The Greek tragedy, which turned out to be quite a farce, is not an isolated instance of distortion in the financial markets. Uncle Sam appears to be the imminent threat today with President Obama striving to have the debt limit of $14.3 trillion enhanced. A payment of $29 billion in interest is due in August. Given the size of the US debt problem, the PIGS story appears to be merely a short tale in an epic of indebtedness. Now, whether or not the limit is enhanced will be more of a political issue with the President having the right to bypass Congress as a last resort. But, more importantly, the fact that the US government can default highlights the fact that the global financial system is not really stronger even after emerging from the crisis of 2008. Lehman and Bear Stearns were institutions that shook the financial markets, but a US government default will damage the credibility of the sole superpower and anchor currency.
A US government default will mean that all holders will have to reconsider their options. The outside world holds around $4.5 trillion of the total debt, which is a little over 30% of the total. Clearly, they would get jittery at this prospect and the country likely to be affected the most would be China, which holds $1.16 trillion. China and the US are now symbiotically bound. If the US defaults then China’s holdings get affected. However, the US cannot afford to default because it will then find it difficult to find buyers for its debt in the future, for which China is a major customer. A fall in the value of these reserves will mean losses to be written off that can be quite substantial. A lower value of reserves will compress money supply, which, in turn, will mean pressure on interest rates. Higher rates impact investment and growth.
The second constituent of the market that would be affected will be the pension funds, provident funds and insurance companies that have to perforce invest in triple-A-rated paper. Any erosion in value would mean a withdrawal, which, in turn, will mean large-scale selling of treasuries that will spur up interest yields in the market. Lastly, this panic will affect around $4 trillion of treasuries that are held as collateral in the futures market—repo, OTC derivative, etc. A default will induce a haircut on these values, leading to a tailspin the market.
The issue may be seen as being more of a political dilemma where the Republicans want an expenditure cut as against Obama who would like to see taxes increased. This impasse has meant that the financial markets remain on the edge. Various packages are being spoken of in terms of expenditure cuts and the rating agencies are intransigent about anything less than $4 trillion in debt to retain the triple-A status.
What does this mean for the world? Even in case a default is eschewed, there will be a certain loss of credibility in the dollar and the global system will have to look for alternatives. Currently, with the dollar being the anchor currency, the US has the prerogative to follow the policy of benign neglect to supply dollars to the world where there is belief that the currency is strong. However, now with doubts being raised, we have to look at another currency. The euro was to be the alternative but given the entanglements with the debt crisis and the existence of a common currency has inextricably put the better performing nations in a compromising position. The euro tangle is one where no one can let the rogue nations sink as it would affect every bank’s and hence nation’s balance sheet.
The recent restructuring of Greek debt turned quite farcical. In the new package, Greece borrows 35 billion euros and buys 30-year bonds, which will be worth 100 billion euros on maturity, which is used to repay the investor. WSJ has estimated that the total loss for EU banks can be around 14 billion euros. This comes shortly after the stress tests were carried out by the European Banking Authority that found only eight banks to be deficient in capital (maintaining core tier-1 capital of 5%) out of a set of 90 banks, but surprisingly did not take into account the most vital stress test of Greek default.
The situation is hence quite fluid for the financial markets. While credibility is the main factor, the implications for global growth are compelling. An overall slowdown in global growth as well as trade cannot be ruled out, as the onus will be more on the emerging nations to provide an impetus. Countries like India and China, which have been the bastions of growth in the past, are trying hard to fight inflation and deflate their economies. In such a situation, growth prospects appear to be muted.
But, on the positive side, we can see this entire process being part of a cleansing process where nations will put their fiscal balances in order. Keynesian pump priming, which worked in 2008 and 2009, has to be reviewed now as it also means building debt, which can shake the edifice of credibility as well as future growth. These episodes should be lessons to be imbibed as we work on modifying, if not creating, a new global financial order against the background of the financial crisis that started with Bear Stearns in 2008 and culminated with Uncle Sam’s sorrows.
Saturday, July 30, 2011
Thursday, July 14, 2011
Challenging the poverty dimension of inflation: Economic Times 13th July 2011
A perverse, yet novel reason put forward to explain high inflation is that the poor are eating more as they are becoming less poor. The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) has been extolled for being responsible for higher consumption, which in a way is a vindication of high inflation. The extended logic used here is that if the poor are eating more and we are paying high prices, then there is nothing amiss.
