44) What causes credit crunch in financial markets?

Credit crunch is a situation in which the wheel of lending gets jammed leading to a sudden decline in lending, that is, credit.

Ladies and gentlemen! Welcome to the Real Simple Best News of the Year award ceremony. We are assembled here to assess people and events in the financial world that kept us engaged for the whole year. And now, this year’s award for the Best Financial Evangelist goes to Mervyn King, governor of the Bank of England, for raising the flag of moral hazard just before a bank run. The Most Sensational News award goes to “credit crunch” for creating a fire after the storm. And the award for the Best Firefighter of financial market goes to...

Jinny: Wake up Johnny! In which world are you lost?

Johnny: Ah! You spoiled my dream. I was the chief guest at the best news of the year awards. “Credit crunch” won the award for the most sensational financial news. They were just going to announce the award for the best firefighter of the financial market.

Jinny: I’m sorry! But you can go back to sleep and finish the dream. What’s the problem?

Johnny: The problem is now yours. You have to pay a penalty for spoiling my dream at the wrong time. Before I go to sleep again, you will have to tell me about a few basic things. First tell me, what exactly is “credit crunch”?

Jinny: As you may be aware, our credit market runs on two wheels. One wheel is borrowing and the other is lending. Credit crunch is a situation in which the wheel of lending gets jammed leading to a sudden decline in lending, that is, credit. This situation will automatically jam the other wheel. So if there is a credit crunch, borrowers are not able to find lenders. And even if they find them, the credit is available at unusually high interest rates. “Credit crunch” could happen due to many reasons, including an increased perception of risk on the part of lenders, imposition of credit controls or a sharp restriction in money supply. Increase in risk perception causes the worst kind of credit crunch. When the lenders are not sure about the creditworthiness of borrowers, there is an increase in the risk perception. This makes lenders nervous and they stop lending. When one of your wheels is in a rut, you can’t expect the other wheel to keep on moving. As a result, the flow of credit comes to a grinding halt.

Johnny: What causes lenders to doubt the creditworthiness of borrowers?

Jinny: Lenders doubt the creditworthiness of borrowers when they are not sure about getting their money back. The memory of recent defaults adds fuel to suspicion, and lenders become reluctant to lend. You may think that the lenders can demand high interest rates for taking a risk and part with their cash. The problem, however, is that it is difficult to set a price for risk when you are uncertain about the likely loss. This is how the defaults of “subprime mortgages” in the US started a fear of the werewolf in the financial markets this year. Lenders were not sure when their borrowers would turn into werewolves. Small depositors started lining up outside their banks. Even banks started fearing each other, which led to the worst kind of credit crunch seen in the inter-bank markets. This kind of fear and uncertainty is a perfect recipe for credit crunch.

Johnny: Tell me, what can happen if credit crunch persists for long?

Jinny: A credit crunch affects not only borrowers and lenders but also our financial markets and the economy. With the onset of credit crunch, interest rates shoot up. But even high rates may fail to bring lenders to the market. High interest rates put a brake on new investments and consumer demands, which may ultimately slow economic growth. New deals are scrapped due to lack of credit. Leveraged borrowers take the heaviest blow. Lenders may start demanding their money back. Even sound borrowers may default due to sudden demand for repayment. This can surely set the financial markets on fire.

Johnny: If there is a fire, there must be a firefighter around. Tell me, who takes care of a fire of this kind?

Jinny: That’s an interesting question. There is indeed a firefighter, known around the world as a “lender of last resort”. But I will tell you about him some other time. Meanwhile, you can make your plans for New Year’s party.

What:Non-availability of credit to the borrowers at a reasonable cost is known as credit crunch.

Why: Doubts about the creditworthiness of borrowers, imposition of capital controls and lack of liquidity are some of the reasons that may cause credit crunch.

Whom: Credit crunch can affect the whole economy by slowing new investments and consumer demands.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com

43) Tough Choice of Tax Cut

The case for a tax cut is not so simple as it seems at first glance.

The taxman is having a great time. His collections are growing much faster than the underlying economy. Is this enough reason for a tax cut?

The government said last week that its collections of direct taxes between 1 April and 15 December this year was 42.5% higher than their level in the same period of 2006. Mid-December is the last date for the payment of the third instalment of advance tax. Of course, these are tentative numbers, but we would be surprised if the final tax numbers to be released at the end of the financial year show any significant slowdown in the rush of rupees into the tax kitty.

By current trends, it seems almost certain that the tax department will cross the target set for it in the Union Budget, especially as far as income and corporation taxes go. So, it’s quite natural that the new data has brought with it a rising demand for tax cuts in the coming Budget. How sensible would that be?

The government should also try to make the tax code simple, to curb deadweight costs and distortions

The long-term case for lower marginal tax rates is quite clear. Lower taxes are an incentive to work, save and invest more. Economic growth rises as a result. And so do tax collections. In short, moderate levels of taxation paradoxically lead to higher tax collections.

But a lot depends on the immediate context as well. Two questions are important here. One, why are direct tax collections rising so fast? Two, does the current economic situation demand a tax cut?

Answer one: direct tax collections could be soaring because of better tax compliance or because the rich and companies are getting a growing share of national income. In other words, the cause could be either that fewer people and companies are evading taxes or that inequality is increasing.

Tax cuts make sense if they are rewards for honesty. But not if they are further sops for those who have benefited the most from the economic boom. The government will have to think through this politically sensitive issue before doing anything hasty in what could be an election year.

Answer two: while there is no doubt that India is in the early stages of a splendid long-term economic boom, there are growing macroeconomic risks to face in the short term. The trade deficit is growing. Capital inflows are swamping the economy. The global economy could be slowing down. Inflation in 2008 is likely to be higher than it was this year. All these call for a tight fiscal policy. A significant tax cut would be a good idea only if the government makes parallel cuts in spending. That seems unlikely to us.

The case for a tax cut is not as clear as it seems at first glance. The finance minister could make a few cuts here and there, perhaps in various surcharges, to signal to investors that there is scope for lower tax rates in the future. He should also focus on making the tax code more simple, so as to cut deadweight costs and reduce distortions in the allocation of capital and labour in the Indian economy. The productivity gains from this are likely to be substantial. (A flat tax of the type seen in certain East European economies is but a distant dream in India.)
And while the current call for lower taxes is not unreasonable, let us not forget how far ahead we have moved since the 1970s.

India’s tax regime has grown less suffocating over the past few decades. It is simpler and the rates of taxation are lower. Import tariffs are getting closer to regional levels, thus making the economy more competitive. The goods and services tax will reduce distortions and help create a single national market. The tax rates on individual income and corporate profits are also at far more sensible levels, right now. All this shows that the marauding state has stepped back a bit.

Thankfully.

42) How do companies raise money through initial public offerings?

A public company must have a minimum of seven owners but there is no restriction on the maximum number.

Can you imagine our movie theatres without any movies or our newspapers without any news? What would it be like to go to a theatre just to eat popcorn and to purchase a newspaper only to wrap up old shoes? Sounds ridiculous? Now try to imagine the existence of our stock markets without initial public offerings (IPOs). Can our stock markets exist without them? Sounds a bit confusing. Maybe our friends Jinny and Johnny can enlighten us about the role IPOs play in the stock markets.

Johnny: Santa Claus, Santa Claus where have you been? I’ve waited one whole year to get a trash bin!

Jinny: What happened Johnny? Why are you talking to yourself?

Johnny: I am complaining to Santa Claus for bringing a trash bin as this year’s Christmas gift. It seems he is running short of money. We may very well see him coming out with an IPO. What do you say?

Jinny: But what makes you think that anybody running short of money can come out with an IPO? You really need to know a few basic things about IPOs.

Johnny: I’d be happy if you would explain them to me.

