of the wealth of success. It was not a long time back that the prime minister asked private sector honchos to be abstemious in their remuneration. Now, all the MPs have gone ahead and given themselves a rise in their salaries.
When Lehman became a euphemism for the greed that the private sector represents, government officials ascended the high horse to say how they were different and that the private sector stinks when it comes to remuneration. Now, we have the RBI as well as the public sector banks arguing for parity with the private sector. What is one to make of it considering that each segment thinks that it deserves the hike and, as a corollary, the others don’t?
The extremes in salaries are stark. US Fed chairman Ben Bernanke takes home $200,000 per annum while European Central Bank president Jean-Claude Trichet earns $500,000.
Bank of England chief Mervyn King has package of $450,000 while Japan’s Masaaki Shirakawa is paid $400,000. Our own RBI governor Duvvuri Subbarao gets the rupee equivalent of around $30,000. In contrast, in 2009 Goldman Sachs was reported to have had a wage bill of $16.2 billion for 32,500 workers, giving an average of $498,246 — half a million dollars per head!
Clearly, the regulated take home larger pay cheques than the regulators, though the latter admittedly have greater powers. The question is how are salaries to be fixed?
In a free economy, salaries should be the function of the owners or shareholders. If it is the private sector, it is the proprietor or the shareholders. This holds just like it does for, say, a household where it determines the salary to be paid to the maid or watchman or driver. However, structures are amorphous here.
Most big companies have shareholders and even an owner-driven company may not really have a majority. Salaries are fixed by the owner on the premise that the majority has voted for it but the majority never really gets together to take a decision and hence the process of salary determination remains fuzzy.
At times it ends up with the owner, who is the management, also appointing the board which ratifies one’s own salary.
This should be treated as an internal affair but it becomes a public concern if bailouts have to be invoked when things go awry. The crisis did not stop at the financial sector, where public money was involved, but also overflowed into manufacturing, which then brought to the fore the issue of executive pay.
When it comes to the government, it is even more complicated. There are hierarchies where a bank chief is at the level of a secretary and one cannot go up without the other doing so. Hence, either all salaries have to move up, or all stagnate. The public sector enterprises are better placed even though there is government ownership, as here the CEOs get better pay packets, which can range between Rs30-40 lakh per annum, though this is still lower than that in the private sector.
Now, there is a strong case for salary revisions in the public sector banks, especially when they perform as well as those in the private sector. But there is a conundrum. A just way of going about it is to increase all salaries by x%.
This is democratic but allows free riders to benefit. It is actually the middle and senior levels where personnel can move to the private sector quite easily and the threat of attrition is real. There are a number of IAS officials who have gotten lucrative deals in the private sector to become heads of commodity exchanges or infrastructure companies. A number of private banks took in public sector officials and have grown really well.
However, does an executive, who is two years away from retirement, deserve a private sector salary? Yes, if the organisation is doing as well as its private counterpart. Critics aver that there are few public sector employees who find jobs after they retire. Salary hikes are needed to prevent attrition and the present system of backdoor increases through the recruitment of consultants with fixed tenures is not sustainable.
The solution is really to leave it open to the companies or banks to decide their pay packets which should be linked to profitability. This will create a problem for the bureaucrats as there is no profit and the incentives must be linked with performance in terms of expense management or implementation of projects.
As a corollary, the grades should be delinked from the bureaucracy charts. This would also mean that banks must have their own system of picking their CEOs with the ministry being out of the picture. This is the only way to make it work and should hence be looked at holistically.
And why not, since we all want to partake a portion of the wealth of success. It was not a long time back that the prime minister asked private sector honchos to be abstemious in their remuneration. Now, all the MPs have gone ahead and given themselves a rise in their salaries.
When Lehman became a euphemism for the greed that the private sector represents, government officials ascended the high horse to say how they were different and that the private sector stinks when it comes to remuneration. Now, we have the RBI as well as the public sector banks arguing for parity with the private sector. What is one to make of it considering that each segment thinks that it deserves the hike and, as a corollary, the others don’t?
The extremes in salaries are stark. US Fed chairman Ben Bernanke takes home $200,000 per annum while European Central Bank president Jean-Claude Trichet earns $500,000.
Bank of England chief Mervyn King has package of $450,000 while Japan’s Masaaki Shirakawa is paid $400,000. Our own RBI governor Duvvuri Subbarao gets the rupee equivalent of around $30,000. In contrast, in 2009 Goldman Sachs was reported to have had a wage bill of $16.2 billion for 32,500 workers, giving an average of $498,246 — half a million dollars per head!
Clearly, the regulated take home larger pay cheques than the regulators, though the latter admittedly have greater powers. The question is how are salaries to be fixed?
