I am with you Mr. Governor

I had written a blog on issues relating to interest rates, inflation and economic growth on September 3, 2012 (http://ajoy-finsight.blogspot.in/2012/09/interest-rate-inflation-and-growth.html), where I discussed the relationship between the three economic variables.  I concluded the same by wondering whether a marginal decrease in interest rates would have any impact on the economic growth.  I was very happy to see a recent article in The Economic Times that the RBI Governor, Dr. Subba Rao's reluctance to decrease the interest rates stems from his concerns towards the poor people who suffer due to high level of inflation.  (The link to this article is given at the bottom).  He believes that the advocates of economic growth through lower interest rates have enough platforms to make their voice heard; whereas the poor people in the country hardly have a platform to voice their concerns.

Yes, you are right Mr. Governor.  All those who are asking RBI to reduce rates belong to higher strata of the society and they have enough platforms like CII, FICCI, and even the print and electronic media to put forward their arguments.  When the inflation is high (especially, the food inflation), the higher strata of the society absorbs it quite easily; the middle ones manage somehow; but people at the lower strata find it extremely difficult to absorb the shock.  Though the inflation, that is the percentage increase in prices, is same for all, the ability to deal with it, is not the same.  Let me take a simple example.  When I came to Tumkur (near Bangalore) 14 years ago, the cost of travelling to Bangalore from Tumkur by bus (Rs.18) was almost same as that of train.  Hence the trains were not crowded much.  But today, it costs Rs.58 to travel to Bangalore by bus, whereas it costs Rs.11 by local train.  And, it is almost impossible to get space to stand in the train (let alone a seat) during the peak hours as it is over crowded.  And if one looks at the crowds that travel, they mostly belong to lower class and lower middle class.  Now, imagine what would happen when the rail fare also starts going up (which might be a reality soon).  Is there anybody to represent the lower class of the society, which suffers the most due to inflation?  Politicians meet them only during the election time!  And the argument that the decrease in rates would propel economic growth, which in turn would eradicate poverty and wipe away the tears of the poor, is a hypothesis yet to be proven.  Even if we were to accept the above argument, it definitely would take a long time.  According to the World Bank statistics of 2010, 32.70% of the population in India live below $1.25 per day; and 68.70% live below $2 per day.  A rough calculation tells me that 68.70% of Indians can not travel to Bangalore from Tumkur and back by bus on a single days as they live on less than what it would cost for the journey!

Let me quote Mahatma Gandhi, "Recall the face of the poorest and the weakest man whom you may have seen, and ask yourself if the steps you contemplate are going to be of any use to him".  Dr. Subba Rao, I am happy that you chose to listen to the above words of the father of the nation.  (Perhaps, many others have not seen 'poorest and weakest people', that they are not able to understand their plight!).  When one looks at the whole issue from the perspective of the poor people, containing inflation becomes a far more important issue than economic growth.  As the Governors himself has said in the past, RBI is not the only agency responsible for managing inflation.  RBI has only limited instruments at its disposal.  It must be a collective effort from the part of government and all others concerned.  I am reminded of some classic cartoons by the legendary cartoonist R K Laxman.

Soaring prices, extortion....we must thank our stars , we are not affected by any of these

One good thing about our political system is that whichever party comes to power, we are left alone to continue our lifestyle

That's good.  This will bring down the deficit.  Now he should do something to bring down the prices.

Link to the ET Article: http://economictimes.indiatimes.com/news/economy/finance/People-suffering-due-to-high-inflation-forces-RBI-governor-D-Subbarao-to-hold-rates/articleshow/18454805.cms.

'Yogflation' - A new Concept !

There is a concept in Economics, which we all learn in our college, that in a developed market, no single individual or a small group of individuals can influence the demand and supply conditions.  This concept has been strongly challenged, if one goes by an article that appeared in yesterday's (6th November 2012) Economic Times.  The article says that the wholesale price of walnuts in shell increased 17-20% during the last one year and the price of walnut kernel jumped 50%.  The demand for walnut has been rising steadily during the last six months.  And the reason: Yoga guru Baba Ramdev has been prescribing consumption of walnut as a remedy for knee-joint arthritis!  This is not the first time the markets witnessed his influence.  Few years ago the prices of vegetables like 'lauki' and 'karela' went up subsequent to his recommendations! Though the modern medical science does not reject the fact that walnut is a source of carbohydrates, proteins and vitamins; there is no study to prove that walnut could cure knee-joint arthritis.  I was really fascinated by this story.  I wrote down some important lessons in Management.

1. Lesson in Economics: In India, it is possible for a highly influential individual like Baba Ramdev to influence the prices of products.  Baba Ramdev is neither a buyer or seller of walnut in bulk quantity (as far as my knowledge goes).  So we are completely challenging the economic theory, as this is a case where the words of an individual, who is not directly linked to the demand and supply factors, is greatly influencing the demand of a product.  
2. Lesson in Marketing: Anything with a tag of 'health consciousness', especially when promoted by a person like Baba, sells like hot cakes in India.  Forget about the scientific evidence.  The above article continues to say that the cashew growers are planning to promote cashew-nut with a 'heath' tag.  I hope they get someone like Baba to endorse cashew nuts!
3. Lesson in Advertising: I don't think any other celebrity endorsement in India (or, for that matter, in the whole world) has ever created such a surge in demand within a small span of time for any product.  It probably happens only in India.  
4. And finally a lesson in Finance: If one could predict with certain degree of accuracy, which commodity Baba is going to recommend during the next six months, one can make lot of money by betting on the underlying commodity derivatives.

