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!

Series on Financial Markets - II

After getting a clear idea about what financial assets are, let us now look at some of its characteristics from an investor's (supplier of capital) point of view.  First, they allow individual investors to spread their consumption pattern.  Every individual goes through periods of excess income (young/middle age) as well as deficit income (retirement/old age) during his/her life.  Financial assets help individuals to save/invest during the excess income periods, so that they can meet their consumption needs during periods of deficit income.  Thus financial assets allow investors to spread their consumption.

Second, the financial assets allow individuals to derive income from real assets and allocate the risk.  An individual investor can not invest directly in productive real assets for two reasons: (a) it requires huge capital and (b) it involves huge risks.  For example, as an individual I may not start manufacturing steel, automobiles or even start a retail chain.  But with the help of financial assets, it is possible for me to invest in the businesses engaged in the above activities and enjoy the profits.  Further they allow me to allocate the risk, even if I have limited amount to invest.  So, if I am holding the shares/bonds of five different companies, it is as good as me getting engaged in five different businesses simultaneously.  Again, I can choose to allocate my risks through a combination of high risk instruments like equity and low risk instruments like bonds.

A third characteristic of financial assets is that they allow separation of ownership from management.  When you have large number of individuals contributing capital to a business, it is practically not possible to involve all of them in the day-to-day management.  Moreover, managers need to be professionally qualified and trained.  So, financial assets allow for sourcing capital from various individuals spread all over the country (or the world); whereas the management of the business vests with the professional managers.  They also allow transfer of ownership without any impact on the management of the business.  

Series on Financial Markets - I

Few days ago one of my ex-students, Nisha (who did not specialise in Finance) asked me whether I could write something on the functioning of stock markets through my blog.  Since it requires lot of discussion, I thought of doing so in a series of blogs, this one being the first.  Though some of my readers may find it elementary, I am sure you would enjoy reading the same.

We generally classify assets into two (a) real assets and (b) financial assets.  You might remember that in an earlier blog, I had mentioned that the wealth is always created with the help of real assets.  The real assets represent land, building, machinery, and all other physical resources required for production of goods and services.  All those involved in production of goods and services require capital for investment.  So they represent the demand for capital.  All those entities who have income in excess of their expenditure are looking out for avenues to invest the same; and they represent the supply of capital.  Like any other market, a market is required for the interaction between those who are in need (demand) of capital and those who have surplus capital (supply).  Financial markets provide a platform for the same.

How does the money move from one set of people to the other? Let us take an example from the real market.  When you place demand for a car, the manufacturer supplies the car to you and you pay him cash.  Here two real assets are exchanged.  But when you are providing money as a supplier of capital, what you are getting back is not a tangible asset; but a promise that the other party would return the same to you in future with interest.  So the supplier of capital has a claim on the other party.  The instruments that help us/ or through which we establish this claim are known as Financial Assets.  Bank pass book, Fixed Deposit receipt, NSC, Equity share, Debenture etc. are all examples of financial assets.  I will explain some characteristics of financial assets in my next blog in this series.