Jinny: You might have heard that there are two types of companies: public and private. Ever wondered what’s the difference between the two? Well, a private company is formed by a small group of individuals for carrying out their business. The ownership of a private company remains confined to this group of individuals. Every owner of the company owns shares, which represent his percentage of ownership of the firm. As per law, a private company can have a minimum of two and a maximum of 50 owners. A public company must have a minimum of seven owners but there is no restriction on the maximum number. These owners contribute the capital of the company by purchasing its shares and take home whatever is their profit or loss. But, a company may require more money than its owners bring in as capital. If you have 50 owners and each of them contributes by purchasing 1,000 shares of Rs100 each, then you will have a capital of Rs50 lakh. But suppose tomorrow you need more money to expand your business. What options do you have?

You can ask the owners to bring in more capital but beyond a limit, even that may not be possible. You can also approach a bank or a financial institution for a loan. This can work to a certain extent but taking a loan makes you liable to pay interest irrespective of what you earn. Beyond a point, even taking a loan may not work. After all this, you may consider offering ownership of your company to the public at large. But a private company can’t have more owners than what has been prescribed by law. The option of offering ownership to the public is only available to another class of company, which we call public companies. This entire process of raising money by offering subscription of shares of the company for the first time to the public is what we call initial public offerings or IPOs in short.

Johnny: I see! It seems an IPO enables a company to get its shares listed on the stock exchange where further trading takes place. Right?

Jinny: That’s right. Now let’s move further. This IPO can be done either by making a fresh issue of shares or by offering for sale the already existing shares or by a combination of both. Fresh issue of shares helps in expanding the capital whereas the sale of already existing shares enables the existing owner to dilute his shareholding. Once the company is listed after IPO, a follow-on public offering can also be made by the company to raise more money from the market. The company can also raise money by coming out with a rights issue. In a rights issue, new shares are offered to the existing shareholders as on the record date in a particular ratio to the number of shares already held. For instance, a ratio of one share for every five shares held will entitle a shareholder having 10 shares to acquire two new shares. This method enables a company to raise more money without diluting the stake of the existing shareholders.

Johnny: So, IPOs provide an easy way of raising money to all public companies.

Jinny: No. This alternative is available only to those companies that satisfy the eligibility criteria laid down by the market regulator, in our case, the Securities and Exchange Board of India.

The eligibility norms ensure that only companies meeting the desired level of standing are able to tap the market through IPOs. So the invitation is strictly on merit.

Johnny: Thanks Jinny. I will ask about the eligibility norms later. I think Santa is back. So, let’s celebrate. Merry Christmas!

What:Initial public offerings (IPOs) enable public companies to raise money through public subscription for the first time.

Where: After IPOs, companies get listed at stock exchanges where subsequent trading of shares takes place.

How: Companies can raise further money after listing through follow-on public offerings and rights issue.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com

41) What are the predominant risks in currency carry trade?

Currency carry trade has two major risks: the interest rate risk and the exchange rate risk.

Financial markets are like oceans. When the tide is low, you enjoy the flow. But when the tide is rough, sailing gets tough. Few know this better than carry traders. Their lives start on one tide and end on another. In between the rise and fall of tides, numerous questions arise. How does carry trade work? What are the risks? These questions leave our friend Johnny clueless. But there is no need to worry when Jinny is around.

Jinny: Hi Johnny! Nice to see you. But why are you playing ping-pong today?

Johnny: Jinny, I was thinking of doing the great ping-pong ball experiment for the financial markets. Even big ships sometimes can’t survive the rough tide, but a simple ping-pong ball can float long distances without any problem. Can’t we have something like a ping-pong ball for the financial markets that can keep on floating come what may?

Jinny: Sounds interesting. What is making you so thoughtful today?

Johnny: I was just wondering what inspires carry traders to take risks when they know they may sink if the tide turns.

Jinny: Well, it is very tempting to jump in the waters when you see easy money flowing around.
In financial markets, carry trade is like fishing for the flowing money. Its working looks so simple that you could say, “Wow! I can do it too.” But how? The answer is pretty straightforward; you borrow at a low rate and invest that money in a high-yielding investment. Is that all? Yes, that’s it.

I will give you an example of a simple carry trade. If the short-term interest rate is less and long-term interest rate is high, you borrow money for the short term and lend the same for the long term. But there is one problem. You would be required to repay your short term borrowing much before you receive repayment from your long term borrower. What would you do? You again borrow for the short term and repay your earlier loan. In this manner you keep your boat sailing. But the problem is that any rise in short term interest rates can sink your boat.If you are ready, we can now move on to a more advanced version of carry trade, popularly known as the currency carry trade, that takes place in the foreign exchange markets.

Johnny: Sure, go ahead.

Jinny: Currency carry trade works on the basis of interest rate differentials of two currencies. Many factors decide what would be the interest rates for a debt denominated in a particular currency. Similarly, many factors decide what would be the exchange rate of one currency against another. For doing carry trade, you borrow the currency which is available at a lower interest rate and convert the same into the currency which is available at a higher interest rate. By doing so, you can invest your money in the debt instruments of the currency carrying a higher interest rate. In this manner, you pay less interest on your loan and get high interest on your investments. This is how currency carry trade works. Currency carry trade is a type of interest rate arbitrage. If you are borrowing Japanese yen to purchase some other currency, then it is called “yen carry trade”. But remember, unlike risk-free profits in other arbitrage opportunities, currency carry trades face many risks.

Johnny: Really? What are the risks?

Jinny: There are two predominant risks. The first is interest rate risk and the second is exchange rate risk.
If the interest rate of the currency that you have borrowed increases, then the gap between the interest rate of the currency that you borrowed and the currency that you have invested will get narrowed. This will reduce your profit margin.

Similarly, the exchange rate of the two currencies also plays a major role. If the currency you have borrowed appreciates, your debt liability increases, and if it depreciates, your debt liability decreases. So you make a profit when your borrowed currency depreciates and you suffer a loss when the borrowed currency appreciates.

Johnny: This puzzle of appreciation and depreciation is a bit confusing. Please explain this with an example.

Jinny: Okay, let’s put it this way. Suppose you borrow Rs5,000 and get this amount converted into $100 at the rate of Rs50 for a dollar. Suppose, after two years you have to repay your debt, for which you will require to convert your dollars into rupees. During these two years, suppose the rupee has appreciated and the exchange rate has become Rs25 to the dollar. At this rate, you would require $200 to purchase Rs5,000. But suppose the rupee depreciates and the exchange rate has become Rs100 for a dollar. Then you would require only $50 to purchase Rs5,000. I think the arithmetic of profit and loss is now clear to you.

Johnny: Yes Jinny. I now also understand what makes a ping-pong ball safer than carry trades.

IN A NUTSHELL:

What:Borrowing one currency at low interest rate for purchasing another currency paying high interest rate is called currency carry trade.

How: Traders earn profit by taking advantage of difference in interest rates of the two currencies.

Why: Any adverse movement of interest rates or exchange rates may bring about unwinding of currency carry trades.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat.
Youcan write to both of them at realsimple@livemint.com

40) What will weigh on the markets in the new year

This year, the forecasting business is even trickier, because of the problems in the credit markets in the US.

It’s that time of the year again when market strategists start polishing their crystal balls in an attempt to predict the fate of the markets a year down the line. Most of these attempts are doomed to failure, but then even the International Monetary Fund’s (IMF) track record at predicting economic growth is suspect.

John Lipsky, IMF’s first deputy managing director, said recently that it would have to lower global growth rates again, even though a downward revision had been made just two months ago in October. And if forecasting economic growth is so fraught with danger, predicting the markets—which are much more uncertain—is far more so.

This year, the forecasting business is even trickier, because of the problems in the credit markets in the US.
But what do these problems have to do with the stock markets, especially with the Indian equity markets? The crux of the issue is the banks’ ability and willingness to lend. One thing is for sure—lending standards for housing loans in the US and elsewhere are going to get a lot tighter. If that affects consumer spending in the US, it could lead to a recession there, and with America accounting for a large chunk of exports from the rest of the world, it’s going to affect the global economy.

European exports have already been hit because of the weak dollar. So one channel of transmitting the credit crunch to the emerging markets is through a weaker US economy.