If things go like this, the babus in Finance ministry would be very happy as they would know whom to blame for the inflation.  When you have inflation influenced by a Yoga guru, what do you call it - 'Yogflation'?

Nobel Prize in Economics - 2012

Two US Economists, Loyd Shapley and Alvin E Roth shared the Nobel Memorial Prize in Economic Sciences for 2012.  Though, I haven't read the works of these Economists, I started reading about their work recently and thought of sharing some interesting points with my readers.  This year's Nobel Prize represents simultaneous recognition for theory and practice.  While Shapely's research along with David Gale in game theory developed the foundation for the theory of match making, Roth applied this theory to various practical situations.

The most interesting part of their research is that it deals with a slightly different aspect of economics compared to the traditional one.  We all learn in basic economics the theory of demand and supply with price as the meeting point.  But Shapley and Gale recognised many situations, where the matching of demand and supply is not done based on price, but other considerations.  Their most influential paper of 1962 discussed the cases of college admissions and stability of marriage.  We can see that in the decisions like marriage, choosing a college etc, the demand and supply interaction (or match making) is not based on price.  They started by asking 'can we develop an algorithm where, from a group of men and women willing to get married, the matching is done in such a way that no individual would have chosen any other individual as their partner?'.  In other words a perfect match making would be possible.  We may wonder, in what way mathematics could help in this process; but that is exactly what Shapley and Gale proved.  Needless to say, in practical life, the model had its own limitations in case of marriages.  However, there were many other situations of match making, where this model proved extremely useful.  That is what Roth did by applying the the above theory to various cases like school admission, kidney transplantation, placement of medical graduates to hospitals etc.  So, Roth was actually putting into practice, what Shapley had developed two decades ago.

There is another speciality for this year's Nobel.  Till now as many as seven economists have won Nobel Prize in Economics for research based on game theory.  But all of them represented research in non-cooperative games, where the objective is to develop strategies for one party to maximize his/her gain.  But this is the first time, two researchers have been awarded the prize for research on cooperative games.  Probably it is time the world starts looking for alternatives from the 'cooperative win-win game models', as Siddharth Singh wrote in Live Mint: 'I was a little surprised by the announcement, but perhaps, the Nobel committee is worried about the consequences of unfettered capitalism of the kind that usual game theory (non-cooperative games) celebrates'. 

Planning - the way to reduce Pain

A recent news item regrading the wife of an airlines employee committing suicide due to financial distress created lot of noise.  She claimed that her husband was not paid salary for 4-5 months and that created lot of financial problems.  The story of suicide by farmers has become a regular one.  But the heat of financial distress pushing the middle income families to take such drastic steps is a recent phenomenon, at least in India.

This brings to light the ignorance of 'personal financial planning' among most of the middle class families.  During the last decade or so the spurt in new-age technology related jobs, where the average salary of an individual was far above the other sectors, created a new section of middle class people.  When a young boy or a girl, in early twenties, is offered a fat salary, they tend to forget the importance of 'financial prudence' and indulge in acquiring assets like luxury apartments, high-end vehicles and develop a life style that demands lot of cash.  Most of these assets are acquired by taking loans against the fat salary.  As long as the salary keeps flowing in, the pinch of EMIs is not know.  But what they fail to realise is that these EMIs are here to stay, even if the salary moves downwards or even stops for a couple of months.  Debt is like a knife with sharpness on both sides.  When the fruit that is being cut is ripe and soft (read, good flow of income), it cuts the fruit easily; but when the fruit is hard (read, fall in income), it cuts your finger.   This is where the importance of financial planning lies.  The most important aspects of financial planning are:
(a) Investment planning
(b) Tax planning
(c) Risk Management & Insurance planning
(d) Retirement planning
(e) Estate planning

Today, there is no dearth for literature on financial planning.  There are many books, websites and even agencies offering this wisdom.  But what is more important is to take the advise from them and use one's own wisdom to plan the finances properly.  A step-by-step approach to financial planning is given below, which is taken from the book, 'Personal Finance' by Jack R Kapoor, Les R Dlabay and Robert J Hughes.

In the first look, this might appear cumbersome, but it is not so.  And moreover, it is not necessary that an individual goes through each step.  What is expected is that each individual is at least aware of these aspects and spends some quality time planning his/her finances.  This would make him/her better prepared to face financial adversities in future; and thus reduce the pain.

Markets on Fire - Boom or Bubble?