There are two thoughts here. The first is that higher demand per se, especially of food items, has to be met by augmenting supplies; and this holds for any good or service. If people want more mobile handsets, industry produces more of them, which leads to lower prices.
Therefore, ideally if people are less poor and demand more food, then we should produce more food at a lower cost. This is the duty of any economy that works and hence we cannot sit back and take pride in such a development as it is a reflection of the failure of the system to deliver if there are persistent supply imbalances. However, for the sake of argument, let us suppose that this theory has a basis and prima facie makes sense.
This leads to the second issue. Do the numbers really add up? The MGNREGS allots around .`40,000 crore on an annual basis, and while the code speaks of an allocation of 60:40 for wages: materials, it has turned out to be 70% for wages. Therefore, there is an additional income of .`28,000 crore. Let us suppose that all this money is actually spent and nothing is saved as the people are poor and think only of the present. Here one cannot be sure whether or not this income will lead to additional spending or will merely substitute other sources of funding.
This is so because on an average, the MGNREGS in reality provides 37 days of employment to households when they are entitled to 100 days, which means that this becomes an income supplement when they are between two harvest seasons. In the extreme case, it will fully substitute other sources of income or else they will spend the money progressively on non-food items.
Now, the consumption pattern in the country points towards around 36% of expenditure going into food items and another 7% or so into clothes, which would be the areas the farmers would be looking at. This means that around 85% of their incomes would go into food as an approximation (36 divided by 43). Total consumption expenditure on food was estimated to be .`16.20 lakh crore for the country by the CSO in FY10 while the MGNREGS money of .`24,000 crore (i.e., 85% of .`28,000 crore) will be the maximum that can be spent on food items.
Now, this amount works out to 1.5% of total food consumption (or 1.7% in case the entire .`28,000 cr is spent on food products), and considering that farm output has increased by 6.6% in FY11, one cannot really see a mismatch between demand and supply for food items in general.
At the next stage we can get down to the micro level and examine whether this theory can still hold. Out of the.`28,000 crore being spent on food products, CSO data shows that around 25% is spent on cereals and pulses, where prices showed a decline or marginal increase.
Besides, they would be covered under the public distribution system where prices have remained unchanged. Fruits and vegetables account for another 26.5% and the problem is not higher demand but high losses on account of absence of storage facilities. The Union Budget admitted that around 40% of the crop is wasted due to the absence of logistics support.
Another 21% is spent on milk products, where the higher price is due to higher cost of production (i.e., animal feed such as oilcakes and fodder) while another 12% is on meat/poultry products where prices have increased due to higher cost of animal feed. There is hence reason to believe that this higher purchasing power would not have significantly affected the demand picture, given that the problem is still on supply and cost factors.
Therefore, either way the theory that inflation in FY11 has been caused by the poor becoming less poor does not hold. The problem is on the supply side as also our inability to manage surpluses. India is traditionally in surplus when it comes to cereals, horticulture, sugar and deficient in pulses and oilseeds. The curious case here is that when production of pulses and oilseeds increase, prices move downwards and we also simultaneously lower our imports as we do not store them for the rainy day.
On the other hand, when production declines, we import more. Given that we import around 15-20% of our pulses requirement and 55% of edible oils, international prices are also influenced by this demand. Hence, inflation gets imported into our system. The wastage in horticulture is now quite well known and the country struggles to create the storage facilities to harness the production levels. Therefore, to use diminishing poverty as a factor causing inflation is neither an explanation nor an excuse.
There are two thoughts here. The first is that higher demand per se, especially of food items, has to be met by augmenting supplies; and this holds for any good or service. If people want more mobile handsets, industry produces more of them, which leads to lower prices.
Therefore, ideally if people are less poor and demand more food, then we should produce more food at a lower cost. This is the duty of any economy that works and hence we cannot sit back and take pride in such a development as it is a reflection of the failure of the system to deliver if there are persistent supply imbalances. However, for the sake of argument, let us suppose that this theory has a basis and prima facie makes sense.
