Implications of RBI's securities buyback: Business Line 28th October 2024

 

The Mumbai Metro Is An Exemplar Of Improper Planning: Free Press Journal: 26th October 2024

 Today the drive to the financial capital via the western express highway best explains everything about the growth model. Motorists tend to use the service road to enter this financial hub. It is lined with little houses with asbestos roofs and unauthorised constructions at the first-floor level. They have withstood the tough monsoons and absence of care over decades. The authorities had erected curtains along the almost 2 kilometre stretch when the G20 was on to ensure that foreign dignitaries did not get to see what lay behind these covers.

The drive through the inner roads reveals that it is the lower middle class which resides and these settlements have only common toilets. The drive along the bumpy lane leads to a high class IB-school which has chauffeurs waiting outside in their BMWs, Audis and Mercedes cars. One would pass the little used metro station which has strays taking shelter before reaching a high-end housing complex named after a European city. Further down before one reaches a five-star hospital, there is open defecation as the hamlet does not have running water and there are myriads of slums. The entry to the financial capital takes a turn for the grandiose as almost every financial institution is located here. Chaotic traffic and several Michelin star restaurants dot the way as one can get lost in this unreal world. How do we plan our cities, as this could be the story anywhere in the country?

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Mumbai Aqua Line Metro Misery: Glitches, Gimmicks, Gaps

Every year all governments — centre, state and municipals spend a lot of money in building infrastructure. The word to use is spend and not invest, which is typical of how capex is structured in the country. There are ambitious targets which are met. The best engineers are given contracts to execute projects. But — as can be seen in Mumbai — there are horrendous time overruns which also leads to cost overruns and vitiates the effort in terms of time and money expended.

The Mumbai metro project was to be completed by October 26 in a period of 15 years. There are to be around 16 lines spanning over 500 kms. The opening of the only underground metro has been celebrated as being quite singular. This is the famous Colaba-Bandra-Seepz line which is to run for 33.5 km long underground metro line. The first 12.44 km has been opened. It has been developed at a cost of over Rs 32,000 crore. The present stretch is open from SEEPZ to Bandra Kurla Complex which is the financial hub of the country. A journey taken during peak time will reveal that there are not too many users of this line. The problem is with the design of the metro line.

Metro lines everywhere in the world operate on the concept of inter-connectivity wherein there are easy transfers to other lines. This enables commuters to cross over across different zones which in Mumbai would mean the western, central and New Mumbai links. While there are only a few lines operational, introspection would call for ensuring there is this connectivity. In fact, there is a pressing need to have a connection to the existing railway lines operated as the Western, Central and Harbour lines by the Indian Railways so that these lines are effective. Further, there is need to ensure that once a person emerges from the metro station, there is road transport available. The aqua line fails on all these scores. The metro lines are under the jurisdiction of MMRDA and MMRCL which are in charge of developing different lines. While it is not clear if they have been talking to each other while designing the network, there is definitely absence of coordination with the suburban railway authorities which come under Indian Railways.

The present station which leads to the financial centre is way off and requires a 15-30 minutes’ walk to the offices which are sprawled across this region. There is no option of using public transport to reach the office nor a taxi-auto service given that the roads do not allow turns given the congestion. The larger question is whether this line will serve any purpose to ease travel. In fact, ideally the aqua line should be connected to what is called the red line or Line 7 which is operational and goes down the western express highway.

In retrospect this sounds a rudimentary idea which should have occurred to those who planned this line as this is the basic concept of metro railway network. While it is true that there will always be commuters who travel once all the lines are operational in the next five years, given the size of the population, it does not reflect well on planning.

Interestingly the mono-rail service which runs between Chembur and Mahalaxmi started in 2014 but had to close down for several reasons including the usage. It has recommenced operations but capacity utilisation is still low at around 20-25%. It is not surprising that the frequency of these trains has been reduced to lower operating costs. But it defeats the purpose of having such a system in place. The losses are supposed to be over Rs 500 crore. There should have been lessons to be learnt when the metro system was drafted.

