A deficient monsoon and rising food prices will continue to be troublesome till demand and supply are resolved
The agriculture saga in India gets repeated almost every year. The two triggers are a delayed or deficient monsoon and higher food prices. This year, there is a combination of the two, which has made the issue even more acute. The official view was that there was no need to panic as the granaries were full, even though the stocks were of only wheat and rice. Imports of foodgrains were banned and we were assured that the monsoon would catch up, which it has somewhat done in July. We probably will end up with a satisfactory aggregate harvest and will soon forget about the problem until next year. And the same saga will start all over again.
There are two sides to this problem. The first is on the supply side. While foodgrain production has increased continuously in the last three years, the performance has been skewed by rice and wheat, while pulses remain neglected. We remain net importers of pulses and higher production in any year merely means that we import less.
The policy thrust has been on rice and wheat; production has been propelled by providing incentives to farmers. The minimum support price (MSP)—the price floor at which the government buys food—of wheat has been increased from Rs630 per quintal in 2003-04 to Rs1,080 in 2008-09, while that of paddy has been increased by Rs300 per quintal during the same period. Production is further bolstered by the presence of the open-ended procurement programme of the Food Corporation of India (FCI).
There have been two consequences. First, farmers prefer to produce these two crops, which in turn reduces the water table level—these crops need relatively more water. Second, the open-ended procurement scheme squeezes private traders. The marketable surplus of rice is around 70%, while that of wheat is 55%. Therefore, when we talk of production of around 80 million tonnes (mt) of wheat this year, only 44 mt enters the market, of which FCI has claimed around 24 mt. This leads to an anomaly where there is surplus production and prices still increase on account of the shortage being inadvertently created. The solution would be to release this stock, which is not being done—ostensibly to retain public confidence!
The second side of the problem is demand: Here, one must realize that with our population growing by 1.4% per annum, individual products need to grow by this level. This has not been so in the case of pulses and oilseeds; this has exacerbated the problem. Shortfall in oilseeds production can be substituted with imports of edible oils; this, however, comes at a price, as international prices respond to India’s demand, given the sheer quantity of imports. In the case of pulses, the conundrum is that we cannot import them easily as there are limited sources of imports and the harvest season in other nations isn’t the same.
The other important factor working towards increasing the demand for food in general is the declining poverty ratio. The Economic Survey 2008-09 has reported that the poverty ratio has come down by almost 9 percentage points between 2000 and 2005. This actually means that around 100 million people have moved out from utter “wretchedness” to a better standard of living, which translates immediately into higher demand for food items beyond the staples of rice and wheat. Therefore, thanks to such economic mobility, demand would be increasing at a faster rate than the population growth and will, hence, have to be matched through higher production or imports.
However, the bigger problem is the cyclical nature of production, which has been alternating between highs and lows. This is because, first, the area under cultivation is not keeping pace with increasing demand. This can partly be explained by the gradual shift of agricultural labour to urban areas, due to the uncertainty in farming. Second, the dependence on the monsoon is still very high. Less than half of cereals production is supported by irrigation, while 85% of pulses are still dependent on the monsoon. Also, just around 30% of oilseeds come under the irrigation belt. The absence of irrigation facilities has contributed further to alienating farmers from their land. Alternatively, they keep changing their cropping pattern, which, in turn, affects the crop output.
What are the solutions? Quite clearly we need to have in place a comprehensive agricultural policy which starts from landholding, inputs, credit, marketing, subsidies and distribution—all of which should be internally consistent. The roles of the state and the private sector should be clearly delineated and adhered to without ad hoc intervention.
We need to improve acreage and yields so that there is a self-sustaining production stream in place—the second Green Revolution. Further, we should seriously consider our pricing policies. MSPs and procurement have caused certain distortions which can be corrected by letting the market forces play a role through futures trading. This way, the procurement process could be capped and targeted primarily at the buffer stock and MSP would be the last resort rather than the first choice for the farmer. Given the shortages that occur in pulses and oilseeds, we could consider buffer-stocking these until we have attained stable production levels. Moreover, we can also conceive of having a system of providing tax incentives to companies, so as to make farming in non-MSP crops more attractive.
Pursuing such a policy will do away with the approach we are taking today, one that myopically looks only at the very short term.