The SENSEX which stood at 17300 points about a month ago, has shown a steady rise to close above 19000 yesterday - a 15 months high.  The economic press was filled with the stories of this continued rally.  I started wondering, what is it that is pushing the markets high.  Did anything change fundamentally during the last few days to justify this rally?  But the markets have always been like this!  And this is where the greatest lesson for small-time retail investors lie.

Let us look at the stated reasons behind this rise.  A slew of announcements from the central government, like FDI in multi-brand retail, aviation etc. and increase in diesel prices and a cap on the number of LPG cylinders, which are expected to push the reforms further, is all that what we had during the last couple of days.  Keeping aside the increase in diesel prices, all other announcements are just announcements and yet to be implemented.  Yes, it is true that the Rupee has gained value against the dollar and the RBI has marginally reduced CRR.  Yet, the hardcore issues like inflation continue to haunt the policy makers.  So, what is it that drove the markets up?  The answer is simple - these announcements, or to be more precise, the news of these announcements.

What the small time retail investor should learn is that the markets do not necessarily react to events.  They react to news!  I keep giving the following example while teaching investments.  When you hear the news that your close friend is getting married, you jump out of excitement and reach out to congratulate him.  You do this immediately, though your friend is yet to get married.  And on the day of his marriage, however happy you might be, you would never experience and exhibit the same excitement that the news of his marriage brought to you when you heard it first.  If this is how individuals behave, can the market, representing a huge congregation of individuals behave differently? No.  Hence the markets almost always react to news and not events.  Barring few occasions, when an event as well as the news of the event comes together, in all other cases the news comes first and the event later.

So, the small-time retail investors have to be very cautious during this time.  Most of the times, they are the last to enter the market lured by the upward trend and after they enter, the markets start moving in the reverse direction!  While I am writing this, I can already see that the Sensex has fallen more than 100 points to close at 18939 today!  My suggestion to such investors would be to avoid speculation based on the short-term movements of the market.  I still believe that the economy is fundamentally strong and investments with medium to long term perspective (in good quality stocks) would definitely generate good returns.  All small investors should always look at equity as a long term investment.

Loss, Profit and Value - Facts or Fiction?

Thanks to the wide media coverage, today, the economic issues concerning the nation are discussed with such great interest, which was, perhaps never seen before.  The CAG's views and his loss calculations on a series of  issues like 2G, coal blocks etc. generated lot of heat.  Recently, the ex- Chief Justice of India, reportedly made a comment that 'the loss is a fact and the profit, a matter of opinion'.  The subsequent days witnessed lot of discussions around this statement.  Let us look at it from a corporate finance perspective.  The reported profit or loss of a company is not sacrosanct, as it is reported by the company itself!  One may argue that the accounts are audited by independent auditors; and hence, could be construed to be presenting a 'true and fair' picture of the state of affairs.  But the towering examples of Lehman Brothers and Satyam go against this argument.

There are many ways in which a company can manipulate its accounts to exhibit a totally different picture as against the reality.  On one side, we have firms which presented rosy profit figures before raising funds from the public; and on the other side, there are firms which kept making losses (intentionally) to attract certain benefits.   Few years ago, the government was forced to introduce Minimum Alternate Tax (MAT) to tax those companies, who had intelligently found ways of avoiding tax by exploiting the loopholes in the tax laws.  A recent issue of ET Wealth (24 Sept 2012) sums up various ways in which a firm dresses up its accounts, like not reporting certain expenses, capitalisation of revenue expenses, tampering with depreciation, over/under invoicing of revenues etc.  Swaminathan Anklesaria Aiyer says 'I know of no principle in economics or audit that says losses are real, but profits are not' ('Profits and Losses Are Not Facts, The Economic Times, 26, September, 2012).

Profits and losses are historical numbers, so let us look at the principles of Valuation.  Value of any asset is defined as the present value of the future benefits expected to be derived from the asset.  There are two important components that go into the valuation exercise - the expected future cash flows representing the future benefits and the required rate of return used to compute the discounted value (present value).  The first component, cash flows, as the name suggests are 'expected'; hence are subjective and a matter of opinion.  Same is the case with the discount rate, which is again, based on the expected rate of returns, and hence subjective.  So, any exercise of valuation is also subjective and not a matter of 'fact'.  As Aiyer says, the only matter of fact is the price that one pays to acquire the asset!  Market price is a fact, as this represents the actual payment made by the buyer to the seller.  But ironically, the market price keeps fluctuating almost on a real time basis!

I would like to go with Prof. V Raghunathan, who says '...CAG has not only shown his innocence of the principles of financial engineering involved, but also confused the entire issue, so that it is difficult for an average person to appreciate where the CAG may be right and where he may be wrong.' (Intent versus Fact, The Economic Times, 21 September 2012).

IPOs - Issues & Alternatives

In a recent blog Prof. J R Varma, quoting a research paper by Adam Pritchard, argues that it is high time we abolish IPOs!  Weird, as it may look, but when one reads Prof. Varma's blog (http://jrvarma.wordpress.com/) as well as the paper by Pritchard (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103246), one is forced to believe their argument.  Pritchard explains that an IPO does not add value to any stakeholder including the issuer and the investor; and those who make money from IPOs are the people who manage the issue.  These people/agencies are paid a specific percentage of the issue size, which is known as 'floatation costs'.  Pritchard suggests a two-tier market system, where the companies would be first allowed to trade in a market where the participants would be Qualified Institutional Buyers.  Once a company matures in the Tier I market, it would be allowed to move to Tier II, which would be open to retail investors.