There is reason to believe that while the authorities are good in starting various projects, there is not much effort which goes into these final details. Mumbai is a city known for not having footpaths, and it does look like the authorities do not have this high on the agenda as scant attention is paid. The state of roads during the monsoon season is well known to the point that the public face potholes with stoicism which comes from accepting the fact that the megapolis will never change.

As the country embarks on the journey to become a developed economy, there is need to stress on quality of growth. Reaching the threshold of $ 14,000 per capita income will happen as the size of the cake expands. But the qualitative aspect would require a different mindset. More importantly, we need to focus on quality along with quantity to bring about real development.

‘Put’ option to aid bond market: Financial Express 24th October 2024

 An issue which has always been debated is getting more retail investors to invest in the corporate debt market. Retail interest is high in the equity segment either directly or indirectly through mutual funds. When it comes to corporate bonds, however, the interest is more through the mutual fund route. Few individuals invest directly in corporate debt. One of the factors that has kept back retail investors is the difficulty in selling the security before maturity. In case of equity or mutual funds, there is a window open at any time for a sale transaction. For a listed debt security it is theoretically possible to be sold, but there may not be buyers as few securities are liquid. The absence of liquidity is the biggest challenge where the secondary market is not active for most securities. Unlike equity which is unique to a firm, a company would have multiple bonds listed at any point of time depending on the number of public issuances. Further, most buyers are institutions who would hold the securities to maturity to match their liability tenures.

It is against this background that the Securities and Exchange Board of India’s (SEBI) recent move to allow companies to announce a voluntary “put” option should be seen. In simple terms, an issuer of debt has the choice to give the investor a choice to redeem the security before maturity at specific points of time post-issuance subject to a minimum holding of one year. There are requisite approvals to be secured from the board for this purpose. The valuation norms for this “put” option have been specified as also the minimum amount of the issue size under this umbrella. The regulation is comprehensive.

On the face of it, having a “put” option on such issuances is a very good idea. It is not mandatory as of now, but it may be considered depending on how things work out. The new regulation fills the lacuna in the system, which has kept retail investors away, and hence is progressive. This becomes analogous to a fixed deposit with a bank that can be withdrawn 

any time after it is opened subject to the minimum period and a penalty clause. The penalty clause here for a debt security would be similar as the value would not be the issue price but something different based on market conditions. Intuitively in a scenario of rising interest rates, the value could be lower. Therefore, from an investor point of view, this should read well as it mimics to a large extent the preferred bank deposit.

What could be the incentive for a company to have a “put” option? The first is that it would have access to a wider investor base. SEBI has made the concept optional to the issuer and also given the prerogative to choose the category of investors who qualify. It could be specified for only retail or all investors. Second, the “put” issuances would go with a different International Securities Identification Number (ISIN) and not clubbed with the existing mandatory limit placed by the regulator on the number of ISINs that can be issued in a year. It would thus enable the company to eschew the necessity of re-issuing a security if it has hit the limit of maximum permissible ISINs.

Third, the issuer may like to take advantage of the changing interest rate regime, and buy back their earlier security and issue a new one. This helps in treasury management. Fourth, depending on the market conditions, the issuer may price it better as it gives the option of early redemption to the investor. The coupon rate offered could be slightly lower with this option being provided. Fifth, for a lower rated company, such issuances with a “put” option would work better as investors can redeem before maturity depending on the prevalent conditions.

For all categories of investors the “put” option would work as it is not necessary to redeem but is an alternative. Individuals, in fact, already invest in some non-redeemable securities like the government floating bond. A better return for the investor on the corporate bond with the “put” option would be a better alternative, especially if the rating is high.

Therefore, SEBI’s move is very good and a big step in the direction of adding depth to the corporate bond market. It also opens the doors for retail investors to enter this segment. However, some awareness programmes should be carried out so that investors know how the bond market works. Unlike a bank deposit which has a fixed principal and interest, a bond which is redeemed in advance will have a variable value depending on the market conditions. Hence while the coupon rate is fixed, the capital redeemed before maturity will not be so. This is an issue also with investing directly in government securities, which is possible through the trading window offered by the Reserve Bank of India. The nuances need to be understood before investing.