Monday, August 10, 2009
Roti. chawal, dal, sabji and a question: Financial Express August 6, 2009
After inflation and agflation, the new economic phenomenon is foodflation: prices of food items increasing sharply across major product groups. An interesting aspect of foodflation today is that it is not captured by the conventional WPI, and CPI numbers only touch the periphery of the issue. Disaggregated WPI data shows that prices of cereals have increased by 10.9%, pulses by 16.9%, vegetables by 26.1% and sugar by 33.4% (as of July 18th). If retail prices at various centres are tracked over the last few months, the jump in prices seem even sharper. What is happening? And what can be done? There are three parts to the answer to the first question. The first pertains to foodgrains, where production has been higher than last year. However, an inherent upward bias in prices has been provided by the higher MSPs which increased by 30% for paddy and 8% for wheat last year. These two cereals constitute 80% of total cereals production and 70% of total foodgrains. An increase in the MSPs automatically pushes up their market prices. Also with changes in income mobility there has been a tendency for shifting preference to rice and wheat from coarse cereals, which has pushed up demand for these grains. With progressively higher procurement of rice and wheat by the FCI, there has been a squeeze in the private market, thus bringing about this anomaly of coexistence of rising prices and excess stocks of 50 mn tonnes of wheat and rice. The second story pertains to pulses, which have witnessed abnormal increases in prices. The basic problem is that July-September is the period when there are no fresh arrivals in the market. The kharif crop of tur, urad and moong arrives from late September onwards and hence, present consumption has to be met from the stocks of last year. Now, in FY09, there was a fall in production of tur, urad and moong. Unlike rice and wheat where there are buffer stocks which can be used, there is no such option for pulses. One way of augmenting supplies is through imports; but in case of pulses there are limitations in terms of harvest timings in countries like Myanmar and Canada, and supplies will continue to be squeezed until then.
There have been two associated issues here. The first pertains to the impact on rabi crops like chana and masoor, where prices have been volatile, albeit to a lower... extent due to substitution in the consumption of pulses. Further, the months of August till November are the festival season in India, when typically demand for food products increase. The second is that inflation expectations have been heightened by the news of the subnormal monsoon this year. Conjectures are that output will be affected across crops, especially rice, tur and urad on account of deficient monsoon, late sowing and probably late harvest. Hence, monsoon-related inflation expectations have added to the price increase that we are witnessing today. The third part of this story of foodflation is in the area of vegetables and sugar. Vegetables prices have increased due to lower output on account of delayed monsoon and higher transport costs due to the increase in fuel prices announced in June. It must be pointed out that even as the WPI shows a decrease in fuel prices of around 12% due to the impact of high base year, higher diesel prices have fed into the price of transportation, which is irreversible for some time now. The indirect impact of a fuel price increase is more significant than the direct increase and will impact prices of all food products which are primarily transported by road. The higher price of sugar witnessed this year has been brought about by low production and a mess-up in policy. Production declined by over 50% in FY09, and indications are that there could be problems this year too given the possible lower production of cane this year. More importantly there are low carry-over stocks which will exert pressure on the prices this year too. In hindsight it may be said that the policy to export surplus sugar of almost 5 mn tonnes in 2007-08 has perhaps led to the problem of high prices today. Foodflation in India is serious because it affects the real standard of living of all households. So, what can be done? There unfortunately appears to be no immediate solution except imports wherever it is possible. With a slightly longer perspective, we need to revisit our policies to ensure that MSPs, procurement or excess procurement, absence of buffer stocks concept in non-rice and wheat products, export-import of farm products are all looked at as part of a comprehensive policy rather than as adhoc measures, which are the norm.
There have been two associated issues here. The first pertains to the impact on rabi crops like chana and masoor, where prices have been volatile, albeit to a lower... extent due to substitution in the consumption of pulses. Further, the months of August till November are the festival season in India, when typically demand for food products increase. The second is that inflation expectations have been heightened by the news of the subnormal monsoon this year. Conjectures are that output will be affected across crops, especially rice, tur and urad on account of deficient monsoon, late sowing and probably late harvest. Hence, monsoon-related inflation expectations have added to the price increase that we are witnessing today. The third part of this story of foodflation is in the area of vegetables and sugar. Vegetables prices have increased due to lower output on account of delayed monsoon and higher transport costs due to the increase in fuel prices announced in June. It must be pointed out that even as the WPI shows a decrease in fuel prices of around 12% due to the impact of high base year, higher diesel prices have fed into the price of transportation, which is irreversible for some time now. The indirect impact of a fuel price increase is more significant than the direct increase and will impact prices of all food products which are primarily transported by road. The higher price of sugar witnessed this year has been brought about by low production and a mess-up in policy. Production declined by over 50% in FY09, and indications are that there could be problems this year too given the possible lower production of cane this year. More importantly there are low carry-over stocks which will exert pressure on the prices this year too. In hindsight it may be said that the policy to export surplus sugar of almost 5 mn tonnes in 2007-08 has perhaps led to the problem of high prices today. Foodflation in India is serious because it affects the real standard of living of all households. So, what can be done? There unfortunately appears to be no immediate solution except imports wherever it is possible. With a slightly longer perspective, we need to revisit our policies to ensure that MSPs, procurement or excess procurement, absence of buffer stocks concept in non-rice and wheat products, export-import of farm products are all looked at as part of a comprehensive policy rather than as adhoc measures, which are the norm.