This leads to the second issue. Do the numbers really add up? The MGNREGS allots around .`40,000 crore on an annual basis, and while the code speaks of an allocation of 60:40 for wages: materials, it has turned out to be 70% for wages. Therefore, there is an additional income of .`28,000 crore. Let us suppose that all this money is actually spent and nothing is saved as the people are poor and think only of the present. Here one cannot be sure whether or not this income will lead to additional spending or will merely substitute other sources of funding.
This is so because on an average, the MGNREGS in reality provides 37 days of employment to households when they are entitled to 100 days, which means that this becomes an income supplement when they are between two harvest seasons. In the extreme case, it will fully substitute other sources of income or else they will spend the money progressively on non-food items.
Now, the consumption pattern in the country points towards around 36% of expenditure going into food items and another 7% or so into clothes, which would be the areas the farmers would be looking at. This means that around 85% of their incomes would go into food as an approximation (36 divided by 43). Total consumption expenditure on food was estimated to be .`16.20 lakh crore for the country by the CSO in FY10 while the MGNREGS money of .`24,000 crore (i.e., 85% of .`28,000 crore) will be the maximum that can be spent on food items.
Now, this amount works out to 1.5% of total food consumption (or 1.7% in case the entire .`28,000 cr is spent on food products), and considering that farm output has increased by 6.6% in FY11, one cannot really see a mismatch between demand and supply for food items in general.
At the next stage we can get down to the micro level and examine whether this theory can still hold. Out of the.`28,000 crore being spent on food products, CSO data shows that around 25% is spent on cereals and pulses, where prices showed a decline or marginal increase.
Besides, they would be covered under the public distribution system where prices have remained unchanged. Fruits and vegetables account for another 26.5% and the problem is not higher demand but high losses on account of absence of storage facilities. The Union Budget admitted that around 40% of the crop is wasted due to the absence of logistics support.
Another 21% is spent on milk products, where the higher price is due to higher cost of production (i.e., animal feed such as oilcakes and fodder) while another 12% is on meat/poultry products where prices have increased due to higher cost of animal feed. There is hence reason to believe that this higher purchasing power would not have significantly affected the demand picture, given that the problem is still on supply and cost factors.
Therefore, either way the theory that inflation in FY11 has been caused by the poor becoming less poor does not hold. The problem is on the supply side as also our inability to manage surpluses. India is traditionally in surplus when it comes to cereals, horticulture, sugar and deficient in pulses and oilseeds. The curious case here is that when production of pulses and oilseeds increase, prices move downwards and we also simultaneously lower our imports as we do not store them for the rainy day.
On the other hand, when production declines, we import more. Given that we import around 15-20% of our pulses requirement and 55% of edible oils, international prices are also influenced by this demand. Hence, inflation gets imported into our system. The wastage in horticulture is now quite well known and the country struggles to create the storage facilities to harness the production levels. Therefore, to use diminishing poverty as a factor causing inflation is neither an explanation nor an excuse.
Are T-bill futures a good idea? Financial Express 11th July 2011
Futures on 91-days’ T-bill is an interesting development, considering that there is scepticism attached to money market derivatives, given the lacklustre response to the IRFs twice over. But, this one can be different because it does address, to a large extent, the concerns that thwarted the growth of the IRF market.
If we look at the structure of the market, the primary market has issues every week of, say, R8,000-10,000 crore depending on the RBI’s calendar. The buyers are banks, mutual funds, corporates and other institutions and some state governments. The secondary market does not inspire too much of trading and at best registers around R2,000 crore a day, which obviously has to change. This may be contrasted with, say, trading of around R20,000 crore a day in the cash segment of the stock market. Overall outstanding on such paper would be around R80,000-90,000 crore, though there is considerable churning of such bills as they expire every 91 days, which, in turn, are replaced by fresh issuances. This makes it an interesting underlying product as there is a virtual rollover of paper on a regular basis. How then will the derivative product on this underlying work?