Way back in 1997, I was involved in a project to analyse the post-issue performance of the IPOs that flooded Indian markets during 1993-94.  (Incidentally, Indian markets witnessed maximum number of IPOs during this period).  We found that majority of the issues were trading below the issue price and many companies had vanished into thin air.  Compared to 1994, today, Indian markets have matured a lot in terms of regulation, disclosures and compliance.  However, the IPO market continues to be a gambling zone.  On one side we have issues like Vaswani Industries (October 2011-Issue Price Rs.49 & Current Price Rs.4.76) and Indo Thai Securities (July 2011-Issue Price Rs.74 & Current Price Rs.9.75); and on the other side, we also have Onelife Capital (October 2011- Issue Price Rs.110 & Current Price Rs.648.10).  The story is not different in developed countries either.  Take for example the much-hyped IPO of Facebook.  The shares issued at $38 in May this year are currently trading at $18.80 in Nasdaq and the firm is embroiled with more than 40 lawsuits.  If a firm trades at huge discount or at huge premium on listing, it reflects the inefficiency of the primary market.

In the wake of the above, I pray that the Government appoints a committee headed by Prof. J R Varma (who has already been a member as well as Chairman of several committees) to restructure the IPO market; the committee comes up with revolutionary suggestions; and above all, the Government accepts and implements these suggestions.  Are the bosses at the Finance Ministry and SEBI listening....?

Interest Rate, Inflation and the Growth Conundrum..!

The Economic Times of 30th August carried three interesting and related reports.  First one was about a speech that the RBI Governor, Dr. Subba Rao, delivered at Cornell University, where he stated that RBI was not planning to reduce policy rates owing to high levels of inflation.  He said that unless inflation reaches an acceptable level of 5% or below, there is no scope for a rate cut.  The second story dealt with the opinion of Mr. K V Kamath, the chairman of the second largest bank of the country.  He argued in favour of a rate cut by RBI by 1% points to spur economic growth.  He said that keeping rates high may not be doing anything to contain inflation.  However, whether a reduction in rate would propel growth, is something that even Kamath says is worth experimenting!  The third one was a column by Prof. T T Ram Mohan of IIMA, where he says that RBI can not be blamed for the economic slowdown.  Based on the recent statistics, he argues that increase in interest rates and global slowdown can explain only a portion of the economic downturn.  He says, it is not the interest rate than can boost growth, but positive policy measures and public investment in sectors like infrastructure.  It was a pleasure reading these three pieces together, as each one represented a specific angle - a regulator, a banker cum businessman and an academician.

Let me quote few lines from the latest RBI Annual Report: '...even at the current level of the policy rate, the real effective lending rates of the banks are relatively lower in comparison with their pre-crisis levels.  This highlights the fact that policy rate alone cannot explain the sharp growth slowdown.....'.

In a global scenario marred by recession, the only hope for growth is from domestic demand.  If the interest rates are reduced, two simultaneous forces should work in the economy in order to propel growth.  First, with reduced interest rates, people should reduce savings and increase consumption.  Second, in order to meet the increased consumption needs, the business sector should increase their output by borrowing money from the market at lower interest rates and investing it in productive activities.  Here is the catch: what is the guarantee that reduced interest rates would enhance demand?  Another trend that is revealed by the RBI data is that household savings have started drifting more towards physical assets like gold and real estate, which people consider as safe bet during times of high inflation.  But these investments are unproductive in nature and do not help in capital formation.  If this is the case (even with high interest rates), one wonders whether a marginal reduction in rates by RBI would have any impact on growth at all.  In a way, we are continuing with the age-old debate in economics between Keynesians and Monetarists.  Let the debate continue.

Correlation......is it All?

A recent article by Prof. Krishnamurthy Subramanian of ISB ('Why research that establishes causality is better than just correlation?', The Economic Times, 10 August 2012) caught my attention.  This article talks about some issues in research that I have been discussing with some of my co-researchers during our week-end meetings.  Correlation is a statistical tool that is widely used in research in social sciences.  This measures the strength of the relationship between the movements of two variables.  But, unfortunately, it measures only that and nothing more.  Many times I have seen researchers trying to look at correlation from the point of view of causality.  But correlation only indicates a possible causality; but does not confirm the same.

Garry Koop ('Analysis of Financial Data', John Wiley & Sons, 2006) explains this with a beautiful example.  In a study conducted on a group of smokers, it was found that there was a very high positive correlation between smoking and the incidence of lung cancer.  Incidentally, a large proportion of these smokers also consumed alcohol and hence, smoking and consumption of alcohol were also highly correlated.  As a result, there was positive correlation between consumption of alcohol and incidence of lung cancer.  Now let us examine each of the above cases.  In case of correlation between smoking and lung cancer, there exists causality and it runs from smoking to cancer. That is, smoking causes lung cancer and not the other way round.  In the second case, the correlation between smoking and alcohol consumption, there is no causality as neither would lead to the other.  Here, the correlation arises from a social behaviour.  As far as the third case is concerned, the correlation (between consumption of alcohol and lung cancer) is just a coincidence as these two are neither related, nor exhibit any causality.  So, based on the third measure of correlation, if one were to conclude that alcohol consumption leads to lung cancer, it would be a Himalayan blunder!