Tuesday, July 14, 2009
Unfounded fiscal deficit fears : Mint 14th July 2009
Concerns that the government borrowing programme will crowd out private investment have been overstated
A view normally held is that higher government borrowing tends to put pressure on interest rates—which, in turn, affects the private sector’s ability to invest, and, hence, probably growth. The rationale is that there are fixed sums of money available with banks which have to be deployed as credit or investments. When the government borrows more, then there are fewer funds available for the private sector and there is a crowding out phenomenon. Further—even if funds are available—the cost goes up as yields on bonds rise, which sets the pitch for the deposit and credit rates as they indicate the risk-free rates that have to be adjusted with the premium to be charged. Intuitively, when more government paper floods the market, the price of government bonds decline due to oversupply conditions which, in turn, push up yields. Also See The fiscal deficit for the year is around Rs4 trillion and the borrowing level in net terms is around the same level. Government officials have maintained that there is not going to be any significant crowding out because there are surplus funds in the system to the tune of Rs1-1.5 trillion presently that are being invested by banks in the reverse repo auctions. Therefore, while interest rates are not expected to come down, they would also not move up significantly to cause disturbances. What, then, is the true picture? The accompanying table provides a peep into the past to show how these numbers have tallied when borrowings were high. The first column provides information on the difference between incremental deposits and credit every year, which is the unadjusted surplus (before accounting for the cash reserve ratio, or CRR) that banks could invest in government paper. The difference between these surpluses/deficits and the net government borrowing programme is seen in the next column as the “system’s deficit”. This gives the deficit that was created on account of the government’s borrowing programme after considering the surpluses that were available with banks from their incremental deposits. Different interest rates, such as the prime lending rate, deposits rate for one year, reverse repo and repo rates and the 10-year bond rate, have then been juxtaposed to discern the reaction of interest rates to this situation. It’s not wrong to say that interest rates have been influenced more by policy rates than by existing liquidity Now, the deficit in funds has been present in eight of the 10 years, with the deficit being very high in fiscal 2005 and fiscal 2006, which has now peaked in fiscal 2010. However, interest rates have shown a continuous decline up to fiscal 2004 and fiscal 2005 and then increased subsequently before declining in fiscal 2010. The rate of increase or decline in interest rates has not been related to the quantum of the system’s deficit increasing or decreasing, and appears to be more a part of a trend. In fact, it would not be incorrect to say that interest rates have been influenced more by policy rates than existing liquidity. Government securities (G-Sec) rates were relatively marginally more related with liquidity when the deficit was high. There is evidently a conundrum here, where we are witnessing large borrowings that are not being financed by the banks, leading to a deficit. Yet, there are surplus funds in the banking system as evidenced in the reverse repo auctions. And interest rates are not in sync with the liquidity trends. How does all this add up? To begin with, it must be pointed out that banks are one set of entities that purchase government paper. Reserve Bank of India (RBI) data for March shows that banks hold around 40% of government paper, followed by insurance companies with 23%, RBI with 10% and primary dealers and provident funds with around 10% each. Therefore, while banks are the most important supplier of funds, the same flows from other entities too. Two, the market stabilization scheme (MSS) of RBI helped to absorb surplus funds a couple of years ago, and these funds have been used astutely to finance the government borrowing programme in the form of unwinding of the same. Three, RBI has been reducing CRR at regular intervals to provide more funds. Since September, for example, a reduction of 400 basis points in CRR meant a supply of at least Rs1.5 trillion. Lastly, key bank interest rates have been guided, though not dictated, more by policy rates than implied liquidity. In fact, even the G-Sec rates which should be most affected by liquidity have a countervailing force that works in the government’s favour. When deposits growth is tardy, savings get channelled into other avenues such as insurance or provident funds which, in turn, invest in government paper. Hence, as long as the gross domestic product is growing and the marginal propensity to save is increasing, there will always be funds for the government—unless there is a major shift to the capital markets. Besides, bank deposits are rarely substituted with equity, as the class of investors is different, as is the risk profile. All this means that we really may not have to despair of the large government borrowing programme for the year, and the system may just be able to tide over this hurdle with minimum pain.