For any market to work for a derivative product, we need to have large number of players—hedgers and speculators besides the arbitragers. The actual holders would be interested in such an instrument as hedgers. In FY12 so far there has been a movement of a little over 100 bps in the primary yield on 91-days T-bills, which means that the prices of these bills have been coming down. Intuitively, in such an environment of rising interest rates, this is a big risk that is being carried in the books of the holder and there is need to hedge it. This is where the investors or speculators could come in and take an opposing view on movement in interest rates. Hence, holders of such instruments would be shorting their futures, so as to buy back at a lower rate and provide cover for their loss on portfolio. At times, when the volatility in interest rate has been high and uncertain, given that one is still not too sure of RBI’s view on interest rates, this is a very useful option for interest rate hedging. As a corollary, it makes a sensible investment option.
T-bill futures have the potential to actually set benchmarks for short-term instruments such as commercial paper, certificates of deposits and other treasury bills. 91-days T-bills futures will hence help enable them to take positions based on their holdings of pother instruments. Corporates who are dealing with floating rate bonds would find this attractive as they are able to benchmark and hedge or trade based on interest rate perceptions. In fact, even within the T-bills market there have been major shifts in yields on other maturities which are above 50 bps for 14-days and around 75 bps for 182- and 362-days bills in the last three months. A major improvement over the IRFs is that there is no delivery and all transactions are cash settled, meaning thereby that one does not have to go running around for the right security to deliver. The absence of securities transactions tax will also help in further lowering costs along with lower margins, which provide greater leverage to investors.
In fact, this instrument should also attract attention from the retail end as one can actually take advantage of interest rate movements, especially in an era of rising interest rates. Deposit holders normally get into the instrument and have their interest rate locked for a fixed tenure. In an increasing rate environment, one can actually start playing on T-bill futures to derive the benefit of hedging or making a profit. The advantage for this derivative segment is that one can directly trade on the NSE platform just like one does for, say, shares.
A vibrant futures market in the IRF segment including T-bills has the potential to make the financial markets more buoyant. Futures typically trade a multiple times that in the physical or cash markets. In stock markets, for example, we have trades of around 6-7 times the cash segment, which, on its own, could mean comparable numbers for this segment. Commodity futures generate business volumes of around R60,000-70,000 crore a day while currency derivatives clock R30,000 crore a day. Quite clearly, the money market, which has a large underlying of GSec paper, corporate bonds, T-bills, CPs and CDs, should be able to match the same once they set acceptable benchmarks for other instruments, given that there is a large mass of GSecs which banks hold on to that always run the risk of MTM losses in a regime of rising interest rates. The IRFs were to address this issue, but the contract structures were a deterrent. Hopefully, we have gotten the product right this time as the initial trading volumes look more respectable than it were when the initial IRFs were launched.
If we look at the structure of the market, the primary market has issues every week of, say, R8,000-10,000 crore depending on the RBI’s calendar. The buyers are banks, mutual funds, corporates and other institutions and some state governments. The secondary market does not inspire too much of trading and at best registers around R2,000 crore a day, which obviously has to change. This may be contrasted with, say, trading of around R20,000 crore a day in the cash segment of the stock market. Overall outstanding on such paper would be around R80,000-90,000 crore, though there is considerable churning of such bills as they expire every 91 days, which, in turn, are replaced by fresh issuances. This makes it an interesting underlying product as there is a virtual rollover of paper on a regular basis. How then will the derivative product on this underlying work?
For any market to work for a derivative product, we need to have large number of players—hedgers and speculators besides the arbitragers. The actual holders would be interested in such an instrument as hedgers. In FY12 so far there has been a movement of a little over 100 bps in the primary yield on 91-days T-bills, which means that the prices of these bills have been coming down. Intuitively, in such an environment of rising interest rates, this is a big risk that is being carried in the books of the holder and there is need to hedge it. This is where the investors or speculators could come in and take an opposing view on movement in interest rates. Hence, holders of such instruments would be shorting their futures, so as to buy back at a lower rate and provide cover for their loss on portfolio. At times, when the volatility in interest rate has been high and uncertain, given that one is still not too sure of RBI’s view on interest rates, this is a very useful option for interest rate hedging. As a corollary, it makes a sensible investment option.