In a free economy, salaries should be the function of the owners or shareholders. If it is the private sector, it is the proprietor or the shareholders. This holds just like it does for, say, a household where it determines the salary to be paid to the maid or watchman or driver. However, structures are amorphous here.
Most big companies have shareholders and even an owner-driven company may not really have a majority. Salaries are fixed by the owner on the premise that the majority has voted for it but the majority never really gets together to take a decision and hence the process of salary determination remains fuzzy.
At times it ends up with the owner, who is the management, also appointing the board which ratifies one’s own salary.
This should be treated as an internal affair but it becomes a public concern if bailouts have to be invoked when things go awry. The crisis did not stop at the financial sector, where public money was involved, but also overflowed into manufacturing, which then brought to the fore the issue of executive pay.
When it comes to the government, it is even more complicated. There are hierarchies where a bank chief is at the level of a secretary and one cannot go up without the other doing so. Hence, either all salaries have to move up, or all stagnate. The public sector enterprises are better placed even though there is government ownership, as here the CEOs get better pay packets, which can range between Rs30-40 lakh per annum, though this is still lower than that in the private sector.
Now, there is a strong case for salary revisions in the public sector banks, especially when they perform as well as those in the private sector. But there is a conundrum. A just way of going about it is to increase all salaries by x%.
This is democratic but allows free riders to benefit. It is actually the middle and senior levels where personnel can move to the private sector quite easily and the threat of attrition is real. There are a number of IAS officials who have gotten lucrative deals in the private sector to become heads of commodity exchanges or infrastructure companies. A number of private banks took in public sector officials and have grown really well.
However, does an executive, who is two years away from retirement, deserve a private sector salary? Yes, if the organisation is doing as well as its private counterpart. Critics aver that there are few public sector employees who find jobs after they retire. Salary hikes are needed to prevent attrition and the present system of backdoor increases through the recruitment of consultants with fixed tenures is not sustainable.
The solution is really to leave it open to the companies or banks to decide their pay packets which should be linked to profitability. This will create a problem for the bureaucrats as there is no profit and the incentives must be linked with performance in terms of expense management or implementation of projects.
As a corollary, the grades should be delinked from the bureaucracy charts. This would also mean that banks must have their own system of picking their CEOs with the ministry being out of the picture. This is the only way to make it work and should hence be looked at holistically.
Look beyond FCRA amendments: Financial Express: 5th October 2010
The possibility of the Forward Contracts (Regulation) Act (FCRA) being amended raises some interesting issues in the context of financial markets in India. There is, of course, the question of what this means for the commodity market. But, at the broader level, it also provokes some introspection of the regulatory issues in the financial space.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
Look beyond FCRA amendments: Financial Express: 5th October 2010
The possibility of the Forward Contracts (Regulation) Act (FCRA) being amended raises some interesting issues in the context of financial markets in India. There is, of course, the question of what this means for the commodity market. But, at the broader level, it also provokes some introspection of the regulatory issues in the financial space.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
Wednesday, September 29, 2010
Why have IRFs not worked? Economic Times 29th September 2010
India is a nation of traders and the success of the United Stock Exchange (USE) in its first week of operations bears testimony to this observation. Coincidentally, the spot markets in equities, foreign exchange and government securities (G-secs) register an average daily turnover of around Rs 20,000 crore.
The derivative markets several multiples of this amount and the only exception is the interest rate (IRFs) market, which has witnessed little interest despite its many versions — the last being in 2008.
The response to F&O trading has been quite remarkable in the past few years, especially in new areas such as commodities and currencies. Currencies currently trade about 3.8 times the physical underlying (comprising foreign trade and external loans) and would go up to 5.5 times if volumes increase by a comparable level with USE coming in.
Gold trades at a multiple of 25, crude oil at four, farm products at unity while stocks three times the cap of the National Stock Exchange (NSE). The nagging thought here is as to why have IRFs not quite caught on.
The market for G-secs is large with the outstanding portfolio being Rs 14 lakh crore. If 25% is excluded, which is classified as ‘held to maturity’ securities, the physical underlying would be Rs 10.5 lakh crore. Institutions trade Rs 20,000 crore of such securities every day and, as interest rates have been volatile in the past, carry a big risk of mark to market (MTM) when they have to value their portfolios. Do IRFs actually satisfy the prerequisites for futures trading?
First, the basic driver of trade is volatility in any market, and NSE Primary Returns Index has witnessed volatility of 7% between April and September. This is comparable to that in other markets, and lies between agri products (5%) and forex (9.5%). Therefore, risk-cover is necessary given the large underlying — 1% change in rates can hit the portfolio by Rs 10,500 crore or 1 bps by Rs 100 crore.