The second channel is through its effect on market liquidity. A recent news report, for instance, says Citi will take $49 billion (about Rs2 trillion) of structured investment vehicles (SIVs) on to its balance sheet. That will sharply constrain its ability to lend. Similar problems have arisen in other banks as well. And since banks have been the primary providers of liquidity to leveraged traders such as hedge funds, a cutback in bank lending will mean less money flowing to emerging markets.

And yet, markets in the developed world have remained remarkably resilient to the crisis, in spite of the direst predictions. As on Thursday, the Dow Jones Industrial Average was just 5% off its all-time high, while the FTSE was also less than 6% off its highs.

That’s probably because the markets are placing their trust in the healing powers of the central banks. But interest rates on 15 - and 30-year US mortgages are only slightly below the levels they were at three months ago, in spite of the Fed having cut its policy rate by 100 basis points since then. Nor have the Libor (London interbank offered rates), which are an indication of the costs of bank funding, fallen by as much as the Fed Funds rate.

However, while the lack of response in the credit markets could be due to disappointment with the scale of the central bank measures, the Fed has clearly signalled that it’s ready and willing to do all it can to bail out the banks.

The problem is that soaring oil prices and a weaker dollar are driving up inflation. Whether the Fed is willing to sacrifice its inflation objective to bail out the banks remains to be seen.

The other sources of liquidity have been China and the West Asian countries. As Strategic Forecasting Inc., a private intelligence agency more well-known as Stratfor, puts it: “We would argue that the money is coming from the dollar bloc and its huge free cash flow from China, and at the moment, the Arabian Peninsula in particular.

This influx usually happens anonymously through ordinary market actions, though occasionally it becomes apparent through large, single transactions that are quite open. Last week, for example, Dubai invested $7 billion in Citigroup, helping to clean up the company’s balance sheet and, not incidentally, letting it be known that dollars being accumulated in the Persian Gulf will be used to stabilize US markets.”

Where does India fit into all this? Lehman Brothers Inc.’s outlook for 2008 says: “Soft Global Landing=Asia eventually overheats.” The report says, “Should the US Fed’s aggressive rate cuts avert a hard landing for the global economy, Asia ex-Japan—because of its high growth, relatively high interest rates and sound economic fundamentals—stands to attract massive capital inflows.” Morgan Stanley’s Malcolm Wood echoes that position: “We expect a combination of aggressive Fed rate cuts, a moderation of Chinese policy rhetoric, Asia’s strong fundamentals, and cautious investor sentiment to drive the Asia-Pacific ex-Japan (APxJ) market higher. Indeed, we see more than 25% upside for APxJ over the next year.” That’s a view backed by anecdotal evidence of money waiting in the wings to come to India—consider Gulf Finance’s recent deal to develop a $10 billion economic development zone near Mumbai.

But this optimistic scenario of money fleeing the devastated credit markets of the West for the safe havens of Asia has one flaw: it presumes that Asian central banks will be sitting idly by while asset bubbles form in their markets. With the examples of Japanese deflation and the Asian crisis fresh in their minds, it’s doubtful if Asian policy makers will do nothing. In India, for instance, the finance ministry was talking of capital controls when the inflows were very high. In short, the credit crisis, the high valuations of Indian equities and the determination of the authorities to prevent asset bubbles will all weigh on the markets in 2008, despite strong growth in the economy.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome atcapitalaccount@livemint.com.

39) Stag there, Flation here

The US, Europe and Japan will slow while India, China and Brazil will battle inflation.

Emerging market equities continue to be in a festive mood. In this Vikram Samvat year 2064, long after the crackers have fallen silent, sweets and dry fruits are being provided by the US Federal Reserve and investors remain in a binge-eating mood.

Intermediaries in the credit markets have taken billions of dollars in write-downs and the problem is slowly spilling over into the next layer—called conduits or SIVs (structured investment vehicles). A $80 billion super-fund to rescue SIVs has been set up by several banks, but many on Wall Street are of the view that it is more likely to do harm than good. In any case, the decision by some large banks to bring SIVs on to their balance sheet may have put paid to the chances of any super SIV being hatched. There seems to be a good chance that SIVs owned and operated by hedge funds or independently (as distinct from those owned by banks) will fail or be severely impaired.

For the next two or three quarters, it is quite conceivable that the US economy grows at 1.5% or a lower rate. China and India, too, are likely to slow from their torrid pace, in a lagged response to tightening conditions through 2007. Europe (operating in macroeconomic terms as the 51st state of the US) and Japan are already slowing. So, there is definitely some “stag” in the air, as the economy hits stall speed in the G3 (the US, Europe and Japan).

In emerging economies, higher crude oil prices are feeding into headline consumer price inflation and the price of intermediate goods (though distorted by subsidies). Runaway food prices in Brazil, India and China seem to be here to stay.

The world is confronted with a rather unique “stag” there, “flation” here problem. At the same time that the Fed has eased, and the European Central bank (ECB) is on hold, the central banks of China, India and Australia, to name a few “here” countries, have tightened.

While the Fed is dealing with a liquidity—bordering on solvency —crisis, India and China are dealing with rapid rises in food prices and the distorting effects of energy subsidies. Many may disagree, suggesting instead that there is a potential for stagflation within the context of the US itself, rather than split in global terms. Policy response there will require a clear view of which of these alternatives is likely. I think evolving evidence will point to benign inflation (not considering crude oil) in the G3.

If so, what next?

I think global markets will go through a pretty serious indigestion phase until the trough of the credit-market crisis, which is likely to come in January or February. Many SIVs will fail and the portfolios of the ultimate buyers of structured paper (hedge funds, pension funds and other institutions) will have to be marked down. Simultaneously, the probability of a significant slowdown or recession in the US will be marked up.

This process will be self-feeding for a while until it becomes clear that the good news is the profitability of US corporations and the robustness of emerging market economies. That, in my view, will set up the final stage of this bull market that began in late 2002/early 2003. In typical late-stage fashion, the bubbling asset with good fundamentals (this time emerging markets) will have a parabolic move. It may end in tears, of course, but in the meanwhile there could well be a significant upward move of 50-100% in global equities lead by emerging markets.

The stag there, flation here scenario will be a tricky one for policymakers to manage. Many “here” economies (Hong Kong, Russia, China) have de facto dollar pegs or managed floats and have, therefore, little real control of interest rates. If the G3 doesn’t cut enough, we may well be stag everywhere (global recession), or if it cuts too much we could well have runaway inflation here, and quickly. Central bankers have a tough enough job managing their economies, they are unlikely to want to try to manage the global situation.

Sovereign funds picking up stakes in Western financial institutions, and massive liquidity injections of the recent ECB $500 billion variety are likely to characterize this new environment. The impact of these on emerging markets is unprecedented and may only be known as it happens. The long-term challenges presented by the unwinding of securitization and structured finance are formidable. In a place like India, where securitization is still in its infancy, the risk is that the baby gets thrown out with the bathwater.

The evolving evidence should sort itself out into low growth/low inflation in the G3 and solid growth/inflationary expectations in the emerging markets. The fuel that is likely to be poured there will keep the fire raging here. As a consequence, capital inflows will likely remain an issue for Indian policymakers in the coming year. In the absence of bold moves by the government to absorb flows, we can look forward to several administrative measures aimed at modulation.

Festive time indeed.

Narayan Ramachandran is country head, Morgan Stanley India. These are his personal views. Comments are welcome at theirview@livemint.com

38) Retirement saving myths

The standard portfolio model is flawed because it ignores human capital, according to economist Joseph Stiglitz

Most of the financial advice we get is hopelessly inadequate and simplistic—if not outright wrong.

Last week, I heard Joseph Stiglitz launch a typically blunt and brilliant attack on some of the sacred cows of the financial advisory business. The economics professor at Columbia University in the US and winner of the 2001 Nobel Prize in economics is popularly known as a trenchant critic of some aspects of globalization, though his academic work spans a wide range of economic issues, including financial ones.