T-bill futures have the potential to actually set benchmarks for short-term instruments such as commercial paper, certificates of deposits and other treasury bills. 91-days T-bills futures will hence help enable them to take positions based on their holdings of pother instruments. Corporates who are dealing with floating rate bonds would find this attractive as they are able to benchmark and hedge or trade based on interest rate perceptions. In fact, even within the T-bills market there have been major shifts in yields on other maturities which are above 50 bps for 14-days and around 75 bps for 182- and 362-days bills in the last three months. A major improvement over the IRFs is that there is no delivery and all transactions are cash settled, meaning thereby that one does not have to go running around for the right security to deliver. The absence of securities transactions tax will also help in further lowering costs along with lower margins, which provide greater leverage to investors.
In fact, this instrument should also attract attention from the retail end as one can actually take advantage of interest rate movements, especially in an era of rising interest rates. Deposit holders normally get into the instrument and have their interest rate locked for a fixed tenure. In an increasing rate environment, one can actually start playing on T-bill futures to derive the benefit of hedging or making a profit. The advantage for this derivative segment is that one can directly trade on the NSE platform just like one does for, say, shares.
A vibrant futures market in the IRF segment including T-bills has the potential to make the financial markets more buoyant. Futures typically trade a multiple times that in the physical or cash markets. In stock markets, for example, we have trades of around 6-7 times the cash segment, which, on its own, could mean comparable numbers for this segment. Commodity futures generate business volumes of around R60,000-70,000 crore a day while currency derivatives clock R30,000 crore a day. Quite clearly, the money market, which has a large underlying of GSec paper, corporate bonds, T-bills, CPs and CDs, should be able to match the same once they set acceptable benchmarks for other instruments, given that there is a large mass of GSecs which banks hold on to that always run the risk of MTM losses in a regime of rising interest rates. The IRFs were to address this issue, but the contract structures were a deterrent. Hopefully, we have gotten the product right this time as the initial trading volumes look more respectable than it were when the initial IRFs were launched.
Yield curve not based on real market conditions: Economic Times 6th July 2011
The government debt market trades almost as much as the cash segment on NSE at around Rs 15,000 crore a day. The size of the market is large with outstanding central government paper of around Rs 25 lakh crore, with net annual addition of around Rs 3.5 lakh crore of paper. Yet, there are some interesting statistics on the topography of trade that takes place in this market. More than 80% takes place in paper with a residual maturity of 10 years and above, despite the fact that around 38% of fresh paper being issued has over 10 years maturity, with an equal share for papers with 5-10 years maturity. What does this indicate? The market is still narrow in terms of trade taking place. A curious factor is that the difference in yields on 1 year and 10 year paper is around 15-20 bps.
Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.
Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.
First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .
Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.
Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .
At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.
Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.
Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.
First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .
Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.
Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .
At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.
We don’t need entry loads: Financial Express: 4th July 2011
Do we need intermediaries to run our financial lives? This is an important question because we tend to normally spurn them in, say, agriculture, where they add to transaction costs—in horticulture, they account for 65-70% of the final consumer price. But when it comes to finance, or in particular mutual funds, the broker has a different position. The broker, sub-broker or agent acts as the final point of contact between the investor and the mutual fund house. As there are costs to be shared here, the issue that arises is whether or not the investor should be mandatorily made to pay for their services.
In the past, until August 2009, the fund forced the investor to pay the commission as part of the euphemistically termed entry load of 2.25%. Sebi had quite rightly pointed out that investors were being misled into buying schemes where the agent got the highest commission. Often the agent would give us a part of it as an incentive, which made us feel good. But the truth was that when we were investing R100, a part actually never went into the market as investment.
The mutual fund industry’s view is that with the entry load concept being banned, less money has come in. First, this is hard to prove because post the ban on entry loads, the market itself has been wobbly, as seen by the fall in trading volumes on the NSE. Second, savings, including deposits, have taken a hit on account of high inflation. Finally, the earlier chairman of Sebi, CB Bhave, had argued that this was not the case and one should not look at net inflows but purchases, as people sell when they want to and not because of agents being there. Purchases had continued to increase.