A view normally held is that higher government borrowing tends to put pressure on interest rates—which, in turn, affects the private sector’s ability to invest, and, hence, probably growth. The rationale is that there are fixed sums of money available with banks which have to be deployed as credit or investments. When the government borrows more, then there are fewer funds available for the private sector and there is a crowding out phenomenon. Further—even if funds are available—the cost goes up as yields on bonds rise, which sets the pitch for the deposit and credit rates as they indicate the risk-free rates that have to be adjusted with the premium to be charged. Intuitively, when more government paper floods the market, the price of government bonds decline due to oversupply conditions which, in turn, push up yields. Also See The fiscal deficit for the year is around Rs4 trillion and the borrowing level in net terms is around the same level. Government officials have maintained that there is not going to be any significant crowding out because there are surplus funds in the system to the tune of Rs1-1.5 trillion presently that are being invested by banks in the reverse repo auctions. Therefore, while interest rates are not expected to come down, they would also not move up significantly to cause disturbances. What, then, is the true picture? The accompanying table provides a peep into the past to show how these numbers have tallied when borrowings were high. The first column provides information on the difference between incremental deposits and credit every year, which is the unadjusted surplus (before accounting for the cash reserve ratio, or CRR) that banks could invest in government paper. The difference between these surpluses/deficits and the net government borrowing programme is seen in the next column as the “system’s deficit”. This gives the deficit that was created on account of the government’s borrowing programme after considering the surpluses that were available with banks from their incremental deposits. Different interest rates, such as the prime lending rate, deposits rate for one year, reverse repo and repo rates and the 10-year bond rate, have then been juxtaposed to discern the reaction of interest rates to this situation. It’s not wrong to say that interest rates have been influenced more by policy rates than by existing liquidity Now, the deficit in funds has been present in eight of the 10 years, with the deficit being very high in fiscal 2005 and fiscal 2006, which has now peaked in fiscal 2010. However, interest rates have shown a continuous decline up to fiscal 2004 and fiscal 2005 and then increased subsequently before declining in fiscal 2010. The rate of increase or decline in interest rates has not been related to the quantum of the system’s deficit increasing or decreasing, and appears to be more a part of a trend. In fact, it would not be incorrect to say that interest rates have been influenced more by policy rates than existing liquidity. Government securities (G-Sec) rates were relatively marginally more related with liquidity when the deficit was high. There is evidently a conundrum here, where we are witnessing large borrowings that are not being financed by the banks, leading to a deficit. Yet, there are surplus funds in the banking system as evidenced in the reverse repo auctions. And interest rates are not in sync with the liquidity trends. How does all this add up? To begin with, it must be pointed out that banks are one set of entities that purchase government paper. Reserve Bank of India (RBI) data for March shows that banks hold around 40% of government paper, followed by insurance companies with 23%, RBI with 10% and primary dealers and provident funds with around 10% each. Therefore, while banks are the most important supplier of funds, the same flows from other entities too. Two, the market stabilization scheme (MSS) of RBI helped to absorb surplus funds a couple of years ago, and these funds have been used astutely to finance the government borrowing programme in the form of unwinding of the same. Three, RBI has been reducing CRR at regular intervals to provide more funds. Since September, for example, a reduction of 400 basis points in CRR meant a supply of at least Rs1.5 trillion. Lastly, key bank interest rates have been guided, though not dictated, more by policy rates than implied liquidity. In fact, even the G-Sec rates which should be most affected by liquidity have a countervailing force that works in the government’s favour. When deposits growth is tardy, savings get channelled into other avenues such as insurance or provident funds which, in turn, invest in government paper. Hence, as long as the gross domestic product is growing and the marginal propensity to save is increasing, there will always be funds for the government—unless there is a major shift to the capital markets. Besides, bank deposits are rarely substituted with equity, as the class of investors is different, as is the risk profile. All this means that we really may not have to despair of the large government borrowing programme for the year, and the system may just be able to tide over this hurdle with minimum pain.