“Long-term financial planning is a very complex task. Individuals cannot judge what they need to do and so they fall prey to wrong advice. This gives rise to fashionable rules of thumb,” said Stiglitz in a presentation at the Second European Colloquia organized by Pioneer Investments in Vienna at the end of November. (Disclosure: I was in Vienna as a guest of Pioneer Investments.)
Most of our value as economic animals resides in our ability to earn over our working lives—our human capital

The most common rule of thumb is that an individual should invest heavily in equities at a young age and then gradually move into bonds as the age of retirement nears. A popular and pseudo-scientific way of defining this rule is as follows: subtract your age from the number 100, and you get your ideal exposure to equities. For example, a 30-year-old should have 70% of his long-term savings in equities (100-30) while a 50-year-old should bring it down to 50%.
Neat, huh? But also wrong, said Stiglitz.

Most financial advice—and the economics that underlies it—is flawed. It assumes that an individual has only two types of capital: relatively safe fixed-income bonds and equities that are more risky but which also give more returns. The question is how long-term savings should be distributed between the two as we age.

“The standard portfolio model ignores other forms of individual capital,” said Stiglitz. One important form of this is human capital, which is usually calculated as the present value of all the future earnings an individual will earn over his working life.

Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. According to some estimates, nearly 80% of an individual’s capital is human capital. This form of capital and its risk profile should ideally be considered while designing a good financial plan for retirement.

Human capital is usually more risky at a young age, points out Stiglitz. You are just starting off on your career and the future is uncertain. As you age and get settled into your chosen profession, the uncertainty about your ability to earn starts declining. Human capital gets less risky as you age.

Seen from this perspective, most financial plans are built on shaky foundations. A 25-year-old setting out down a fresh career path faces huge amounts of risk in his overall portfolio (financial and human), because his future earnings are uncertain. Ideally, his financial portfolio should have low risk to balance out the high risk in his human capital. He should be buying more bonds than he is usually advised to do. But the cookie-cutter financial advice that he gets is to put most of his savings into equities—and increase his overall risk.

The big question is whether human capital resembles a safe bond or risky equity. In a separate presentation, Stephen P. Zeldes, a professor of finance and economics at Columbia University, asked: “Is labour income stock-like or bond-like?” He suggested there are no easy answers here. Without disagreeing with Stiglitz, Zeldes said labour income has both characteristics, depending on the circumstances.

All this makes financial planning a complicated process. Besides, other factors such as which industry one is working in, the nature of one’s family responsibilities and home ownership also need to be thrown into the consideration. In a country such as India, for example, where a large part of the population is self-employed, labour income would tend to be risky.

Perhaps we are wrong in blindly assuming that we should cut our exposure to equities as we age. In fact, a well-settled professional with stable earnings perhaps has more reason to invest in equities than, say, a young entrepreneur in a technology start-up.

These are nuances that are often ignored, even in our grander debates on how pension fund

money should be used in India.

One challenge before those involved in designing social security systems is how to balance freedom of choice and good guidance. Choice is important because an individual knows about his retirement needs than outsiders. But, as Stiglitz pointed out, individuals make rational decisions by learning from past experiences—their own and of others. That’s not possible for retirement planning. A person who realizes at 60 that he has not saved enough for his retirement cannot say: “I’ll do better next time.”

There is no second chance.

37) Arbitrage favours those who can wait and watch

Arbitrage takes place if the price of the same asset is different in two or more markets. You buy the asset from one market at a lower price and simultaneously sell it at a higher price in another market.

Trying to keep arbitrageurs out of financial markets is like trying to keep compulsive chain-smokers out of public toilets. Putting a sign saying “No smoking” or even a fire alarm or a guard round the clock is not enough. Compulsive smokers manage to slip into public toilets the moment there is an opportunity. Similarly, arbitrageurs also make inroads in the market to cash in on every minute opportunity of arbitrage. Our friend Johnny wonders how this whole business of arbitrage works. Let’s see what answers Jinny provides:

Johnny: Hi Jinny, I see you are in a great hurry today. Are you also looking for some opportunity?

Jinny: Opportunity? You can’t look for an opportunity in a hurry. You need to have patience to wait for the right thing to happen at the right moment. But anyway, what is this prelude all about?

Johnny: Well, Jinny, a couple of weeks ago, I read an article in Mint that talked about arbitrage opportunity in the financial market. I do not understand how this whole business of arbitrage actually works. Do you have any idea?

Jinny: Sure. Arbitrage is the favourite way of earning a risk-free profit. But arbitrage prefers those who can patiently wait and watch. Theoretically speaking, arbitrage takes place if the price of the same product or asset is different in two or more markets. You purchase the product or asset from one market at a lower price and simultaneously sell the same at a higher price in another market. In this manner, you earn a risk-free profit by indulging in what we call arbitrage. The people who indulge in arbitrage are called arbitrageurs. This kind of arbitrage can take place in any market in respect of any commodity or product; however, the financial markets are one of the most preferred places for arbitrageurs. This is so because all the financial markets today are interconnected through electronic means and you can simultaneously execute trades in different markets to take advantage of even a small price difference.

In financial markets, most of the financial instruments such as stocks, bonds, currencies or derivatives, or even variables such as interest rates, are subject to arbitrage.

You may hear about arbitrage of different kinds such as currency arbitrage, interest rates arbitrage, or even labour arbitrage, regulatory arbitrage, cash and carry arbitrage etc.

Johnny: It seems even a dumb person such as me can earn a money by simply doing arbitrage. What do you say?

Jinny: Well, looking for an arbitrage opportunity requires the eyesight of an eagle and the quickness of a leopard. Nowadays, arbitrageurs use sophisticated computer programs for locating every microscopic discrepancy in price. Once the opportunity is located, you quickly need to jump on it before others do.

Arbitrage opportunities in financial markets, or any other market, evaporate very quickly because they carry the seed of their own destruction. The moment arbitrageurs start to cash in on the differences in the price of two markets, the prices of both the markets start to converge. The price of the asset in the market where it is priced low starts rising due to the buying activity of the arbitrageurs. Similarly, the price of the asset in the market where it is priced high starts falling due to the selling activity of the arbitrageurs. Finally, the prices of both the markets converge at a price that is called the arbitrage equilibrium price.

So arbitrageurs play an important role in filling the gap between the demand and supply. How quickly this happens depends upon how efficient your markets are.

But, so far, I have told you about arbitrage that takes place if the same asset does not trade at the same price in different markets at the present time. However, arbitrage can also take place if there is divergence between the present price and the future price of any asset.

Johnny: How does that kind of exotic arbitrage work?

Jinny: There is nothing exotic about it. Suppose the future price of an asset is higher than its present price, you simply buy that asset now at a lower price and simultaneously sell the same in the futures market at a higher price. But this kind of arbitrage can work only if the purchase price of the asset at present, after adding the carrying cost, is less than the future price. Carrying cost includes cost of money in terms of interest and cost of preservation and storage, depending on the type of asset. This type of arbitrage, in technical terms, is known as “cash and carry arbitrage”.

There is an opposite version of this arbitrage also, which is known as “reverse cash and carry arbitrage”, in which you simply sell the asset at a higher price now and simultaneously purchase the same at a lower price from the futures market. In this manner, you can take advantage of the difference between the spot and future prices.

Johnny: Thank you Jinny, for giving me the opportunity to arbitrage my doubts with your wisdom.

What:Buying an asset or product at a lesser price in one market and simultaneously selling the same at a higher price in another market is called arbitrage.

How: Arbitrageurs use sophisticated computer analysis to detect even minute differences in prices of the same asset in different markets.

Why: Arbitrageurs are important because they fill the gap between the demand and supply, leading to arbitrage equilibrium price.

36) What gives gold its glitter

A look at the factors that drive the yellow metal in the global markets, and what investors need to track if they want the sheen of the precious metal to rub off onto them.

To investors, gold is more than just a symbol of purity, royalty and prestige. Gold is also increasingly being sought after as an investment avenue. Investing in gold is an ideal way of protecting one’s wealth against erosion in purchasing power of money under inflationary conditions.

Over the years, gold has also shown a negative correlation with the other widely preferred asset classes such as stocks and bonds. This is because the fundamental factors that impact the other asset classes don’t significantly affect gold.