But, for the sake of argument, let’s assume that the broker had actually brought in the money. By counter-intuitive logic, it can be argued that the fact that funds are not coming in only proves Sebi’s point that investors were being driven to invest by the brokers making promises that were probably not fulfilled. This is so because investors would continue to invest in mutual funds if they thought they took the right decisions when the broker was around. In fact, they would be willing to pay the broker for such guidance, which they are not willing to do today. In fact, today there is a plethora of ranking and guidance on the performance of mutual funds schemes and, in retrospect, it appears that agents were actually getting a commission for doing the administrative job of filling in forms and submitting to the fund. If this were so, then the logical corollary is that mutual funds should run their schemes on their own, just like banks do with getting deposits without agents.
A way out for mutual funds is to pay the agent separately, which will be an indirect way of loading the investor as it would go under operating expenses, which will impact the profit and NAV of the schemes. But this will add a modicum of transparency. Alternatively, mutual funds can have their own staff to do so, just like banks do for their credit products. This will also be loaded indirectly on the investor in terms of cost, but clearly the investors can choose those schemes that finally deliver better returns or have lower operating costs. Here, the onus is on the fund to perform.
This is where investor education is important. The Association of Mutual Funds in India should take the lead and run such programmes more aggressively across the country so that the benefit of these funds is extolled and investors educated about how they should view investments. The NSE does this even today, as do commodity exchanges like NCDEX where investor programmes are held to just inform the public about what stock or commodity trading is about and how to trade so that people are not just guided by brokers into doing what they want. This can be coupled with more effective direct online access to investors.
Given the expanse of the country and the level of financial literacy, there is information asymmetry between investors and suppliers of a product. Intermediation is a way out to bridge this gap and that is why we have banks, mutual funds and insurance companies. But when these intermediates bring in further lines of intermediaries, which can go to at least three levels, then the cost increases and the chance of misselling products is very high. Simplifying processes is a better way out for funds to garner money.
This is even more glaring when we look at insurance products where the insured are not aware that large percentages of the premium (going up to 20-30%) actually go as commissions in the first year, with a trailing commission that goes up to 5%. Quite clearly, the authorities need to check this and Sebi’s move is commendable and needs to be stretched to insurance where, invariably, the high paying commission products mobilise funds—the single premium products that serve the insured well but not the agent are rarely marketed.
At the ideological level, we need to actually see if intermediation is taking place efficiently. As we increase the tiers, different levels of efficiency and performance issues come up. Online trading addresses the issue adequately and the mutual funds should progressively work towards cutting down these layers. Clearly, the ones that can bridge this gap will be the most preferred, which is what competitive financial systems are all about.
In the past, until August 2009, the fund forced the investor to pay the commission as part of the euphemistically termed entry load of 2.25%. Sebi had quite rightly pointed out that investors were being misled into buying schemes where the agent got the highest commission. Often the agent would give us a part of it as an incentive, which made us feel good. But the truth was that when we were investing R100, a part actually never went into the market as investment.
The mutual fund industry’s view is that with the entry load concept being banned, less money has come in. First, this is hard to prove because post the ban on entry loads, the market itself has been wobbly, as seen by the fall in trading volumes on the NSE. Second, savings, including deposits, have taken a hit on account of high inflation. Finally, the earlier chairman of Sebi, CB Bhave, had argued that this was not the case and one should not look at net inflows but purchases, as people sell when they want to and not because of agents being there. Purchases had continued to increase.
But, for the sake of argument, let’s assume that the broker had actually brought in the money. By counter-intuitive logic, it can be argued that the fact that funds are not coming in only proves Sebi’s point that investors were being driven to invest by the brokers making promises that were probably not fulfilled. This is so because investors would continue to invest in mutual funds if they thought they took the right decisions when the broker was around. In fact, they would be willing to pay the broker for such guidance, which they are not willing to do today. In fact, today there is a plethora of ranking and guidance on the performance of mutual funds schemes and, in retrospect, it appears that agents were actually getting a commission for doing the administrative job of filling in forms and submitting to the fund. If this were so, then the logical corollary is that mutual funds should run their schemes on their own, just like banks do with getting deposits without agents.
A way out for mutual funds is to pay the agent separately, which will be an indirect way of loading the investor as it would go under operating expenses, which will impact the profit and NAV of the schemes. But this will add a modicum of transparency. Alternatively, mutual funds can have their own staff to do so, just like banks do for their credit products. This will also be loaded indirectly on the investor in terms of cost, but clearly the investors can choose those schemes that finally deliver better returns or have lower operating costs. Here, the onus is on the fund to perform.