Correlation, being a mathematical measure, can be computed across any variables!  But whether there exists a relationship between these variables, that merits inferences based on correlation, is something that the researcher has to decide based on his intellectual and intuitive capabilities.  Hence, while using correlation as a measure to draw inferences, the following issues become important:
a) Are the variables related to each other?
b) Is there causality between the variables?
c) If there is causality, in which direction does it flow?

As Prof. Subramanian argues, one should not be satisfied with correlation while drawing conclusions on causality.  Correlation can only be the first step towards establishing causality.  In order to confirm causality, one has to move beyond correlation, and use some advanced Econometric tools specially designed for this purpose.

Commodity & Equity Markets

The commodity derivatives markets in India remained subdued for almost 4 decades due to prohibitions and excessive regulations till 2002, when the Government decided to permit national level electronic exchanges like MCX to trade in futrures contracts on commodities.  Since then, the commodity derivatives markets have witnessed phenomenal growth in trading.  The equity markets, on the other hand, were well established much before.  During stock markets went through prolonged bearish state starting from January 2008 and continue to remain so, with minor improvements now and then.  Commodity derivatives markets witnessed a steady growth during the same period, lead primarily by the growth in trade in bullion contracts. The volume of trade in bullion rose from Rs.17.26 trillion in 2007-08 to Rs.101.82 trillion in 2011-12, with CAGR of 156%.  This kind of growth pattern raised several questions like whether there is any relationship between the equity and commodity market movements in India or are they moving independently.

In a recent research work, it was found these two markets do not exhibit statistically significant co-movements (or long term equilibrium in movements).  The study was conducted based on the relationship between the movements of equity markets (measured by NSE Nifty and BSE Sensex) and commodity markets (measured by MCX Comdex, Metal and Energy indices).  Period of the study was 4 years from January 2008 to December 2011.  Correlation and Engle-Granger Test for Cointegration were used to analyse the data.  Though there was positive correlation between both the markets (about 0.60), the Cointegration test proved that there was no significant co-movement between these two markets.

(The above post is based on a research paper co-authored by me and Dr. M R Shollapur, which was presented in an International Conference recently at Bangalore)

Series on Financial Markets - VI

After a brief gap (due to various preoccupations), let me resume my blogs.  Let me brief on the past posts in the above series.  The first one dealt with basics of real assets and financial assets.  The second one explained the characteristics of financial assets; the third one was about the financial system and the fourth and fifth dealt with raising funds (capital) from through borrowing and from the shareholders through the primary markets respectively.  The last post ended with a question: when raising funds directly from public involves lot of costs (in various forms), why do firms raise funds from the public?  Let me try to answer.

Let us first understand why firms do not like too much of debt.  Debt capital, though less costly as the interest rates are fixed and they do not participate in the profits of the firs, has its own disadvantages.  Firstly, the interest payments on debt are committed costs and the firm has to pay the same, irrespective of whether the firm makes profit or not and whether it has enough cash balance or not.  Default in payment payment leads to lot of complications like hampering the image of the firm, reduced credit rating, and even legal proceedings by the lenders in extreme cases.  Secondly, the lenders start insisting on certain operational restrictions.  They would require the firm to take them into confidence before implementing major decisions like expansion of business, payment of dividend, raising further funds etc.  Thirdly, as the going gets tough for a firm (may be due to unfavourable external environment), firms with more debt find it difficult to sail through, as they have to deal simultaneously with the hostile business conditions and the highly demanding lenders.  This is exactly what the aviation sector is facing now.

Now let me explain, why equity (owner's funds) may be attractive inspite of relatively higher costs.  The equity capital is almost a permanent source of capital.  The firm is under no obligation to repay this capital under any circumstances, except in case of winding up of business or buyback of shares.  Here again, the decision to buyback the shares is not demanded by the shareholders.  The firm is also not under any obligation as far as payment of dividend (the share of profit) is concerned.  A firm with more equity capital attracts a better image in the business circles and financial markets.  Such a firm also enjoys better bargaining power with the lenders, when it comes to raising additional funds through borrowing.

Interest on Small Saving Schemes - Clarification

Let me wish a Very Happy New Year to all my readers. In my blog on Small Saving Schemes dated Nov 15, I had brought to your notice that the Government had accepted the suggestions of a Committee to link the interest rates on small saving schemes to the market yield. It also said that the Government would announce the rates applicable to various investments on 1st of April every year. Even though the implications were well understood, some people had a doubt whether the interest rates on an existing instrument would be revised every year. The ministry of finance has now given a clarification that the interest on all small saving schemes, except Public Provident Fund (PPF) will remain fixed till its maturity. That means, when the rates are announced on 1st April, it would apply to all the investments made in instruments (other than PPF) during the relevant financial year. New rate, when announced during the next year would apply to subsequent investments only. So, if one invests in NSC on 15th June 2012, the rate announced by government on 1st April 2012 would apply to his investment and the same would remain fixed till its maturity. When the government announces new rates on 1st April 2013, such rate would apply only to those who invest in NSC during 2013-14.