Indian investors, for whom gold is a new investment option, need an understanding of the demand and supply side factors that impact prices in order to gauge its return potential. This apart, keeping track of global economic events, the rupee dollar exchange rate and trends in crude oil prices are also becoming increasingly important as all these can impact returns on gold. ‘Gold fix’

Historically, gold has been the asset that has commonly backed the currencies of various countries. Though both spot and futures contracts in gold are widely traded across various global commodity exchanges, the London “Gold Fix” is the most commonly followed benchmark for gold prices. The Gold Fix is the procedure by which the London bullion market fixes the price of gold and this is used as a benchmark for pricing the majority of gold products and gold derivatives across world markets. Gold : Supply side factors

One unique facet of gold as a commodity is that its existing stock with the world’s central banks has a key bearing on its supply. Central banks across the world procure and stock gold as a part of their reserves to bail them out at difficult times. The view that central banks across the world take on the direction of gold prices, and the expected liquidation of gold inventories by them, is an important influence on prices. Large gold sales by central banks can lead to a spike in gold supply and weigh on prices. Another facet of gold is that it also acts as an alternative to the US dollar in the reserves held by central banks. Fears about a sustained decline in the value of the dollar can thus prompt central banks to lean towards gold as an investment option. This is one key reason for the inverse relationship between the US dollar and gold prices. The latter tends to rise when the former depreciates.

Gold mining companies, another key source of gold supplies also base their production decisions on price trends. An extended period of low gold prices may make it unviable for miners to make investments in their operations. Sustained increases in gold prices may lead to a re-opening of mines and higher supplies into the gold market.

As in the case of other commodities, the balance between supply and demand is a key influence on the price of gold. At present, the demand side fundamentals do look strong with year-on-year demand for gold rising by 30 per cent to $20.7 billion in the third quarter of 2007 (Source: World Gold Council). Investment demand, rather than jewellery demand for gold has been the key driver of this. Recent years have seen increased investment in gold exchange traded funds, which invest in physical gold. India is the world’s largest gold jewellery market and thus Indian demand for gold is a key fundamental factor affecting gold.US Market & Dollar Value

Fundamentals apart, investors need to keep watch on other key macro factors that have an impact on gold prices- trends in the US dollar, crude oil prices and global economic or political events.

One feature that makes gold attractive as a safe haven asset is that it is a hedge against an erosion in the value of currency, particularly the US dollar. In recent months, fears of sub-prime issues hurting the US economy have weakened the dollar, indirectly contributing to increasing global gold prices. Any negative news about the US economy, such as slowdown in consumption, rise in inflation, or a cut in interest rates by the Federal Reserve, that weakens the dollar could

strengthen gold prices.

However, Indian investors in gold need to remember that returns on gold prices in rupee terms may be quite different from those in dollar terms. In dollar terms, gold has given a return of 19.5 per cent this year.

But with the rupee appreciating by 10.9 per cent, domestic gold prices have gained only 6.6 per cent. It may make sense for Indian investors, seeking to replicate global returns on gold, to invest in Exchange Traded Funds that track global gold prices. Crude fires gold too

If currency movements impact gold, another key influence on gold prices comes from crude oil prices. Inflationary conditions in crude oil markets, which stoke uncertainty, have inevitably sparked a rally in global gold prices. The oil crisis of 1980 was the previous occasion when gold flared to all- time highs. In 1980, crude oil prices rose by 120 per cent, and this pulled gold prices up by 99.74 per cent, too. Other factors influencing crude oil prices are accidents, bad weather, transport disruptions from producers, labour disputes as well as other disruptions to production, including war and natural disasters. Therefore, if, as an investor, you are worried about a brewing energy crisis, you should be adding gold to your portfolio. Equity market turbulence

Volatile financial markets also appear to be good for gold as an investment. As gold is seen as a safe haven asset, any turmoil in the equity or bond markets sparked by fears of an economic slowdown, downturn in an industry or political disturbance, can drive investors to gold. Since mid-August this year, when sub-prime woes in the US first raised fears of a global credit crunch, global gold prices have appreciated by almost 21.4 per cent.

But this inverse relationship between the financial markets and gold may not necessarily hold good for Indian investors, as our gold requirements are almost completely imported. A plunge in the domestic equity market because of political turmoil may not impact gold prices, as domestic gold prices are largely a function of global trends. All this may suggest that investing in gold is no less complicated than investing in the stock markets.

You may have to research fundamentals, keep track of economic and macro factors as well as global events to time your investments in gold to a nicety. But allocating 5-10 per cent of your portfolio to gold is relatively simple and you can do this to provide a “safety net” to your equity portfolio.

35) A FEDERAL RESERVE RATE CUT MAY NOT WORK

C onditions in the credit markets in developed economies are getting worse. Global bond issuance in November was a trickle, down to its lowest level in the last six years.

Corporate bond spreads are at their widest in years. Onemonth euro Libor rates are their highest since May 2001.

The money markets are seizing up and the scale of the seizure can be seen from 17% shrinking of the commercial paper market in the US since last July.

Amid the carnage, stock markets are looking to a rate cut by the US Federal Reserve to bail them out. That may, however, be wishful thinking. One reason for that was pointed out last Thursday by Mervyn King, governor of the Bank of England. In his opening statement to the treasury committee, he said, "The committee's current judgment is that the most likely outcome is for output growth to slow and inflation to rise, at least for a period." That's the recipe for "stagflation"-the combination of stagnation and inflation that plagued the 1970s. High crude oil and food prices continue to be a worry for central banks, inhibiting their ability to reduce rates. And if King is worried about inflation in the UK, with its strong currency, the US Fed should be far more concerned, thanks to the ultra-low dollar.

But it could be argued that if the US enters into a recession, inflationary pressures would ease and since monetary policy operates with a lag, it's necessary for central banks to reduce interest rates now. The markets are in any case pricing in further rate cuts by the US Fed, and Bernanke's recent speech has strengthened their belief.

The problem will arise if the rate cuts and the provision of additional liquidity to banks do not work. In a note titled Do not forget about changes in Velocity, independent research firm GaveKal had said last September that an increase in money supply may not necessarily lead to a rise in prices (including asset prices) or a rise in output. As proof, they point to the equation MV=PQ, also known as the quantity theory of money. M in the equation stands for the quantity of money, V for the velocity of money or the average number of times money changes hands in a year, Q for the quantity of real goods and services created, and P is the average price of those goods and services.

GaveKal says that most observers seem to be assuming that a rise in the money supply will automatically lead to a rise in output or inflation or asset prices. What they seem to be forgetting is the V of the equation, which has plummeted.

As a matter of fact, it is to offset the falling V that the US Fed lowered its policy rate in the first place. Said GaveKal: "The $100bn question for investors now has to be whether the world's commercial banks will actively multiply the money that the Fed (and other central banks) have been injecting into their economies over the past few weeks. If they do, then the world should witness a roaring boom of unprecedented magnitude. If they do not, then the investment environment will have changed."

GaveKal went on to list the reasons why they thought velocity was unlikely to accelerate. These were: Bank balance sheets are stretched, with the losses they have suffered; nobody trusts the rating agencies any more; and regulators and governments are likely to ask uncomfortable questions about how the mess started, leading to even greater caution by the banks. GaveKal's analysis was bang on target.

Merely throwing money at the problem will not make it go away-that could very well be, in Keynes' words, pushing on a string. And if that analysis is correct, then the rally induced by the Fed easing in September was nothing but a brief flareup before the final demise of the bull market.

Emerging markets Where will emerging markets feature in all this? The obvious parallel is that of 2000, when the bursting of the tech bubble not only led to a meltdown in the US stock market, in spite of several interest rate cuts by the Fed, but also led to sharp falls in emerging markets. More importantly, it took three long years for the markets to recover.

This time, the 50 basis point rate cut by the Fed last September saw a rush of money to emerging markets, giving rise to the hope that they would be safe havens against a US slowdown. But things have changed since then. This month, the MSCI World index is down 4.8%, but the Emerging Markets index is down 8.29% and the Bric (Brazil, Russia, India and China) index is lower by 7.76%. Emerging markets have been underperformers this month. The big difference between September and now is that, at that time, everybody expected the rate cuts to take care of the credit problems and set the US economy back on the growth path. That's why US equities too rallied at the time.