This is where investor education is important. The Association of Mutual Funds in India should take the lead and run such programmes more aggressively across the country so that the benefit of these funds is extolled and investors educated about how they should view investments. The NSE does this even today, as do commodity exchanges like NCDEX where investor programmes are held to just inform the public about what stock or commodity trading is about and how to trade so that people are not just guided by brokers into doing what they want. This can be coupled with more effective direct online access to investors.
Given the expanse of the country and the level of financial literacy, there is information asymmetry between investors and suppliers of a product. Intermediation is a way out to bridge this gap and that is why we have banks, mutual funds and insurance companies. But when these intermediates bring in further lines of intermediaries, which can go to at least three levels, then the cost increases and the chance of misselling products is very high. Simplifying processes is a better way out for funds to garner money.
This is even more glaring when we look at insurance products where the insured are not aware that large percentages of the premium (going up to 20-30%) actually go as commissions in the first year, with a trailing commission that goes up to 5%. Quite clearly, the authorities need to check this and Sebi’s move is commendable and needs to be stretched to insurance where, invariably, the high paying commission products mobilise funds—the single premium products that serve the insured well but not the agent are rarely marketed.
At the ideological level, we need to actually see if intermediation is taking place efficiently. As we increase the tiers, different levels of efficiency and performance issues come up. Online trading addresses the issue adequately and the mutual funds should progressively work towards cutting down these layers. Clearly, the ones that can bridge this gap will be the most preferred, which is what competitive financial systems are all about.
Don’t carry CSR overboard: Financial Express, 30th June 2011
Philanthropy is a good thing to talk about, and the visit of Warren Buffet to India has added more spice to the art of giving, which is what everyone wants others to do today. Several corporate honchos have gone on to have it well publicised that they give an awful lot of money for the needy and several pages in the media have been devoted to the same. At another level, it is averred that philanthropy should always be anonymous or else it is the cost of branding, of either the company or the individual. It works well both ways and is a win-win situation for everyone.
At a more serious level, it has been argued that companies should devote a certain amount for CSR (corporate social responsibility) or, more specifically, set aside money for the poor or social causes that are distinct from making statements on saving the planet. In fact, critics say that this should be mandatory and must be reckoned as a fixed percentage of their profits. This is so because society enables corporates to grow and prosper. Hence, it becomes obligatory for this sector to give something in return. Is there merit in this argument?
If one takes the overall net profits of the corporate sector, it would have been around R3.2 lakh crore in FY10. This is substantial and would be around 4% of India’s GDP at current market prices. Taking a portion out (1% would mean around R3,200 crore) can be benchmarked with various development schemes that will help society at large. Or so the argument goes.
While CSR is a good idea, it cannot and should not be made mandatory. Corporates are like any entity in the country that work for a profit and abide by the rules of the game. Therefore, taxes are paid and several other regulatory covenants are adhered to in the process. There would be a lot of lobbying going on to seek concessions but that is another issue as they are decided on merit. Therefore, we should not be going beyond the rules already laid down. If it were done, then it should be extended to individuals too, as there are several millionaires in the country who could contribute to CSR by the same logic.
There are essentially three arguments that can be made in this context. First, let us go back to the world of Adam Smith, which we are trying to pursue based on free markets. In this capitalist society driven by markets, private enterprise works with self interest in mind to earn profits. The government lays down the framework and ensures that the rules are obeyed. As we never do have a fully capitalist system, the government also enters economic activity and undertakes projects, for which we have the Budget and the entire tax system. At times, the government could go a step ahead and earmark specific charges in the form of additional taxes or cess for specific purposes. This goes for drought relief or education and is levied universally on all entities, which are fair measures. Instead of charging a corporate tax rate of, say, 30.6%, it is broken up into 30% tax on which there is a cess of 2%. The idea is that there is transparency insofar as the money from this additional charge is earmarked for a purpose. This being the case, CSR cannot be imposed beyond the realm of the tax system.