Why should anyone farm? 3rd July 2009 Financial Express
The Union Budget is normally seen as a policy package or concessions to be given to India Inc while paying formal obeisance to the common man by giving a few concessions. Agriculture and rural development keep getting allocations that have never really been analysed; and with the exception of the NREG, which has been successful, there has been no concerted action taken to boost agriculture. The Economic Survey, which is a precursor to the Budget, shows that even though agriculture plays a vital role in the prospects of industry besides sustaining employment to a large number of households, its share in GDP has declined from 21.7% in FY04 to 17.8% in FY09. Also, its share in capital formation has been declining over the years. As the recent monsoon forecast is not too favourable, we need to address this issue head-on in the Budget. The government’s reactions to droughts, low harvests and suicide deaths have followed a fixed pattern. To begin with, we delay the acceptance of the problem. When the problem arises, we brush it aside as being atypical and not pandemic. Then we panic and look for the causes. While trying to apportion the blame, we decide to import the product. When India decides to import, we push up global prices and end up paying more. The solution is in terms of increasing MSPs quite mindlessly —mindless because while this helps to reward the farmer better for one crop, it leads to crop shifting which solves the problem of one crop but transfers the same to another one. Also, once increased, prices cannot be rolled back. Budgets react to an agrarian crisis by going in for loan waivers and interest rate subventions that transfers the problem to banks. When they cry foul over their NPAs and lower profits, the amount then gets into the fiscal deficit of the government. Intuitively the question that should be posed is whether or not it is possible to eschew this chain of agony by simply budgeting for practical numbers in a phased manner based on a firm policy. In simple terms, this means that we need to have a comprehensive farm policy that tackles the issues of land under cultivation, inputs for farming and improving yields. The Economic Survey has highlighted that food grains production in FY09 was just about at the same level as FY08. Also, the area under cultivation has come down for food grains and oilseeds and increased marginally for sugarcane. Not much progress has been witnessed in area under irrigation except for oilseeds in the last decade, while productivity remains stagnant at best. With output levels remaining uncertain, farming is not an attractive proposition today and there has been a tendency for migration to the urban centres where unskilled labour still finds jobs that provide a sustainable income stream. Hence, we have a situation where demand for farm products has gone up and supply is erratic. The results are seen in constant price spikes for consumers and desperation for farmers who have been driven to extreme action at times when crops fail in the face of indebtedness. Under these conditions, there is the need to usher a new Green Revolution where we have a comprehensive package of quality of seeds, irrigation facilities, pesticides and fertilisers that is spread across the country and the crop spectrum. The funds have to necessarily emanate from the government if they are to come on a large scale as this is analogous to contract farming or corporate farming schemes, which however are restricted to the choice made by the company concerned. Assuming a cost of Rs 15-30,000 for a small pump set, the government could upfront provide the same to a fixed set of farmers every year. Providing 1 million such sets would amount to up to Rs 3,000 crore, which can be provided by the Budget. To make this work, there is of course the need to continue supplying free power to the farmers. The same could be done for seeds, fertilisers and say pesticides so that we are able to have a broad-based strategy for growth in agriculture. The basic point is that we need to provide the inputs gratis to the farmers if we are to encourage them to remain in business. MSPs and credit are only supplements that cannot solve the problem. More importantly, we need not always be reactive to agriculture as we are well aware of the cycles and amplitudes of farm growth. Planned growth in agriculture is doable and will eschew a crisis and hence be more pragmatic.
Tuesday, June 23, 2009
Hedging Interest: Financial Express 19th June 2009
The direction of interest rates is a subject of conjecture as there are implications of RBI policy on one side and the market reality of high levels of liquidity and rigid interest rates on the other. Further, the bond market, comprising essentially of GSecs, has its own whims and may not always be in sync with the credit market. With a super-large government borrowing programme, interest rates tend to move in the upward direction, as interest rates and bond prices are inversely related. In such a situation, holders of GSecs such as banks are susceptible to market risk arising out of the mark-to-market principle when interest rates change. A solution out here is in an interest rate futures product. The RBI-Sebi report on interest rate futures (IRF) is quite appropriate in these circumstances and tries to address the lacunae in the earlier system that did not quite take off.