But in case of PPF, this doesn’t work. PPF, unlike many other instruments, is a long term (15 year) deposit on which interest is paid on the outstanding balance every year. So, the interest on PPF account will be revised every year. From the point of view of Interest Rate Risk, it means the yield from all small saving instruments, other than PPF would remain constant, once invested. But when it comes to re-investments or investments planned annually over a period of time for availing tax benefits, one would have to face the fluctuations in interest rates.

Reliability of the Most Reliabale

Any research, analysis or even a commentary on the economy draws heavily on the macro-economic data.  When it comes to data, analysts all over the world unanimously agree that the most reliable data source is the Government.  They just accept the data provided by the government without even the slightest doubt on its reliability.  The data released by governments has various roles to play.  (a) It indicates the direction and momentum of the economy, which has great influence on the confidence levels of business enterprises; (b) It acts as guiding tool for attracting both domestic and foreign capital; (c) It influences the decisions of Foreign as well as Domestic Institutional Investors, and (d) It sends signals to the financial markets, taking them to new levels.  Such is the importance of data provided by the government, that many people eagerly wait for the release of the most recent data.  Now let us look at some recent headlines:

(a) Govt Admits Subsidy Math has Gone Awry (Economic Times, 8 Dec)
(b) $9B Goof-up in Export Numbers, Admits Govt (Economic Times, 10 Dec)
(c) Export Nos. Gaffe Adds $7.2B Headache to Govt (Economic Times, 15 Dec)
(d) Rangarajan Spots Sampling Errors in IIP Data (The Hindu, 21 Dec)

The first one is an error of forecasting, where the subsidy bill has overshot the budget estimates by a huge margin.  This is very much possible and does happen at times.  But the last three are calculation/estimation errors.  In the second case, "computer and human errors overstated India's export figures", says the report.  It gives further reasons as "wrong data entry, double counting of certain items and computer malfunction".  The difference was to the tune of $8.8Billion.  Within 5 days of revising the export numbers downwards, the government got the next shock.  The export data compiled by RBI for 2011-12 exceeded the government estimates by $7.2Billion.  The RBI data is considered to be more reliable as it is based on the actual payments received.  Then came the big announcement of IIP's contraction by 5.1% during October 2011.  This sent shock waves among the business fraternity and the financial markets alike.  And today, Dr. Rangarajan, Chairperson of the Prime Minister's Economic Advisory Council spots sampling errors in the IIP numbers for Oct 2011.  He had expressed his shock and disbelief when the IIP numbers were released last week.

If one were to make any conclusion on the conditions of the economy based on the data released by the government, the data needs to be compiled properly and computed scientifically without errors.  With the advent of advanced computing technology, we have increased the frequency of reporting by shrinking the reporting interval.  In some cases, this type of increased frequency in reporting can only create unwanted panic in the market.  It looks like a doctor monitoring the temperature of his patient every 15 minutes and reporting the same to the patient.  It only adds to his panic, especially when the news is not good.  What is worse is that the doctors is using a flawed thermometer! 

Series on Financial Markets - V

Continuing with the discussion on raising capital by business entities, unlike what I mentioned in my earlier post, capital can also be raised directly from the savers.  Small businesses borrow money from the friends/relatives of the promoter directly; whereas large corporate houses raise money from public at large.  (There are various reasons why businesses do not fully depend on banks and financial institutions for capital, which is not explained here).  A business enterprise can raise capital in the form of debt or equity (ownership).  When an enterprise raises capital directly from the public, it is said to be raising the money from the 'Primary Market'.  Unlike many other forms of market, primary market is a notional one, with no specific location or office.  However, this market is regulated by the government through appropriate regulatory bodies.

Since there is no specific location; and savers, who would be interested in supplying capital to the firm are geographically scattered throughout the country, the firm has to put in place a complete system to reach the prospective suppliers of capital.  It resorts to the following processes and depends on the respective intermediaries in the process.
(a) Obtaining regulatory approvals (wherever required)
(b) Releasing advertisement inviting public to subscribe to the bonds/shares
(c) Preparing and printing prospectus containing various details of the issue
(d) Printing application forms
(e) Approaching brokers/sub-brokers to promote the issue
(f) Appointing registrars to manage the issue
(g) Appointing bankers to collect the payment etc.

Thus, as against loan from a bank or financial institution, the process of raising capital directly from the public involves lot of money (spent on the above activities) and it is time consuming.  Then why do businesses raise capital directly from public?