A pertinent conundrum for the issuer is that once there is a “put” option, provisions have to be made periodically for possible redemption. This will mean having an active treasury which ensures funds are available. While this holds even for instruments that are redeemed on the due date, the exercise becomes periodic for such bonds. This could mean borrowing in the market or taking a loan from financial institutions to repay such debt in case normal business operations do not generate the requisite funds.

Developing the corporate bond market to include more retail players is a necessity. To do this, one has to mimic what happens in the conventional banking sector where deposits are offered with certain flexibility. The “put” option largely addresses a major concern for any household. Intuitively it can be seen that this idea will resonate well where the company is rated AAA or AA. The risk factor for a lower rated paper will always be overwhelming because a possible default will be a consideration. A way out would be to consider providing “bond insurance” much like deposit insurance where issuers would have to pay the insurer to provide cover of up to Rs 5 lakh as is the case with bank deposits. This could be an issue which can be further deliberated.

Equities reign atop the league table of investment returns: Mint 23rd October 2024

 https://www.livemint.com/opinion/online-views/currency-gold-silver-investment-portfolio-equities-fixed-income-instruments-inflation-crude-oil-chana-tur-dal-11729562693859.html

The Economics Nobel for 2024 underlines the connection between wealth of nations and democracy: Indian Express 14th October 2024

We are all aware of the fact that there is a rather large gap between rich and poor countries. The income gap between these two sets is persistent, and while the poorest countries have become richer, they are not catching up with the richest. Some part of this inequality is historical, but there is strong reason to believe that institutional differences in countries can explain this difference. The developed world has a common thread in the form of political and economic structures, and probably mindsets too. This is the theory espoused by three economists, Daron Acemoglu, Simon Johnson and James Robinson, who have been accorded this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

What exactly do they mean by institutions? It is a gamut of political and economic edifices which drive the growth agenda of a country. Simply put, the regime can be inclusive, which is best exemplified by the West which is also largely democratic. This would mean a strong legal system where rules are defined, with an adjudication system in place. There are transparent laws relating to doing business, covering taxes, trade and commerce etc. This provides the contours for doing business.

Alternatively, it can be exploitative as can be seen in autocratic regimes, such as in some parts of Africa. Quite clearly, societies with poor rule of law and institutions that exploit the population do not generate growth or change for the better. When multilateral institutions keep harping on economic reforms, this is what they are talking about.

The 2024 Nobel Laureates do trace their theory to colonialism where they link the quality of institutions to the number of settlers in colonies post-independence. In some places, the aim of the colonists was to exploit the indigenous population and extract resources for their own benefit. In others, the colonists formed inclusive political and economic systems for the long-term benefit of European migrants. This varied across Europe and Asia and Africa. Where colonists remained and settled due to lower mortality, there was evidence of creation of institutions which worked well. They do not justify colonialism, which was exploitative, but do find this positive correlation in places where the colonists became settlers and contributed to this development.

The two main takeaways from their body of work is the importance of a democratic set up and the creation of the right institutions that foster investment. Democracies definitely work better, as there are free elections and while different parties may have varied motivations, one needs to perform in order to get back to power. Hence institutions would necessarily have to be built. Protection of private property is such an institution which comes automatically if there is a strong judicial system. Similarly, various policies that support the growth process would be part of the system.

A question which would come to mind is how China has managed to create one of the largest economies with the latest state-of-the-art infrastructure and production processes. The political system is autocratic for all practical purposes, but has delivered well. Here, the counter argument can be that while the economy is large and competes well with other developed nations, there is immense inequality within the country. Therefore, such guided growth, where the government owns and controls a large part of the means of production, does not bring about an optimal solution in terms of equality.

Singapore can be another contrarian example which is not democratic but has strong institutions. It can be considered an outlier for sure. There are also some of India’s neighbouring countries which are ostensibly democratic but tend to get oligarchic, which has impeded development.