Just to illustrate how these instruments would work, we can think of players like banks or insurance companies with large GSec portfolios who can reduce their risk of loss by hedging their positions using IRF. Suppose we are expecting interest rates to decline in the near future, we can take a long position by buying a futures contract for delivery of the designated GSecs. If interest rates fall, the price of the underlying GSecs would go up, and the value of underlying GSec futures contract would also increase. The hedger then can benefit from the sale of the underlying GSec futures contract at a higher price. In the proposed scheme, the underlying bond would be a ten-year notional coupon bearing GSecs.
The opposite would occur when the market player is able to anticipate a rise in interest rates. The participant would short (sell) the bond futures contract, and when the rates of interest increase, the value of the GSec futures contract will fall. Hence, bond portfolios managers, banks, pension funds, insurance companies and individuals with such portfolios can hedge against raises in interest rates by selling short bonds that resemble the markup of the kind of bonds that are in their portfolio.
Interest rate futures are not a new concept in India and the OTC market is popular. Exchange-traded futures will have the advantages of transparency, trade guarantees and liquidity. In fact, RBI had introduced IRFs in 2003 which were traded on the NSE and were cash-settled with a maximum maturity of one-year. The settlement price was based on the zero coupon yield curve (ZCYC) method.
Though the volumes in the IRF initially were encouraging, they had disappeared by October 2003, due to inherent problems in the product design, regulations and accounting framework. Also banks, PDs and FIs were allowed to only hedge their held for trading (HFT) and available for sale (AFS) categories of their investment portfolio. Anecdotal feedback from the market indicated that the use of a ZCYC for determining the settlement and daily MTM price, resulted in large errors between zero coupon yields and underlying bond yields leading to wider basis risk between the IRF and the underlying. Or to use jargon, the linear regression for the best fit resulted in statistically significant number of outliers. Further, the prohibition on banks taking trading positions in the IRF contracts deprived the market of an active set of participants who could have provided the much needed liquidity.
The present design would hopefully take care of these issues as the notional ten-year bond with a coupon of 7% has been fixed. Further, the contracts are delivery-based and has been linked with securities with a maturity of between 7.5 and 15 years and a stock of Rs 10,000 cr. Hence, to a large extent the earlier deficiencies may be tackled.
However, to induce liquidity, trading positions should be permitted and the Report suggests that hedging should not be restricted to the AFS and HFT portfolios and should be extended to cover interest rate risk in the entire balance sheet. The success of this endeavour depends a lot on market participation and acceptance. The present success achieved in the currency futures market is reason for optimism here.
Just to illustrate how these instruments would work, we can think of players like banks or insurance companies with large GSec portfolios who can reduce their risk of loss by hedging their positions using IRF. Suppose we are expecting interest rates to decline in the near future, we can take a long position by buying a futures contract for delivery of the designated GSecs. If interest rates fall, the price of the underlying GSecs would go up, and the value of underlying GSec futures contract would also increase. The hedger then can benefit from the sale of the underlying GSec futures contract at a higher price. In the proposed scheme, the underlying bond would be a ten-year notional coupon bearing GSecs.
The opposite would occur when the market player is able to anticipate a rise in interest rates. The participant would short (sell) the bond futures contract, and when the rates of interest increase, the value of the GSec futures contract will fall. Hence, bond portfolios managers, banks, pension funds, insurance companies and individuals with such portfolios can hedge against raises in interest rates by selling short bonds that resemble the markup of the kind of bonds that are in their portfolio.
Interest rate futures are not a new concept in India and the OTC market is popular. Exchange-traded futures will have the advantages of transparency, trade guarantees and liquidity. In fact, RBI had introduced IRFs in 2003 which were traded on the NSE and were cash-settled with a maximum maturity of one-year. The settlement price was based on the zero coupon yield curve (ZCYC) method.
Though the volumes in the IRF initially were encouraging, they had disappeared by October 2003, due to inherent problems in the product design, regulations and accounting framework. Also banks, PDs and FIs were allowed to only hedge their held for trading (HFT) and available for sale (AFS) categories of their investment portfolio. Anecdotal feedback from the market indicated that the use of a ZCYC for determining the settlement and daily MTM price, resulted in large errors between zero coupon yields and underlying bond yields leading to wider basis risk between the IRF and the underlying. Or to use jargon, the linear regression for the best fit resulted in statistically significant number of outliers. Further, the prohibition on banks taking trading positions in the IRF contracts deprived the market of an active set of participants who could have provided the much needed liquidity.