Series on Financial Markets - IV

Let us now understand the role of Financial Institutions in an economy.  These institutions act as intermediaries between the suppliers of capital and those in need of it.  It is always possible for the business enterprises to raise capital directly from the individuals who have surplus money.  But there are few problems:
(a) many individuals may have only small amounts of money as surplus
(b) the individual investors do not have the expertise to analyse the business that the firm is engaged in
(c) the individuals find it difficult to understand and assume the risks involved
(d) there is a question of credibility as the business enterprise may cheat the investors

This is where the role financial institutions becomes relevant.  Lets take commercial banks for example.  Banks collect small as well as large amounts of money from those who are willing to invest their surplus, make a big pool of money, which is then used for lending to business enterprises or individuals placing demand for money.  Thus the surplus money that would have directly flowed from the investors to the firm, now takes a detour through the bank.  This solves most of the above concerns.  Lets see how:
(a) individuals can deposit even small amounts as banks pool the funds
(b) banks have the expertise to analyse the business projects
(c) banks can reduce the risk of lending as they lend to many enterprises and thus diversify the risk
(d) banks are regulated by the government which brings in credibility (though not all banks share the same credibility and risk)

Similarly, the financial institutions like insurance companies, mutual funds, pension funds etc. act as financial intermediaries.  They are all regulated, though the extent of regulation differs.  The process of financial institutions bringing suppliers and users of funds together is known as 'Financial Inter-mediation'.  

Inflation, Interest Rates & Growth

Based on Sushma's comment on an earlier post, I thought of elaborating on the relationship between the three basic economic measures - inflation, interest rates and growth rate.  Inflation, as everyone knows, is the rise in prices of goods and services.  There are various factors contributing to inflation, and one among them is the excess supply of money in the economy.  Central banks (RBI in our case) use 'Monetary Policy' to control money supply and thus inflation.  In order to control money supply, RBI can resort to one of (or all of) the following actions: (a) open market operation, where it sells bonds and thus absorbs money from the market; (b) increase in interest rates (the rate at which it lends to banks), thus making the borrowings costlier for banks; and (c) increase in reserve requirements (percentage of deposits the banks are required to maintain with RBI), which leaves lower amounts of loanable funds with banks.  In all the above cases, the excess liquidity is sucked by RBI in order to reduce the inflation.

When banks are asked to pay higher interest while borrowing from RBI and are left with lesser amounts of loanable funds, they start charging higher interest rates on their loans.  This makes bank loans costlier.  On one side the individuals will borrow less amounts of money and thus reduce their demand for goods and services; whereas on the other side, with higher interest rates, they would start investing more in banks/govt bonds etc. 

But every economic action has a flip side.  When the central bank tries to control inflatilon, beyond a point, through tight monetary policy, demand for goods and services comes down heavily as the loans become unaffordable.  For example, when the interest rates are high, demand for housing comes down.  On the other hand, the industry will put its expansion plans on hold as the borrowed capital becomes costlier.  This reduces the overall economic activity of production of goods and services and thus the growth rate of the economy (measured in terms of GDP growth) slides down.  So, beyond a point, you control inflation by compromisng the growth!

IPO Pricing - A Big Puzzle!

Unlike many other products and services, pricing of IPOs is very tricky.  Our age-old Economic theory says that the best price emerges when demand and supply factors are allowed to freely interact.  With all market imperfections, interaction of demand and supply forces determine price in case of most of the products and services.  But when it comes to IPO pricing, what is being sold is not a product or service; but a portion of the ownership of an enterprise.  Thus, the price depends on the value of the enterprise at large.  A fair pricing of IPO is important as the under-pricing deprives capital to the issuer and over-pricing misleads the investor.  There are three popular methods of determining the price at which shares are to be offered by a company.  They are (a) fixed price; (b) book-building and (c) auction.

Until 1999, IPOs were made through fixed price offers in India.  Here, the issuing company, in consultation with its investment banker, decides the price at which the shares are to be issued.  The price and the quantity of shares offered are announced and the investors are asked to apply for the number of shares they would like to buy.  The inherent problem of this method was, 'how could the issuer decide the price?'  In most of the cases, there were huge under-pricing as the issuer, for the fear of the issue failing, was forced to price the shares below its actual value.  (I am ignoring huge over-pricing of issues by few promoters with an intention to cheat investors).  Our basic theory was compromised here as the demand side factors were not given participation in the process of pricing.

In 1999, Hughes Software became the first company in India to make IPO through the book-building route.  Here the issuer, again in consultation with the investment banker, announces a range of price (with a band of 20% or so).  The investors are asked to bid for shares with prices within the range.  The issue price is decided by considering the demand extracted through the bids.  Once the price is determined, all investors who submitted bids for the issue price and above are allotted shares at the issue price.  Here the demand side gets participation in the process of pricing in a limited manner as the price range is fixed by the issuer.

The third method, an auction, allows greater interaction between the demand and supply forces.  It can be a French Auction (tried by REC and NTPC last year) where the floor price is fixed and the bidders are asked to bid at floor price or above.  Or, it can be a Dutch Auction (not prevalent in India, but tried by companies like Google in USA), where the issuer fixes an extremely high price and asks the bidders to bid at lower prices.