Let us look internally now. The government has focused a lot on the ease of doing business which has been achieved by creating the appropriate institutional structure through a series of reforms in every sector. Providing access to infrastructure, land laws, dispute resolution, strong financial systems etc. are all part of the institutional set up that is required to keep growth ticking. This has been vindicated in our context in the last 10 years or so where India has become the fastest-growing economy though, admittedly, there is a long way to go in becoming a developed economy.

Therefore, while the Laureates do not provide specific solutions, a takeaway can be that unless there are democratic regimes which foster the building of strong institutions, growth across countries will remain lopsided.

How Should Households View The Credit Policy? Free Press Journal: 14th October 2024

 As a layman what is one to make of the credit policy? Credit policies are all about deciding on the repo rate which is the benchmark used as part of the toolkit for ensuring macro-economic stability by the central bank. The repo rate, which is nothing but the rate at which the RBI lends to banks on an overnight basis, is the anchor rate. It is just like the Fed rate which is similar in scope. What these anchor rates do is to guide the direction of movement in all other interest rates in the financial system.

As far as banks are concerned the repo rate becomes the anchor to decide on all other interest rates concerning their deposits and lending rates. The lending rates of banks are driven by two sets of factors. The first is what are called external benchmark lending rates where the interest rate is fixed to a benchmark which is normally the repo rate. It could also be the yield on a security or Treasury bill. Therefore any change in the repo rate would automatically tend to move the lending rate for all banks for loans that are tied to this formula. By statute all retail loans and those to MSMEs are linked to this benchmark.

The second is what is called the MCLR which is the marginal cost lending rate that is a formula-based rate. Here the lending rate is based on the marginal cost of funds which is primarily the deposit cost with other variables being included. This is the minimum rate at which anyone can borrow from a bank and normally there is a spread over the MCLR. Therefore it could be in the range of 50-300 bps and can stretch higher given the risk profile of the customer.

Intuitively it can be seen that what matters here is the deposit rate which is again linked somewhere to the repo rate. The credit policy was eagerly awaited this time because conditions looked seemingly appropriate for expecting some action on the repo rate given that the last two inflation numbers for July and August are less than 4%. The RBI has decided not to change the repo rate which will remain at 6.5%. Therefore, there is no policy push to alter the lending rates as of now.

However, after a long hiatus the stance has been changed to neutral. The stance is something which has been debated for quite some time now. It has been kept as ‘withdrawal of accommodation’ ever since the Ukraine war started. It has been interpreted as a position taken when the RBI is waiting for all past actions on repo rate — the increase by 250 bps invoked since 2022, to be transmitted to the deposit and lending rates.

A ‘neutral’ stance can be taken to be interpreted as the central bank being comfortable with the present state of the system where transmission of interest rates is more or less complete and there is reason to look at rolling back rates when the time is opportune. Here, the policy actually blows hot and cold. There is a lot of caution being expressed over the future course of inflation. The high base effects kept inflation low in July and August and the expectation is that inflation will cross 5% in September. Further the forecast for inflation for Q3 of the year is 4.8% which is much higher than what was witnessed in the first two quarters. This gives a sense of caution that a rate cut cannot be in the offing any time soon.

The RBI has highlighted three factors which can be influencing inflation in times to come. The first is the impact of climate which has manifested in extreme heat and rains in different parts of the country. The potential to affect agricultural output is high, and this is already seen for tomatoes and onions. The second is the geo-political situation which is becoming unstable ever since the Israel issue has resurfaced with Iran getting involved. The potential impact on crude prices as well as logistics costs is sharp and cannot be conjectured at present. Last, there has been a tendency for global commodity prices to rise which will feed into the costs of manufactured goods and increase core inflation.

What does all this mean? It appears that the RBI believes that the worst of high inflation is over. But there is some uncertainty on the durability of the present low inflation and therefore there will be a wait and watch approach. The fact that the stance has been changed to neutral is indicative that a rate cut would be on the horizon, as a stance change prepares the system for a rate change which can be only in the downward direction.