Now, they're not so sure, and almost everybody is predicting at least a 50% chance of a US recession next year. And when there's a recession, fear triumphs over greed. That's why US bond yields have plummeted, as investors rush to these safe havens.

For the week ended 21 November, data from research firm Trim Tabs show that US investors pulled out $7.93 billion (Rs31,482 crore) from funds that invest mainly in US equities and $2.22 billion from funds that invest primarily in non-US stocks. In short, funds flow to all equity markets-both US and non-US-have been affected. The hope is that once things settle down, investors will make a rational decision to prefer high growth markets such as India over those affected by a recession. But it's still far too early for that.

34) Why not hedge away oil price shocks?

The sharp rise in oil and other commodity prices over the past several months and its possible adverse impact on inflation/inflation expectations has been a matter of deep concern to governments and policy makers the world over. This concern has been particularly acute in emerging economies such as India.

How to reconcile the soaring energy requirements of a rapidly expanding economy and the inevitable price pressures brought on by such surging demand with the objective of non-inflationary growth? As has been pointed out by the Reserve Bank of India, the greatest challenge now is to manage the transition to a higher level of economic growth without entrenching higher inflation expectations.

Double-digit economic growth and stable/low inflation (around 4 per cent) may not be mutually exclusive objectives. The exercise to attain that, though, could be painful for many economic agents in the interim — such as the Indian oil companies for instance.Blind alley

The oil companies possibly are bearing the brunt of the policy-makers’ reluctance to subject the domestic price level to the full force of international/market prices. In a complex social and political environment, it does not appear conceivable that the oil pricing mechanism will move to a market-driven format any time soon.

The APM, for instance, was officially dismantled earlier in this decade but is now again well in operation, de facto. Debate and discussion on oil pricing is endless, though it seems futile as all debate finally zeroes in on a market-driven pricing mechanism as the only panacea.

It (market-determined end product prices) may be the ideal solution. But what is surprising about the oil debate is that there seems to be not much of a focus on interim, alternative solutions, which, incidentally, may also be market-related. Hedging input costs

In a scenario where there are constraints on end-product prices on the selling side, it is surprising that the oil companies have not attempted to more fully hedge the risks of rising raw material prices and attempted to fix their input costs. An analysis of petroleum statistics shows that only around 3-4 per cent of the total imports of crude oil are being hedged by the oil companies. In 2006-07, Indian crude imports were around 90 million tonnes.

To be sure, the hedging ratio of Indian companies is no different from what prevails globally. Indeed, even though the global oil derivatives markets provide a very good platform for hedging for both oil producers and consumers — with contracts stretching out as far as 10 years — the use of this market for hedging has been historically limited.

For instance, as on November 7, 2007, the total volume of outstanding futures contracts (the open interest) for various forward maturities up to December 2008 on the NYMEX and the ICE amounted to around 1.8 billion barrels. Against that, crude production in the next 12 months will be around 30 billion barrels (assuming a production of 85 million barrels per day – the current figure) giving a hedge ratio of around 6 per cent. This has been the case historically also.Reasons for low hedging

There are a number of structural reasons for the low level of hedging by both oil producers and consumers globally. As far as consumers are concerned, in a competitive environment, unless all players in an industry hedge their consumption of oil, it does not make sense for individual companies to do so. Companies which do not follow industry practice will be subjecting their earnings to greater variability.

More generally, as far as consumers are concerned, the absence of hedging markets with respect to their end products on the selling side inherently limits their hedging. Airline companies, for instance, do not have forward markets for airline tickets.

Also, the price of airline tickets will vary in future with the spot price of oil. Where input price pressures can be passed on to the selling side, the incentive for hedging is weak.
On the production side, many countries with state-owned producers also do not hedge their future production. Even commercial oil producers such as an Exxon or BP are not in the market for hedging in any noticeable way.

This is quite understandable given the structural trend in oil prices over the past many years. Indeed, oil, more than possibly any other commodity, has proved that the futures price curve — for assets which carry a high degree of positive systematic risk — may be significantly understating the expected future spot price of the asset. That is, while oil (because of the high convenience yields associated with holding physical stocks) displays an inverted forward price curve (backwardation), the curve does not necessarily capture the future spot price to any degree of accuracy.

For instance, the futures price curve in February 2006, when spot oil was quoting around $53/55, indicated the forward price for maturities up to December 2007 to be in the range of $60/62. But where are spot prices now? And such divergences between the futures curve and the realised spot prices have occurred many times in the past also. Costs and calculation
It is this divergence between the futures curve and realised spot prices which should provide a powerful incentive for big consumers such as India to have a structured hedging programme in place. The “industry competitors” argument does not anyway apply here because of the constraints in end-product pricing.

What are the costs of hedging? Assuming the current margin costs of around $6500 per contract of 1000 barrels, the entire Indian import of 90 million tonnes in 2006-07 would have involved a margin outlay of around $4.5 billion – that is around Rs18,000 crore – if Indian companies had taken long hedges on the NYMEX in early 2006, based on the then spot price of around $55.
This margin deposit would have earned some interest (say 3.5/4 per cent) and given the structural trend in prices, the companies would have been able to take back a good part of the margin deposits as mark-to-market profits on the futures positions (over and above the maintenance margins). Most importantly, the input oil costs would have been hedged and fixed based on the futures price curve which prevailed in February/March 2006. It may have been possible then to hold the line on end-product prices as the hedging on the input side effectively lowers the costs relative to the prevailing spot market.

And, who is to fund the cash outlay on the margins required on long futures positions? Note that the Government issued oil bonds worth at least Rs 12,000-13,000 crore in 2006-07. More had been issued in the earlier years also. A hedging policy could mean that, instead of oil bonds, an equivalent amount of money goes into margin deposits.

The cash outflow for placing margins, of course, will be immediate. The advantage still is that with hedging, the importer is able to fix his costs. And unless oil prices fall, there would be no more cash outflow on account of margin calls. A policy of “no hedging and issuing oil bonds”, on the other hand, means that the quantum of bonds (to be) issued could be open-ended.

It, of course, is quite easy in hindsight to point out all this. It is also important to remember that hedging need not always provide the most optimal solutions. And there may be a number of operational issues (key among them being the level of hedging interest among oil producers) to be tackled before Indian companies can institute a structured hedging programme. But, still, the absence of a debate on how India as a big consuming nation can hedge its oil price risks is somewhat disconcerting.

33) No alarm bells over rising oil prices

Crude oil price jumped to an all-time high towards the end of October. Growing tensions in northern Iraq, supply outages from Nigeria and the worries over Iran’s nuclear programme will continue to fuel oil price increases. There is unlikely to be any relief even in the next year.

Analysts forecast that the average price in 2008 will be $70 per barrel. During January-September 2007, the average Brent price was $67 per barrel.

While oil price surges cause oil-import-intensive economies to panic, India, which is also in the same bandwagon and depends almost entirely on imported oil, seems almost unfazed.

The country depends on imports for 80 per cent of its crude oil requirement. The average price of imported crude rose by a whopping 22-plus per cent during the past two years. Notwithstanding this, the country’s GDP grew at an impressive 8-9 per cent against the world average of 5 per cent.

There are basically three factors which have helped insulate the Indian economy from the impact of rising oil prices. Effect on manufacturing

First, the manufacturing sector, the key driver of economic growth over the past few years, is not oil-sensitive. According to FICCI, a survey of 417 medium and large firms revealed that the energy bill constituted 20 per cent of the production cost. Of this, oil energy accounted for only 20 per cent. This means oil made up only one-fifth of the energy bill. Thus, oil prices have not had much of an impact on manufacturing growth. Exports offset import burden

Second, the recent spurt in oil product exports have cushioned the impact on the balance of payments. Petroleum product exports have emerged the biggest foreign exchange earners, notwithstanding the substantial dependence on imported crude. During the past two years, petroleum products were the biggest item among the single group of exports in the export basket. They accounted for about 11 per cent and 15 per cent in the total exports during 2005-06 and 2006-07 respectively. Petroleum product exports grew by 67 per cent and 59 per cent during 2005-06 and 2006-07 respectively. This largely counterbalanced the heavy burden of crude oil imports on the balance of payment.