Second, given that is a single product contract which can be settled with other pre-specified ones, for this to be a success, there should be strong correlation with other securities. Here, RBI data shows that there is strong correlation between change in yields on 10-year paper and those on 5, 11, 12 and 20 years and moderately high (around 60%) for eight and nine years. Hence, this too cannot be a reason to reject the product as the contract can be benchmarked with the other papers, though admittedly, the others are not as widely traded as the five- and 10- year securities.
Third, the cost of trading could be another militating factor. But, this segment, like the currency market, is free of this charge unlike the commodity or stock markets, where the charges vary between 0.002 and 0.003%. Therefore, this too could not be an explanation. Fourth, one can surmise that the absence of a yield curve, which is vibrant along all points, is the reason holding back the market, as liquidity in the spot market should enthuse the IRF market.
But still one should expect high volumes of trade for the most widely traded and held 10-year security.
Fifth, the market may not interested in such hedging, especially in an environment when interest rates are expected to move up as there would be less incentive to get into such contracts. Sixth, and probably the more plausible reason could be that players are making use of the volatility in the market through purchase and sale to book their gains and find no need to go in for a hedge.
This could explain why the 75% of G-secs, which are ‘available for sale’ or ‘held for trading’ is actually traded. Lastly, non-G-sec participants do not see this as a hedge as lending rates, for example, do not move in tandem with these rates and hence one could get left out of this market.
Globally, 60% of the derivative market is dominated by equities, followed by interest futures with 15% and currencies with 11%. In India, things are different with equities taking a share of 45%, followed by currencies with 38% (assuming that the Rs 60,000 crore daily volumes are maintained) and gold with just less than 10%. The IRF segment is the missing link that has to be connected. The unanswered question is, how?
The derivative markets several multiples of this amount and the only exception is the interest rate (IRFs) market, which has witnessed little interest despite its many versions — the last being in 2008.
The response to F&O trading has been quite remarkable in the past few years, especially in new areas such as commodities and currencies. Currencies currently trade about 3.8 times the physical underlying (comprising foreign trade and external loans) and would go up to 5.5 times if volumes increase by a comparable level with USE coming in.
Gold trades at a multiple of 25, crude oil at four, farm products at unity while stocks three times the cap of the National Stock Exchange (NSE). The nagging thought here is as to why have IRFs not quite caught on.
The market for G-secs is large with the outstanding portfolio being Rs 14 lakh crore. If 25% is excluded, which is classified as ‘held to maturity’ securities, the physical underlying would be Rs 10.5 lakh crore. Institutions trade Rs 20,000 crore of such securities every day and, as interest rates have been volatile in the past, carry a big risk of mark to market (MTM) when they have to value their portfolios. Do IRFs actually satisfy the prerequisites for futures trading?
First, the basic driver of trade is volatility in any market, and NSE Primary Returns Index has witnessed volatility of 7% between April and September. This is comparable to that in other markets, and lies between agri products (5%) and forex (9.5%). Therefore, risk-cover is necessary given the large underlying — 1% change in rates can hit the portfolio by Rs 10,500 crore or 1 bps by Rs 100 crore.
Second, given that is a single product contract which can be settled with other pre-specified ones, for this to be a success, there should be strong correlation with other securities. Here, RBI data shows that there is strong correlation between change in yields on 10-year paper and those on 5, 11, 12 and 20 years and moderately high (around 60%) for eight and nine years. Hence, this too cannot be a reason to reject the product as the contract can be benchmarked with the other papers, though admittedly, the others are not as widely traded as the five- and 10- year securities.
Third, the cost of trading could be another militating factor. But, this segment, like the currency market, is free of this charge unlike the commodity or stock markets, where the charges vary between 0.002 and 0.003%. Therefore, this too could not be an explanation. Fourth, one can surmise that the absence of a yield curve, which is vibrant along all points, is the reason holding back the market, as liquidity in the spot market should enthuse the IRF market.
But still one should expect high volumes of trade for the most widely traded and held 10-year security.
Fifth, the market may not interested in such hedging, especially in an environment when interest rates are expected to move up as there would be less incentive to get into such contracts. Sixth, and probably the more plausible reason could be that players are making use of the volatility in the market through purchase and sale to book their gains and find no need to go in for a hedge.
This could explain why the 75% of G-secs, which are ‘available for sale’ or ‘held for trading’ is actually traded. Lastly, non-G-sec participants do not see this as a hedge as lending rates, for example, do not move in tandem with these rates and hence one could get left out of this market.
Globally, 60% of the derivative market is dominated by equities, followed by interest futures with 15% and currencies with 11%. In India, things are different with equities taking a share of 45%, followed by currencies with 38% (assuming that the Rs 60,000 crore daily volumes are maintained) and gold with just less than 10%. The IRF segment is the missing link that has to be connected. The unanswered question is, how?
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