Therefore, one can assume that the era of ‘peak interest rates’ may have ended. Therefore from the point of view of borrowers the picture is clear. The lending rates will only come down though the timing is hard to guess. But from the point of view of deposit holders, it may not be very clear. While deposit rates in general are unlikely to increase across all banks and tenures, the downward movement would also not be generalised. This is so as liquidity conditions vary across banks. While system wide liquidity is comfortable, individual banks are using other means of raising funds including raising deposit rates across specific tenures. Hence it is still possible for certain banks to offer higher rates on some deposits.

In a way it can be said that we may be starting on the cycle of lower rates in future. Going by the inflation forecasts of the RBI and the current geo-political situation, a rate cut is possible earliest in February 2025. While this would be good news for borrowers, it should also be mentioned that in this particular cycle of lower rates, the repo rate cuts could sum to 50 bps as 6% repo rate has been the average over the years. Anything lower could at best be temporary, as inflation would always be a variable that would be hard to keep low for all time.

RBI policy: Prelude to future rate cuts? Inflation numbers hold the key: Business Standard 9th October 2024

 The major takeaway from the credit policy is the change in stance, as it was unexpected. The fact that this was unanimous points to a common view taken by all the six members. This is important because it is largely assumed that a change in stance to ‘neutral’ is a prelude to a rate cut possibility in the future policies. This follows from the view that changing both the repo rate and the stance at the same time is not appropriate, as the power of the stance gets diluted when they are done in unison.  

The change in stance is based on the premise that the growth-inflation matrix is well balanced and conditions are favourable for attaining the goal of durable low inflation in the near future. This raises the issue of whether a repo rate cut is possible in December, as the stance has been changed in this policy.

Going by the forecasts made by the Reserve Bank of India (RBI) on inflation for the balance quarters, there will be an uptick to 4.8 per cent in the third quarter (Q3), which will be the October-December period. It is subsequently supposed to come down in Q4 to 4.2 per cent, which is a signal for assuming durable low inflation. Therefore, a cut in repo rate in the December policy looks unlikely and will have to be pushed forward to February 2025, unless the inflation numbers surprise significantly on the downside in the next couple of months. 

Inflation risks

The policy remains open-ended on the future possibility of rate cut, which sounds reasonable given that the future course of inflation is hard to gauge. The policy highlights three possible risks for inflation. The first is weather changes that can affect food inflation. The monsoon has not yet withdrawn fully, and any possibility of heavy rains can affect harvests. 

Second, the geo political situation is tenuous with the threat of oil prices going up again. While this has not happened when the Israel conflict started, the entry of Iran can change this direction. Third, other commodity prices such as those of metals have been going up, which can add to core inflation. Here the China factor will have a role to play. 

The policy has presented a balanced view of risks and signaled that while it does feel that conditions would be improving on the inflation front, one cannot be too sure. Therefore, the change in stance to neutral echoes that sentiment. There has been no change in the GDP growth forecast, which means that there is no concern on this variable. This has been supported by strong growth in both consumption and investment, which is expected to continue. 

It is hence indicative of the fact that the present interest rate regime does not militate against growth.  With inflation moving down and a good kharif harvest, chances of rural and urban consumption improving looks likely.  

The market reaction would need to be seen. While bank deposit and lending rates would be driven more by liquidity conditions of individual banks, bond yields should move down further. So far they have been influenced more by decisions taken by other central banks as well as liquidity situations. A further downward movement can be expected that will help the government in particular as borrowing costs come down. 

The change in stance is the first alteration made by the MPC ever since the Ukraine war when rates and stance were changed. This does indicate a return to equilibrium state for the economy in the coming months.

Food inflation has strong linkages with other parts of the price index; keeping interest rates high amid high food inflation helps prevent excess demand pressures: Financial Express 8th October 2024

 The economist Milton Friedman had said that inflation is always and everywhere a monetary phenomenon. That is how monetary policy came to the forefront with inflation targeting being the result. An issue which has come up particularly in India is that if inflation is being driven by food products over which monetary policy has no control, are we barking up the wrong tree? As a corollary, some arguments suggest that the share of food in the index should come down or that the central bank should be targeting core inflation which excludes food and fuel. These issues are prima facie pertinent but deserve further probing.