While imports of petroleum products (mainly crude oil) amounted to $45 billion and $57 billion in 2005-06 and 2006-07, respectively, exports of the same rose to $11 billion and $18 billion respectively. This helped offset over one-third of the oil import burden on the balance of payment. Global hub for refining

India is emerging as a global hub for oil refining. The cost-effectiveness of oil refining has drawn the attention of several MNCs. This is because India is logistically well-placed for refineries in terms of oil imports from West Asia and is better placed to help serve the large consumption needs of petroleum products of adjoining countries.
To become a global hub for petroleum product exports, India plans to add about 60 per cent to its existing capacity over five years. The present refining capacity is 149 million tonnes per annum. Another 90 million tonnes are proposed to be added by 2012. The domestic consumption is estimated to touch 196 million tonnes by then. This leaves a balance of 43 million tonnes, which are to be exported. At the average export price level of 2006-07, petroleum product exports may touch $23 billion.Controlled price mechanism

Third, the prices of petroleum products are not determined by the free market mechanism. The prices of certain petroleum products which have larger bearing on inflation are kept artificially low.

Even though the Administrative Price Mechanism (by which the prices of petroleum products were controlled by the government since oil nationalisation in the 1970s) was done away in April 2002, the prices of major petroleum products still continue to be under control regime through backdoor. About 60 per cent of the petroleum product prices are controlled by the Government.

The prices of four products, which have an impact on inflation, are petrol, diesel, kerosene and LPG. These account for 60 per cent of the total petroleum product consumption in the country.

Currently, over 95 per cent of the marketing of these four price-sensitive products are controlled by the Government through its public sector oil marketing companies — Indian Oil Corporation, Bharat Petroleum Corporation and Hindustan Petroleum Corporation. These companies are not free to set prices based on the crude oil prices; the prices are decided by the Ministry of Petroleum and Natural Gas. Social, political reasons
The Ministry, while fixing the prices, takes into consideration, besides economic reasons, several social and political implications. For some petroleum products, social and political reasons overshadow the economic implications.

There is a huge subsidy on kerosene and LPG prices. LPG and kerosene prices have not changed since early 2005, whereas petrol and diesel prices have been tinkered with eight times. The huge subsidy on LPG and kerosene have resulted in their prices ruling at less than half of that in Pakistan; this despite Pakistan importing crude oil at a preferential rate. While the prices of kerosene and LPG are Rs 9.09 per litre and Rs 294.74 per cylinder respectively in Delhi, they are sold (in Indian rupee terms) at Rs 23.64 per litre and Rs 427.90 per cylinder respectively in Karachi

As public sector oil marketing companies continue to control the prices and distribution of petroleum products, the fear of any major impact on the economy seems unfounded.

32) Lessons from US crisis

The crisis is leading to fears that the US credit market may reach a gridlock and the country itself may be facing a recession due to shortage of credit, since banks have problems raising further funds. The problem has spread to European banks as well.

The collapse of the titans of Wall Street should open our eyes to the potential potholes in the road ahead. Universal banking can be a glamorous model, but it has its risks.

The sub-prime crisis has taken a heavy toll on banks around the world. US banks have been most vulnerable since sub-prime house loans rose to high levels in the US in the last few years. Banks lent more and more to sub-prime house owners, aided and abetted by the liberal flow of funds from Wall Street investment banks, which sold these loans in securitised packages to investors, who were tempted by the above par interest rates yielded by the loans.

The banks soon came to realise that the sub-prime loans had more than expected default rates and underwent heavy losses. The investment banks have also taken a heavy hit. The crisis is leading to fears that the US credit market may face a gridlock and the US itself may be facing a recession due to shortage of credit, since banks have problems raising further funds. The problem has spread to European banks as well, taking down even the venerable UBS.Assessing losses

The magnitude of losses faced by US banks and other developed country institutions is still being assessed. Analysts of Goldman Sachs — which incidentally has come out unscathed — estimate that the losses may run into hundreds of billions of dollars, especially when the third quarter results of banks and institutions are unveiled.
The Citibank group itself has disclosed losses of as much as $8-9 billion . Some estimates coming in from respectable bank analysts pitch possible losses at as high as $50 billion. The losses are, indeed, heavy.

There were also similar crippling losses at Bear Stearns, the investment bank, and the leader of bulls, Merrill Lynch, again in billions of dollars. The CEOs lost their jobs, although in typical American fashion, they were paid handsome retirement bonuses running into millions of dollars.Going about it differently

The media has been running a series of exposés on the behaviour of these banks. Fortune wrote a derisive article entitled “What were they smoking?” But, by and large, the Americans have been relatively relaxed about the manner in which the system has dealt with the chiefs of banks. It perhaps speaks of the tolerance and maturity of the American business system that it takes both risk and reward in a calm and composed manner.

Not for them the hoopla of CBI or FBI investigations or FBI experts or non-experts raiding CEOs’ houses and offices, subjecting them to public humiliation and condemning the system to a fear of taking any decision. Nor has there been a call for a Joint Parliamentary or Congressional Committee comprising non-expert Members of Parliament or Congress treating the country to a spectacle of a Roman circus, shooting questions on how and why a particular banker took or did not take a lending decision. Much heat and not much light came out of our own Parliamentary enquiries.

Unlike in the Indian case, there was no accusing finger pointed at the bank supervisor — the central bank, in the American case. Questions were not raised as to what the central bank was doing when the banks were lending. The public at large was aware that it is the banker’s job to manage his loans and investments, a supervisor can only lay down guidelines and prudential norms and inspect from time to time. It cannot be expected to micromanage banks — which is what some members of the Indian political class expected in 1991.

True, some questions were raised in the US about the Federal Reserve’s benign interest policy, which had allegedly led to loans being disbursed too liberally. But that was considered a central banker’s privilege — whether to raise or lower interest rates. Conglomerate model

A more material aspect of the US banking debate, which is threatening a global recession, is how valid is the US conglomerate banking model, on which India and other developing countries, barring China, are shaping their banking system.

Citibank, for example, became a massive conglomerate employing nearly 3,00,000 people, with an insurance wing and investment bank and private equity arms. True, it grew through many acquisitions in Sandy Weill’s days. The latest CEO, Chuck Prince, who has now quit, tried to cut down the number of businesses.

Whether a universal bank model, such as Citibank, is managerially the optimal one is being hotly debated. Analysts are arguing that Citibank has become too much of a massive conglomerate for the top to manage. Calls are out for breaking it up. Arguments will, no doubt, be found for keeping it whole.

But the warning signals are there for Indian banks to read. Should we go the same way? Or should we try to manage complexity better in the under-served financial scenario in India?

There are doubtless advantages to the universal banking model. A bank, which lends money to its customers, gains access to a large market for selling insurance, mutual fund products and investment advice.

There is synergy between the different operations. So, the logic for selling insurance, credit card, mutual fund under the same umbrella! But management has to be appropriately strengthened. Supervision also has to be discrete and separately organised.

An important question raised in this context is whether Basle-II norms were themselves responsible, to some extent, for banks resorting to special purpose vehicle housing securitised assets formed out of their loans.
In one sense, this point of view gains support from the fact that banks, which securitise loans and take them off their balance sheets, require that much less capital. But Basle-II norms also put rating agencies in the centre of the risk computation.

Rating agencies have been criticised for their role in assessing the riskiness of securitised packages of sub-prime loans, which were sold to investors.

But the extent to which securitisation distances the originators — the lenders — from the packages that are sold to investors is a telling point in the criticism that Basle-II norms have been partly responsible for the latest crisis.
Once lenders sell off their securitised packages to investors, they stop taking care about the performance of their borrowers — or so it has turned out. This is partly the result of the way in which the American investment banks used securitisation. But we have to ensure that the model gets the full impact of continued monitoring of the loans disbursed even after they are packaged and sold.Potential potholes

The collapse of the titans of Wall Street, the heavy losses that have hurt the bankers of the US and Europe, should open our eyes to the potential potholes in the road ahead. Universal banking can be a glamorous model, but it has its risks.