Though lot of empirical research has been done on which method of pricing is the most suitable in terms of fair valuation, no conclusive evidence has emerged.  Thus pricing of IPOs remains a big puzzle.

Series on Financial Markets - III

The first post in this series emphasized the significance of transfer of money from the savers (investors) to the borrowers and the second one talked about various instruments (financial assets) available for such transfer.  Now let us look at the system that facilitates the interaction between the two groups.  An economy is divided into three sectors: (a) household sector, comprising of individuals; (b) business sector, comprising of various business enterprises and (c) the government.  Each of these sectors constitute entities who save as well as borrow.  For example some individuals save whereas some others borrow.  Same is the case with business units and the government.  So lending (same as saving) and borrowing happens among the three sectors as well as within the three sectors.  However, household sector is almost always net saver (with savings exceeding the borrowing) and the government almost always net borrower.

In order to have smooth interaction between the lenders and the borrowers, the following becomes necessary:
(a) proper instruments to facilitate the interaction
(b) a platform for them to interact, and
(c) well-defined rules and regulations

We have already discussed about the instruments (financial assets).  Financial markets and various financial institutions provide the platform for interaction among the lenders and borrowers.  Financial markets can be divided into primary market and secondary market.  Financial institutions take various forms like commercial banks, insurance firms, mutual funds etc.  Various regulators like RBI, SEBI, FMC, IRDA etc. are involved in  framing rules and regulations and ensuring their implementation.  Thus the system comprising of financial markets, financial institutions and regulators is known as 'The Financial System'.  Every country has its own financial system, even though the level of development of these systems differ from country to country.  In the absence of a well-developed financial system, the basic economic process of capital formation becomes constrained.  

IPO & Retail Investors

A recent issue of The Financial Express (08-11-2011) reported that SEBI is about to constitute a committee to review various aspects relating to improvement of the Primary market for stocks in the country.  The major issues of concern are (a) bringing back the retail investors to the primary market; (b) reduction of issue costs,  which currently amount to as high as 10%; and (c) reduction of the time gap between closure of issue and listing to 3 days from the current 12 days.

From my experience of participating in the primary market (though in a limited manner) for the last 10 years, I feel the confidence levels of retail (small) investors is now at the rock bottom.  The increased volatility in the market and the poor performance of many IPOs listed recently are responsible for the same.  By looking at the huge discounts at which some issues are listed, one wonders whether there is anything wrong with the way the issues are priced.  I am not denying the fact that small investors should approach equity from a long term perspective; however, the huge listing loss definitely shakes their confidence.  Another area of concern is that the investors are expected to thoroughly study the issuer using the Red Herring Prospectus.  But the size of the prospectus is so large, that no small investor would ever have the expertise or the patience to read the same.  An abridged version of the same is supplied along with the IPO application form.  But, in order to achieve the objective (b) and (c) listed above, SEBI wants majority of the applications to be made through electronic form.  And when one applies through the electronic route, he does not get the abridged prospectus, but the full version.  I feel an abridged prospectus, written in simple language, is what the small investors are looking forward to.

Above all, investor education plays a crucial role.  Retail investors, especially those from the Tier II cities, participate in IPOs based on the recommendations of their friends/relatives or by being attracted by the advertisements and internet.  It is essential for them to clearly understand the risk factors involved in the issue and their future implications.  While making the red herring prospectus more investor friendly, SEBI has to also take initiatives to educate the small investors.  Their behaviour is well described by an old adage: Once bitten, twice shy!
     

Small Saving Schemes - Restructured

If anyone thought that the deregulation of interest rate on savings bank account by RBI a couple of weeks ago was a major step towards aligning interest rates to the market forces, hold on, there is more in the offing.  Ministry of Finance has accepted the recommendations of a Committee headed by Mrs. Shyamala Gopinath on restructuring Small Savings Schemes, namely, PPF, NSC, and all Post Office Deposit Schemes.  In a recent notification, the ministry has suggested implementation of the proposals with effect from December 1st this year.

The most important aspect is that the interest rates on these instruments (except PO Savings Bank Account, which is fixed at 4%) will now be linked to the yields on government securities of comparable maturities.  The interest rates applicable to a particular year will be announced by the Government on 1st of April.  In fact, the interest rates on some of these instruments were aligned to the market rate between 1999 and 2003.  But since then, the rates on these instruments remained constant at 8%.  This created huge inflows and outflows from these instruments depending on the market rate.  For example, when the market rates were below 8%, people rushed to buy these instruments and when the market rates were above 8%, there was net outflow from these funds.

The Committee has also recommended discontinuation of Kisan Vikas Patra (KVP) and reduction in the maturity period of Monthly Income Scheme (MIS) and NSC from 6 years to 5 years.  A new series of NSC with 10 years maturity will be introduced.  Moreover, the accrued interest on NSC will not be eligible for tax benefits under Section 80C.  As far as Public Provident Fund is concerned, the maximum contribution during a financial year has been raised from Rs.75,000 to Rs.1,00,000.

The writing on the wall is clear: Gone are the days of stable/constant interest rates!