The present design would hopefully take care of these issues as the notional ten-year bond with a coupon of 7% has been fixed. Further, the contracts are delivery-based and has been linked with securities with a maturity of between 7.5 and 15 years and a stock of Rs 10,000 cr. Hence, to a large extent the earlier deficiencies may be tackled.
However, to induce liquidity, trading positions should be permitted and the Report suggests that hedging should not be restricted to the AFS and HFT portfolios and should be extended to cover interest rate risk in the entire balance sheet. The success of this endeavour depends a lot on market participation and acceptance. The present success achieved in the currency futures market is reason for optimism here.
IRFs augur well for derivatives market : Economic Times: 24th June 2009
INTEREST rate futures (IRFs) are probably the last piece in the puzzle of derivatives that was missing from the menu. The need to hedge interest-rate fluctuations is immense for all participants in the financial market. And here, the purpose is to look at the extent of participation from the market. Banks and other financial institutions carry the highest-consolidated interest-rate risk on their books. This holds on the assets and liabilities side. Banks have investments in government paper of around Rs 13 lakh crore, of which 25% can be kept under the held-to-maturity bucket (HTM). The rest of the paper would be under available-for-sale (AFS) or held-for-trading (HFT) categories, which means that roughly Rs 10 lakh crore of government paper runs the risk of mark-to market (MTM) depreciation. The Reserve Bank of India’s (RBI) rules say that these losses should be booked while appreciation, when it occurs, is ignored. Hence, any increase in interest rates or excess of paper in the market will cause bond prices to fall, thus leading to losses. Even 10-bps rise in rates can lead to a theoretical Rs 1,000 crore of booking of loss. Clearly, banks would use this instrument to hedge their risk based on their individual perception of interest-rate movements. The current model proposes to allow banks to even go beyond their investment portfolio and include other components on balance sheet which are vulnerable to interest rate changes. In the past 6-7 years, it has been noticed that the interest spread of banks has come down to 4% from around 6%. Further, when lending rates come down, deposit rates are slower to adjust which affects banking margins. Therefore, they should typically be going long in the IRF market, buying bonds with the anticipation of rates moving down, which means that bond prices would increase in the future which would compensate for the potential loss on net interest income. Hence, banks should ideally do a sensitivity analysis of the potential hit on their net interest income in the event of a downturn in interest rates and accordingly invest an equivalent net income worth of securities in the market as buy position, as the notional yield has also been specified in the contract. Now, IRFs would be a very effective tool for individuals who as savers often find themselves short-charged by banks with the idiosyncratic nature of deposit rates. It often happens when individuals get into a deposit when interest rates are low and realise within three months that the rates have gone up. As flexible deposit rates do not exist, the IRF market can be tapped for this purpose. The fact that the minimum lot size is Rs 2 lakh makes it attractive. Also, since it would be only the margin that will have to be put upfront, which could be in the region of around 20%, it will not be too significant for individuals provided they are taking a call on interest rates. Hence, this will help in portfolio diversification. Maybe our policy should gear towards allowing mutual funds to float schemes that invest in IRFs which will appeal to the retail investor. Another interesting option which is open to participants in the derivatives market is that IRFs can be used effectively by players who are dealing with either commodity or forex futures. The futures prices of any product are defined as spot and cost of carry, with interest rates being the chief component. Hence, the direction and pace of movement of the futures prices in an efficient market will depend a lot on interest-rate risk which is embedded in this structure besides the underlying. Taking a view in the IRF segment will help. Let’s suppose that the investment is in, say, soybean where the futures value of contract would fall in case interest rates decline under ceteris paribus conditions leading to a notional loss. To counter this movement, the player could also go long in the IRF market and have his position covered to the extent of interest-rate risk which is embedded in any derivative product. Quite clearly, we are moving into a sophisticated system where the three markets — commodities, forex and interest rates — are getting integrated offering opportunities to cross-hedge and arbitrage to bring about all around efficiency. Therefore, this move does augur for exciting times in the derivatives market.