Securitisation may look like an easy way out of Basle-II norms, but it can lead to disaster unless the loans securitised are continually followed up. True, supervisors cannot shirk their responsibilities. But the overall responsibility remains squarely on the lender to ensure that the loans are properly disbursed and monitored, investments are properly accounted for.

After all, the banker has a heavy responsibility. Millions trust their savings to him or her.

The way Citibank’s Chuck Prince or Merrill Lynch’s O’Neil has gone is standing warning to the chiefs of all financial institutions around the world. They have to take risks, but not too much, seems to be the abiding lesson. Otherwise, they may risk not only their jobs and their banks but also the national economy.

31) Demystifying Sensex

The BSE SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media.

The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1, 2003. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. All major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float methodology.

Due to is wide acceptance amongst the Indian investors; SENSEX is regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides the time series data over a fairly long period of time (From 1979 onwards). Small wonder, the SENSEX has over the years become one of the most prominent brands in the country.

Q.1 What is SENSEX? The SENSEX, short form of the BSE-Sensitive Index, is a "Market Capitalization-Weighted" index of 30 stocks representing a sample of large, well-established and financially sound companies. It is the oldest index in India and has acquired a unique place in the collective consciousness of investors. The index is widely used to measure the performance of the Indian stock markets. SENSEX is considered to be the pulse of the Indian stock markets as it represents the underlying universe of listed stocks at The Stock Exchange, Mumbai. Further, as the oldest index of the Indian Stock market, it provides time series data over a fairly long period of time (since 1978-79).

Q.2 What are the objectives of SENSEX? The SENSEX is the benchmark index of the Indian Capital Markets with wide acceptance among individual investors, institutional investors, foreign investors and fund managers. The objectives of the index are:

To measure market movements Given its long history and its wide acceptance, no other index matches the SENSEX in reflecting market movements and sentiments. SENSEX is widely used to describe the mood in the Indian Stock markets.

Benchmark for funds performance The inclusion of blue chip companies and the wide and balanced industry representation in the SENSEX makes it the ideal benchmark for fund managers to compare the performance of their funds.

For index based derivative products Institutional investors, money managers and small investors all refer to the SENSEX for their specific purposes The SENSEX is in effect the proxy for the Indian stock markets. The country's first derivative product i.e. Index-Futures was launched on SENSEX.

Q.3 What are the criteria for selection and review of scrips for the SENSEX? A. Quantitative Criteria:

1. Market Capitalization:The scrip should figure in the top 100 companies listed by market capitalization. Also market capitalization of each scrip should be more than 0.5 % of the total market capitalization of the Index i.e. the minimum weight should be 0.5 %. Since the SENSEX is a market capitalization weighted index, this is one of the primary criteria for scrip selection. (Market Capitalization would be averaged for last six months)

2. Liquidity:(i) Trading Frequency: The scrip should have been traded on each and every trading day for the last one year. Exceptions can be made for extreme reasons like scrip suspension etc. (ii) Number of Trades: Number of Trades: The scrip should be among the top 150 companies listed by average number of trades per day for the last one year. (iii) Value of Shares Traded: Value of Shares Traded: The scrip should be among the top 150 companies listed by average value of shares traded per day for the last one year.

3. Continuity: Whenever the composition of the index is changed, the continuity of historical series of index values is re-established by correlating the value of the revised index to the old index (index before revision). The back calculation over the last one-year period is carried out and correlation of the revised index to the old index should not be less than 0.98. This ensures that the historical continuity of the index is maintained.

4. Industry Representation: Scrip selection would take into account a balanced representation of the listed companies in the universe of BSE. The index companies should be leaders in their industry group.

5. Listed History: The scrip should have a listing history of at least one year on BSE.

B. Qualitative Criteria:

Track Record: In the opinion of the Index Committee, the company should have an acceptable track record.

Q.4 What is the beta of SENSEX scrips?

Beta measures the sensitivity of a scrip movement relative to movement in the benchmark index i.e. SENSEX. A Beta of one means that for every change of 1% in index, the scrip moves by 1%. Statistically Beta is defined as: Covariance (SENSEX, Stock )/ Variance(SENSEX)Note: Covariance and variance are calculated from the Daily Returns data of the SENSEX and SENSEX scrips.

Q.5 How is SENSEX calculated?

SENSEX is calculated using a "Market Capitalization-Weighted" methodology. As per this methodology, the level of index at any point of time reflects the total market value of 30 component stocks relative to a base period. (The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company). An index of a set of a combined variables (such as price and number of shares) is commonly referred as a 'Composite Index' by statisticians. A single indexed number is used to represent the results of this calculation in order to make the value easier to work with and track over time. It is much easier to graph a chart based on indexed values than one based on actual values.

The base period of SENSEX is 1978-79. The actual total market value of the stocks in the Index during the base period has been set equal to an indexed value of 100. This is often indicated by the notation 1978-79=100. The formula used to calculate the Index is fairly straightforward. However, the calculation of the adjustments to the Index (commonly called Index maintenance) is more complex.

The calculation of SENSEX involves dividing the total market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index maintenance adjustments. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX every 15 seconds and disseminated in real time.

Q.6 How is the closing Index calculated?

The closing SENSEX is computed taking the weighted average of all the trades on SENSEX constituents in the last 15 minutes of trading session. If a SENSEX constituent has not traded in the last 15 minutes, the last traded price is taken for computation of the Index closure. If a SENSEX constituent has not traded at all in a day, then its last day's closing price is taken for computation of Index closure. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value.

Q.7 How is the routine maintenance of SENSEX carried out?

One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that additional issue of capital and other corporate announcements like bonus etc. do not destroy the value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The Index Cell of the Exchange does the day-to-day maintenance of the index within the broad index policy framework set by the Index Committee. The Index Cell takes special care to ensure that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between high turnover in Index scrips and its representative character. The Index Committee of the Exchange has experts from different field of finance related to the capital markets. They include Academicians, Fund-managers from leading Mutual Funds, Finance - Journalists, Market Participants, Independent Governing Board members, and Exchange administration.

Q.8 How are adjustments for Bonus, Rights and newly issued Capital carried out in SENSEX?

The arithmetic calculation involved in calculating SENSEX is simple, but problem arises when one of the component stocks pays a bonus or issues rights shares. If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value. The Index Cell of the Exchange periodically adjusts the base value to take care of such corporate announcements. Adjustments for Rights Issues: When a company, included in the compilation of the index, issues right shares, the market capitalisation of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market Capitalisation (see ' Base Market Capitalisation Adjustment' below). Adjustments for Bonus Issue: When a company, included in the compilation of the index, issues bonus shares, the market capitalisation of that company does not undergo any change.

Therefore, there is no change in the Base Market Capitalisation, only the 'number of shares' in the formula is updated. Other Issues: Base Market Capitalisation Adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-back of shares, corporate restructuring etc. Base Market Capitalisation Adjustment: The formula for adjusting the Base Market Capitalisation is as follows: New Base Market Capitalisation = Old Base Market Capitalisation X (New Market Capitalisation/Old Market Capitalisation) To illustrate, suppose a company issues right shares which increases the market capitalisation of the shares of that company by say, Rs.100 crores. The existing Base Market Capitalisation (Old Base Market Capitalisation), say, is Rs.2450 crores and the aggregate market capitalisation of all the shares included in the index before the right issue is made is, say Rs.4781 crores. The "New Base Market Capitalisation " will then be: Rs.2501.24 crores = 2450 X (4781+100)/4781 This figure of 2501.24 will be used as the Base Market Capitalisation for calculating the index number from then onwards till the next base change becomes necessary.

Q.9 With what frequency is SENSEX calculation done?

During market hours, prices of the index scrips, at which trades are executed, are automatically used by the trading computer to calculate the SENSEX every 15 seconds and continuously updated on all trading workstations connected to the BSE trading computer in real time.