Second, it should be recognised that a company belongs to investors finally as the shareholders have made investments in the enterprise. While they could vote for such an allocation, it can never be made a rule for all as it comes in the way of economic freedom and imposes an additional cost to running an enterprise. Any mandatory move should be opposed, though corporates can always be made more responsible for the harm that may be coming about on account of their business activity. Asking them to pay for fuel emission is okay while asking them to donate to the poor is not in order. It has to evidently to come from within and we cannot stand on any such judgement.
The third is, even if we make it mandatory, who will administer the same? The public sector is considered to be inefficient when it comes to creating social infrastructure. Currently, there is little accountability for the money allocated for, say, health and education in the Budgets. We have hospitals without doctors and schools without teachers. These are issues beyond the leakages that are there. It is not surprising that even when corporates indulge in philanthropy; it goes in the name of the organisation or person because keeping it within one’s own purview makes sure that resources are better utilised. However, the core competence of companies is in specific lines of business and diversification into social infrastructure is inefficient.
Addressing the concerns of the poor is a public sector issue that has to be addressed separately by the government. Asking the private sector to mandatorily pitch in is against the grain of free enterprise and imposes costs, besides leading to undesirable and inefficient solutions. This should be opposed.
At a more serious level, it has been argued that companies should devote a certain amount for CSR (corporate social responsibility) or, more specifically, set aside money for the poor or social causes that are distinct from making statements on saving the planet. In fact, critics say that this should be mandatory and must be reckoned as a fixed percentage of their profits. This is so because society enables corporates to grow and prosper. Hence, it becomes obligatory for this sector to give something in return. Is there merit in this argument?
If one takes the overall net profits of the corporate sector, it would have been around R3.2 lakh crore in FY10. This is substantial and would be around 4% of India’s GDP at current market prices. Taking a portion out (1% would mean around R3,200 crore) can be benchmarked with various development schemes that will help society at large. Or so the argument goes.
While CSR is a good idea, it cannot and should not be made mandatory. Corporates are like any entity in the country that work for a profit and abide by the rules of the game. Therefore, taxes are paid and several other regulatory covenants are adhered to in the process. There would be a lot of lobbying going on to seek concessions but that is another issue as they are decided on merit. Therefore, we should not be going beyond the rules already laid down. If it were done, then it should be extended to individuals too, as there are several millionaires in the country who could contribute to CSR by the same logic.
There are essentially three arguments that can be made in this context. First, let us go back to the world of Adam Smith, which we are trying to pursue based on free markets. In this capitalist society driven by markets, private enterprise works with self interest in mind to earn profits. The government lays down the framework and ensures that the rules are obeyed. As we never do have a fully capitalist system, the government also enters economic activity and undertakes projects, for which we have the Budget and the entire tax system. At times, the government could go a step ahead and earmark specific charges in the form of additional taxes or cess for specific purposes. This goes for drought relief or education and is levied universally on all entities, which are fair measures. Instead of charging a corporate tax rate of, say, 30.6%, it is broken up into 30% tax on which there is a cess of 2%. The idea is that there is transparency insofar as the money from this additional charge is earmarked for a purpose. This being the case, CSR cannot be imposed beyond the realm of the tax system.
Second, it should be recognised that a company belongs to investors finally as the shareholders have made investments in the enterprise. While they could vote for such an allocation, it can never be made a rule for all as it comes in the way of economic freedom and imposes an additional cost to running an enterprise. Any mandatory move should be opposed, though corporates can always be made more responsible for the harm that may be coming about on account of their business activity. Asking them to pay for fuel emission is okay while asking them to donate to the poor is not in order. It has to evidently to come from within and we cannot stand on any such judgement.
The third is, even if we make it mandatory, who will administer the same? The public sector is considered to be inefficient when it comes to creating social infrastructure. Currently, there is little accountability for the money allocated for, say, health and education in the Budgets. We have hospitals without doctors and schools without teachers. These are issues beyond the leakages that are there. It is not surprising that even when corporates indulge in philanthropy; it goes in the name of the organisation or person because keeping it within one’s own purview makes sure that resources are better utilised. However, the core competence of companies is in specific lines of business and diversification into social infrastructure is inefficient.
Addressing the concerns of the poor is a public sector issue that has to be addressed separately by the government. Asking the private sector to mandatorily pitch in is against the grain of free enterprise and imposes costs, besides leading to undesirable and inefficient solutions. This should be opposed.
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