Not so rosy: DNA:22nd June 2009
In a rather hard-hitting comic strip on the front page of a daily newspaper, a lady shopping for her daily vegetables is aghast at the price of potatoes having doubled. The unperturbed husband says that they need not worry as the PM had just said the other day that inflation was under control. The unbridled optimism in the air around us, which is supported in its own whimsical way by the stock market movements, must make us think and reflect.We may just be living in a world of economic illusions or delusions as nothing much has really changed in the last few months to warrant such a turnaround in the confidence levels in the country. What has guided our spirits or made us feel more elated than we should be?The first myth so as to call it is that the Congress with just over 200 seats (without the support of the Left) is in a position to drive reforms forward. The Left was antagonistic to an extent on certain aspects of reforms but it was the economic crisis that slowed things down for the government. In fact Nandigram could bring back certain ghosts that may have to be faced going ahead -- all coalition partners may not think alike when it comes to reforms. There is little reason to believe that Foreign Direct Investment (FDI) will now pour into our banks and insurance companies. Or for that matter all those pending bills in Parliament would receive high priority.The second is that the economy will grow at 7 per cent this year. Economies do not grow because someone wishes it. Growth has to come essentially from the industrial sector, which has put up a dismal performance in April. In the past, growth has been at around 6 per cent at the lowest in April, so a number of 1.4 per cent does not bode well for the future. Agriculture will be a deciding factor, which is not because of any government action per se but because of climatic conditions which are uncertain. There is little solace to be had in saying that the 1.4 per cent growth heard last week is a turnaround from the negative numbers we have had in the last two months.The third distorted image is that inflation is low at 0.13 per cent and we are on the edge of a 'pleasant problem' called deflation. However, price inflation, going by the consumer price index, is actually still around 8.5 per cent. Even wholesale prices have climbed by close to 2 per cent since March end. Besides, we are being told that the economy is on the growth path while deflation is always a result of a recession. The reason why prices are down is that the government has not raised oil product prices even though global prices are increasing rapidly. Food prices remain high and global prices too have increased. This means that while the base year effect may bring down the inflation numbers, every Thursday we will still be paying more for our daily wares.The fourth concern is that our exports are declining or rather have come down for the last seven months. The fortunes of our exports are dictated by the global recovery which is now expected only in the third quarter of 2009 - not exactly a cheerful picture.
The fifth area, which is intriguing, is the budget. The government has come to power riding the clichéd troika of inclusion, infrastructure and growth. This being so, it is not possible to really go slow on expenditure for the poor, including subsidies. The private sector's exhortation on infrastructure means that the government has to spend more. Further, to placate the masses there have to be some income tax concessions, as well as excise and customs benefits. The call for high levels of disinvestment is therefore not surprising. While the government had in the past discreetly downplayed the role of disinvestment to support budgets, the issue has been proposed by the same critics who ran it down earlier. Given the limited options now available, it would be tempting to again use this route to finance the budget.Lastly, every time there is a call for lowering interest rates, it means problems for the common man who receives less money as interest on deposits. The bias between interest on deposits which is taxable, and dividend, which is tax free in the hands of the shareholder has never been addressed.In this scenario, should we really feel over-optimistic? There are two takeaways. One, conditions are actually not very different from what they were a month back. Second, even if we do choose to see rainbows in the sky, we will be more reassured if these scattered trends are sustained. Therefore, to appear positive to an extent is reasonable but with a fairly fuzzy economic picture before us, one must tarry awhile before opening the champagne.
The fifth area, which is intriguing, is the budget. The government has come to power riding the clichéd troika of inclusion, infrastructure and growth. This being so, it is not possible to really go slow on expenditure for the poor, including subsidies. The private sector's exhortation on infrastructure means that the government has to spend more. Further, to placate the masses there have to be some income tax concessions, as well as excise and customs benefits. The call for high levels of disinvestment is therefore not surprising. While the government had in the past discreetly downplayed the role of disinvestment to support budgets, the issue has been proposed by the same critics who ran it down earlier. Given the limited options now available, it would be tempting to again use this route to finance the budget.Lastly, every time there is a call for lowering interest rates, it means problems for the common man who receives less money as interest on deposits. The bias between interest on deposits which is taxable, and dividend, which is tax free in the hands of the shareholder has never been addressed.In this scenario, should we really feel over-optimistic? There are two takeaways. One, conditions are actually not very different from what they were a month back. Second, even if we do choose to see rainbows in the sky, we will be more reassured if these scattered trends are sustained. Therefore, to appear positive to an extent is reasonable but with a fairly fuzzy economic picture before us, one must tarry awhile before opening the champagne.
Subscribe to:
Posts (Atom)