The answer is not straightforward even when one talks of food inflation. While overtly it does seem that supply shocks lead to higher prices there is a demand factor also at play. For example, demand for coarse cereals has been rising over time with the society being driven by health motivations. This has increased the prices of the products. The same holds for cereals where value added products are driven by demand conditions and often not related to supply-side factors. Besides with an open-ended procurement programme run by the Food Corporation of India a lot of grain gets diverted, leaving less for the market in the face of rising demand. At times, such diversion leads to excess demand in markets, which pushes up prices.

Higher incomes make people move to higher-value products, which play in the background. This is but natural. The proliferation of catering, hospitality, and travel businesses has added to the demand of edible oils. A similar example is pulses (especially chana) whose prices rise during festivals due to exceptional demand.

Further, leverage is used for the purchase of goods at supermarkets by even lower income groups. Personal loans have grown at a smart rate across all segments where interest charged has a bearing on purchases. Thus, there is merit in the link between interest rates and demand for food. The problem comes to the fore when there are supply shortages and sharper price increases. Interestingly, even the “core inflation” products do not always witness price rise due to demand factors alone. The increase in, say, telecom prices has nothing to do with demand which remains inelastic once it is a habit. Similarly, when hospitals or educational institutions increase fees, it is not due to demand but the “cost factor”. The cost will include staff salary as well as cost of other inputs going into the service. The same holds true for consumer products, where higher input costs are not driven by demand but global and domestic factors that feed into the final price.

Hence it can be argued that price changes for non-food products are also driven by supply. Further, housing price included in the index is linked to the house rent allowance of government officials, which too is a periodic change and not a demand-side factor though high demand increases housing rent in the real world. It can be countered that with the boom in housing the supply of tenements for rent would always be increasing and often the movements in rent are sluggish.

Therefore, it is hard to distinguish between price increases due to pure demand or supply factors. Both are at play and separating the two forces on the assumption that product (or service) prices are driven exclusively by one can lead to erroneous conclusions. Today, retail credit is the leading segment which involves households. Higher interest rates do keep a check on spending based on leverage as budgets are realigned. Hence even if, for the sake of argument, it is assumed that the food price shock is purely due to supply factors, interest rates have a bearing on household borrowing and hence spending, making policy very relevant.

The problem with food inflation is that when it is high, it feeds into inflationary expectations which then spreads to core inflation and over time becomes generalised. This happens in two ways. One, when there is an upward adjustment of incomes, including wages, which in turn trigger demand pull forces for other non-food products. The Mahatma Gandhi National Rural Employment Guarantee Act wage, which is a benchmark for wage setting in other sectors, gets adjusted with inflation every year and hence automatically increases incomes in other professions. Second, there is a tendency for producers of manufactured goods to also raise prices once food price inflation is anchored at a high level. This happens with a lag of two-three quarters. In fact, often producers absorb higher input costs to begin with before transmitting the same to the final consumer. For example, higher wages paid by movie theatres get reflected in higher ticket prices.

Therefore, it may not be prudent to ignore food inflation from the point of view of monetary policy as there are strong linkages with other parts of the price index. Further, by keeping interest rates higher when food inflation is high, it helps in preventing the build-up of excess demand pressures. This is why it is often argued that monetary policy has to be reactive and keep looking continuously at the rear-view mirror. The precise impact of food shocks on inflation is hard to guess. The price shocks either last for a couple of weeks, or get entrenched in the system and become durable.

This is why it is observed that central banks target headline inflation and do not ignore food inflation. In India especially, consumption trends of food products have changed greatly with demand-side factors coming into play. Ignoring this aspect of inflation will mean missing one significant piece of the puzzle.

Indian agencies should get into sovereign ratings: Buisness Line 8th October 2024